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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our Consolidated Financial Statements and Notes thereto. Discussion regarding our financial condition and results of operations for fiscal 2019 as compared to fiscal 2018 is included in Item 7 of our Annual Report on Form 10-K for the fiscal year ended November 29, 2019, filed with the SEC on January 21, 2020.ACQUISITIONS Subsequent to November 27, 2020, we completed our acquisition of Workfront, a privately held company that provides a work management platform for marketers, for approximately $1.5 billion in cash consideration. Workfront will be integrated into our Digital Experience reportable segment for financial reporting purposes in the first quarter of fiscal 2021.During fiscal 2019, we acquired the remaining interest in Allegorithmic SAS (“Allegorithmic”), a privately held 3D editing and authoring software company for gaming and entertainment, for approximately $106 million in cash consideration, and integrated it into our Digital Media reportable segment.During fiscal 2018, we completed our acquisitions of Marketo, a privately held marketing cloud platform company, for approximately $4.73 billion and Magento, a privately held commerce platform company, for approximately $1.64 billion, and integrated them into our Digital Experience reportable segment.We also completed other immaterial business acquisitions during the fiscal years presented. See Note 3 of our Notes to Consolidated Financial Statements for further information regarding these acquisitions, including pro forma financial information related to the Marketo acquisition. Pro forma information has not been presented for our other acquisitions during the fiscal years presented as the impact to our Consolidated Financial Statements was not material.CRITICAL ACCOUNTING POLICIES AND ESTIMATESIn preparing our Consolidated Financial Statements in accordance with GAAP and pursuant to the rules and regulations of the SEC, we make assumptions, judgments and estimates that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures of contingent assets and liabilities. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. We evaluate our assumptions, judgments and estimates on a regular basis. We also discuss our critical accounting policies and estimates with the Audit Committee of the Board of Directors.We believe that the assumptions, judgments and estimates involved in the accounting for revenue recognition, business combinations and income taxes have the greatest potential impact on our Consolidated Financial Statements. These areas are key components of our results of operations and are based on complex rules requiring us to make judgments and estimates, and consequently, we consider these to be our critical accounting policies. Historically, our assumptions, judgments and estimates relative to our critical accounting policies have not differed materially from actual results.Revenue Recognition Our contracts with customers may include multiple goods and services. For example, some of our offerings include both on-premise and/or on-device software licenses and cloud services. Determining whether the software licenses and the cloud services are distinct from each other, and therefore performance obligations to be accounted for separately, or not distinct from each other, and therefore part of a single performance obligation, may require significant judgment. We have concluded that the on-premise/on-device software licenses and cloud services provided in our Creative Cloud and Document Cloud subscription offerings are not distinct from each other such that revenue from each offering should be recognized ratably over the subscription period for which the cloud services are provided. In reaching this conclusion, we considered the nature of our promise to Creative Cloud and Document Cloud customers, which is to provide a complete end-to-end creative design or document workflow solution that operates seamlessly across multiple devices and teams. We fulfill this promise by providing access to a solution that integrates cloud-based and on-premise/on-device features that, together through their integration, provide functionalities, utility and workflow efficiencies that could not be obtained from either the on-premise/on-device software or cloud services on their own.Cloud-based features that are integral to our Creative Cloud and Document Cloud offerings and that work together with the on-premise/on-device software include, but are not limited to: Creative Cloud Libraries, which enable customers to access their work, settings, preferences and other assets seamlessly across desktop and mobile devices and collaborate across teams in 42Table of Contentsreal time; shared reviews which enable simultaneous editing and commenting of PDFs across desktop, mobile and web; automatic cloud rendering of a design which enables it to be worked on in multiple mediums; and Sensei, Adobe’s cloud-hosted artificial intelligence and machine learning framework, which enables features such as automated photo-editing, photograph content-awareness, natural language processing, optical character recognition and automated document tagging.Business CombinationsWe allocate the purchase price of acquired companies to tangible and intangible assets acquired and liabilities assumed based upon their estimated fair values at the acquisition date. The purchase price allocation process requires management to make significant estimates and assumptions with respect to intangible assets and deferred revenue obligations. Although we believe the assumptions and estimates we have made are reasonable, they are based in part on historical experience, market conditions and information obtained from management of the acquired companies and are inherently uncertain. Examples of critical estimates in valuing certain of the intangible assets we have acquired or may acquire in the future include but are not limited to:•future expected cash flows from software license sales, subscriptions, support agreements, consulting contracts and acquired developed technologies and patents;•historical and expected customer attrition rates and anticipated growth in revenue from acquired customers;•the acquired company’s trade name and trademarks as well as assumptions about the period of time the acquired trade name and trademarks will continue to be used in the combined company’s product portfolio;•the expected use of the acquired assets; and •discount rates.In connection with the purchase price allocations for our acquisitions, we estimate the fair value of the deferred revenue obligations assumed. The estimated fair value of these obligations is determined utilizing a cost build-up approach. The cost build-up approach determines fair value by estimating the costs related to fulfilling the obligations plus a normal profit margin. Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results.Accounting for Income TaxesWe use the asset and liability method of accounting for income taxes. Under this method, income tax expense is recognized for the amount of taxes payable or refundable for the current year. In addition, deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Management must make assumptions, judgments and estimates to determine our current provision for income taxes and also our deferred tax assets and liabilities.Our assumptions, judgments and estimates relative to the current provision for income taxes take into account current tax laws, our interpretation of current tax laws and possible outcomes of current and future audits conducted by foreign and domestic tax authorities. We have established reserves for income taxes to address potential exposures involving tax positions that could be challenged by tax authorities. In addition, we are subject to the continual examination of our income tax returns by the U.S. Internal Revenue Service and other domestic and foreign tax authorities. These tax examinations are expected to focus on our intercompany transfer pricing practices, application of tax rules, and other matters. We regularly assess the likelihood of outcomes resulting from these examinations to determine the adequacy of our provision for income taxes and have reserved for potential adjustments that may result from such examinations. We believe such estimates to be reasonable; however, we cannot provide assurance that the final determination of any of these examinations will not have a significant impact on the amounts provided for income taxes in our Consolidated Financial Statements.During fiscal 2020, we completed intra-entity transfers of certain intellectual property rights (“IP rights”) which resulted in the establishment of deferred tax assets, net of valuation allowance, and related tax benefits of $224 million and $1.13 billion, based on the fair value of the IP rights transferred in April and November 2020, respectively. The determination of the fair value involves significant judgment on future revenue growth, operating margins and discount rates. Unanticipated events and circumstances may occur that could affect either the accuracy or validity of such assumptions, estimates or actual results. The sustainability of our future tax benefits is dependent upon the acceptance of the valuation estimates and assumptions by the taxing authorities.43Table of ContentsRecent Accounting Pronouncements See Note 1 of our Notes to Consolidated Financial Statements for information regarding recent accounting pronouncements that are of significance, or potential significance to us. RESULTS OF OPERATIONSOverview of 2020For our fiscal 2020, we experienced strong demand across our Digital Media offerings consistent with the continued execution of our long-term plans with respect to this segment. In our Digital Experience segment, we continued to experience growth in software-based subscription revenue across our portfolio of offerings. During the second quarter of fiscal 2020, we began to discontinue our transaction-driven Advertising Cloud offerings, allowing us to focus our investment on strategic growth initiatives. In the fourth quarter of fiscal 2020, we moved our Advertising Cloud offerings from our Digital Experience segment into our new Publishing and Advertising segment, which combined Advertising Cloud with our previous Publishing segment. This realignment is consistent with how we manage our Digital Experience segment to better reflect the strategic shift related to Advertising Cloud and to align with our overall core value proposition of delivering on customer experience management. Digital MediaIn our Digital Media segment, we are a market leader with Creative Cloud, our subscription-based offering which provides desktop tools, mobile apps and cloud-based services for designing, creating and publishing rich and immersive content. Creative Cloud delivers value with deep, cross-product integration, frequent product updates and feature enhancements, cloud-enabled services including storage and syncing of files across users’ machines, machine learning and artificial intelligence, access to marketplace, social and community-based features with our Adobe Stock and Behance services, app creation capabilities, tools which assist with enterprise deployments and team collaboration, and affordable pricing for cost-sensitive customers.We offer Creative Cloud for individuals, students, teams and enterprises. We expect Creative Cloud will drive sustained long-term revenue growth through a continued expansion of our customer base by acquiring new users as a result of low cost of entry and delivery of additional features and value to Creative Cloud, as well as keeping existing customers current on our latest release. We have also built out a marketplace for Creative Cloud subscribers to enable the delivery and purchase of stock content in our Adobe Stock service. Overall, our strategy with Creative Cloud is designed to enable us to increase our revenue with users, attract more new customers, and grow our recurring and predictable revenue stream that is recognized ratably.We continue to implement strategies that will accelerate awareness, consideration and purchase of subscriptions to our Creative Cloud offerings. These strategies include increasing the value Creative Cloud users receive, such as offering new desktop and mobile applications, as well as targeted promotions and offers that attract past customers and potential users to try out and ultimately subscribe to Creative Cloud. Because of the shift towards Creative Cloud subscriptions and Enterprise Term License Agreements (“ETLAs”), revenue from perpetual licensing of our Creative products has been immaterial to our business.We are also a market leader with our Document Cloud offerings built around our Adobe Acrobat family of products, including Adobe Acrobat Reader DC, and a set of integrated mobile apps and cloud-based document services, including Adobe Scan and Adobe Sign. Acrobat provides reliable creation and exchange of electronic documents, regardless of platform or application source type. Document Cloud, which we believe enhances the way people manage critical documents at home, in the office and across devices, includes Adobe Acrobat DC and Adobe Sign, and a set of integrated services enabling users to create, review, approve, sign and track documents whether on a desktop or mobile device. Adobe Acrobat DC is offered both through subscription and perpetual licenses.44Table of ContentsAnnualized Recurring Revenue (“ARR”) is currently the key performance metric our management uses to assess the health and trajectory of our overall Digital Media segment. ARR should be viewed independently of revenue, deferred revenue, unbilled backlog and remaining performance obligation as ARR is a performance metric and is not intended to be combined with any of these items. We adjust our reported ARR on an annual basis to reflect any material exchange rates changes. Our reported ARR results in the current fiscal year are based on currency rates set at the beginning of the year and held constant throughout the year. We calculate ARR as follows:Creative ARRAnnual Value of Creative Cloud Subscriptions and Services+ Annual Creative ETLA Contract Value Document Cloud ARRAnnual Value of Document Cloud Subscriptions and Services +Annual Document Cloud ETLA Contract ValueDigital Media ARRCreative ARR+ Document Cloud ARRCreative ARR exiting fiscal 2020 was $8.72 billion, up from $7.25 billion at the end of fiscal 2019. Document Cloud ARR exiting fiscal 2020 was $1.46 billion, up from $1.08 billion at the end of fiscal 2019. Total Digital Media ARR grew to $10.18 billion at the end of fiscal 2020, up from $8.33 billion at the end of fiscal 2019. Revaluing our ending ARR for fiscal 2020 using currency rates at the beginning of fiscal 2021, our Digital Media ARR at the end of fiscal 2020 would be $10.26 billion or approximately $77 million higher than the ARR reported above.Our success in driving growth in ARR has positively affected our revenue growth. Creative revenue in fiscal 2020 was $7.74 billion, up from $6.48 billion in fiscal 2019 and representing 19% year-over-year growth. Document Cloud revenue in fiscal 2020 was $1.50 billion, up from $1.22 billion in fiscal 2019 and representing 22% year-over-year revenue growth and reflecting an increase in demand driven by the shift to remote work as well as our continued efforts to transition Document Cloud to a subscription-based model. Total Digital Media segment revenue grew to $9.23 billion in fiscal 2020, up from $7.71 billion in fiscal 2019 and representing 20% year-over-year growth. These increases were driven by strong net new user growth, including those resulting from the current work-from-home environment reflecting expanded digital engagement.Digital ExperienceWe are a market leader in the fast-growing category addressed by our Digital Experience segment. The Adobe Experience Cloud applications, services and platform are designed to manage customer journeys, enable shoppable experiences and deliver intelligence for businesses of any size in any industry. Our differentiation and competitive advantage is strengthened by our ability to use the Adobe Experience Platform to connect our comprehensive set of solutions.Adobe Experience Cloud is focused on delivering solutions for our enterprise customers across the following strategic growth pillars:•Customer data and insights. Our solutions deliver real-time customer profiles and intelligence across the customer journey. Our offerings include Adobe Experience Platform, Adobe Analytics, Adobe Audience Manager, Customer Journey Analytics, Real-time Customer Data Platform and Intelligent Services.•Content and commerce. Our solutions to help customers manage, deliver, test, target and optimize content delivery and enable shopping experiences that scale from mid-market to enterprise businesses. Our offerings include Adobe Experience Manager, Adobe Target and Adobe Commerce.•Customer journey management. Our solutions help businesses manage, personalize and orchestrate campaigns and customer journeys across B2E use cases. Our offerings include Adobe Campaign, Marketo Engage and Journey Orchestration.In addition to chief marketing officers, chief revenue officers and digital marketers, users of our Digital Experience solutions include advertisers, campaign managers, publishers, data analysts, content managers, social marketers, marketing executives and information management and technology executives. These customers often are involved in workflows that utilize other Adobe products, such as our Digital Media offerings. By combining the creativity of our Digital Media business 45Table of Contentswith the science of our Digital Experience business, we help our customers to more efficiently and effectively make, manage, measure and monetize their content across every channel with an end-to-end workflow and feedback loop.We utilize a direct sales force to market and license our Digital Experience solutions, as well as an extensive ecosystem of partners, including marketing agencies, systems integrators and independent software vendors that help license and deploy our solutions to their customers. We have made significant investments to broaden the scale and size of all of these routes to market, and our recent financial results reflect the success of these investments. Digital Experience revenue for all fiscal years presented has been updated to reflect the Advertising Cloud segment move. Digital Experience revenue was $3.13 billion in fiscal 2020, up from $2.80 billion in fiscal 2019 which represents 12% year-over-year growth. Driving this increase was the increase in subscription revenue across our offerings which grew to $2.66 billion in fiscal 2020 from $2.28 billion in fiscal 2019, representing 17% year-over-year growth. COVID-19 UPDATEIn March 2020, the World Health Organization declared the outbreak of a disease caused by a novel strain of the coronavirus (COVID-19) to be a pandemic. This pandemic has had widespread, rapidly-evolving and unpredictable impacts on global societies, economies, financial markets and business practices. Federal and state governments have implemented measures in an effort to contain the virus, including physical distancing, travel restrictions, border closures, limitations on public gatherings, work from home, supply chain logistical changes and closure of non-essential businesses. Our focus remains on promoting employee health and safety, serving our customers and ensuring business continuity. As a result, we have taken action to direct our teams to work from home, suspend travel and replace in-person events such as Adobe Summit and MAX, with digital events through July 2021. During the pandemic, digital has become the primary way for people to connect, work, learn and be entertained, and for businesses to engage with customers. This macro trend towards all things digital has increased the importance and relevance of our solutions and accelerated the tailwinds that benefit our business, which contributed to our continued growth year over year. However, while our revenue and earnings are relatively predictable as a result of our subscription-based business model, the broader implications of the pandemic on our results of operations and overall financial performance remain uncertain. See Risk Factors for further discussion of the possible impact of the pandemic on our business.Financial Performance Summary for Fiscal 2020•Total Digital Media ARR of approximately $10.18 billion as of November 27, 2020 increased by $1.85 billion, or 22%, from $8.33 billion as of November 29, 2019. The increase in our Digital Media ARR was primarily due to new user adoption of our Creative Cloud and Document Cloud offerings. •Creative revenue of $7.74 billion increased by $1.25 billion, or 19%, during fiscal 2020, from $6.48 billion in fiscal 2019. Document Cloud revenue of $1.50 billion increased by $272 million, or 22%, during fiscal 2020, from $1.22 billion in fiscal 2019. The increases were primarily due to subscription revenue growth associated with our Creative Cloud and Document Cloud offerings.•Digital Experience revenue of $3.13 billion increased by $330 million, or 12%, during fiscal 2020, from $2.80 billion in fiscal 2019. The increase was primarily due to subscription revenue growth across our offerings.•Remaining performance obligation of $11.34 billion as of November 27, 2020 increased by $1.52 billion, or 15%, from $9.82 billion as of November 29, 2019, primarily due to new contracts and renewals for our Digital Media and Digital Experience offerings. •Cost of revenue of $1.72 billion increased by $49 million, or 3%, during fiscal 2020, from $1.67 billion in fiscal 2019 primarily due to increases in hosting services and data center costs, offset in large part by decreases in Advertising Cloud media costs.•Operating expenses of $6.91 billion increased by $679 million, or 11%, during fiscal 2020, from $6.23 billion in fiscal 2019 primarily due to increases in base and incentive compensation and related benefits costs, as well as increased marketing spend. These increases were offset in part by decreases in travel-related expenses. •Net income of $5.26 billion increased by $2.31 billion, or 78%, during fiscal 2020 from $2.95 billion in fiscal 2019 primarily due to increases in revenue and the non-recurring benefit from income taxes resulting from intra-entity transfers of certain intellectual property rights. 46Table of Contents•Net cash flows from operations of $5.73 billion during fiscal 2020 increased by $1.31 billion, or 30%, from $4.42 billion during fiscal 2019 primarily due to higher net income adjusted for the net effect of non-cash items.Presentation ChangesIn the fourth quarter of fiscal 2020, we moved our Advertising Cloud offerings from our Digital Experience segment into our new Publishing and Advertising segment, which combined our Advertising Cloud offerings with our previous Publishing segment. This realignment is consistent with how we manage our Digital Experience segment to better reflect the strategic shift related to Advertising Cloud and to align with our overall core value proposition of delivering on customer experience management. Further, we reclassified revenue and related cost of revenue of our Advertising Cloud offerings from subscription to services and other on our Consolidated Statements of Income.Financial information for all fiscal years presented has been updated to reflect these reclassifications. There were no other updates to disclosures included in our prior year report in relation to the reclassifications.RevenueOur financial results for fiscal 2020 and 2019 are presented in accordance with Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), which was adopted under the modified retrospective method at the beginning of fiscal 2019. Fiscal 2018 results have not been restated which limits its comparability with other fiscal years presented.(dollars in millions)202020192018% Change2020-2019% Change2019-2018Subscription$11,626 $9,634 $7,604 21 %27 %Percentage of total revenue90 %86 %84 % Product507 648 622 (22)%4 %Percentage of total revenue4 %6 %7 % Services and other735 889 804 (17)%11 %Percentage of total revenue6 %8 %9 % Total revenue$12,868 $11,171 $9,030 15 %24 %SubscriptionOur subscription revenue is comprised primarily of fees we charge for our subscription and hosted service offerings, and related support, including Creative Cloud and certain of our Adobe Experience Cloud and Document Cloud services. We primarily recognize subscription revenue ratably over the term of agreements with our customers, beginning with commencement of service. Subscription revenue related to certain offerings, where fees are based on a number of transactions and invoicing is aligned to the pattern of performance, customer benefit and consumption, are recognized on a usage basis.We have the following reportable segments: Digital Media, Digital Experience, and Publishing and Advertising. Subscription revenue by reportable segment for fiscal 2020, 2019 and 2018 is as follows:(dollars in millions)202020192018% Change2020-2019% Change2019-2018Digital Media$8,813 $7,208 $5,858 22 %23 %Digital Experience2,660 2,280 1,600 17 %43 %Publishing and Advertising153 146 146 5 %*Total subscription revenue$11,626 $9,634 $7,604 21 %27 %_________________________________________(*) Percentage is less than 1%.ProductOur product revenue is comprised primarily of fees related to licenses for on-premise software purchased on a perpetual basis, for a fixed period of time or based on usage for certain of our OEM and royalty agreements. We primarily recognize 47Table of Contentsproduct revenue at the point in time the software is available to the customer, provided all other revenue recognition criteria are met.Services and OtherOur services and other revenue is comprised primarily of fees related to consulting, training, maintenance and support and our advertising offerings. We typically sell our consulting contracts on a time-and-materials and fixed-fee basis. These revenues are recognized as the services are performed for time and materials contracts and on a relative performance basis for fixed-fee contracts. Training revenues are recognized as the services are performed. Our maintenance and support offerings, which entitle customers, partners and developers to receive desktop product upgrades and enhancements or technical support, depending on the offering, are generally recognized ratably over the term of the arrangement. Transaction-based advertising revenue is recognized on a usage basis as we satisfy the performance obligations to our customers.Segments In fiscal 2020, we categorized our products into the following reportable segments:•Digital Media—Our Digital Media segment provides tools and solutions that enable individuals, teams and enterprises to create, publish, promote and monetize their digital content anywhere. Our customers include content creators, experience designers, app developers, enthusiasts, students, social media users and creative professionals, as well as marketing departments and agencies, companies and publishers. Our customers also include knowledge workers who create, collaborate on and distribute documents and creative content. •Digital Experience—Our Digital Experience segment provides products, services and solutions for creating, managing, executing, measuring, monetizing and optimizing customer experiences from analytics to commerce. Our customers include marketers, advertisers, agencies, publishers, merchandisers, merchants, web analysts, data scientists, developers, marketing executives, information management and technology executives, product development executives, and sales and support executives. •Publishing and Advertising—Our Publishing and Advertising segment addresses market opportunities ranging from the diverse authoring and publishing needs of technical and business publishing to our legacy type and OEM printing businesses. It also includes our platforms for Advertising Cloud, web conferencing, document and forms, and Primetime.Segment Information(dollars in millions)202020192018% Change2020-2019% Change2019-2018Digital Media$9,233 $7,707 $6,325 20 %22 %Percentage of total revenue72 %69 %70 % Digital Experience3,125 2,795 2,073 12 %35 %Percentage of total revenue24 %25 %23 % Publishing and Advertising510 669 632 (24)%6 %Percentage of total revenue4 %6 %7 % Total revenue$12,868 $11,171 $9,030 15 %24 %Digital MediaRevenue from Digital Media increased $1.53 billion during fiscal 2020 as compared to fiscal 2019, driven by increases in revenue associated with our Creative and Document Cloud offerings due to increased demand and digital engagement amid the work-from-home environment. Revenue associated with our Creative offerings, which includes our Creative Cloud, perpetually licensed Creative and stock photography offerings, increased during fiscal 2020 primarily due to increases in net new subscriptions across our Creative Cloud offerings. Document Cloud revenue, which includes our Acrobat product family and Adobe Sign service, increased during fiscal 2020 primarily due to increases in subscription revenue driven by strong adoption of our Document Cloud offerings including Adobe Sign.48Table of ContentsDigital ExperienceRevenue from Digital Experience increased $330 million during fiscal 2020, as compared to fiscal 2019 primarily due to subscription revenue growth across our offerings of which the largest contributors were our AEM and Marketo Engage offerings. Geographical Information(dollars in millions)202020192018% Change2020-2019% Change2019-2018Americas$7,454 $6,506 $5,117 15 %27 %Percentage of total revenue58 %58 %57 % EMEA3,400 2,975 2,550 14 %17 %Percentage of total revenue26 %27 %28 % APAC2,014 1,690 1,363 19 %24 %Percentage of total revenue16 %15 %15 % Total revenue$12,868 $11,171 $9,030 15 %24 %Overall revenue during fiscal 2020 increased in all geographic regions as compared to fiscal 2019 primarily due to increases in Digital Media revenue and, to a lesser extent, increases in Digital Experience revenue. Within each geographic region, the fluctuations in revenue by reportable segment were attributable to the factors noted in the segment information above. Included in the overall change in revenue for fiscal 2020 and fiscal 2019 were impacts associated with foreign currency as shown below. Our cash flow hedging program is used to mitigate a portion of the foreign currency impact to revenue. (in millions)20202019Revenue impact: Increase/(Decrease)Euro$(24)$(73)Australian Dollar(16)(27)British Pound(5)(27)Japanese Yen14 2 Brazilian Real(14)(2)Other currencies(8)(11)Total revenue impact(53)(138)Hedging impact:Euro8 30 British Pound(2)8 Japanese Yen(2)2 Australian Dollar(1)— Total hedging impact3 40 Total impact$(50)$(98) During fiscal 2020, the U.S. Dollar strengthened largely against EMEA currencies and the Australian Dollar, which decreased revenue in U.S. Dollar equivalents. The foreign currency impact to revenue was partially offset by gains primarily from our Euro cash flow hedging program.See Note 2 of our Notes to Consolidated Financial Statements for additional details of revenue by geography.49Table of ContentsCost of Revenue(dollars in millions)202020192018% Change2020-2019% Change2019-2018Subscription$1,108 $926 $574 20 %61 %Percentage of total revenue9 %8 %6 % Product36 40 46 (10)%(13)%Percentage of total revenue**1 % Services and other578 707 575 (18)%23 %Percentage of total revenue4 %6 %6 % Total cost of revenue$1,722 $1,673 $1,195 3 %40 %_________________________________________(*) Percentage is less than 1%SubscriptionCost of subscription revenue consists of third-party hosting services and data center costs, royalty fees and other expenses related to operating our network infrastructure, including depreciation expense and operating lease payments associated with computer equipment, salaries and related expenses of network operations, implementation, account management and technical support personnel, amortization of certain intangible assets and allocated overhead. Cost of subscription revenue increased due to the following: Components of% Change2020-2019Components of% Change2019-2018Hosting services and data center costs10 %16 %Incentive compensation, cash and stock-based5 5 Royalty costs3 5 Base compensation and related benefits associated with headcount3 5 Software licenses2 2 Amortization of intangibles(2)24 Various individually insignificant items(1)4 Total change20 %61 %Product Cost of product revenue is primarily comprised of third-party royalties, amortization related to purchased intangibles and acquired rights to use technology, excess and obsolete inventory, localization costs and the costs associated with the manufacturing of our products.Services and OtherCost of services and other revenue is primarily comprised of employee-related and other associated costs incurred to provide consulting services, training and product support. Cost of services and other also includes media costs related to impressions purchased from third-party ad inventory sources for our transaction-based Adobe Advertising Cloud offerings, which we began to discontinue in the second quarter of fiscal 2020. Cost of services and other fluctuations were due to the following:Components of% Change2020-2019Components of% Change2019-2018Media costs(9)%10 %Base compensation and related benefits associated with headcount(7)4 Incentive compensation, cash and stock-based(1)6 Professional and consulting fees3 — Various individually insignificant items(4)3 Total change(18)%23 %50Table of ContentsOperating Expenses(dollars in millions)202020192018% Change2020-2019Research and development$2,188 $1,930 $1,538 13 %Percentage of total revenue17 %17 %17 % Sales and marketing3,591 3,244 2,621 11 %Percentage of total revenue28 %29 %29 % General and administrative968 881 745 10 %Percentage of total revenue8 %8 %8 % Amortization of intangibles162 175 91 (7)%Percentage of total revenue1 %2 %1 % Total operating expenses$6,909 $6,230 $4,995 11 %Research and Development Research and development expenses consist primarily of salary and benefit expenses for software developers, contracted development efforts, third party fees for hosting services, related facilities costs and expenses associated with computer equipment used in software development.Research and development expenses increased due to the following: Components of% Change2020-2019Incentive compensation, cash and stock-based11 %Base compensation and related benefits associated with headcount3 Travel(1)Total change13 %We believe that investments in research and development, including the recruiting and hiring of software developers, are critical to remain competitive in the marketplace and are directly related to continued timely development of new and enhanced offerings and solutions. We will continue to focus on long-term opportunities available in our end markets and make significant investments in the development of our subscription and service offerings, applications and tools.Sales and MarketingSales and marketing expenses consist primarily of salary and benefit expenses, amortization of contract acquisition costs, including sales commissions, travel expenses and related facilities costs for our sales, marketing, order management and global supply chain management personnel. Sales and marketing expenses also include the costs of programs aimed at increasing revenue, such as advertising, trade shows and events, public relations and other market development programs.Sales and marketing expenses increased due to the following: Components of% Change2020-2019Marketing spend related to campaigns, events and overall marketing efforts8 %Incentive compensation, cash and stock-based4 Transaction fees2 Base compensation and related benefits associated with headcount1 Professional and consulting fees(1)Travel(3)Total change11 %51Table of ContentsGeneral and AdministrativeGeneral and administrative expenses consist primarily of compensation and benefit expenses, travel expenses and related facilities costs for our finance, facilities, human resources, legal, information services and executive personnel. General and administrative expenses also include outside legal and accounting fees, provision for bad debts, expenses associated with computer equipment and software used in the administration of the business, charitable contributions and various forms of insurance.General and administrative expenses increased due to the following: Components of% Change2020-2019Incentive compensation, cash and stock-based5 %Charges related to cancellation of corporate events, net of recoveries3 Bad debt expense2 Charitable contributions2 Base compensation and related benefits associated with headcount1 Travel(2)Various individually insignificant items(1)Total change10 % During fiscal 2020, we recorded net charges related to the cancellation of our corporate events due to concerns over the pandemic. Certain of these charges were reversed as we successfully negotiated the right to apply certain commitments to other events.Bad debt expense increased during fiscal 2020 primarily due to specific reserves for certain categories of customers that were more impacted by the changes in the macroeconomic environment as a result of the pandemic.Amortization of IntangiblesAmortization expense decreased during fiscal 2020 as compared to fiscal 2019 primarily due to certain intangible assets from previous acquisitions, including from Marketo and Omniture, becoming fully amortized during the year.Non-Operating Income (Expense), Net(dollars in millions)202020192018% Change2020-2019Interest expense$(116)$(157)$(89)(26)%Percentage of total revenue(1)%(1)%(1)%Investment gains (losses), net13 52 3 (75)%Percentage of total revenue*** Other income (expense), net42 42 40 **Percentage of total revenue***Total non-operating income (expense), net$(61)$(63)$(46)(3)%_________________________________________(*) Percentage is less than 1%.(**) Percentage is not meaningful.Interest ExpenseInterest expense represents interest associated with our debt instruments. Interest on our Notes is payable semi-annually, in arrears, on February 1 and August 1. Interest on our Term Loan, which was terminated in the first quarter of fiscal 2020, was payable periodically at the end of each interest period. Floating interest payments on the interest rate swaps, which matured in the first quarter of fiscal 2020, were paid monthly and the fixed-rate interest receivable on the swaps was received semi-annually concurrent with the Notes interest payments.Interest expense decreased during fiscal 2020 as compared to fiscal 2019 primarily due to lower average interest rates on our debt instruments that were refinanced in the first quarter of fiscal 2020.52Table of ContentsInvestment Gains (Losses), NetInvestment gains (losses), net consists principally of unrealized holding gains and losses associated with our deferred compensation plan assets which are classified as trading securities, and gains and losses associated with our direct and indirect investments in privately held companies.Investment gains (losses), net decreased during fiscal 2020 as compared to fiscal 2019 primarily due to the gain recognized upon our acquisition of the remaining interest in Allegorithmic in January 2019.Other Income (Expense), Net Other income (expense), net consists primarily of interest earned on cash, cash equivalents and short-term fixed income investments. Other income (expense), net also includes realized gains and losses on fixed income investments and foreign exchange gains and losses.Other income (expense), remained stable during fiscal 2020 primarily due to decreases in interest income driven by lower average interest rates offset by our change in methodology of accounting for foreign currency cash flow hedges. Effective in the third quarter of fiscal 2019, option premiums, which were previously recorded in other income (expense), net, are recorded in accumulated other comprehensive income (loss).Provision for (Benefit from) Income Taxes (dollars in millions)202020192018% Change2020-2019Provision for (benefit from) income taxes$(1,084)$254 $203 **Percentage of total revenue(8)%2 %2 % Effective tax rate(26)%8 %7 % _________________________________________(**) Percentage is not meaningful.Our effective tax rate decreased by approximately 34 percentage points during fiscal 2020 as compared to fiscal 2019. The change is primarily due to non-recurring tax benefits resulting from the intra-entity transfers of certain intellectual property rights (“IP rights”) completed during fiscal 2020. Our effective tax rate for fiscal 2020 was lower than the U.S. federal statutory tax rate of 21% primarily due to tax benefits resulting from the intra-entity transfers of certain IP rights, a favorable geographic mix of earnings and tax benefits related to stock-based compensation.During fiscal 2020, we completed intra-entity transfers of certain IP rights to our Irish subsidiary in order to better align the ownership of these rights with how our business operates. The transfers did not result in taxable gains; however, our Irish subsidiary recognized deferred tax assets for the book and tax basis difference of the transferred IP rights. As a result of these transactions, we recorded deferred tax assets, net of valuation allowance, and related tax benefits of $224 million and $1.13 billion, based on the fair value of the IP rights transferred in April and November 2020, respectively. The tax-deductible amortization related to the transferred IP rights will be recognized over the period of economic benefit. In years beyond fiscal 2020, the change in the geographic mix of international income resulting from these transfers is anticipated to adversely affect our effective income tax rates and cash flows. However, the adverse impact to effective rates for cash paid for income taxes will be partially offset by future deductions on the transferred IP rights.On December 22, 2017, the U.S. Tax Act was enacted into law, which significantly changed existing U.S. tax law and includes many provisions applicable to us. Certain international provisions of the U.S. Tax Act, such as a tax on global intangible low-tax income, a base erosion and anti-abuse tax and a special tax deduction for foreign-derived intangible income, took effect in fiscal 2019. As the U.S. Treasury releases regulations that impact these provisions, we account for finalized regulations in the period of enactment.We recognize deferred tax assets to the extent that we believe these assets are more likely than not to be realized. In making such a determination, we considered all available positive and negative evidence, including our past operating results, forecasted earnings, future taxable income and prudent and feasible tax planning strategies. On the basis of this evaluation, we continue to maintain a valuation allowance to reduce our deferred tax assets to the amount realizable. The total valuation allowance was $276 million as of November 27, 2020 and is primarily attributable to certain state and foreign credits and foreign intangible assets. 53Table of ContentsWe are a United States-based multinational company subject to tax in multiple U.S. and foreign tax jurisdictions. A significant portion of our foreign earnings for the current fiscal year were earned by our Irish subsidiaries. The current U.S. tax law provides an exemption from federal income taxes for distributions from foreign subsidiaries made after December 31, 2017, including certain earnings that were not subject to the one-time transition or global intangible low-tax income tax. As we repatriate the undistributed foreign earnings for use in the U.S., the distributions will generally not be subject to further U.S. federal tax.In June 2020, California enacted legislation which includes a limitation on the utilization of research and development tax credits for a three-year period beginning in fiscal 2021. The net impact of the legislation is uncertain but is anticipated to increase our California tax and, consequently, adversely impact our effective tax rates for the three-year period beginning in fiscal 2021.See Note 10 of our Notes to Consolidated Financial Statements for further information on our provision for (benefit from) income taxes. Accounting for Uncertainty in Income TaxesThe gross liabilities for unrecognized tax benefits excluding interest and penalties were $201 million, $173 million and $196 million for fiscal 2020, 2019 and 2018, respectively. If the total unrecognized tax benefits at November 27, 2020, November 29, 2019 and November 30, 2018 were recognized, $136 million, $116 million and $136 million would decrease the respective effective tax rates.The combined amount of accrued interest and penalties related to tax positions taken on our tax returns were approximately $26 million and $25 million for fiscal 2020 and 2019, respectively. These amounts were included in long-term income taxes payable in their respective years.The timing of the resolution of income tax examinations is highly uncertain as are the amounts and timing of tax payments that are part of any audit settlement process. These events could cause large fluctuations in the balance sheet classification of our tax assets and liabilities. We believe that within the next 12 months, it is reasonably possible that either certain audits will conclude or statutes of limitations on certain income tax examination periods will expire, or both. Given the uncertainties described above, we can only determine a range of estimated potential decreases in underlying unrecognized tax benefits ranging from $0 to approximately $20 million over the next 12 months.In addition, in countries where we conduct business and in jurisdictions in which we are subject to tax, including those covered by governing bodies that enact tax laws applicable to us, such as the European Commission of the European Union, we are subject to potential changes in relevant tax, accounting and other laws, regulations and interpretations, including changes to tax laws applicable to corporate multinationals such as Adobe. These countries, other governmental bodies and intergovernmental economic organizations such as the Organization for Economic Cooperation and Development, have or could make unprecedented assertions about how taxation is determined in their jurisdictions that are contrary to the way in which we have interpreted and historically applied the rules and regulations described above in such jurisdictions. In the current global tax policy environment, any changes in laws, regulations and interpretations related to these assertions could adversely affect our effective tax rates, cause us to respond by making changes to our business structure, or result in other costs to us which could adversely affect our operations and financial results.Moreover, we are subject to the continual examination of our income tax returns by the U.S. Internal Revenue Service and other domestic and foreign tax authorities. These tax examinations are expected to focus on our intercompany transfer pricing practices, application of tax rules and other matters. We regularly assess the likelihood of outcomes resulting from these examinations to determine the adequacy of our provision for income taxes and have reserved for potential adjustments that may result from these examinations. We cannot provide assurance that the final determination of any of these examinations will not have an adverse effect on our operating results and financial position.54Table of Contents LIQUIDITY AND CAPITAL RESOURCESThis data should be read in conjunction with our Consolidated Statements of Cash Flows.As of(in millions)November 27, 2020November 29, 2019Cash and cash equivalents$4,478 $2,650 Short-term investments$1,514 $1,527 Working capital$2,634 $(1,696)Stockholders’ equity$13,264 $10,530 Working CapitalWorking capital as of November 27, 2020 and November 29, 2019 was $2.63 billion of a surplus and $1.70 billion of a deficit, respectively. During the first quarter of fiscal 2020, we refinanced our 2.25 billion term loan due April 30, 2020 (“Term Loan”) and $900 million 4.75% senior notes due February 1, 2020 (“2020 Notes”). See the section titled “Cash Flows from Financing Activities” below. A summary of our cash flows for fiscal 2020, 2019 and 2018 is as follows:(in millions)202020192018Net cash provided by operating activities$5,727 $4,422 $4,029 Net cash used for investing activities(414)(456)(4,685)Net cash used for financing activities(3,488)(2,946)(5)Effect of foreign currency exchange rates on cash and cash equivalents3 (13)(2)Net increase (decrease) in cash and cash equivalents$1,828 $1,007 $(663)Our primary source of cash is receipts from revenue and, to a lesser extent, proceeds from participation in the employee stock purchase plan. The primary uses of cash are our stock repurchase program as described below, payroll-related expenses, general operating expenses including marketing, travel and office rent, and cost of revenue. Other uses of cash include business acquisitions, purchases of property and equipment and payments for taxes related to net share settlement of equity awards.Cash Flows from Operating ActivitiesFor fiscal 2020, net cash provided by operating activities of $5.73 billion was primarily comprised of net income adjusted for the net effect of non-cash items. The primary working capital sources of cash were net income together with increases in deferred revenue and decreases in trade receivables, which were offset in part by increases in prepaid expenses and other assets. The increase in deferred revenue was primarily driven by Digital Media offerings with cloud-enabled services, and the decrease in trade receivables was largely attributable to strong collections. The primary working capital use of cash was due to increases in prepaid expenses and other assets driven by sales commissions paid and capitalized and, to a lesser extent, increases due to the timing of billings and payments associated with certain vendors.Cash Flows from Investing ActivitiesFor fiscal 2020, net cash used for investing activities of $414 million was primarily due to ongoing capital expenditures. These cash outflows were offset in part by proceeds from sales and maturities of short-term investments, net of purchases.Cash Flows from Financing ActivitiesFor fiscal 2020, net cash used for financing activities of $3.49 billion was primarily due to payments for our treasury stock repurchases and taxes paid related to the net share settlement of equity awards, which were offset by proceeds from re-issuance of treasury stock for our employee stock purchase plan. See the section titled “Stock Repurchase Program” discussed below.In February 2020, we issued $500 million of 1.70% senior notes due February 1, 2023 (“2023 Notes”), $500 million of 1.90% senior notes due February 1, 2025 (“1.90% 2025 Notes”), $850 million of 2.15% senior notes due February 1, 2027 (“2027 Notes”) and $1.30 billion of 2.30% senior notes due February 1, 2030 (“2030 Notes”). We used the proceeds to repay the Term Loan and 2020 Notes concurrently. See Note 17 of our Notes to Consolidated Financial Statements for information regarding our debt refinancing.55Table of ContentsOther Liquidity and Capital Resources ConsiderationsOur existing cash, cash equivalents and investment balances may fluctuate during fiscal 2021 due to changes in our planned cash outlay. Cash from operations could also be affected by various risks and uncertainties, including, but not limited to, the effects of the pandemic and other risks detailed in Part I, Item 1A titled “Risk Factors.” While the pandemic has not negatively impacted our liquidity and capital resources to date, it has led to increased disruption and volatility in capital markets and credit markets which could adversely affect our liquidity and capital resources in the future. However, based on our current business plan and revenue prospects, we believe that our existing cash, cash equivalents and investment balances, our anticipated cash flows from operations and our available credit facility will be sufficient to meet our working capital, operating resource expenditure and capital expenditure requirements for the next twelve months.Our cash equivalent and short-term investment portfolio as of November 27, 2020 consisted of asset-backed securities, corporate debt securities, foreign government securities, money market mutual funds, municipal securities and time deposits. We use professional investment management firms to manage a large portion of our invested cash.We have a $1 billion senior unsecured revolving credit agreement (“Revolving Credit Agreement”) with a syndicate of lenders, providing for loans to us and certain of our subsidiaries through October 17, 2023. As of November 27, 2020, there were no outstanding borrowings under this credit agreement and the entire $1 billion credit line remains available for borrowing. As of November 27, 2020, we have $4.15 billion senior notes outstanding, consisting of the 2023 Notes, 1.90% 2025 Notes, 2027 Notes, 2030 Notes and the $1 billion of 3.25% senior notes due February 1, 2025 (the “3.25% 2025 Notes,” and together with the aforementioned notes, the “Notes”). The Notes rank equally with our other unsecured and unsubordinated indebtedness.We expect to continue our investing activities, including short-term and long-term investments, purchases of computer systems for research and development, sales and marketing, product support and administrative staff, and facilities expansion. As of November 27, 2020, we expect our capital investment to be approximately $550 million to $650 million, primarily to fund our San Jose and Bangalore construction projects through fiscal 2022. Furthermore, cash reserves may be used to repurchase stock under our stock repurchase program and to strategically acquire companies, products or technologies that are complementary to our business.Subsequent to November 27, 2020, we completed our acquisition of Workfront, a privately held company that provides a work management platform for marketers, for approximately $1.5 billion in cash consideration. See Note 3 of our Notes to Consolidated Financial Statements for further information regarding this acquisition.Stock Repurchase ProgramTo facilitate our stock repurchase program, designed to return value to our stockholders and minimize dilution from stock issuances, we may repurchase shares in the open market or enter into structured repurchase agreements with third parties. In May 2018, our Board of Directors granted us an authority to repurchase up to $8 billion in common stock through the end of fiscal 2021.During fiscal 2020, 2019 and 2018, we entered into several structured stock repurchase agreements with large financial institutions, whereupon we provided them with prepayments totaling $3.05 billion, $2.75 billion, and $2.05 billion, respectively. We enter into these agreements in order to take advantage of repurchasing shares at a guaranteed discount to the Volume Weighted Average Price (“VWAP”) of our common stock over a specified period of time. We only enter into such transactions when the discount that we receive is expected to be higher than the foregone return on our cash prepayments to the financial institutions. There were no explicit commissions or fees on these structured repurchases. Under the terms of the agreements, there is no requirement for the financial institutions to return any portion of the prepayment to us. The financial institutions agree to deliver shares to us at monthly intervals during the contract term. The parameters used to calculate the number of shares deliverable are: the total notional amount of the contract, the number of trading days in the contract, the number of trading days in the interval and the average VWAP of our stock during the interval less the agreed upon discount.56Table of ContentsThe following is a summary of our structured stock repurchases executed with large financial institutions during fiscal 2020, 2019 and 2018:(in millions, except average price per share)202020192018Board approval datesSharesAverage per shareSharesAverage per shareSharesAverage per shareJanuary 2017— $— — $— 8.7 $230.43 May 20188.0 $376.38 9.9 $270.23 — $— Total cost$3,024$2,671$2,002For fiscal 2020, 2019 and 2018, the prepayments were classified as treasury stock on our Consolidated Balance Sheets at the payment date, though only shares physically delivered to us by November 27, 2020, November 29, 2019 and November 30, 2018 were excluded from the computation of earnings per share. As of November 27, 2020, $255 million of prepayments remained under the agreement. Subsequent to November 27, 2020, we entered into a structured stock repurchase agreement with a large financial institution whereupon we provided them with a prepayment of $950 million. This amount will be classified as treasury stock on our Consolidated Balance Sheets. Upon completion of the $950 million stock repurchase agreement, $1.1 billion remains under our May 2018 authority. Further, in December 2020, our Board of Directors granted us additional authority to repurchase up to $15 billion in common stock through the end of fiscal 2024. We have not drawn from our new $15 billion authority as of the issuance of these financial statements.See Item 5, Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities for share repurchases during the quarter ended November 27, 2020.Off-Balance Sheet Arrangements and Aggregate Contractual Obligations Our principal commitments as of November 27, 2020 consist of our Notes and obligations under operating leases, royalty agreements and various service agreements. See Notes 16, 17 and 18 of our Notes to Consolidated Financial Statements for additional information regarding our contractual commitments.Contractual ObligationsThe following table summarizes our contractual obligations as of November 27, 2020:(in millions) Payment Due by Period TotalLess than1 year1-3 years3-5 yearsMore than5 yearsNotes, including interest$4,763 $99 $693 $1,659 $2,312 Operating lease obligations657 104 162 119 272 Purchase obligations 1,885 872 1,012 1 — Total$7,305 $1,075 $1,867 $1,779 $2,584 Senior NotesAs of November 27, 2020, the carrying value of our Notes was $4.12 billion. Interest is payable semi-annually, in arrears on February 1 and August 1. At November 27, 2020, our maximum commitment for interest payments was $613 million for the remaining duration of our outstanding Notes.CovenantsOur Revolving Credit Agreement contains a financial covenant requiring us not to exceed a maximum leverage ratio. As of November 27, 2020, we were in compliance with this covenant. We believe this covenant will not impact our credit or cash in the coming fiscal year or restrict our ability to execute our business plan. Our Notes do not contain any financial covenants.Under the terms of our Revolving Credit Agreement, we are not prohibited from paying cash dividends unless payment would trigger an event of default or if one currently exists. We do not anticipate paying any cash dividends in the foreseeable future.57Table of ContentsTransition Taxes LiabilityOur transition tax liability which was accrued as a result of the U.S. Tax Act was approximately $390 million as of November 27, 2020 and is payable in installments through fiscal 2026. The U.S. Tax Act provides an exemption from federal income taxes for distributions from foreign subsidiaries made after December 31, 2017, including certain earnings that were not subject to the one-time transition or global intangible low-tax income tax. As we repatriate the undistributed foreign earnings for use in the U.S., the distributions will generally not be subject to further U.S. federal tax.Accounting for Uncertainty in Income TaxesSee Results of Operations - Provision for (Benefit from) Income Taxes above and Note 10 of our Notes to Consolidated Financial Statements for our discussion on accounting for uncertainty in income taxes.RoyaltiesWe have certain royalty commitments associated with the licensing of certain offerings. Royalty expense is generally based on a dollar amount per unit sold or a percentage of the underlying revenue.IndemnificationsIn the normal course of business, we provide indemnifications of varying scope to customers and channel partners against claims of intellectual property infringement made by third parties arising from the use of our products and from time to time, we are subject to claims by our customers under these indemnification provisions. Historically, costs related to these indemnification provisions have not been significant and we are unable to estimate the maximum potential impact of these indemnification provisions on our future results of operations.To the extent permitted under Delaware law, we have agreements whereby we indemnify our directors and officers for certain events or occurrences while the director or officer is or was serving at our request in such capacity. The indemnification period covers all pertinent events and occurrences during the director’s or officer’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have director and officer insurance coverage that limits our exposure and enables us to recover a portion of any future amounts paid. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKAll market risk sensitive instruments were entered into for non-trading purposes.Foreign Currency RiskForeign Currency Exposures and Hedging InstrumentsIn countries outside the United States, we transact business in U.S. Dollars and various other currencies, which subject us to exposure from movements in exchange rates. We may use foreign exchange option contracts or forward contracts to hedge a portion of our forecasted foreign currency denominated revenue. Additionally, we hedge our net recognized foreign currency monetary assets and liabilities with foreign exchange forward contracts to reduce the risk that our earnings and cash flows will be adversely affected by changes in exchange rates. Our significant foreign currency revenue exposures for fiscal 2020, 2019 and 2018 were as follows :(in millions)202020192018Euro€1,887 €1,603 €1,310 Japanese Yen¥88,640 ¥73,158 ¥60,791 British Pounds£562 £503 £423 Australian Dollars$645 $538 $441 As of November 27, 2020, the total notional amounts of all outstanding foreign exchange contracts, including options and forwards, was $2.03 billion, which included the notional equivalent of $923 million in Euros, $385 million in Japanese Yen, $321 million in British Pounds, $212 million in Australian Dollars and $186 million in other foreign currencies. As of November 27, 2020, all contracts were set to expire at various dates through June 2021. The bank counterparties in these contracts could expose us to credit-related losses that would be largely mitigated with master netting arrangements with the same counterparty by permitting net settlement transactions. In addition, we enter into collateral security agreements that 58Table of Contentsprovide for collateral to be received or posted when the net fair value of these contracts fluctuates from contractually established thresholds.A sensitivity analysis was performed on all of our foreign exchange derivatives as of November 27, 2020. This sensitivity analysis measures the hypothetical market value resulting from a 10% shift in the value of exchange rates relative to the U.S. Dollar. For option contracts, the Black-Scholes option pricing model was used. A 10% increase in the value of the U.S. Dollar and a corresponding decrease in the value of the hedged foreign currency asset would lead to an increase in the fair value of our financial hedging instruments by $97 million. Conversely, a 10% decrease in the value of the U.S. Dollar would result in a decrease in the fair value of these financial instruments by $9 million.As a general rule, we do not use foreign exchange contracts to hedge local currency denominated operating expenses in countries where a natural hedge exists. For example, in many countries, revenue in the local currencies substantially offsets the local currency denominated operating expenses. We also have long-term investment exposures consisting of the capitalization and retained earnings in our non-U.S. Dollar functional currency foreign subsidiaries. As of November 27, 2020 and November 29, 2019, this long-term investment exposure totaled an absolute notional equivalent of $598 million and $385 million, respectively, with the year-over-year increase primarily driven by earnings growth. At this time, we do not hedge these long-term investment exposures.We do not use foreign exchange contracts for speculative trading purposes, nor do we hedge our foreign currency exposure in a manner that entirely offsets the effects of changes in foreign exchange rates. We regularly review our hedging program and assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis.Cash Flow Hedges of Forecasted Foreign Currency Revenue We may use foreign exchange purchased options or forward contracts to hedge foreign currency revenue denominated in Euros, British Pounds, Japanese Yen and Australian Dollars. We hedge these cash flow exposures to reduce the risk that our earnings and cash flows will be adversely affected by changes in exchange rates. These foreign exchange contracts, carried at fair value, have maturities of up to twelve months. We enter into these foreign exchange contracts to hedge forecasted revenue in the normal course of business and accordingly, they are not speculative in nature.We record changes in fair value of these cash flow hedges of foreign currency denominated revenue in accumulated other comprehensive income (loss) in our Consolidated Balance Sheets, until the forecasted transaction occurs. When the forecasted transaction affects earnings, we reclassify the related gain or loss on the cash flow hedge to revenue. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, we reclassify the gain or loss on the related cash flow hedge from accumulated other comprehensive income (loss) to revenue. For the fiscal year ended November 27, 2020, there were no net gains or losses recognized in revenue relating to hedges of forecasted transactions that did not occur.Non-Designated Hedges of Foreign Currency Assets and LiabilitiesOur derivatives not designated as hedging instruments consist of foreign currency forward contracts that we primarily use to hedge monetary assets and liabilities denominated in non-functional currencies to reduce the risk that our earnings and cash flows will be adversely affected by changes in foreign currency exchange rates. These foreign exchange contracts are carried at fair value with changes in fair value of these contracts recorded to other income (expense), net in our Consolidated Statements of Income. These contracts reduce the impact of currency exchange rate movements on our assets and liabilities. At November 27, 2020, the outstanding balance sheet hedging derivatives had maturities of 180 days or less.See Note 6 of our Notes to Consolidated Financial Statements for information regarding our derivative financial instruments.59Table of ContentsInterest Rate RiskShort-Term Investments and Fixed Income SecuritiesAt November 27, 2020, we had debt securities classified as short-term investments of $1.51 billion. Changes in interest rates could adversely affect the market value of these investments. A sensitivity analysis was performed on our investment portfolio as of November 27, 2020. The analysis is based on an estimate of the hypothetical changes in market value of the portfolio that would result from an immediate parallel shift in the yield curve of various magnitudes.The following tables present the hypothetical fair values of our debt securities classified as short-term investments assuming immediate parallel shifts in the yield curve of 50 basis points (“BPS”), 100 BPS and 150 BPS. The analysis is shown as of November 27, 2020 and November 29, 2019: (dollars in millions)-150 BPS-100 BPS-50 BPSFair Value 11/27/20+50 BPS+100 BPS+150 BPS$1,521 $1,520 $1,519 $1,514 $1,507 $1,500 $1,493 -150 BPS-100 BPS-50 BPSFair Value 11/29/19+50 BPS+100 BPS+150 BPS$1,545 $1,539 $1,533 $1,527 $1,521 $1,515 $1,509 Senior NotesFollowing our debt refinancing in February 2020, our outstanding Notes have fixed interest rates. As of November 27, 2020, the total carrying amount of our Notes was $4.12 billion and the related fair value based on observable market prices in less active markets was $4.48 billion.See Note 17 of our Notes to Consolidated Financial Statements for information regarding our senior notes.60Table of Contents

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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThis Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, should be read in conjunction with our consolidated financial statements and notes thereto that appear elsewhere in this annual report on Form 10-K. See “Risk Factors” elsewhere in this annual report on Form 10-K for a discussion of certain risks associated with our business. The following discussion contains forward-looking statements. The forward-looking statements do not include the potential impact of any mergers, acquisitions, divestitures or other events that may be announced after the date hereof.OverviewWe provide solutions for securing, delivering and optimizing content and business applications over the internet. The key factors that influence our financial success are our ability to build on recurring revenue commitments for our security and performance offerings, increase media traffic on our network, effectively manage the prices we charge for our solutions, develop new products and carefully manage our capital spending and other expenses.22Table of ContentsRevenueFor most of our solutions, our customers commit to contracts having terms of a year or longer, which allows us to have a consistent and predictable base level of revenue. In addition to a base level of revenue, we are also dependent on media customers where usage of our solutions is more variable. As a result, our revenue is impacted by the amount of media and software download traffic we serve on our network, the rate of adoption of gaming, social media and video platform offerings, the timing and variability of customer-specific one-time events and geopolitical, economic and other developments that impact our customers' businesses. Seasonal variations that impact traffic on our network, such as holiday shopping, can cause revenue fluctuations from quarter to quarter. Over the longer term, our ability to expand our product portfolio and to effectively manage the prices we charge for our solutions are key factors impacting our revenue growth.We have observed the following trends related to our revenue in recent years:•Increased sales of our security solutions have made a significant contribution to revenue growth. We plan to continue to invest in this area with a focus on further enhancing our product portfolio and extending our go-to-market capabilities, particularly in certain markets and through our channel partners.•We have experienced increases in the amount of traffic delivered for customers that use our solutions for video, gaming downloads and social media, contributing to an increase in our revenue in 2020 as compared to 2019. In addition, as a result of the COVID-19 outbreak and resultant pandemic-related shutdowns and restrictions in various locations around the world during some of 2020, the rate of growth in traffic in 2020, as compared to prior years, accelerated significantly due to increased consumption of streaming media and games online and online commerce. We expect this year-over-year growth to moderate in 2021, assuming the restrictions experienced in 2020 do not continue.•While we have increased committed recurring revenue from our solutions by upselling incremental solutions to our existing customers and adding new customers, we have also experienced slower revenue growth in recent quarters in our web performance solutions. We expect the trend of slower revenue growth in our web solutions to continue in 2021 as our customers, particularly in the commerce and travel and hospitality industries, continue to experience financial pressure, especially in light of the negative impacts of the COVID-19 pandemic on these customers' operations.•The prices paid by some of our customers have declined, particularly in the context of contract renewals and large media consolidations, reflecting the impact of competition and volume discounts. Our revenue would have been higher absent these price declines.•Revenue from our international operations has been growing at a faster pace than from our U.S. operations, particularly in terms of new customer acquisition and cross-selling of incremental solutions. Because we publicly report in U.S. dollars, if the dollar strengthens, our reported revenue results will be negatively impacted. Conversely, a continuing weaker dollar would benefit our reported results.•We have experienced variations in certain types of revenue from quarter to quarter. In particular, we typically experience higher revenue in the fourth quarter of each year for some of our solutions as a result of holiday season activity. In addition, we experience quarterly variations in revenue attributable to, among other things, the nature and timing of software and gaming releases by our customers; whether there are large live sporting or other events or situations (like the COVID-19 pandemic) that impact the amount of media traffic on our network; and the frequency and timing of purchases of custom solutions or licensed software. ExpensesOur level of profitability is also impacted by our expenses, including direct costs to support our revenue such as bandwidth and co-location costs. We have observed the following trends related to our profitability in recent years:•Our profitability improved in 2020 as compared to 2019 due to higher revenue and the effects of cost savings and efficiency initiatives we have undertaken in recent years, as well as from lower travel and marketing expenses in 2020 due to pandemic-related shutdowns and restrictions. In order to maintain our current levels of profitability, we will need to continue to undertake efforts intended to improve the efficiency of operations and ensure that our expense growth does not exceed our revenue growth.23Table of Contents•Network bandwidth costs represent a significant portion of our cost of revenue. Historically, we have been able to mitigate increases in these costs by reducing our network bandwidth costs per unit and investing in internal-use software development to improve the performance and efficiency of our network. Our total bandwidth costs may increase in the future as a result of expected higher traffic levels and serving more traffic from higher cost regions. We will need to continue to effectively manage our bandwidth costs to maintain current levels of profitability.•Co-location costs are also a significant portion of our cost of revenue. By improving our internal-use software and managing our hardware deployments to enable us to use servers more efficiently, we have been able to manage the growth of co-location costs. We expect to continue to scale our network in the future and will need to continue to effectively manage our co-location costs to maintain current levels of profitability.•We expect to continue to manage our headcount and payroll costs in the future to focus investments on certain areas of the business while maintaining efficient operations in others. We expect to continue to hire employees in support of our strategic initiatives but do not expect overall headcount to increase significantly in 2021.•Depreciation expense related to our network equipment also contributes to our overall expense levels. During the last three quarters of 2020, we accelerated our purchases of servers and other equipment used in our network to help meet the increased traffic demands arising during the COVID-19 pandemic and to make up for supply chain issues we experienced in the first quarter. We expect to see higher depreciation expense in 2021 to reflect the deployment of this equipment. We plan to continue to invest in our network in 2021, although not at the same levels we experienced in 2020, which will further increase our capital expenditures and resulting depreciation expense.We currently report our revenue by division, which is a customer-focused reporting view that reflects revenue from customers that are managed by the division. We report our revenue in two divisions: the Web Division and the Media and Carrier Division. As the purchasing patterns and required account expertise of customers change over time, we may reassign a customer from one division to another. In 2020, we reassigned some of our customers between the Media and Carrier Division and the Web Division and revised historical results in order to reflect the most recent categorization and to provide a comparable view for all periods presented.In March 2021, we will reorganize into two groups: the Edge Technology Group, or ETG, and the Security Technology Group, or STG. The reorganization will align leaders of the two groups around our product offerings, with support from a single global sales organization, and is intended to position us to become more agile in delivering our solutions. Beginning in 2021, we will report revenue from the STG (previously Cloud Security Solutions revenue) and the ETG (revenue from our remaining solutions), separately.Nearly all of our employees are working remotely due to the COVID-19 pandemic, and we are not requiring employees whose roles do not require in-person presence to perform their jobs to return to offices before January 1, 2022. We have implemented a comprehensive evaluation process to determine whether offices in different locations should be open or closed. Our operations have not been significantly disrupted by the shift to remote working. While we expect to incur expenses associated with enabling remote work and reconfiguring work spaces to help ensure the safety and well being of employees accessing our locations, we do not currently believe those costs will materially impact our financial condition or results of operations. 24Table of ContentsResults of OperationsThe following sets forth, as a percentage of revenue, consolidated statements of income data for the years indicated: 202020192018Revenue100.0 %100.0 %100.0 %Costs and operating expenses:Cost of revenue (exclusive of amortization of acquired intangible assets shown below)35.4 34.1 35.1 Research and development8.4 9.0 9.1 Sales and marketing16.0 18.1 19.1 General and administrative17.1 17.8 21.1 Amortization of acquired intangible assets1.3 1.3 1.2 Restructuring charge1.2 0.6 1.0 Total costs and operating expenses79.4 80.9 86.6 Income from operations20.6 19.1 13.4 Interest income0.9 1.2 1.0 Interest expense(2.2)(1.7)(1.6)Other expense, net(0.1)— (0.1)Income before provision for income taxes19.2 18.6 12.7 Provision for income taxes(1.4)(1.8)(1.6)Loss from equity method investment(0.4)— — Net income17.4 %16.8 %11.1 %RevenueRevenue during the periods presented is as follows (in thousands):For the Years Ended December 31,For the Years Ended December 31,20202019% Change% Change at Constant Currency20192018% Change% Change at Constant CurrencyWeb Division$1,666,305 $1,556,252 7.1 %7.2 %$1,556,252 $1,439,772 8.1 %9.4 %Media and Carrier Division1,531,844 1,337,365 14.5 14.5 1,337,365 1,274,702 4.9 6.1 Total revenue$3,198,149 $2,893,617 10.5 %10.6 %$2,893,617 $2,714,474 6.6 %7.8 %The increase in our revenue in 2020 as compared to 2019 was primarily the result of higher media traffic volumes due in part to behavioral changes prompted by the COVID-19 pandemic and continued strong growth in sales of our Cloud Security Solutions. Cloud Security Solutions revenue for the year ended December 31, 2020 was $1,061.6 million, compared to $848.7 million for the year ended December 31, 2019, which represents a 25.1% increase. The increase in our revenue in 2019 as compared to 2018 was primarily the result of higher media traffic volumes, including from our large internet platform customers, and continued strong growth in sales of our Cloud Security Solutions. Cloud Security Solutions revenue for the year ended December 31, 2019 was $848.7 million, compared to $658.7 million for the year ended December 31, 2018, which represents a 28.8% increase.25Table of ContentsThe increase in Web Division revenue for 2020 as compared to 2019, and 2019 as compared to 2018, was primarily the result of increased sales of both new and existing Cloud Security Solutions to this customer base. Customers that have been experiencing financial difficulties as a result of the COVID-19 pandemic, specifically those in the commerce, retail and travel and hospitality verticals, are primarily assigned to our Web Division. Accordingly, Web Division revenue was negatively impacted during 2020 as a result of this pandemic. It is difficult to predict the length of time and amount by which the Web Division will continue to be impacted by the pandemic given its uncertain nature.The increase in Media and Carrier Division revenue for 2020 as compared to 2019 was primarily the result of increased customer traffic volumes from video delivery, gaming and social media usage, due in part to behavioral changes tied to the COVID-19 and higher sales of Cloud Security Solutions. The increase in Media and Carrier Division revenue for 2019 as compared to 2018 was primarily the result of increased customer traffic volumes from video delivery and gaming customers and higher sales of Cloud Security Solutions.Revenue derived in the U.S. and internationally during the periods presented is as follows (in thousands):For the Years Ended December 31,For the Years Ended December 31,20202019% Change% Change at Constant Currency20192018% Change% Change at Constant CurrencyU.S.$1,777,435 $1,694,211 4.9 %4.9 %$1,694,211 $1,683,272 0.6 %0.6 %International1,420,714 1,199,406 18.4 18.5 1,199,406 1,031,202 16.3 19.6 Total revenue$3,198,149 $2,893,617 10.5 %10.6 %$2,893,617 $2,714,474 6.6 %7.8 %The U.S. revenue growth rate for 2020 was positively impacted by the increase in traffic on our network in 2020, including from our U.S.-based large internet platform customers. The U.S. revenue growth rate for 2019 was negatively impacted by a reduction in prices paid by some of our customers, partially offset by an increase in revenue from large internet platform companies, as these companies are based in the U.S.Internationally, during 2020 and 2019, we continued to see strong revenue growth from our operations in the Asia-Pacific region. Changes in foreign currency exchange rates negatively impacted our revenue by $1.2 million in 2020 as compared to 2019, and negatively impacted our revenue by $33.9 million in 2019 as compared to 2018.For the year ended December 31, 2020, approximately 44% of our revenue was derived from our operations located outside of the U.S., compared to 41% for the year ended December 31, 2019 and 38% for the year ended December 31, 2018. No single country outside of the U.S. accounted for 10% or more of revenue during any of these periods.26Table of ContentsCost of RevenueCost of revenue consisted of the following for the periods presented (in thousands): For the Years Ended December 31,For the Years Ended December 31, 20202019% Change20192018% ChangeBandwidth fees$200,167 $165,335 21.1 %$165,335 $154,853 6.8 %Co-location fees156,275 127,024 23.0 127,024 128,082 (0.8)Network build-out and supporting services134,952 101,135 33.4 101,135 88,543 14.2 Payroll and related costs262,972 248,146 6.0 248,146 238,920 3.9 Stock-based compensation, including amortization of prior capitalized amounts52,863 51,607 2.4 51,607 45,765 12.8 Depreciation of network equipment167,017 125,589 33.0 125,589 150,458 (16.5)Amortization of internal-use software158,426 168,788 (6.1)168,788 146,864 14.9 Total cost of revenue$1,132,672 $987,624 14.7 %$987,624 $953,485 3.6 %As a percentage of revenue35.4 %34.1 %34.1 %35.1 %The increase in total cost of revenue for 2020 as compared to 2019 was primarily due to increases in investments in our network to support current and anticipated future traffic growth, which resulted in increases to amounts paid for network build-out and supporting services, higher depreciation costs of our network equipment and higher expenses related to our co-location facilities. Bandwidth fees also increased during this period due to growth in the amount of traffic served on our network.The increase in total cost of revenue for 2019 as compared to 2018 was primarily due to increases in amortization of internal-use software as we continued to release internally-developed software onto our network related to new product launches and significant enhancements to our existing services, network build-out and supporting service costs due to investments in network expansion and bandwidth fees to support the increase in traffic served on our network. These increases were partially offset by lower depreciation expense of network equipment of $31.5 million for the year ended December 31, 2019, due to software and hardware initiatives we implemented to manage our global network more efficiently, resulting in an increase in the expected average useful lives of our network assets, primarily servers, from four to five years effective January 1, 2019.During 2021, we plan to continue to focus our efforts on managing our operating margins, including continuing to manage our bandwidth and co-location costs. We anticipate depreciation of network equipment to increase in 2021 due to increased investments in our network to address expected traffic increases.Research and Development ExpensesResearch and development expenses consisted of the following for the periods presented (in thousands):For the Years Ended December 31,For the Years Ended December 31, 20202019% Change20192018% ChangePayroll and related costs$410,568 $382,084 7.5 %$382,084 $365,713 4.5 %Stock-based compensation48,854 49,685 (1.7)49,685 44,034 12.8 Capitalized salaries and related costs(200,143)(183,282)9.2 (183,282)(174,373)5.1 Other expenses10,036 12,878 (22.1)12,878 10,791 19.3 Total research and development$269,315 $261,365 3.0 %$261,365 $246,165 6.2 %As a percentage of revenue8.4 %9.0 %9.0 %9.1 %The increases in research and development expenses for 2020 as compared to 2019 were due to growth in payroll and related costs as a result of merit increases and headcount growth to support investments in new product development and 27Table of Contentsnetwork scaling. These increases were partially offset by increases in capitalized salaries and related costs due to continued investment in internal-use software deployed on our network.The increases in research and development expenses for 2019 as compared to 2018 were due to increases in payroll and related costs, including stock-based compensation, as a result of headcount growth to support investments in new product development and network scaling, and as a result of employees joining us through acquisitions. These increases were partially offset by increases in capitalized salaries and related costs due to continued investment in internal-use software deployed on our network.Research and development costs are expensed as incurred, other than certain internal-use software development costs eligible for capitalization. Capitalized development costs consist of payroll and related costs for personnel and external consulting expenses involved in the development of internal-use software used to deliver our services and operate our network. For the years ended December 31, 2020, 2019 and 2018, we capitalized $35.7 million, $33.7 million and $31.9 million, respectively, of stock-based compensation. These capitalized internal-use software development costs are amortized to cost of revenue over their estimated useful lives, which is generally two years, but can be up to seven years based on the software developed and its expected useful life.We expect research and development costs to increase in 2021 as we plan to maintain our focus on innovation; however, we do not expect these costs to increase as a percentage of revenue as we continue to manage costs.Sales and Marketing ExpensesSales and marketing expenses consisted of the following for the periods presented (in thousands):For the Years Ended December 31,For the Years Ended December 31, 20202019% Change20192018% ChangePayroll and related costs$393,800 $382,570 2.9 %$382,570 $388,320 (1.5)%Stock-based compensation65,257 62,149 5.0 62,149 64,372 (3.5)Marketing programs and related costs39,272 52,787 (25.6)52,787 41,796 26.3 Other expenses12,076 26,377 (54.2)26,377 22,865 15.4 Total sales and marketing$510,405 $523,883 (2.6)%$523,883 $517,353 1.3 %As a percentage of revenue16.0 %18.1 %18.1 %19.1 %During much of 2020, restrictions associated with the COVID-19 pandemic have resulted in the cancellation or postponement of in-person marketing events and led to a decline in travel expenses such as airfare, lodging and other costs related to in-person customer events and meetings; as a result, we experienced a decrease in sales and marketing expenses in 2020 as compared to 2019.The increase in sales and marketing expenses for 2019 as compared to 2018 was primarily due to increased spending for marketing programs and other expenses, primarily for a customer conference that took place during 2019 that did not take place in 2018, partially offset by a decrease in payroll and related costs and stock-based compensation due to reduced headcount in the marketing organization.We expect the decreased level of marketing and travel related expenditures to continue into 2021 as we continue to be impacted by the COVID-19 pandemic. We also plan to continue to carefully manage costs in our efforts to refine and optimize our go-to-market efforts and manage operating margins.28Table of ContentsGeneral and Administrative ExpensesGeneral and administrative expenses consisted of the following for the periods presented (in thousands):For the Years Ended December 31,For the Years Ended December 31, 20202019% Change20192018% ChangePayroll and related costs$199,992 $194,232 3.0 %$194,232 $188,635 3.0 %Stock-based compensation58,470 52,826 10.7 52,826 53,514 (1.3)Depreciation and amortization82,862 78,587 5.4 78,587 80,014 (1.8)Facilities-related costs98,805 90,674 9.0 90,674 86,107 5.3 Provision for doubtful accounts2,881 1,924 49.7 1,924 2,672 (28.0)Acquisition-related costs5,579 1,920 190.6 1,920 2,868 (33.1)License of patent— (8,855)(100.0)(8,855)(17,146)(48.4)Legal and stockholder matter costs275 10,000 (97.3)10,000 23,091 (56.7)Endowment of Akamai Foundation20,000 — 100.0 — 50,000 (100.0)Professional fees and other expenses79,024 94,785 (16.6)94,785 104,312 (9.1)Total general and administrative$547,888 $516,093 6.2 %$516,093 $574,067 (10.1)%As a percentage of revenue17.1 %17.8 %17.8 %21.1 %The increase in general and administrative expenses for 2020 as compared to 2019 was primarily due to:•an endowment contribution to the Akamai Foundation in 2020, which did not occur in 2019, to support the Foundation's increased initiatives (for additional information see Note 21 to the consolidated financial statements included elsewhere in this annual report on Form 10-K);•expansion of company infrastructure throughout 2019, including moving into our new corporate headquarters in Cambridge, Massachusetts, which increased facilities-related costs and depreciation and amortization in 2020; and•a reduction to license patent fees as a result of our litigation with Limelight Networks, Inc., or Limelight, that did not recur in 2020.The 2020 increases in general and administrative expenses were also partially offset by a decrease in amounts paid to professional service providers for advisory services as well as a legal settlement charge in 2019.The decrease in general and administrative expenses in 2019 as compared to 2018 was primarily due to the 2018 contribution to the Akamai Foundation, a reduction in legal and stockholder matter costs and a decrease in other expenses due to a decrease in non-income tax reserves. These decreases were partially offset by cessation of payments to us under the terms of the litigation settlement agreement with Limelight.General and administrative expenses for 2020 and 2019 are broken out by category as follows (in thousands):For the Years Ended December 31,For the Years Ended December 31,20202019% Change20192018% ChangeGlobal functions$193,719$198,077 (2.2)%$198,077 $197,377 0.4 %As a percentage of revenue6.1 %6.8 %6.8 %7.3 %Infrastructure325,434307,500 5.8 307,500 308,915 (0.5)As a percentage of revenue10.2 %10.6 %10.6 %11.4 %Other28,73510,516 173.3 10,516 67,775 (84.5)Total general and administrative expenses$547,888 $516,093 6.2 %$516,093 $574,067 (10.1)%As a percentage of revenue17.1 %17.8 %17.8 %21.1 %Global functions expense includes payroll, stock-based compensation and other employee-related costs for administrative functions, including finance, purchasing, order entry, human resources, legal, information technology and executive personnel, as well as third-party professional service fees. Infrastructure expense includes payroll, stock-based compensation and other 29Table of Contentsemployee-related costs for our network infrastructure functions, as well as facility rent expense, depreciation and amortization of facility and IT-related assets, software and software-related costs, business insurance and taxes. Our network infrastructure function is responsible for network planning, sourcing, architecture evaluation and platform security. Other expense includes acquisition-related costs, provision for doubtful accounts, legal settlements, non-routine stockholder matter costs, the endowment contribution to the Akamai Foundation, transformation costs and the licensing of a patent.During 2021, we plan to continue to focus our efforts on managing our operating margins.Amortization of Acquired Intangible AssetsFor the Years Ended December 31,For the Years Ended December 31,(in thousands)20202019% Change20192018% ChangeAmortization of acquired intangible assets$42,049 $38,581 9.0 %$38,581 $33,311 15.8 %As a percentage of revenue1.3 %1.3 %1.3 %1.2 %The increase in amortization of acquired intangible assets in 2020 as compared to 2019, as well as 2019 as compared to 2018, was the result of amortization of assets related to our recent acquisitions. Based on acquired intangible assets as of December 31, 2020, future amortization is expected to be $47.4 million, $43.8 million, $36.3 million, $28.4 million and $22.9 million for the years ending December 31, 2021, 2022, 2023, 2024 and 2025, respectively. Restructuring ChargeFor the Years Ended December 31,For the Years Ended December 31,(in thousands)20202019% Change20192018% ChangeRestructuring charge$37,286 $17,153 117.4 %$17,153 $27,594 (37.8)%As a percentage of revenue1.2 %0.6 %0.6 %1.0 %The restructuring charge in 2020 was primarily the result of management actions initiated in the fourth quarter of 2020 to better position us to become more agile in delivering our solutions. The restructuring charge for this action relates to certain headcount reductions and software charges for software not yet placed into service that will not be implemented due to this action. Also included in 2020 is an $8.7 million impairment of lease related assets incurred to exit leased facilities related to the 2019 action.The restructuring charge in 2019 was primarily the result of management actions that focused on investments with the potential to accelerate revenue growth. The restructuring charge relates to certain headcount reductions and software charges for software not yet placed into service that will not be implemented due to this action.The restructuring charge in 2018 was primarily the result of management actions intended to re-balance investments to focus on long-term growth and scale. The restructuring charge relates to certain headcount reductions and software charges for software not yet placed into service that will not be implemented due to this action.In addition to the actions described above, we have also recognized restructuring charges for redundant employees, facilities and contracts associated with completed acquisitions.We expect to incur up to $7.0 million in 2021 for severance and related benefits related to the 2020 action. We do not expect to incur any material additional charges related to previously completed acquisitions.30Table of ContentsNon-Operating Income (Expense)For the Years Ended December 31,For the Years Ended December 31,(in thousands)20202019% Change20192018% ChangeInterest income$29,122 $34,355 (15.2)%$34,355 $26,940 27.5 %As a percentage of revenue0.9 %1.2 %1.2 %1.0 %Interest expense$(69,120)$(49,364)40.0 %$(49,364)$(43,202)14.3 %As a percentage of revenue(2.2)%(1.7)%(1.7)%(1.6)%Other expense, net$(2,454)$(1,428)71.8 %$(1,428)$(3,148)(54.6)%As a percentage of revenue(0.1)%— %— %(0.1)%For the periods presented, interest income primarily consists of interest earned on invested cash balances and marketable securities. The decrease to interest income in 2020 as compared to 2019 was primarily the result of investing in marketable securities having lower rates of return due to lower interest rates in 2020 as compared to 2019. The increase to interest income in 2019 as compared to 2018 was primarily the result of increased cash, cash equivalents and marketable securities balances as a result of our August 2019 issuance of $1,150.0 million in par value of convertible senior notes due 2027.Interest expense is related to our debt transactions, which are described in Note 11 to the consolidated financial statements included elsewhere in this annual report on Form 10-K. The increase to interest expense for 2020 as compared to 2019 was primarily due to the August 2019 issuance of $1,150.0 million in par value of convertible senior notes due 2027, or 2027 Notes, which bear regular interest of 0.375%, but have an effective interest rate of 3.1% due to the conversion feature. The increase to interest expense for 2019 as compared to 2018 was primarily due to the May 2018 issuance of $1,150.0 million in par value of convertible senior notes due 2025, which bear regular interest of 0.125%, but have an effective interest rate of 4.26% due to the conversion feature, and the issuance of the 2027 Notes.Other expense, net for the years ended December 31, 2020, 2019 and 2018 primarily represents net foreign exchange gains and losses mainly due to foreign currency exchange rate fluctuations on intercompany and other non-functional currency transactions. Other expense, net may fluctuate in the future based on changes in foreign currency exchange rates or other events. Other expense, net also includes a $7.2 million gain from the sale of an equity investment in 2020.Provision for Income TaxesFor the Years Ended December 31,For the Years Ended December 31,(in thousands)20202019% Change20192018% ChangeProvision for income taxes$45,922 $53,350 (13.9)%$53,350 $44,716 19.3 %As a percentage of revenue1.4 %1.8 %1.8 %1.6 %Effective income tax rate7.5 %10.0 %10.0 %13.0 %The decrease in the provision for income taxes for 2020 as compared to 2019 was mainly due to a decrease in intercompany sales of intellectual property, a decrease in the valuation allowance recorded against deferred tax assets related to state tax credits and an increase in foreign income taxed at lower rates. These amounts were partially offset by an increase in profit before tax and the release of certain tax reserves related to the expiration of local statues of limitations in 2019.The increase in the provision for income taxes for 2019 as compared to 2018 was mainly due to an increase in profit before taxes and an increase in the valuation allowance recorded against deferred tax assets related to state tax credits. These amounts were partially offset by the composition of income from foreign jurisdictions that is taxed at lower rates and the release of certain tax reserves related to the expiration of local statutes of limitations.For the year ended December 31, 2020, our effective income tax rate was lower than the federal statutory tax rate due to foreign income taxed at lower rates, the impact of the excess tax benefit related to stock-based compensation and the benefit of U.S. federal, state and foreign research and development credits. These amounts were partially offset by non-deductible stock-based compensation, state taxes and the valuation allowance recorded against tax credits and foreign net operating loss carryforwards.31Table of ContentsFor the year ended December 31, 2019, our effective income tax rate was lower than the federal statutory tax rate due to the release of certain tax reserves related to the expiration of local statutes of limitations, foreign income taxed at lower rates, the excess tax benefit related to stock-based compensation and the benefit of the U.S. federal, state and foreign research and development credits. These amounts were partially offset by the valuation allowance recorded against deferred tax assets related to state tax credits, non-deductible executive compensation, an intercompany sale of intellectual property and state income taxes.For the year ended December 31, 2018, our effective income tax rate was lower than the federal statutory tax rate due to foreign income taxed at lower rates, the excess tax benefit related to stock-based compensation, a decrease in the provisional amount of the one-time transition tax that was recorded in 2017, the release of certain tax reserves related to the expiration of local statutes of limitations and the benefit of U.S. federal, state and foreign research and development credits. These amounts were partially offset by an intercompany sale of intellectual property and state income taxes.Our effective income tax rate may fluctuate between fiscal years and from quarter to quarter due to items arising from discrete events, such as tax benefits from the disposition of employee equity awards, tax law changes and settlements of tax audits and assessments. Our effective income tax rate is also impacted by, and may fluctuate in any given period because of, the composition of income in foreign jurisdictions where tax rates differ depending on the local statutory rates.Refer to Note 19 to the consolidated financial statements included elsewhere in this annual report on Form 10-K for additional information regarding unrecognized tax benefits that, if recognized, would impact the effective income tax rate in the next 12 months and the potential impact that current litigation related to an adverse audit finding could have on our results of operations.Loss from Equity Method InvestmentFor the Years Ended December 31,For the Years Ended December 31,(in thousands)20202019% Change20192018% ChangeLoss from equity method investment$13,106 $1,096 1,095.8 %$1,096 $— 100.0 %As a percentage of revenue0.4 %— %— %— %During 2019, we began recognizing our share of earnings from our investment with Mitsubishi UFJ Financial Group in a joint venture, Global Open Network, Inc., or GO-NET. GO-NET intends to operate a new blockchain-based online payment network. For the year ended December 31, 2020, the losses recognized reflect our share of the losses incurred by GO-NET as well as an $11.0 million impairment charge to adjust our carrying value of our investment to fair value, due to a modified business plan and continued negative projected cash flows. We expect to record additional equity method losses in 2021 and beyond as GO-NET continues executing on the early stages of its business plan.Non-GAAP Financial MeasuresIn addition to providing financial measurements based on generally accepted accounting principles in the United States of America, or GAAP, we provide additional financial metrics that are not prepared in accordance with GAAP, or non-GAAP financial measures. Management uses non-GAAP financial measures, in addition to GAAP financial measures, to understand and compare operating results across accounting periods, for financial and operational decision making, for planning and forecasting purposes, to measure executive compensation and to evaluate our financial performance. These non-GAAP financial measures are non-GAAP income from operations, non-GAAP operating margin, non-GAAP net income, non-GAAP net income per share, Adjusted EBITDA, Adjusted EBITDA margin, capital expenditures and impact of foreign currency exchange rates, as discussed below.Management believes that these non-GAAP financial measures reflect our ongoing business in a manner that allows for meaningful comparisons and analysis of trends in the business, as they facilitate comparing financial results across accounting periods and to those of peer companies. Management also believes that these non-GAAP financial measures enable investors to evaluate our operating results and future prospects in the same manner as management. These non-GAAP financial measures may exclude expenses and gains that may be unusual in nature, infrequent or not reflective of our ongoing operating results.The non-GAAP financial measures do not replace the presentation of our GAAP financial measures and should only be used as a supplement to, not as a substitute for, our financial results presented in accordance with GAAP.32Table of ContentsThe non-GAAP adjustments, and our basis for excluding them from non-GAAP financial measures, are outlined below:•Amortization of acquired intangible assets – We have incurred amortization of intangible assets, included in our GAAP financial statements, related to various acquisitions we have made. The amount of an acquisition's purchase price allocated to intangible assets and term of its related amortization can vary significantly and are unique to each acquisition; therefore, we exclude amortization of acquired intangible assets from our non-GAAP financial measures to provide investors with a consistent basis for comparing pre- and post-acquisition operating results. •Stock-based compensation and amortization of capitalized stock-based compensation – Although stock-based compensation is an important aspect of the compensation paid to our employees, the grant date fair value varies based on the stock price at the time of grant, varying valuation methodologies, subjective assumptions and the variety of award types. This makes the comparison of our current financial results to previous and future periods difficult to interpret; therefore, we believe it is useful to exclude stock-based compensation and amortization of capitalized stock-based compensation from our non-GAAP financial measures in order to highlight the performance of our core business and to be consistent with the way many investors evaluate our performance and compare our operating results to peer companies. •Acquisition-related costs – Acquisition-related costs include transaction fees, advisory fees, due diligence costs and other direct costs associated with strategic activities. In addition, subsequent adjustments to our initial estimated amounts of contingent consideration and indemnification associated with specific acquisitions are included within acquisition-related costs. These amounts are impacted by the timing and size of the acquisitions. We exclude acquisition-related costs from our non-GAAP financial measures to provide a useful comparison of our operating results to prior periods and to our peer companies because such amounts vary significantly based on the magnitude of our acquisition transactions and do not reflect our core operations. •Restructuring charges – We have incurred restructuring charges that are included in our GAAP financial statements, primarily related to workforce reductions and estimated costs of exiting facility lease commitments. We exclude these items from our non-GAAP financial measures when evaluating our continuing business performance as such items vary significantly based on the magnitude of the restructuring action and do not reflect expected future operating expenses. In addition, these charges do not necessarily provide meaningful insight into the fundamentals of current or past operations of our business.•Amortization of debt discount and issuance costs and amortization of capitalized interest expense – In August 2019, we issued $1,150 million of convertible senior notes due 2027 with a coupon interest rate of 0.375%. In May 2018, we issued $1,150 million of convertible senior notes due 2025 with a coupon interest rate of 0.125%. In February 2014, we issued $690 million of convertible senior notes due 2019 with a coupon interest rate of 0%. The imputed interest rates of these convertible senior notes were 3.10%, 4.26% and 3.20%, respectively. This is a result of the debt discounts recorded for the conversion features that are required to be separately accounted for as equity under GAAP, thereby reducing the carrying values of the convertible debt instruments. The debt discounts are amortized as interest expense together with the issuance costs of the debt. The interest expense excluded from our non-GAAP results is comprised of these non-cash components and is excluded from management's assessment of our operating performance because management believes the non-cash expense is not representative of ongoing operating performance. •Gains and losses on investments – We have recorded gains and losses from the disposition, changes to fair value and impairment of certain investments. We believe excluding these amounts from our non-GAAP financial measures is useful to investors as the types of events giving rise to them are not representative of our core business operations and ongoing operating performance. •Legal and stockholder matter costs – We have incurred losses related to the settlement of legal matters and costs from professional service providers related to a non-routine stockholder matter. We believe excluding these amounts from our non-GAAP financial measures is useful to investors as the types of events giving rise to them are not representative of our core business operations. 33Table of Contents•Endowment of Akamai Foundation – We have incurred expenses to endow the Akamai Foundation, a private corporate foundation dedicated to encouraging the next generation of technology innovators by supporting math and science education. Our first endowment was in 2018 to enable a permanent endowment for the Akamai Foundation to allow it to expand its reach. In the fourth quarter of 2020 we supplemented the endowment to enable specific initiatives to increase diversity in the technology industry. We believe excluding these amounts from non-GAAP financial measures is useful to investors as these infrequent expenses are not representative of our core business operations. •Transformation costs – We have incurred professional services fees associated with internal changes that are designed to improve operating margins and that are part of a discrete planned transformation program intended to significantly change the manner in which business is conducted. We believe excluding these amounts from our non-GAAP financial measures is useful to investors as the types of events and activities giving rise to them occur infrequently and are not representative of our core business operations and ongoing operating performance. •Income and losses from equity method investment – We record income or losses on our share of earnings and losses from our equity method investment. We exclude such income and losses because we do not direct control over the operations of the investment and the related income and losses are not representative of our core business operations. •Income tax effect of non-GAAP adjustments and certain discrete tax items – The non-GAAP adjustments described above are reported on a pre-tax basis. The income tax effect of non-GAAP adjustments is the difference between GAAP and non-GAAP income tax expense. Non-GAAP income tax expense is computed on non-GAAP pre-tax income (GAAP pre-tax income adjusted for non-GAAP adjustments) and excludes certain discrete tax items (such as recording or releasing of valuation allowances), if any. We believe that applying the non-GAAP adjustments and their related income tax effect allows us to highlight income attributable to our core operations.34Table of ContentsThe following table reconciles GAAP income from operations to non-GAAP income from operations and non-GAAP operating margin for the years ended December 31, 2020, 2019 and 2018 (in thousands): 202020192018Income from operations$658,534 $548,918 362,499 Amortization of acquired intangible assets42,049 38,581 33,311 Stock-based compensation197,411 187,140 183,813 Amortization of capitalized stock-based compensation and capitalized interest expense33,202 34,438 28,603 Restructuring charge37,286 17,153 27,594 Acquisition-related costs5,579 1,920 2,868 Legal and stockholder matter costs275 10,000 23,091 Endowment of Akamai Foundation20,000 — 50,000 Transformation costs— 5,527 7,730 Non-GAAP income from operations$994,336 $843,677 $719,509 GAAP operating margin21 %19 %13 %Non-GAAP operating margin31 %29 %27 %The following table reconciles GAAP net income to non-GAAP net income for the years ended December 31, 2020, 2019 and 2018 (in thousands): 202020192018Net income$557,054 $478,035 $298,373 Amortization of acquired intangible assets42,049 38,581 33,311 Stock-based compensation197,411 187,140 183,813 Amortization of capitalized stock-based compensation and capitalized interest expense33,202 34,438 28,603 Restructuring charge37,286 17,153 27,594 Acquisition-related costs5,579 1,920 2,868 Legal and stockholder matter costs275 10,000 23,091 Endowment of Akamai Foundation20,000 — 50,000 Transformation costs— 5,527 7,730 Amortization of debt discount and issuance costs62,823 45,857 41,958 (Gain) loss on investments(7,228)60 1,481 Loss from equity method investment13,106 1,096 — Income tax effect of above non-GAAP adjustments and certain discrete tax items(103,280)(80,488)(86,391)Non-GAAP net income$858,277 $739,319 $612,431 35Table of ContentsThe following table reconciles GAAP net income per diluted share to non-GAAP net income per diluted share for the years ended December 31, 2020, 2019 and 2018 (shares in thousands): 202020192018GAAP net income per diluted share$3.37 $2.90 $1.76 Adjustments to net income:Amortization of acquired intangible assets0.25 0.23 0.20 Stock-based compensation1.19 1.14 1.09 Amortization of capitalized stock-based compensation and capitalized interest expense0.20 0.21 0.17 Restructuring charge0.23 0.10 0.16 Acquisition-related costs0.03 0.01 0.02 Legal and stockholder matter costs— 0.06 0.14 Endowment of Akamai Foundation0.12 — 0.30 Transformation costs— 0.03 0.05 Amortization of debt discount and issuance costs0.38 0.28 0.25 (Gain) loss on investments(0.04)— 0.01 Loss from equity method investment0.08 0.01 — Income tax effect of above non-GAAP adjustments and certain discrete tax items(0.63)(0.49)(0.51)Adjustment for shares (1)0.04 — — Non-GAAP net income per diluted share (2)$5.22 $4.49 $3.62 Shares used in GAAP diluted per share calculations165,213 164,573 169,188 Impact of benefit from note hedge transactions (1)(873)— — Shares used in non-GAAP diluted per share calculations (1)164,340 164,573 169,188 (1) Shares used in non-GAAP diluted per calculations have been adjusted for the year ended December 31, 2020, for the benefit of our note hedge transactions. During 2020, our average stock price was in excess of $95.10, which is the initial conversion price of our convertible senior notes due in 2025. See further discussion below.(2) May not foot due to rounding.Non-GAAP net income per diluted share is calculated as non-GAAP net income divided by diluted weighted average common shares outstanding. GAAP diluted weighted average common shares outstanding are adjusted in non-GAAP per share calculations for the shares that would be delivered to us pursuant to the note hedge transactions entered into in connection with the issuance of our convertible senior notes. Under GAAP, shares delivered under hedge transactions are not considered offsetting shares in the fully-diluted share calculation until they are delivered. However, we would receive a benefit from the note hedge transactions and would not allow the dilution to occur, so management believes that adjusting for this benefit provides a meaningful view of net income per share. Unless our weighted average stock price is greater than $95.10, the initial conversion price of the convertible senior notes due 2025, or $116.18, the initial conversion price of the convertible senior notes due 2027, there will be no difference between our GAAP and non-GAAP diluted weighted average common shares outstanding.We consider Adjusted EBITDA to be another important indicator of the operational strength and performance of our business and a good measure of our historical operating trends. Adjusted EBITDA eliminates items that we do not consider to be part of our core operations. We define Adjusted EBITDA as GAAP net income excluding the following items: interest income; income taxes; depreciation and amortization of tangible and intangible assets; stock-based compensation; amortization of capitalized stock-based compensation; acquisition-related costs; restructuring charges; gains and losses on legal settlements; costs from professional service providers related to a non-routine stockholder matter; costs incurred related to endowment contributions to the Akamai Foundation; transformation costs; foreign exchange gains and losses; interest expense; amortization of capitalized interest expense; certain gains and losses on investments; gains and losses from equity method investments; and other non-recurring or unusual items that may arise from time to time. Adjusted EBITDA margin represents Adjusted EBITDA stated as a percentage of revenue.36Table of ContentsThe following table reconciles GAAP net income to Adjusted EBITDA and Adjusted EBITDA margin for the years ended December 31, 2020, 2019 and 2018 (in thousands): 202020192018Net income$557,054 $478,035 $298,373 Amortization of acquired intangible assets42,049 38,581 33,311 Stock-based compensation197,411 187,140 183,813 Amortization of capitalized stock-based compensation and capitalized interest expense33,202 34,438 28,603 Restructuring charge37,286 17,153 27,594 Acquisition-related costs5,579 1,920 2,868 Legal and stockholder matter costs275 10,000 23,091 Interest income(29,122)(34,355)(26,940)Endowment of Akamai Foundation20,000 — 50,000 Transformation costs— 5,527 7,730 Amortization of debt discount and issuance costs69,120 49,364 43,202 Provision for income taxes45,922 53,350 44,716 Depreciation and amortization403,160 367,655 372,606 (Gain) loss on investments(7,228)60 1,481 Loss from equity method investment13,106 1,096 — Other expense, net9,682 1,368 1,667 Adjusted EBITDA$1,397,496 $1,211,332 $1,092,115 Adjusted EBITDA margin44 %42 %40 %Impact of Foreign Currency Exchange RatesRevenue and earnings from our international operations have historically been an important contributor to our financial results. Consequently, our financial results have been impacted, and management expects they will continue to be impacted, by fluctuations in foreign currency exchange rates. For example, when the local currencies of our foreign subsidiaries weaken, generally our consolidated results stated in U.S. dollars are negatively impacted.Because exchange rates are a meaningful factor in understanding period-to-period comparisons, management believes the presentation of the impact of foreign currency exchange rates on revenue and earnings enhances the understanding of our financial results and evaluation of performance in comparison to prior periods. The dollar impact of changes in foreign currency exchange rates presented is calculated by translating current period results using monthly average foreign currency exchange rates from the comparative period and comparing them to the reported amount. The percentage change at constant currency presented is calculated by comparing the prior period amounts as reported and the current period amounts translated using the same monthly average foreign currency exchange rates from the comparative period.Liquidity and Capital ResourcesTo date, we have financed our operations primarily through public and private sales of debt and equity securities and cash generated by operations. As of December 31, 2020, our cash, cash equivalents and marketable securities, which primarily consisted of corporate bonds and U.S. government agency obligations, totaled $2.5 billion. Factoring in our outstanding convertible senior notes of $2.3 billion, our net cash at December 31, 2020 was $196.9 million. We place our cash investments in instruments that meet high-quality credit standards, as specified in our investment policy. Our investment policy also limits the amount of our credit exposure to any one issue or issuer and seeks to manage these assets to achieve our goals of preserving principal and maintaining adequate liquidity at all times.Changes in cash, cash equivalents and marketable securities are dependent upon changes in, among other things, working capital items such as accounts receivable, deferred revenue, accounts payable and various accrued expenses, as well as changes in our capital and financial structure due to common stock repurchases, debt repurchases and issuances, purchases and sales of marketable securities and similar events. The events related to the COVID-19 pandemic have not had a material impact to our 37Table of Contentsliquidity in 2020; however, we continue to monitor our customer base, particularly those in industries most impacted by the pandemic, and their ability to pay us for our services or to pay us in a timely manner due to financial stresses the outbreak may have caused them. We believe that, particularly in situations like these, our strong balance sheet and cash position are important competitive differentiators that provide the financial stability and flexibility to enable us to continue to make investments at opportune times.As of December 31, 2020, we had cash and cash equivalents of $278.7 million held in accounts outside the U.S. The U.S. Tax Cuts and Jobs Act establishes a territorial tax system in the U.S., which provides companies with the potential ability to repatriate earnings with minimal U.S. federal income tax impact beginning in 2018. As a result, our liquidity is not materially impacted by the amount of cash and cash equivalents held in accounts outside the U.S.Cash Provided by Operating ActivitiesFor the Years Ended December 31,(in thousands)202020192018Net income$557,054 $478,035 $298,373 Non-cash reconciling items included in net income727,829 683,132 679,648 Changes in operating assets and liabilities(69,883)(102,863)30,306 Net cash flows provided by operating activities$1,215,000 $1,058,304 $1,008,327 The increase in cash provided by operating activities for 2020 as compared to 2019 was primarily due to increased profitability in 2020 and timing of vendor payments. The increase was partially offset by the timing of payments from customers.The increase in cash provided by operating activities for 2019 as compared to 2018 was primarily due to increased profitability in 2019, partially offset by the timing of cash collections from customers, an increase of $28.8 million in cash paid for income taxes and timing of collections and payments of other working capital items.Cash Used in Investing ActivitiesFor the Years Ended December 31,(in thousands)202020192018Cash paid for acquired businesses, net of cash acquired$(127,999)$(165,329)$(79)Cash paid for asset acquisition(36,376)— — Cash paid for equity method investment— (36,008)— Purchases of property and equipment and capitalization of internal-use software development costs(731,872)(562,077)(405,741)Net marketable securities activity(154,848)(904,919)(98,647)Other investing activities8,121 399 (2,066)Net cash used in investing activities$(1,042,974)$(1,667,934)$(506,533)The decrease in cash used in investing activities in 2020 as compared to 2019 was driven by a decrease in purchases of marketable securities. During 2019 we invested some of the proceeds from our August 2019 issuance of convertible senior notes in marketable securities, which increased our purchases in that year and did not recur in 2020. The decrease in cash used in investing activities in 2020 as compared to 2019 was partially offset by an increase in purchases of property and equipment during 2020 to support the increase in traffic we experienced on our network and expect to continue to experience in the future.The increase in cash used in investing activities in 2019 as compared to 2018 was primarily driven by an increase in purchases of marketable securities with the proceeds from our August 2019 issuance of convertible senior notes, cash paid for acquired companies in 2019, increased capital expenditures and cash invested in an equity method investment.38Table of ContentsCash (Used in) Provided by Financing ActivitiesFor the Years Ended December 31,(in thousands)202020192018Activity related to convertible senior notes$— $318,554 $990,390 Activity related to stock-based compensation(30,053)(18,154)(1,697)Repurchases of common stock(193,588)(334,519)(750,000)Other financing activities— (1,558)(5,085)Net cash (used in) provided by financing activities$(223,641)$(35,677)$233,608 The increase in cash used in financing activities in 2020 as compared to 2019 was due to the net proceeds received from our August 2019 issuance of our convertible senior notes and related bond hedge and warrant transaction. The increase was partially offset by the repayment of our convertible senior notes that were due in February 2019 and a decrease in shares repurchased under our repurchase programs.The change in net cash used in or provided by financing activities during 2019 as compared to 2018 was due to our repayment of $690 million of aggregate principal of convertible notes in 2019, partially offset by a decrease in shares repurchased under our repurchase programs.Effective November 2018, the board of directors authorized a $1.1 billion repurchase program through December 2021. Our goal for the share repurchase programs is to offset the dilution created by our employee equity compensation programs and provide the flexibility to return capital to shareholders as business and market conditions warrant. As of December 31, 2020, we have $571.9 million available for future purchases of shares under this repurchase program.During 2020, 2019 and 2018, we repurchased 2.0 million, 4.0 million and 10.2 million shares of our common stock, respectively, at an average price per share of $98.53, $82.90 and $73.54, respectively.Convertible Senior NotesIn August 2019, we issued $1,150.0 million in par value of convertible senior notes due 2027 and entered into related convertible note hedge and warrant transactions. We have used and expect to continue to use the net proceeds of the offering for share repurchases, working capital and general corporate purposes, including potential acquisitions and other strategic transactions.In May 2018, we issued $1,150.0 million in par value of convertible senior notes due 2025 and entered into related convertible note hedge and warrant transactions. We used a portion of the net proceeds to repay at maturity all of our $690.0 million outstanding aggregate principle amount of convertible senior notes due in 2019. In addition, we have used and expect to continue to use the remaining net proceeds of the offering for share repurchases, working capital and general corporate purposes, including potential acquisitions and other strategic transactions.In February 2014, we issued $690.0 million in par value of convertible senior notes due 2019 and entered into related convertible note hedge and warrant transactions. We repaid the full $690.0 million in principal amount of the notes in cash in February 2019, as the notes matured and no conversions occurred.The terms of the notes and the hedge and warrant transactions are discussed more fully in Note 11 to the consolidated financial statements included elsewhere in this annual report on Form 10-K. Revolving Credit FacilityIn May 2018, we entered into a $500.0 million, five-year revolving credit agreement, or the Credit Agreement. Borrowings under the facility may be used to finance working capital needs and for general corporate purposes. The facility provides for an initial $500.0 million in revolving loans. Under specified circumstances, the facility can be increased to up to $1.0 billion in aggregate principal amount.Borrowings under the Credit Agreement bear interest, at our option, at a base rate plus a spread of 0.00% to 0.25% or an adjusted LIBOR rate plus a spread of 0.875% to 1.25%, in each case with such spread being determined based on our 39Table of Contentsconsolidated leverage ratio specified in the Credit Agreement. Regardless of what amounts, if any, are outstanding under the Credit Agreement, we are also obligated to pay an ongoing commitment fee on undrawn amounts at a rate of 0.075% to 0.15%, with such rate being based on our consolidated leverage ratio specified in the Credit Agreement.The Credit Agreement contains customary representations and warranties, affirmative and negative covenants and events of default. Principal covenants include a maximum consolidated leverage ratio and a minimum consolidated interest coverage ratio. There were no outstanding borrowings under the Credit Agreement as of December 31, 2020. Liquidity OutlookBased on our present business plan, we expect our current cash, cash equivalents and marketable securities balances and our forecasted cash flows from operations to be sufficient to meet our foreseeable cash needs for at least the next 12 months. Our foreseeable cash needs, in addition to our recurring operating costs, include our expected capital expenditures, investments in information technology, opportunistic business acquisitions, anticipated share repurchases, lease and purchase commitments and settlements of other long-term liabilities.Contractual Obligations, Contingent Liabilities and Commercial CommitmentsThe following table presents our contractual obligations and commercial commitments, as of December 31, 2020, for the next five years and thereafter (in thousands): Payments Due by PeriodTotalLess than12 Months12 to 36Months36 to 60MonthsMore than60 MonthsOperating lease obligations: (1)Real estate arrangements$854,829 $80,787 $163,308 $137,176 $473,558 Co-location arrangements186,539 73,540 60,201 27,590 25,208 Bandwidth agreements119,495 95,923 23,232 240 100 Open vendor purchase orders266,644 231,059 31,654 3,931 — Convertible senior notes2,300,000 — — 1,150,000 1,150,000 Total contractual obligations$3,727,507 $481,309 $278,395 $1,318,937 $1,648,866 (1) Excludes $13.6 million of obligations for operating leases that have not yet commenced. See Note 12 to our consolidated financial statements included elsewhere in this annual report on Form 10-K for additional information.In accordance with the authoritative guidance for accounting for uncertainty in income taxes, as of December 31, 2020, we had unrecognized tax benefits of $29.5 million, including $7.7 million of accrued interest and penalties. We believe that it is reasonably possible that $9.6 million of our unrecognized tax benefits will be recognized by the end of 2021. The settlement period for the remaining amount of the unrecognized tax benefits is unknown.Letters of CreditAs of December 31, 2020, we had outstanding $5.8 million in irrevocable letters of credit issued by us in favor of third party beneficiaries, primarily related to facility leases. These irrevocable letters of credit, which are not included in the table of contractual obligations above, are unsecured and are expected to remain in effect, in some cases, until 2026. Off-Balance Sheet ArrangementsWe have entered into indemnification agreements with third parties, including vendors, customers, landlords, our officers and directors, shareholders of acquired companies, joint venture partners and third parties to which we license technology. Generally, these indemnification agreements require us to reimburse losses suffered by a third party due to various events, such as lawsuits arising from patent or copyright infringement or our negligence. These indemnification obligations are considered off-balance sheet arrangements in accordance with the authoritative guidance for guarantor’s accounting and disclosure requirements for guarantees, including indirect guarantees of indebtedness of others. See Note 13 to our consolidated financial statements included elsewhere in this annual report on Form 10-K for further discussion of these indemnification agreements. The fair value of guarantees issued or modified during 2020 and 2019 was determined to be immaterial.40Table of ContentsLegal MattersWe are party to litigation that we consider routine and incidental to our business. We do not currently expect the results of any of these litigation matters to have a material effect on our business, results of operations, financial condition or cash flows.Significant Accounting Policies and EstimatesSee Note 2 to the consolidated financial statements included elsewhere in this annual report on Form 10-K for information regarding recent and newly adopted accounting pronouncements. Application of Critical Accounting Policies and EstimatesOverviewOur MD&A is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, cash flow and related disclosure of contingent assets and liabilities. Our estimates include those related to revenue recognition, accounts receivable and related reserves, valuation and impairment of marketable securities, capitalized internal-use software development costs, goodwill and acquired intangible assets, income tax reserves, impairment and useful lives of long-lived assets and stock-based compensation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances at the time such estimates are made. Actual results may differ from these estimates. For a complete description of our significant accounting policies, see Note 2 to our consolidated financial statements included elsewhere in this annual report on Form 10-K.DefinitionsWe define our critical accounting policies as those policies that require us to make subjective estimates and judgments about matters that are uncertain and are likely to have a material impact on our consolidated financial statements. Our estimates are based upon assumptions and judgments about matters that are highly uncertain at the time an accounting estimate is made and applied and require us to assess a range of potential outcomes.Review of Critical Accounting Policies and EstimatesRevenue RecognitionOur contracts with customers sometimes include promises to transfer multiple services to a customer. Determining whether services are distinct performance obligations often requires the exercise of judgment by management. Advanced features that enhance a main product or service and are highly interrelated are generally not considered distinct; rather, they are combined with the service they relate to into one performance obligation. Different determinations related to combining services into performance obligations could result in differences in the timing and amount of revenue recognized in a period.Determination of the standalone selling price, or SSP, also requires the exercise of judgment by management. SSP is based on observable inputs such as the price we charge for the service when sold separately, or the discounted list price per management’s approved price list. In cases where services are not sold separately or price list rates are not available, a cost-plus-margin approach or adjusted market approach is used to determine SSP. Changes to SSP could result in differences in the allocation of transaction price among performance obligations, which could result in differences in the timing and amount of revenue recognized in a period.From time to time, we enter into contracts to sell services or license technology to unrelated enterprises at or about the same time that we enter into contracts to purchase products or services from the same enterprises. Consideration payable to a customer is reviewed as part of the transaction price. If the payment to the customer does not represent payment for a distinct service, revenue is recognized only up to the net amount of consideration after customer payment obligations are considered. Different determinations on whether a payment represents a distinct service could result in differences in the amount of revenue recognized.We may also resell the licenses or services of third parties. If we are acting as an agent in an arrangement with a customer to provide third party services, the transaction price reflects only the net amount to which we will be entitled, after accounting for payments made to the third party responsible for satisfying the performance obligation. Different determinations on whether we are acting as an agent or a principal could change the amount of revenue recognized.41Table of ContentsAccounts Receivable and Related ReservesTrade accounts receivable are recorded at the invoiced amounts and do not bear interest. In addition to trade accounts receivable, our accounts receivable balance includes unbilled accounts that represent revenue recorded for customers that is typically billed within one month. We record allowance against our accounts receivable balance, primarily for current expected credit losses. Increases and decreases in the allowance for current expected credit losses are included as a component of general and administrative expense in the consolidated statements of income.Estimates are used in determining our allowance for current expected credit losses using historical loss rates for the previous twelve months as well as expectations about the future where we have been able to develop forecasts to supports our estimates. In addition, the allowance for current expected credit losses considers outstanding balances on a customer-specific, account-by-account basis. We assess collectibility based upon a review of customer receivables from prior sales with collection issues where we no longer believe that the customer has the ability to pay for services previously provided. We also perform ongoing credit evaluations of our customers. If such an evaluation indicates that payment is no longer reasonably assured for services provided, any future services provided to that customer will result in the creation of a cash basis reserve until we receive consistent payments. Valuation and Impairment of Marketable SecuritiesWe measure the fair value of our financial assets and liabilities at the end of each reporting period. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. We have certain financial assets and liabilities recorded at fair value (principally cash equivalents and short- and long-term marketable securities) that have been classified as Level 1, 2 or 3 within the fair value hierarchy. Fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that we can access at the reporting date. Fair values determined by Level 2 inputs utilize data points other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Fair values determined by Level 3 inputs are based on unobservable data points for the asset or liability.Marketable securities are considered to be impaired when a decline in fair value below cost basis is determined to be other-than-temporary. We periodically evaluate whether a decline in fair value below cost basis is other-than-temporary by considering available evidence regarding these investments including, among other factors, the duration of the period that, and extent to which, the fair value is less than cost basis; the financial health of, and business outlook for, the issuer, including industry and sector performance and operational and financing cash flow factors; overall market conditions and trends; and our intent and ability to retain our investment in the security for a period of time sufficient to allow for an anticipated recovery in market value. Once a decline in fair value is determined to be other-than-temporary, a write-down is recorded and a new cost basis in the security is established. Assessing the above factors involves inherent uncertainty. Write-downs, if recorded, could be materially different from the actual market performance of marketable securities in our portfolio if, among other things, relevant information related to our investments and marketable securities was not publicly available or other factors not considered by us would have been relevant to the determination of impairment.Impairment and Useful Lives of Long-Lived AssetsWe review our long-lived assets, such as property and equipment and acquired intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Events that would trigger an impairment review include a change in the use of the asset or forecasted negative cash flows related to the asset. When such events occur, we compare the carrying amount of the asset to the undiscounted expected future cash flows related to the asset. If this comparison indicates that impairment is present, the amount of the impairment is calculated as the difference between the carrying amount and the fair value of the asset. If a readily determinable market price does not exist, fair value is estimated using discounted expected cash flows attributable to the asset. The estimates required to apply this accounting policy include forecasted usage of the long-lived assets, the useful lives of these assets and expected future cash flows. Changes in these estimates could materially impact results from operations.42Table of ContentsGoodwill and Acquired Intangible AssetsWe test goodwill for impairment on an annual basis, as of December 31, or more frequently if events or changes in circumstances indicate that the asset might be impaired. We have concluded that we have one reporting unit and that our chief operating decision maker is our chief executive officer and the executive management team. We have assigned the entire balance of goodwill to our one reporting unit. The fair value of the reporting unit was based on our market capitalization as of each of December 31, 2020 and 2019, and it was substantially in excess of the carrying value of the reporting unit at each date. Acquired intangible assets consist of completed technologies, customer relationships, trademarks and trade names, non-compete agreements and acquired license rights. We engaged third party valuation specialists to assist us with the initial measurement of the fair value of acquired intangible assets. Acquired intangible assets, other than goodwill, are amortized over their estimated useful lives based upon the estimated economic value derived from the related intangible assets.Income Taxes Our provision for income taxes is comprised of a current and a deferred portion. The current income tax provision is calculated as the estimated taxes payable or refundable on tax returns for the current year. The deferred income tax provision is calculated for the estimated future tax effects attributable to temporary differences and carryforwards by using expected tax rates in effect in the years during which the differences are expected to reverse or the carryforwards are expected to be realized.We currently have net deferred tax assets, comprised of net operating loss, or NOL, carryforwards, tax credit carryforwards and deductible temporary differences. Our management periodically weighs the positive and negative evidence to determine if it is more-likely-than-not that some or all of the deferred tax assets will be realized. In determining our net deferred tax assets and valuation allowances, annualized effective tax rates and cash paid for income taxes, management is required to make judgments and estimates about domestic and foreign profitability, the timing and extent of the utilization of NOL carryforwards, applicable tax rates, transfer pricing methodologies and tax planning strategies. Judgments and estimates related to our projections and assumptions are inherently uncertain; therefore, actual results could differ materially from our projections.We have recorded certain tax reserves to address potential exposures involving our income tax positions. These potential tax liabilities result from the varying application of statutes, rules, regulations and interpretations by different taxing jurisdictions. Our estimate of the value of our tax reserves contains assumptions based on past experiences and judgments about the interpretation of statutes, rules and regulations by taxing jurisdictions. It is possible that the costs of the ultimate tax liability or benefit from these matters may be more or less than the amount that we estimated.Uncertainty in income taxes is recognized in our consolidated financial statements using a two-step process to determine the amount of tax benefit to be recognized. First, the tax position must be evaluated to determine the likelihood that it will be sustained upon external examination. If the tax position is deemed more-likely-than-not to be sustained based on technical merit, the tax position is then assessed to determine the amount of benefit to recognize in the financial statements. The amount of the benefit that may be recognized is the largest amount that we believe has a greater than 50% likelihood of being realized upon ultimate settlement.Accounting for Stock-Based CompensationWe issue stock-based compensation awards including stock options, restricted stock units and deferred stock units. We measure the fair value of these awards at the grant date and recognize such fair value as expense over the vesting period. We have selected the Black-Scholes option pricing model to determine the fair value of stock option awards and the Monte Carlo simulation model to determine the fair value of market-based restricted stock unit awards. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating the expected life of the stock awards and the volatility of the underlying common stock. Our assumptions may differ from those used in prior periods. Changes to the assumptions may have a significant impact on the fair value of stock-based awards, which could have a material impact on our financial statements. Judgment is also required in estimating the number of stock-based awards that are expected to be forfeited. Should our actual forfeiture rates differ significantly from our estimates, our stock-based compensation expense and results of operations could be materially impacted. In addition, for awards that vest and become exercisable only upon achievement of specified performance conditions, we make judgments and estimates each quarter about the probability that such performance conditions will be met or achieved. Changes to the estimates we make from time to time may have a significant impact on our stock-based compensation expense and could materially impact our result of operations.43Table of ContentsCapitalized Internal-Use Software CostsWe capitalize salaries and related costs, including stock-based compensation, of employees and consultants who devote time to the development of internal-use software development projects, as well as interest expense related to our senior convertible notes. Capitalization begins during the application development stage, once the preliminary project stage has been completed. If a project constitutes an enhancement to previously-developed software, we assess whether the enhancement creates additional functionality to the software, thus qualifying the work incurred for capitalization. Once the project is available for general release, capitalization ceases and we estimate the useful life of the asset and begin amortization. We periodically assess whether triggering events are present to review internal-use software for impairment. Changes in our estimates related to internal-use software would increase or decrease operating expenses or amortization recorded during the period.Item 7A. Quantitative and Qualitative Disclosures About Market RiskInterest Rate Risk Our portfolio of cash equivalents and short- and long-term investments is maintained in a variety of securities, including U.S. government agency obligations, high-quality corporate debt securities, commercial paper, mutual funds, money market funds and municipal securities. The majority of our investments are classified as available-for-sale securities and carried at fair market value with cumulative unrealized gains or losses recorded as a component of accumulated other comprehensive loss within stockholders' equity. A sharp rise in interest rates could have an adverse impact on the fair market value of certain securities in our portfolio. We do not currently hedge our interest rate exposure and do not enter into financial instruments for trading or speculative purposes. Foreign Currency RiskGrowth in our international operations will incrementally increase our exposure to foreign currency fluctuations as well as other risks typical of international operations that could impact our business, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures and other regulations and restrictions.Transaction ExposureForeign exchange rate fluctuations may adversely impact our consolidated results of operations as exchange rate fluctuations on transactions denominated in currencies other than functional currencies result in gains and losses that are reflected in our consolidated statements of income. We enter into short-term foreign currency forward contracts to offset foreign exchange gains and losses generated by the re-measurement of certain assets and liabilities recorded in non-functional currencies. Changes in the fair value of these derivatives, as well as re-measurement gains and losses, are recognized in our consolidated statements of income within other expense, net. Foreign currency transaction gains and losses from these forward contracts were determined to be immaterial during the years ended December 31, 2020, 2019 and 2018. We do not enter into derivative financial instruments for trading or speculative purposes.Translation ExposureTo the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign currency-denominated transactions will result in increased revenue and operating expenses. Conversely, our revenue and operating expenses will decrease when the U.S. dollar strengthens against foreign currencies.Foreign exchange rate fluctuations may also adversely impact our consolidated financial condition as the assets and liabilities of our foreign operations are translated into U.S. dollars in preparing our consolidated balance sheet. These gains or losses are recorded as a component of accumulated other comprehensive loss within stockholders' equity.Credit RiskConcentrations of credit risk with respect to accounts receivable are limited to certain customers to which we make substantial sales. Our customer base consists of a large number of geographically dispersed customers diversified across numerous industries. We believe that our accounts receivable credit risk exposure is limited. As of December 31, 2020 and 2019, no customer had an accounts receivable balance of 10% or more of our accounts receivable. We believe that at December 31, 2020, the concentration of credit risk related to accounts receivable was insignificant.44Table of Contents

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+ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.A discussion regarding our financial condition and results of operations for fiscal 2020 compared to fiscal 2019 is presented under Results of Operations of this Form 10-K. Discussions regarding our financial condition and results of operations for fiscal 2019 compared to 2018 have been omitted from this Annual Report on Form 10-K, but can be found in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, filed with the SEC on February 28, 2020, which is available without charge on the SEC's website at www.sec.gov and on our investor relations website at investor.aligntech.com.OverviewOur purpose is to transform smiles and change lives, and we are accomplishing this goal by establishing clear aligners as the principal solution for the treatment of malocclusions and our Invisalign clear aligners as the treatment solution of choice by orthodontists, general dental practitioners and patients globally. To date, over 9.6 million people worldwide have been treated with our Invisalign System.To encourage consumers to treat malocclusions with clear aligners under the direction and supervision of licensed dental professionals, we have developed a business strategy designed to bring to market solutions that we believe strengthen our digital dental platform for doctors, labs and partners, including establishing the iTero intraoral scanner and related services as the preferred 3D digital scanning solution and integrating computer-aided design and computer-aided manufacturing (“CAD/CAM”) solutions and workflows into the markets for clear aligner orthodontics and dental restorative treatments. Our business strategic priorities are currently based on four principal pillars of growth: (i) International expansion; (ii) GP adoption; (iii) Patient demand & conversion; and (iv) Orthodontic utilization. For a further description of our strategic growth drivers, please see the Business - Business Strategy section of this Annual Report on Form 10-K.We strive to deliver on each of our strategic growth drivers through a variety of interrelated enterprise-wide efforts including:•New Technology, Products, and Feature Enhancements. We believe technological innovations allowing dental professionals to more quickly and accurately diagnose, plan and treat a wide range of cases from simple to complex combined with new and improved products drives greater treatment predictability, clinical applicability, ease of use and confidence for the dental professionals we serve; thereby supporting adoption of Invisalign treatment in their practices. Furthermore, we believe the digital revolution in dentistry is an important aspect of the experience for our customers and their patients, encouraging the utilization of our Invisalign solution and therefore comprising an important component of our digital approach.▪Invisalign clear aligners: Our product portfolio includes Invisalign treatment with Mandibular Advancement, Invisalign Go, Invisalign First and Invisalign Moderate. We also continue to increase the clinical efficacy and applicability of our products as exemplified most recently in the announcement of Invisalign G8 with SmartForce Aligner Activation, and our ClinCheck Pro 6.0 3D treatment planning software. Each of these advancements broadens and strengthens our reach into key markets and demographics central to our strategic plans.34▪iTero Scanner: We continue to expand our intraoral digital scanning solutions; periodically launching or announcing new offerings including most recently the iTero Element® Plus Series of scanner solutions and previously the iTero Element 2, iTero Element Flex and the iTero Element 5D Imaging System, for which we announced in March 2020 that we had obtained U.S. FDA 501(K) clearance and which we continue to release in additional countries. The clearance of the iTero Element 5D Imaging system in the U.S. markets and its release in other countries allows us to sell this first integrated dental imaging system that simultaneously records 3D, intra-oral color and near-infrared (“NIRI”) images into a single, integrated scan that enables comparison over time using the iTero TimeLapse technology; thereby improving doctor experiences and improving engagement opportunities and communications with their patients. The iTero Element 5D aids in the detection and monitoring of interproximal caries lesions above the gingiva without using harmful radiation.•exocad: On April 1, 2020, we completed the acquisition of privately-held exocad Global Holdings GmbH (“exocad”), a German dental CAD/CAM software company that offers fully integrated workflows to dental labs and practices. We believe the acquisition strengthens our digital platform by adding exocad’s expertise in restorative dentistry, implantology, guided surgery, and smile design to extend our digital dental solutions and broadens the Align digital platform towards fully interdisciplinary end-to-end workflows dentistry in lab and at chairside. exocad also broadens our reach in digital dentistry with over 200 partners and more than 40,000 licenses installed worldwide. To further the transformation of dental and orthodontic practices from outdated manual and analog practices to end-to-end digital workflows, in 2020 we introduced virtual solutions such as Invisalign® Virtual Appointment and Invisalign® Virtual Care; solutions that facilitate the safe, effective and successful continuity of treatment of patients by conveniently connecting doctors and their patients throughout their treatment plans.•Invisalign Adoption. Our goal is to establish Invisalign clear aligners as the treatment of choice for treating malocclusion, ultimately driving increased product adoption and frequency of use by dental professionals, which we refer to as “utilization rates.”•For the fourth quarter of 2020, total Invisalign cases submitted with a digital scanner in the Americas increased to 84.0%, up from 79.5% in the fourth quarter of 2019 and international scans increased to 73.7%, up from 64.7% in the fourth quarter of 2019. For the fourth quarter of 2020, 94.8% of Invisalign cases submitted by North American orthodontists were submitted digitally. Our annual utilization rates for the last three fiscal years are as follows:* Invisalign utilization rates are calculated by dividing the number of cases shipped by the number of doctors to whom cases were shipped. Our International region includes Europe, Middle East and Africa (“EMEA”) and Asia Pacific (“APAC”). Latin America (“LATAM”) is excluded from the above chart based on its immateriality. 35•Total utilization rate in 2020 increased to 16.1 cases per doctor compared to 15.9 cases per doctor in 2019 and 15.7 cases per doctor in 2018. •North America: Utilization rate among our North American orthodontist customers increased to 67.3 cases per doctor in 2020 compared to 65.0 cases per doctor in 2019 and 56.7 cases per doctor in 2018 and the utilization rate among our North American GP customers increased to 9.6 cases per doctor in 2020 compared to 9.5 cases per doctor in 2019 and 9.1 cases per doctor in 2018. •International: International doctor utilization rate was 14.5 cases per doctor in 2020 compared to 13.8 cases in 2019 and 13.9 cases per doctor in 2018. We expect global utilization rates to steadily improve as doctors’ clinical confidence in the use of Invisalign clear aligners increases with advancements in products and technology and as patient and doctor demands for treatments that emphasize convenience and safety through fewer in office visits and less invasive and quicker treatments rise. In addition, the teenage and younger market makes up 75% of the approximately 15 million total orthodontic case starts each year, and as we continue to drive adoption by teenage and younger patients through sales and marketing programs, we expect utilization rates to improve. However, our utilization rates will fluctuate from period to period due to a variety of factors, which may include seasonal trends in our business, COVID-19-related preventative measures and adoption rates for new products and features.•Invisalign Doctor Training. We believe our training and education efforts are an important aspect of each of our strategic growth drivers and, accordingly, we continue to expand our Invisalign customer base through the training of new doctors. During 2020, we trained 21,100 new Invisalign doctors of which 9,075 were trained in the Americas region and 12,025 in the International region. In 2019, we trained a total of 22,275 new Invisalign doctors, of which 9,765 were trained in the Americas region and 12,510 in the International region. •International Invisalign Growth. Our future growth is dependent upon the continued penetration and expansion of Invisalign product usage in international markets. Accordingly, we continue to focus our efforts towards increasing Invisalign clear aligner adoption by dental professionals internationally. In 2020, the COVID-19 pandemic caused unprecedented disruptions in our business as we, our customers, and suppliers experienced varying degrees of business and facilities closures and restrictions at various times that differed by geography and conditions and significant uncertainties remain. For a further discussion of COVID-19 and its impact on our business, see the section entitled "COVID-19 Update" below. Moreover, even under ideal circumstances the difficulties and intricacies of international sales and operations can be difficult to manage and we expect to periodically experience fluctuations in growth rates in emerging markets for reasons ranging from regional and macroeconomic conditions, geopolitical tensions and competition among others. For a description of the risks related our international growth efforts, please see the Risk Factors section of this Annual Report on Form 10-K. For instance, prior to the impact of COVID-19, we experienced slower growth rates than prior periods in China which we believe were primarily due to the U.S.-China trade war and resulting economic uncertainty which caused headwind for consumer demand especially for consumption of luxury goods and considered purchases. We also believe there has been increased competitive activity in China from clear aligner suppliers. Notwithstanding these uncertainties, we continue to see growth opportunities with international orthodontists and GP customers, particularly with adopters of digital dentistry platforms and as we continue to segment our sales and marketing resources and programs specifically around each customer channel. Furthermore, we continue to expand in our existing markets through targeted investments in sales coverage and professional marketing and education programs, along with consumer marketing in select country markets. For instance, we increased our sales presence in APAC in the first half of 2020 and will continue to strategically invest in regions as we deem appropriate for long-term success. We also intend to continue expanding our manufacturing and treatment planning operations to meet local and regional demand. Overall, we expect International revenues to grow at a faster rate than Americas' revenues for the foreseeable future due to our continued investment in international market expansion, the size of the market opportunities and our relatively low market penetration of these regions.•Increasing Competition. Our primary competition for the sale of our clear aligners remains traditional wires and brackets although the number of clear aligner competitors, primarily targeting the young adult demographic, continues to increase. We also have competitors in the markets for other products and services, including intraoral scanners and CAD/CAM software. We believe our continued investments in product improvements and operational efficiencies make our products more compelling for our customers and their patients and we intend to maintain these efforts. Additionally, we believe that well-designed, targeted sales and marketing promotions help us build on our strong brand awareness and differentiate us from traditional and emerging competitors. Accordingly, we continue to increase investments intended to grow consumer demand. During 2020, our marketing and consumer engagement included 36social media campaigns targeting teens and mothers through social media influencers, becoming the Official Clear Aligner Sponsor of the National Football League and introducing Invisalign Stickables which patients can apply to their aligners as a fun and simple way to distinguish themselves and our products from the competition. We expect to make further investments to create additional demand for Invisalign System treatment; driving more consumers to dental professionals for those treatments.We also believe that investing in our sales teams is important to our success. The addition of sales representatives in APAC in 2020 follows increases in the U.S. in 2019. We believe the realignment of our sales teams to focus on the channels they serve, allows us to partner with doctors in more meaningful ways; assessing their specific needs and helping to tailor their practices for success while encouraging increased adoption and engagement of a variety of our products and services.COVID-19 UpdateThe COVID-19 pandemic disrupted our business and the businesses and lives of our customers, their patients and our suppliers in unprecedented ways; requiring us to reevaluate priorities, adapt to new ways of doing business and developing new strategies and plans quickly and revising them frequently as conditions evolved. By the end of the fourth quarter of 2020, many dental practices had resumed operations although often at capacities less than pre-pandemic levels. Additionally, in virtually all practices the effects of COVID-19 persist, typically in the form of additional preventative safety measures such as added sterilization requirements, increased costs for personal protective equipment and staggered patient visits intended to reduce the risks of cross contamination, each of which contribute to fewer patient visits per day.To help doctors through the pandemic and to stimulate demand for our products and services during the recovery, we modified existing programs and implemented new promotions in 2020, some of which remain in effect. For instance, we did not implement annual price increases on our various clear aligner products in 2020, offered promotions to encourage doctors with patients in wires and brackets to switch to our Invisalign clear aligners, allowed doctors to maintain their promotional status levels notwithstanding declining sales, increased advertising and launched new media campaigns, implemented new promotions and modified others, all in an effort to help our customers and accelerate our mutual return to normal operations. As a result of these efforts, during the year ended December 31, 2020, we recorded net revenues of $2.5 billion, an increase of 2.7% compared to the same period in 2019. During the year ended December 31, 2020, clear aligner case volume was 1.6 million, an increase of 7.0% compared to the same period in 2019 and Systems and Services net revenues decreased by 2.8% compared to the same period in 2019.In the short term, our business remains susceptible to the COVID-19 pandemic. Concerns about additional outbreaks of the virus, the spread of new variants of the virus and the efficacy of vaccines against those variants, and efforts to slow or prevent a recurrence of its spread are likely to continue causing disruption and uncertainties in the markets, adversely impacting our customers and their patients for an indeterminate period of time. This in turn could impact our operations as purchasing decisions are delayed or lost, create logistics complexities related to uneven or rapid changes in demand, and sales and marketing efforts are postponed or prove ineffective. Conversely, we believe the pandemic emphasizes the benefits of digital dentistry and virtual appointments over traditional practice methods that require frequent in office patient visits to manually adjust wires and brackets. We further believe that this will in turn motivate doctors to use more digital solutions, including our iTero scanner, exocad CAD/CAM software and the Invisalign System.As we assess the possible future short- and long-term impacts to our revenues, operations and financial condition from the COVID-19 pandemic, we are continually evaluating macroeconomic as well as industry-specific factors. For instance, among the many factors we continue to monitor are governmental and societal reactions to the virus, global and regional economic activity, unemployment and its potential impact on discretionary spending and health insurance coverage, patient reluctance or fear of exposure as a result of orthodontic or dental office visits, travel restrictions on employees, suppliers, customers and their patients and other external factors beyond our control. Furthermore, if the threat of further spread of COVID-19 occurs or the pace of recovery by dental practices is haphazard or inconsistent, there may be a substantial impact on our employees or suppliers, our operations, including our ability to timely obtain the materials needed to manufacture our products and manufacture and deliver those products to customers; any of which may harm our results of operations, financial condition and overall financial performance. Moreover, many of the measures we implemented to protect our employees from the spread of the virus remain in effect. For instance, many of our offices across the globe remain underutilized as employees continue to work from home. We are also screening our employees, providing them with personal protective equipment, and altering work environments to facilitate social distancing, which has in the past and may in the future harm productivity. Furthermore, if our employees or their families are sickened by COVID-19, our ability to respond or mitigate the impact of COVID-19 may be adversely impacted.37Ultimately, we believe the markets we serve will continue to recover from the COVID-19 preventative measures at differing rates and times corresponding with regional outbreaks and recoveries. Should any one or more events or circumstances previously mentioned or others occur or materially adversely increase or other unknown circumstances arise, they could materially impact our business and results of operations in 2021 and beyond.Further discussion of the impact of the COVID-19 pandemic on our business may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.”2021 ExpensesOverall, we expect expenses in 2021 to increase over 2020 levels; however, as a result of the financial impacts of COVID-19, we expect to continue controlling our discretionary spending, such as travel and meeting related expenses, and focus investments in the following key areas:▪Manufacturing capacity and facilities to enhance our regional capabilities;▪Sales and marketing, including additional direct sales force personnel and consumer marketing; and▪Product and technology innovation to enhance product efficiency and operational productivity.We believe these investments position us to take advantage of a recovering market and thereafter once markets return to greater normalcy, increasing our revenues and growing our market share over the long term, but they could negatively impact our results of operations, particularly in the near term.Relocating HeadquartersEffective January 1, 2021, we moved our corporate headquarters from San Jose, California to Tempe, Arizona which offers a favorable corporate operating environment along with long-term operating efficiencies. The San Jose office will remain our hub for global innovation, product, and market organization and home to our new Digital Innovation Center. There were no layoffs associated with this move. Results of OperationsNet Revenues by Reportable Segment We group our operations into two reportable segments: Clear Aligner segment and Imaging Systems and CAD/CAM Services (“Systems and Services”) segment.•Our Clear Aligner segment consists of Comprehensive Products, Non-Comprehensive Products and Non-Case revenues as defined below:•Comprehensive Products include, but are not limited to, Invisalign Comprehensive and Invisalign First. •Non-Comprehensive Products include, but are not limited to, Invisalign Moderate, Lite and Express packages and Invisalign Go. •Non-Case includes, but is not limited to, Vivera retainers along with our training and ancillary products for treating malocclusion. •Our Systems and Services segment consists of our iTero intraoral scanning systems, which includes a single hardware platform and restorative or orthodontic software options, OrthoCAD services and ancillary products, as well as exocad’s CAD/CAM software solution that integrates workflows to dental labs and dental practices.38Net revenues for our Clear Aligner and Systems and Services segments by region for the year ended December 31, 2020, 2019 and 2018 are as follows (in millions): Year Ended December 31,Year Ended December 31,Net Revenues20202019Change20192018ChangeClear Aligner revenues: Americas$1,010.2 $1,022.1 $(11.9)(1.2)%$1,022.1 $903.3 $118.8 13.2 % International965.4 881.4 84.1 9.5 %881.4 684.2 197.2 28.8 % Non-case 125.8 122.3 3.5 2.9 %122.3 104.0 18.3 17.6 %Total Clear Aligner net revenues $2,101.5 $2,025.8 $75.7 3.7 %$2,025.8 $1,691.5 $334.3 19.8 %Systems and Services net revenues370.5 381.0 (10.6)(2.8)%381.0 275.0 106.0 38.5 %Total net revenues$2,471.9 $2,406.8 $65.1 2.7 %$2,406.8 $1,966.5 $440.3 22.4 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Clear Aligner Case Volume by RegionCase volume data which represents Clear Aligner case shipments by region for the year ended December 31, 2020, 2019 and 2018 is as follows (in thousands): Year Ended December 31,Year Ended December 31,Region 20202019Change20192018Change Americas 886.5 867.3 19.2 2.2 %867.3 780.7 86.6 11.1 % International 758.9 669.8 89.0 13.3 %669.8 499.9 169.9 34.0 %Total case volume1,645.3 1,537.1 108.3 7.0 %1,537.1 1,280.6 256.5 20.0 % Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Total net revenues increased by $65.1 million in 2020 as compared to 2019 primarily as a result of higher Clear Aligner volumes in the International region partially offset by lower average selling prices (“ASP”) in the Americas region and lower Systems and Services net revenues in most regions. Clear Aligner - AmericasAmericas net revenues decreased by $11.9 million in 2020 as compared to 2019 primarily due to lower Clear Aligner ASP that decreased net revenues by $34.6 million. The lower ASP was as a result of higher promotional discounts which reduced net revenues by $44.6 million and unfavorable foreign exchange rates reduced net revenues by $15.2 million; however, these were partially offset by July 2019 price increases which contributed $23.3 million to net revenues. The reduction in net revenues due to lower ASP was partially offset by higher Clear Aligner volume which increased net revenues by $16.1 million.Clear Aligner - InternationalInternational net revenues increased by $84.1 million in 2020 as compared to 2019 primarily due to higher Clear Aligner volume which increased net revenues by $117.2 million partially offset by lower ASP which reduced net revenues by $33.1 million. Lower ASP was the result of higher promotional discounts that reduced net revenues by $44.3 million, higher net deferrals that reduced net revenues by $19.3 million and a product mix shift towards lower priced products. These reductions were partially offset by July 2019 price increases across most products along with a benefit from going direct in several additional countries and therefore we now recognize direct sales at full ASP rather than the discounted distributor ASP which combined, increased net revenues by $20.9 million and favorable foreign exchange rates increased net revenues by $14.5 million.Clear Aligner - Non-CaseNon-case net revenues increased by $3.5 million in 2020 compared to 2019 due to increased Vivera volume across all regions. 39Systems and ServicesSystems and services net revenues decreased by $10.6 million in 2020 as compared to 2019 due to a lower number of scanners recognized which decreased net revenues by $31.7 million and a lower scanner ASP which decreased net revenues by $21.2 million. The ASP decrease was mostly due to higher promotional discounts partially offset by product mix shift to higher priced scanners. These decreases were partially offset by higher iTero service revenues mostly due to a larger scanner install base and the addition of exocad’s CAD/CAM revenues from our acquisition which combined increased net revenues by $42.3 million.Cost of net revenues and gross profit (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeClear AlignerCost of net revenues$569.3 $526.0 $43.3 $526.0 $411.0 $115.0 % of net segment revenues27.1 %26.0 %26.0 %24.3 %Gross profit$1,532.1 $1,499.7 $32.4 $1,499.7 $1,280.5 $219.2 Gross margin %72.9 %74.0 %74.0 %75.7 %Systems and ServicesCost of net revenues$139.4 $136.9 $2.5 $136.9 $107.7 $29.2 % of net segment revenues37.6 %35.9 %35.9 %39.1 %Gross profit$231.1 $244.2 $(13.1)$244.2 $167.4 $76.8 Gross margin %62.4 %64.1 %64.1 %60.9 %Total cost of net revenues$708.7 $662.9 $45.8 $662.9 $518.6 $144.3 % of net revenues28.7 %27.5 %27.5 %26.4 %Gross profit$1,763.2 $1,743.9 $19.3 $1,743.9 $1,447.9 $296.0 Gross margin %71.3 %72.5 %72.5 %73.6 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Cost of net revenues includes personnel-related costs including payroll and stock-based compensation for staff involved in the production process, the cost of materials, packaging, shipping costs, depreciation on capital equipment and facilities used in the production process, amortization of acquired intangible assets and training costs.Clear AlignerThe gross margin percentage decreased in 2020 compared to 2019 primarily due to lower ASP, higher manufacturing spend partially driven by operational expansion activities and an increase in aligners per case driven by additional aligners which was offset in part by manufacturing efficiencies.Systems and ServicesThe gross margin percentage decreased in 2020 compared to 2019 primarily driven by lower ASP and manufacturing inefficiencies due to lower volumes which was offset in part by higher service revenues. Selling, general and administrative (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeSelling, general and administrative$1,200.8 $1,072.1 $128.7 $1,072.1 $852.4 $219.7 % of net revenues48.6 %44.5 %44.5 %43.3 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Selling, general and administrative expense includes personnel-related costs including payroll, stock-based compensation and commissions for our sales force, marketing and advertising expenses including media, clinical education, trade shows and 40industry events, legal and outside service costs, equipment and maintenance costs, depreciation and amortization expense and allocations of corporate overhead expenses including facilities and Information Technology (“IT”).Selling, general and administrative expense increased in 2020 compared to 2019 primarily due to higher compensation related costs of $86.5 million mainly from an approximate 21% increase in headcount resulting in higher salaries expense, fringe benefits, commissions and stock-based compensation partially offset by lower incentive bonuses. Additionally, we also incurred higher expenses on equipment, software and maintenance costs of $30.3 million, advertising and marketing costs of $24.2 million and legal and outside service costs of $19.1 million which included transaction costs related to our acquisition of exocad. These increases were partially offset by a decrease in travel related costs of $26.7 million due to the impact of COVID-19.Research and development (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeResearch and development$175.3 $157.4 $17.9 $157.4 $128.9 $28.5 % of net revenues7.1 %6.5 %6.5 %6.6 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Research and development expense includes the personnel-related costs including payroll and stock-based compensation, equipment, material and maintenance costs, outside consulting expenses associated with the research and development of new products and enhancements to existing products, depreciation and amortization expense and allocations of corporate overhead expenses including facilities and IT.Research and development expense increased in 2020 compared to 2019 primarily due to higher compensation, equipment and material costs. Higher compensation costs, including fringe benefits and stock-based compensation, was mainly from an approximate 27% increase in headcount which was partially offset by lower incentive bonuses as well as a decrease in travel related costs due to the impact of COVID-19.Impairments and other charges (gains), net (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeImpairments and other charges (gains), net$— $23.0 $(23.0)$23.0 $— $23.0 % of net revenues— %1.0 %1.0 %— %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.In 2019, we recorded impairments and other charges (gains), net of $23.0 million which are comprised of operating lease right-of-use assets impairments of $14.2 million, store leasehold improvement and other fixed asset impairments of $14.3 million, and employee severance and other expenses of $1.3 million, partially offset by the Invisalign store lease termination gains of $6.8 million (Refer to Note 9“Impairments and Other Charges (Gains), net” for more information).Litigation settlement gain (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeLitigation settlement gain$— $(51.0)$51.0 $(51.0)$— $(51.0)% of net revenues— %(2.1)%(2.1)%— %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.In 2019, we recorded a gain of $51.0 million due to the litigation settlement with Straumann Group.41Income from operations (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeClear AlignerIncome from operations$768.0 $836.0 $(67.9)$836.0 $712.4 $123.6 Operating margin %36.5 %41.3 %41.3 %42.1 %Systems and ServicesIncome from operations$96.1 $137.7 $(41.7)$137.7 $99.0 $38.7 Operating margin %25.9 %36.1 %36.1 %36.0 %Total income from operations 1$387.2 $542.5 $(155.3)$542.5 $466.6 $75.9 Operating margin %15.7 %22.5 %22.5 %23.7 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.1 Refer to Note 18 “Segments and Geographical Information” of the Notes to Consolidated Financial Statements for details on unallocated corporate expenses and the reconciliation to Consolidated Income from OperationsClear AlignerOperating margin percentage decreased in 2020 compared to 2019 primarily due to a $51.0 million gain recognized from the litigation settlement with Straumann during 2019 as well as a lower gross margin. These decreases were offset in part by a net impairment charge of $23.0 million recognized in 2019 related to the Invisalign store closures.Systems and ServicesOperating margin percentage decreased in 2020 compared to 2019 primarily due to higher operating expenses, primarily from compensation, material, equipment, software and maintenance costs, in addition to a lower gross margin. Interest income (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeInterest income$3.1 $12.5 $(9.4)$12.5 $8.6 $3.9 % of net revenues0.1 %0.5 %0.5 %0.4 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Interest income includes interest earned on cash, cash equivalents, investment balances and our unsecured promissory note.Interest income decreased in 2020 compared to 2019 mainly due to the divestiture of our marketable securities portfolio during the first quarter of 2020 and lower interest rates earned on our cash and cash equivalents.Other income (expense), net (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeOther income (expense), net$(11.3)$7.7 $(19.0)$7.7 $(8.5)$16.2 % of net revenues(0.5)%0.3 %0.3 %(0.4)%Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Other income (expense), net, includes foreign exchange gains and losses, gains and losses on foreign currency forward contracts, interest expense, gains and losses on equity investments and other miscellaneous charges.Other income (expense), net, decreased in 2020 compared to 2019 primarily due to a $15.8 million gain from the sale of our investment in SDC recorded in 2019 and a $10.2 million loss on a foreign currency forward contract related to the exocad 42acquisition recorded in 2020. These decreases were partially offset by net foreign exchange gains in 2020 as compared to net foreign exchange losses in 2019.Equity in losses of investee, net of tax (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeEquity in losses of investee, net of tax$— $7.5 $(7.5)$7.5 $8.7 $(1.2)% of net revenues— %0.3 %0.3 %0.4 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.For 2020, there were no equity in losses of investee, net of tax. After the second quarter of 2019, we no longer incurred equity in losses of investee, net of tax related to SDC as we tendered our SDC equity interest on April 3, 2019 (Refer to Note 7 “Equity Method Investments” of the Notes to Consolidated Financial Statements for details on equity method investments).Provision for (benefit from) income taxes (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeProvision for (benefit from) income taxes$(1,396.9)$112.3 $(1,509.3)$112.3 $57.7 $54.6 Effective tax rates(368.6)%20.0 %20.0 %12.4 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.During 2020, we completed an intra-entity transfer of certain intellectual property rights and fixed assets to our Swiss subsidiary, where our EMEA regional headquarters is located beginning January 1, 2020. The transfer of intellectual property rights did not result in a taxable gain; however, it did result in a step-up of the Swiss tax deductible basis in the transferred assets, and accordingly, created a temporary difference between the book basis and the tax basis of such intellectual property rights. Consequently, this transaction resulted in the recognition of a deferred tax asset and related one-time tax benefit of approximately $1,493.5 million during the year ended December 31, 2020, which is the net impact of the deferred tax asset recognized as a result of the additional Swiss tax deductible basis in the transferred assets and certain costs related to the transfer of fixed assets and inventory. The amortization of this deferred tax asset depends on the profitability of our Swiss headquarters and the recognition of this tax benefit is allowed for a maximum recovery period of 15 years. The decrease in our effective tax rate for the year ended December 31, 2020 compared to the same period in 2019 is primarily attributable to the recognition of a deferred tax asset related to the intra-entity transfer of certain intellectual property rights during the year ended December 31, 2020.Liquidity and Capital ResourcesWe fund our operations from product sales. As of December 31, 2020 and 2019, we had the following cash and cash equivalents and short-term marketable securities (in thousands): December 31, 20202019Cash and cash equivalents$960,843 $550,425 Marketable securities, short-term — 318,202 Total$960,843 $868,627 Cash equivalents and marketable securities are comprised of money market funds and highly liquid debt instruments which primarily include corporate bonds, U.S. government treasury bonds, U.S. government agency bonds, commercial paper and certificates of deposit.As of December 31, 2020 and 2019, approximately $412.5 million and $278.5 million, respectively, of cash and cash equivalents was held by our foreign subsidiaries. Our intent is to permanently reinvest our earnings from our international operations going forward, and our current plans do not require us to repatriate them to fund our U.S. operations as we generate sufficient domestic operating cash flow and have access to external funding under our revolving line of credit. We believe that 43our current cash balances and the borrowing capacity under our credit facility, if necessary, will be sufficient to fund our business for at least the next 12 months. Our business was materially adversely affected in 2020 by the COVID-19 pandemic and the global and regional efforts by governments to mitigate its spread. While these impacts lessened in the third and fourth quarters of 2020, we could experience further adverse impacts to our business. In addition, as a result of the COVID-19 pandemic, we could experience reduced cash flow from operations as a result of decreased revenues and slower collections on our accounts receivable. Additional information regarding the impact of COVID-19 on our liquidity and capital resources may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors”. Cash flows (in thousands): Year Ended December 31, 202020192018Net cash provided by (used in):Operating activities$662,174 $747,270 $554,681 Investing activities(231,506)(350,444)6,927 Financing activities(30,808)(485,540)(369,434)Effects of foreign exchange rate changes on cash, cash equivalents, and restricted cash 10,480 2,282 (4,733)Net increase (decrease) in cash, cash equivalents, and restricted cash$410,340 $(86,432)$187,441 Operating ActivitiesFor the year ended December 31, 2020, cash flows from operations of $662.2 million was primarily comprised of our net income of approximately $1.8 billion as well as the following:Significant non-cash activities•Deferred taxes of $1.5 billion related to the one-time tax benefit associated with the intra-entity sale of certain intellectual property rights;•Stock-based compensation of $98.4 million related to equity awards granted to employees and directors;•Depreciation and amortization of $93.5 million related to our investments in property, plant and equipment and intangible assets;•Non-cash operating lease costs of $22.5 million; •Allowance for doubtful accounts provisions of $12.1 million related to slower collections and other impacts as a result of COVID-19; and •Impairment charges of $5.9 million related to our equity investments in privately held companies.Significant changes in working capital •Increase of $228.1 million in deferred revenues primarily related to increased case volumes and timing of revenue recognition;•Increase of $139.8 million in accounts receivable which is primarily a result of the increase and timing in our sales; and •Increase of $52.2 million in accounts payable due to timing of certain invoice payments.For the year ended December 31, 2019, cash flows from operations of $747.3 million was primarily comprised of our net income of approximately $442.8 million as well as the following:Significant non-cash activities•Stock-based compensation of $88.2 million related to equity awards granted to employees and directors;•Depreciation and amortization of $79.0 million related to our investments in property, plant and equipment and intangible assets; •Impairment charges of $28.5 million related to decreases in the fair value of certain assets related to the closure of our Invisalign stores;44•Non-cash operating lease costs of $18.5 million; and•Gain from the sale of equity method investment of $15.8 million.Significant changes in working capital•Increase of $189.1 million in deferred revenues corresponding to the increase in case volume;•Increase of $121.0 million in accounts receivable which is primarily a result of the increase in our sales; and•Increase of $60.2 million in accrued and other long-term liabilities due to timing of payment and activities.Investing ActivitiesNet cash used in investing activities was $231.5 million for the year ended December 31, 2020, which primarily consisted of cash paid for the acquisition of exocad of $420.8 million, net of cash acquired and purchases of property, plant and equipment of $154.9 million. These outflows were partially offset by maturities and sales of marketable securities of $321.5 million and $26.9 million received from payments on an unsecured promissory note issued by SDC in exchange for tendering our shares to them.For 2021, we expect to invest approximately $400.0 million in capital expenditures related to building construction and improvements as well as additional manufacturing capacity to support our international expansion.Net cash used in investing activities was $350.4 million for the year ended December 31, 2019, which primarily consisted of purchases of marketable securities of $693.3 million, purchases of property, plant and equipment of $149.7 million and other investing activities of $14.7 million. These outflows were partially offset by maturities and sales of marketable securities of $485.4 million and payments of $21.8 million received on an unsecured promissory note issued by SDC in exchange for tendering our shares to them.Financing ActivitiesNet cash used in financing activities was $30.8 million for the year ended December 31, 2020 consisted of payroll taxes paid for equity awards through share withholdings of $51.1 million which was partially offset by $20.3 million of proceeds from the issuance of common stock. Net cash used in financing activities was $485.5 million for the year ended December 31, 2019 primarily consisted of common stock repurchases of $400.0 million, payroll taxes paid for equity awards through share withholdings of $57.7 million and the purchase of a building that we previously leased under a finance lease of $45.8 million. These outflows were offset in part by $17.9 million proceeds from the issuance of common stock.Common Stock RepurchasesRefer to Note 13 “Common Stock Repurchase Programs” of the Notes to Consolidated Financial Statements for details on our stock repurchase programs.Credit FacilityOn July 21, 2020, we entered into a new credit facility for a $300.0 million unsecured revolving line of credit, with a $50.0 million letter of credit sublimit, and a maturity date of July 21, 2023 (“2020 Credit Facility”), replacing our previous credit facility which provided for a $200.0 million revolving line of credit with a $50.0 million letter of credit. As of December 31, 2020, we had no outstanding borrowings under this credit facility (Refer to Note 8 "Credit Facility" of the Notes to Consolidated Financial Statements for details of the credit facility). 45Contractual Obligations / Off Balance Sheet Arrangements The impact that our contractual obligations as of December 31, 2020 are expected to have on our liquidity and cash flows in future periods is as follows (in thousands): Payments Due by Period TotalLess than1 Year1-3Years4-5YearsMore than5 YearsOperating leases obligations$100,520 $25,358 $34,388 $11,494 $29,280 Unconditional purchase obligations704,961 474,204 203,977 26,780 — Total contractual cash obligations$805,481 $499,562 $238,365 $38,274 $29,280 Our contractual obligations table above excludes approximately $47.5 million of non-current uncertain tax benefits which are included in other long-term obligations and deferred tax assets on our balance sheet as of December 31, 2020. We have not included this amount because we cannot make a reasonably reliable estimate regarding the timing of settlements with taxing authorities, if any. As of December 31, 2020, we had additional operating leases that have not yet commenced with future lease payments of $18.1 million. These operating leases will commence during 2021 with non-cancelable lease terms of one to seven years. We had no material off-balance sheet arrangements as defined in Regulation S-K Item 303(a)(4) as of December 31, 2020 other than certain items disclosed in Note 11 "Commitments and Contingencies" of the Notes to Consolidated Financial Statements.Indemnification ProvisionsIn the normal course of business to facilitate transactions in our services and products, we indemnify certain parties: customers, vendors, lessors, and other parties with respect to certain matters, including, but not limited to, services to be provided by us and intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and our executive officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim.It is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2020, we did not have any material indemnification claims that were probable or reasonably possible.Critical Accounting Policies and Estimates Management’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses and disclosures at the date of the financial statements. We evaluate our estimates on an on-going basis, including those related to revenue recognition, goodwill and finite-lived assets and related impairment, business combinations and income taxes. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results could differ from those estimates.We believe the following critical accounting policies and estimates affect our more significant judgments used in the preparation of our consolidated financial statements. For further information on all of our significant accounting policies, see Note 1 “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements under

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+Item 7.Management’s Discussion and Analysis of Financial Condition and Results of OperationsForward-Looking StatementsThis Annual Report on Form 10-K includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact, including statements regarding guidance, industry prospects, or future results of operations or financial position, made in this Annual Report on Form 10-K are forward-looking. We use words such as anticipates, believes, expects, future, intends, and similar expressions to identify forward-looking statements. Forward-looking statements reflect management’s current expectations and are inherently uncertain. Actual results could differ materially for a variety of reasons, including, among others, fluctuations in foreign exchange rates, changes in global economic conditions and customer spending, world events, the rate of growth of the Internet, online commerce, and cloud services, the amount that Amazon.com invests in new business opportunities and the timing of those investments, the mix of products and services sold to customers, the mix of net sales derived from products as compared with services, the extent to which we owe income or other taxes, competition, management of growth, potential fluctuations in operating results, international growth and expansion, the outcomes of claims, litigation, government investigations, and other proceedings, fulfillment, sortation, delivery, and data center optimization, risks of inventory management, variability in demand, the degree to which we enter into, maintain, and develop commercial agreements, proposed and completed acquisitions and strategic transactions, payments risks, and risks of fulfillment throughput and productivity. In addition, the global economic climate and additional or unforeseen effects from the COVID-19 pandemic amplify many of these risks. These risks and uncertainties, as well as other risks and uncertainties that could cause our actual results to differ significantly from management’s expectations, are described in greater detail in Item 1A of Part I, “Risk Factors.”OverviewOur primary source of revenue is the sale of a wide range of products and services to customers. The products offered through our stores include merchandise and content we have purchased for resale and products offered by third-party sellers, and we also manufacture and sell electronic devices and produce media content. Generally, we recognize gross revenue from items we sell from our inventory as product sales and recognize our net share of revenue of items sold by third-party sellers as service sales. We seek to increase unit sales across our stores, through increased product selection, across numerous product categories. We also offer other services such as compute, storage, and database offerings, fulfillment, advertising, publishing, and digital content subscriptions.Our financial focus is on long-term, sustainable growth in free cash flows. Free cash flows are driven primarily by increasing operating income and efficiently managing accounts receivable, inventory, accounts payable, and cash capital expenditures, including our decision to purchase or lease property and equipment. Increases in operating income primarily result from increases in sales of products and services and efficiently managing our operating costs, partially offset by investments we make in longer-term strategic initiatives, including capital expenditures focused on improving the customer experience. To increase sales of products and services, we focus on improving all aspects of the customer experience, including lowering prices, improving availability, offering faster delivery and performance times, increasing selection, producing original content, increasing product categories and service offerings, expanding product information, improving ease of use, improving reliability, and earning customer trust. See “Results of Operations — Non-GAAP Financial Measures” below for additional information on our non-GAAP free cash flows financial measures.We seek to reduce our variable costs per unit and work to leverage our fixed costs. Our variable costs include product and content costs, payment processing and related transaction costs, picking, packaging, and preparing orders for shipment, transportation, customer service support, costs necessary to run AWS, and a portion of our marketing costs. Our fixed costs include the costs necessary to build and run our technology infrastructure; to build, enhance, and add features to our online stores, web services, electronic devices, and digital offerings; and to build and optimize our fulfillment networks and related facilities. Variable costs generally change directly with sales volume, while fixed costs generally are dependent on the timing of capacity needs, geographic expansion, category expansion, and other factors. To decrease our variable costs on a per unit basis and enable us to lower prices for customers, we seek to increase our direct sourcing, increase discounts from suppliers, and reduce defects in our processes. To minimize unnecessary growth in fixed costs, we seek to improve process efficiencies and maintain a lean culture.Because of our model we are able to turn our inventory quickly and have a cash-generating operating cycle1. On average, our high inventory velocity means we generally collect from consumers before our payments to suppliers come due. We expect variability in inventory turnover over time since it is affected by numerous factors, including our product mix, the mix of sales 1 The operating cycle is the number of days of sales in inventory plus the number of days of sales in accounts receivable minus accounts payable days.19Table of Contentsby us and by third-party sellers, our continuing focus on in-stock inventory availability and selection of product offerings, our investment in new geographies and product lines, and the extent to which we choose to utilize third-party fulfillment providers. We also expect some variability in accounts payable days over time since they are affected by several factors, including the mix of product sales, the mix of sales by third-party sellers, the mix of suppliers, seasonality, and changes in payment terms over time, including the effect of balancing pricing and timing of payment terms with suppliers.We expect spending in technology and content will increase over time as we add computer scientists, designers, software and hardware engineers, and merchandising employees. Our technology and content investment and capital spending projects often support a variety of product and service offerings due to geographic expansion and the cross-functionality of our systems and operations. We seek to invest efficiently in several areas of technology and content, including AWS, and expansion of new and existing product categories and service offerings, as well as in technology infrastructure to enhance the customer experience and improve our process efficiencies. We believe that advances in technology, specifically the speed and reduced cost of processing power, data storage and analytics, improved wireless connectivity, and the practical applications of artificial intelligence and machine learning, will continue to improve users’ experience on the Internet and increase its ubiquity in people’s lives. To best take advantage of these continued advances in technology, we are investing in AWS, which offers a broad set of on-demand technology services, including compute, storage, database, analytics, and machine learning, and other services, to developers and enterprises of all sizes. We are also investing in initiatives to build and deploy innovative and efficient software and electronic devices. We seek to efficiently manage shareholder dilution while maintaining the flexibility to issue shares for strategic purposes, such as financings, acquisitions, and aligning employee compensation with shareholders’ interests. We utilize restricted stock units as our primary vehicle for equity compensation because we believe this compensation model aligns the long-term interests of our shareholders and employees. In measuring shareholder dilution, we include all vested and unvested stock awards outstanding, without regard to estimated forfeitures. Total shares outstanding plus outstanding stock awards were 512 million and 518 million as of December 31, 2019 and 2020.Our financial reporting currency is the U.S. Dollar and changes in foreign exchange rates significantly affect our reported results and consolidated trends. For example, if the U.S. Dollar weakens year-over-year relative to currencies in our international locations, our consolidated net sales and operating expenses will be higher than if currencies had remained constant. Likewise, if the U.S. Dollar strengthens year-over-year relative to currencies in our international locations, our consolidated net sales and operating expenses will be lower than if currencies had remained constant. We believe that our increasing diversification beyond the U.S. economy through our growing international businesses benefits our shareholders over the long-term. We also believe it is useful to evaluate our operating results and growth rates before and after the effect of currency changes.In addition, the remeasurement of our intercompany balances can result in significant gains and losses associated with the effect of movements in foreign currency exchange rates. Currency volatilities may continue, which may significantly impact (either positively or negatively) our reported results and consolidated trends and comparisons.For additional information about each line item addressed above, refer to Item 8 of Part II, “Financial Statements and Supplementary Data — Note 1 — Description of Business, Accounting Policies, and Supplemental Disclosures.”Our Annual Report on Form 10-K for the year ended December 31, 2019 includes a discussion and analysis of our financial condition and results of operations for the year ended December 31, 2018 in Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”Effects of COVID-19The COVID-19 pandemic and resulting global disruptions have affected our businesses, as well as those of our customers, suppliers, and third-party sellers. To serve our customers while also providing for the safety of our employees and service providers, we have modified numerous aspects of our logistics, transportation, supply chain, purchasing, and third-party seller processes. Beginning in Q1 2020, we made numerous process updates across our operations worldwide, and adapted our fulfillment network, to implement employee and customer safety measures, such as enhanced cleaning and physical distancing, personal protective gear, disinfectant spraying, and temperature checks. Since February 2020, we have hired over 400,000 full-time and part-time employees to increase our fulfillment network capacity. We incurred approximately $4.0 billion in COVID-19 related costs in Q4 2020, for a total of more than $11.5 billion during 2020. We will continue to prioritize employee and customer safety and comply with evolving federal, state, and local standards as well as to implement standards or processes that we determine to be in the best interests of our employees, customers, and communities.20Table of ContentsCritical Accounting JudgmentsThe preparation of financial statements in conformity with generally accepted accounting principles of the United States (“GAAP”) requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent liabilities in the consolidated financial statements and accompanying notes. The SEC has defined a company’s critical accounting policies as the ones that are most important to the portrayal of the company’s financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the critical accounting policies and judgments addressed below. We also have other key accounting policies, which involve the use of estimates, judgments, and assumptions that are significant to understanding our results. For additional information, see Item 8 of Part II, “Financial Statements and Supplementary Data — Note 1 — Description of Business, Accounting Policies, and Supplemental Disclosures.” Although we believe that our estimates, assumptions, and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments, or conditions.InventoriesInventories, consisting of products available for sale, are primarily accounted for using the first-in first-out method, and are valued at the lower of cost and net realizable value. This valuation requires us to make judgments, based on currently available information, about the likely method of disposition, such as through sales to individual customers, returns to product vendors, or liquidations, and expected recoverable values of each disposition category. These assumptions about future disposition of inventory are inherently uncertain and changes in our estimates and assumptions may cause us to realize material write-downs in the future. As a measure of sensitivity, for every 1% of additional inventory valuation allowance as of December 31, 2020, we would have recorded an additional cost of sales of approximately $270 million.In addition, we enter into supplier commitments for certain electronic device components and certain products. These commitments are based on forecasted customer demand. If we reduce these commitments, we may incur additional costs.Income TaxesWe are subject to income taxes in the U.S. (federal and state) and numerous foreign jurisdictions. Tax laws, regulations, administrative practices, principles, and interpretations in various jurisdictions may be subject to significant change, with or without notice, due to economic, political, and other conditions, and significant judgment is required in evaluating and estimating our provision and accruals for these taxes. There are many transactions that occur during the ordinary course of business for which the ultimate tax determination is uncertain. In addition, our actual and forecasted earnings are subject to change due to economic, political, and other conditions, such as the COVID-19 pandemic, and significant judgment is required in determining our ability to use our deferred tax assets. Our effective tax rates could be affected by numerous factors, such as changes in our business operations, acquisitions, investments, entry into new businesses and geographies, intercompany transactions, the relative amount of our foreign earnings, including earnings being lower than anticipated in jurisdictions where we have lower statutory rates and higher than anticipated in jurisdictions where we have higher statutory rates, losses incurred in jurisdictions for which we are not able to realize related tax benefits, the applicability of special tax regimes, changes in foreign currency exchange rates, changes in our stock price, changes to our forecasts of income and loss and the mix of jurisdictions to which they relate, changes in our deferred tax assets and liabilities and their valuation, changes in the laws, regulations, administrative practices, principles, and interpretations related to tax, including changes to the global tax framework, competition, and other laws and accounting rules in various jurisdictions. In addition, a number of countries have enacted or are actively pursuing changes to their tax laws applicable to corporate multinationals. We are also currently subject to tax controversies in various jurisdictions, and these jurisdictions may assess additional income tax liabilities against us. Developments in an audit, investigation, or other tax controversy could have a material effect on our operating results or cash flows in the period or periods for which that development occurs, as well as for prior and subsequent periods. We regularly assess the likelihood of an adverse outcome resulting from these proceedings to determine the adequacy of our tax accruals. Although we believe our tax estimates are reasonable, the final outcome of audits, investigations, and any other tax controversies could be materially different from our historical income tax provisions and accruals.21Table of ContentsLiquidity and Capital ResourcesCash flow information is as follows (in millions): Year Ended December 31, 20192020Cash provided by (used in):Operating activities$38,514 $66,064 Investing activities(24,281)(59,611)Financing activities(10,066)(1,104)Our principal sources of liquidity are cash flows generated from operations and our cash, cash equivalents, and marketable securities balances, which, at fair value, were $55.0 billion and $84.4 billion as of December 31, 2019 and 2020. Amounts held in foreign currencies were $15.3 billion and $23.5 billion as of December 31, 2019 and 2020, and were primarily Euros, British Pounds, and Japanese Yen.Cash provided by (used in) operating activities was $38.5 billion and $66.1 billion in 2019 and 2020. Our operating cash flows result primarily from cash received from our consumer, seller, developer, enterprise, and content creator customers, and advertisers, offset by cash payments we make for products and services, employee compensation, payment processing and related transaction costs, operating leases, and interest payments on our long-term obligations. Cash received from our customers and other activities generally corresponds to our net sales. Because consumers primarily use credit cards to buy from us, our receivables from consumers settle quickly. The increase in operating cash flow in 2020, compared to the prior year, was primarily due to the increase in net income, excluding non-cash expenses, and changes in working capital. Working capital at any specific point in time is subject to many variables, including variability in demand, inventory management and category expansion, the timing of cash receipts and payments, vendor payment terms, and fluctuations in foreign exchange rates.Cash provided by (used in) investing activities corresponds with cash capital expenditures, including leasehold improvements, incentives received from property and equipment vendors, proceeds from asset sales, cash outlays for acquisitions, investments in other companies and intellectual property rights, and purchases, sales, and maturities of marketable securities. Cash provided by (used in) investing activities was $(24.3) billion and $(59.6) billion in 2019 and 2020, with the variability caused primarily by our decision to purchase or lease property and equipment, and purchases, maturities, and sales of marketable securities. Cash capital expenditures were $12.7 billion, and $35.0 billion in 2019 and 2020, which primarily reflect investments in additional capacity to support our fulfillment operations and in support of continued business growth in technology infrastructure (the majority of which is to support AWS), which investments we expect to continue over time. We made cash payments, net of acquired cash, related to acquisition and other investment activity of $2.5 billion and $2.3 billion in 2019 and 2020.Cash provided by (used in) financing activities was $(10.1) billion and $(1.1) billion in 2019 and 2020. Cash inflows from financing activities resulted from proceeds of short-term debt, and other and long-term-debt of $2.3 billion and $17.3 billion in 2019 and 2020. Cash outflows from financing activities resulted from payments of short-term debt, and other, long-term debt, finance leases, and financing obligations of $12.3 billion and $18.4 billion in 2019 and 2020. Property and equipment acquired under finance leases was $13.7 billion and $11.6 billion in 2019 and 2020, reflecting investments in support of continued business growth primarily due to investments in technology infrastructure for AWS.We had no borrowings outstanding under the unsecured revolving credit facility (the “Credit Agreement”), $725 million of borrowings outstanding under the commercial paper program (the “Commercial Paper Program”), and $338 million of borrowings outstanding under our secured revolving credit facility (the “Credit Facility”) as of December 31, 2020. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 6 — Debt” for additional information. As of December 31, 2020, cash, cash equivalents, and marketable securities held by foreign subsidiaries were $17.2 billion. We intend to invest substantially all of our foreign subsidiary earnings, as well as our capital in our foreign subsidiaries, indefinitely outside of the U.S. in those jurisdictions in which we would incur significant, additional costs upon repatriation of such amounts. Tax benefits relating to excess stock-based compensation deductions and accelerated depreciation deductions are reducing our U.S. taxable income, and all remaining federal tax credits, which were primarily related to the U.S. federal research and development credit, reduced our federal tax liability in 2020. U.S. tax rules provide for enhanced accelerated depreciation deductions by allowing the election of full expensing of qualified property, primarily equipment, through 2022. Our federal tax provision included the election of full expensing of qualified property for 2018 and 2019 and a partial election for 2020. Cash taxes paid (net of refunds) were $881 million and $1.7 billion for 2019 and 2020. We endeavor to manage our global taxes on a cash basis, rather than on a financial reporting basis. In connection with the European Commission’s October 2017 decision against us on state aid, Luxembourg tax authorities computed an initial recovery amount, consistent with the 22Table of ContentsEuropean Commission’s decision, of approximately €250 million, that we deposited into escrow in March 2018, subject to adjustment pending conclusion of all appeals. As of December 31, 2019 and 2020, restricted cash, cash equivalents, and marketable securities were $321 million and $257 million. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 7 — Commitments and Contingencies” for additional discussion of our principal contractual commitments, as well as our pledged assets. Additionally, purchase obligations and open purchase orders, consisting of inventory and significant non-inventory commitments, were $26.6 billion as of December 31, 2020. These purchase obligations and open purchase orders are generally cancellable in full or in part through the contractual provisions.We believe that cash flows generated from operations and our cash, cash equivalents, and marketable securities balances, as well as our borrowing arrangements, will be sufficient to meet our anticipated operating cash needs for at least the next twelve months. However, any projections of future cash needs and cash flows are subject to substantial uncertainty. See Item 1A of Part I, “Risk Factors.” We continually evaluate opportunities to sell additional equity or debt securities, obtain credit facilities, obtain finance and operating lease arrangements, enter into financing obligations, repurchase common stock, pay dividends, or repurchase, refinance, or otherwise restructure our debt for strategic reasons or to further strengthen our financial position.The COVID-19 pandemic and resulting global disruptions have caused significant market volatility. These disruptions can contribute to defaults in our accounts receivable, affect asset valuations resulting in impairment charges, and affect the availability of lease and financing credit as well as other segments of the credit markets. We have utilized a range of financing methods to fund our operations and capital expenditures and expect to continue to maintain financing flexibility in the current market conditions. However, due to the rapidly evolving global situation, it is not possible to predict whether unanticipated consequences of the pandemic are reasonably likely to materially affect our liquidity and capital resources in the future.The sale of additional equity or convertible debt securities would be dilutive to our shareholders. In addition, we will, from time to time, consider the acquisition of, or investment in, complementary businesses, products, services, capital infrastructure, and technologies, which might affect our liquidity requirements or cause us to secure additional financing, or issue additional equity or debt securities. There can be no assurance that additional credit lines or financing instruments will be available in amounts or on terms acceptable to us, if at all.23Table of ContentsResults of OperationsWe have organized our operations into three segments: North America, International, and AWS. These segments reflect the way the Company evaluates its business performance and manages its operations. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 10 — Segment Information.” Effects of COVID-19As reflected in the discussion below, the impact of the COVID-19 pandemic and actions taken in response to it had varying effects on our 2020 results of operations. Higher net sales in the North America and International segments reflect increased demand, particularly as people are staying at home, including for household staples and other essential and home products, partially offset by fulfillment network capacity and supply chain constraints. Other effects in the North America and International segments include increased fulfillment costs and cost of sales as a percentage of net sales, primarily due to the impact of lower productivity, increased employee hiring and benefits, and costs to maintain safe workplaces.We expect the effects of fulfillment network capacity and supply chain constraints, elevated collection risk in our accounts receivable, and increased fulfillment costs and cost of sales as a percentage of net sales to continue into all or portions of Q1 2021. However, it is not possible to determine the duration and scope of the pandemic, including any recurrence, the actions taken in response to the pandemic, the scale and rate of economic recovery from the pandemic, any ongoing effects on consumer demand and spending patterns, or other impacts of the pandemic, and whether these or other currently unanticipated consequences of the pandemic are reasonably likely to materially affect our results of operations.24Table of ContentsNet SalesNet sales include product and service sales. Product sales represent revenue from the sale of products and related shipping fees and digital media content where we record revenue gross. Service sales primarily represent third-party seller fees, which includes commissions and any related fulfillment and shipping fees, AWS sales, advertising services, Amazon Prime membership fees, and certain digital content subscriptions. Net sales information is as follows (in millions): Year Ended December 31, 20192020Net Sales:North America$170,773 $236,282 International74,723 104,412 AWS35,026 45,370 Consolidated$280,522 $386,064 Year-over-year Percentage Growth:North America21 %38 %International13 40 AWS37 30 Consolidated20 38 Year-over-year Percentage Growth, excluding the effect of foreign exchange rates:North America21 %38 %International17 38 AWS37 30 Consolidated22 37 Net sales mix:North America61 %61 %International27 27 AWS12 12 Consolidated100 %100 %Sales increased 38% in 2020, compared to the prior year. Changes in foreign currency exchange rates impacted net sales by $(2.6) billion and $1.4 billion for 2019 and 2020. For a discussion of the effect of foreign exchange rates on sales growth, see “Effect of Foreign Exchange Rates” below.North America sales increased 38% in 2020, compared to the prior year. The sales growth primarily reflects increased unit sales, including sales by third-party sellers. Increased unit sales were driven largely by our continued efforts to reduce prices for our customers, including from our shipping offers, and increased demand, including for household staples and other essential and home products, partially offset by fulfillment network capacity and supply chain constraints.International sales increased 40% in 2020, compared to the prior year. The sales growth primarily reflects increased unit sales, including sales by third-party sellers. Increased unit sales were driven largely by our continued efforts to reduce prices for our customers, including from our shipping offers, and increased demand, including for household staples and other essential and home products, partially offset by fulfillment network capacity and supply chain constraints. Changes in foreign currency exchange rates impacted International net sales by $(2.4) billion and $1.7 billion in 2019 and 2020.AWS sales increased 30% in 2020, compared to the prior year. The sales growth primarily reflects increased customer usage, partially offset by pricing changes. Pricing changes were driven largely by our continued efforts to reduce prices for our customers. 25Table of ContentsOperating Income (Loss) Operating income (loss) by segment is as follows (in millions):Year Ended December 31,20192020Operating Income (Loss):North America$7,033 $8,651 International(1,693)717 AWS9,201 13,531 Consolidated$14,541 $22,899 Operating income was $14.5 billion and $22.9 billion for 2019 and 2020. We believe that operating income (loss) is a more meaningful measure than gross profit and gross margin due to the diversity of our product categories and services.The increase in North America operating income in absolute dollars in 2020, compared to the prior year, is primarily due to increased unit sales, including sales by third-party sellers, and advertising sales and slower growth in certain operating expenses, partially offset by increased shipping and fulfillment costs due in part to COVID-19. We expect North America operating income to continue to be negatively impacted through at least Q1 2021 by COVID-19 related costs. Changes in foreign exchange rates impacted operating income by $23 million and $8 million for 2019 and 2020.The International operating income in 2020, as compared to the operating loss in the prior year, is primarily due to increased unit sales, including sales by third-party sellers, and advertising sales, and slower growth in certain operating expenses, partially offset by increased shipping and fulfillment costs due in part to COVID-19. We expect International operating income to continue to be negatively impacted through at least Q1 2021 by COVID-19 related costs. Changes in foreign exchange rates impacted operating income (loss) by $(116) million and $411 million for 2019 and 2020. The increase in AWS operating income in absolute dollars in 2020, compared to the prior year, is primarily due to increased customer usage and cost structure productivity, including a reduction in depreciation and amortization expense from our change in the estimated useful life of our servers, partially offset by increased payroll and related expenses and spending on technology infrastructure, both of which were primarily driven by additional investments to support the business growth, and reduced prices for our customers. Changes in foreign exchange rates impacted operating income by $273 million and $30 million for 2019 and 2020.26Table of ContentsOperating ExpensesInformation about operating expenses is as follows (in millions): Year Ended December 31, 20192020Operating expenses:Cost of sales$165,536 $233,307 Fulfillment40,232 58,517 Technology and content35,931 42,740 Marketing18,878 22,008 General and administrative5,203 6,668 Other operating expense (income), net201 (75)Total operating expenses$265,981 $363,165 Year-over-year Percentage Growth:Cost of sales19 %41 %Fulfillment18 45 Technology and content25 19 Marketing37 17 General and administrative20 28 Other operating expense (income), net(32)(137)Percent of Net Sales:Cost of sales59.0 %60.4 %Fulfillment14.3 15.2 Technology and content12.8 11.1 Marketing6.7 5.7 General and administrative1.9 1.7 Other operating expense (income), net0.1 — Cost of SalesCost of sales primarily consists of the purchase price of consumer products, inbound and outbound shipping costs, including costs related to sortation and delivery centers and where we are the transportation service provider, and digital media content costs where we record revenue gross, including video and music.The increase in cost of sales in absolute dollars in 2020, compared to the prior year, is primarily due to increased product and shipping costs resulting from increased sales. We expect cost of sales as a percentage of net sales to continue to be negatively impacted through at least Q1 2021 by COVID-19 related costs.Shipping costs to receive products from our suppliers are included in our inventory and recognized as cost of sales upon sale of products to our customers. Shipping costs, which include sortation and delivery centers and transportation costs, were $37.9 billion and $61.1 billion in 2019 and 2020. We expect our cost of shipping to continue to increase to the extent our customers accept and use our shipping offers at an increasing rate, we use more expensive shipping methods, including faster delivery, and we offer additional services. We seek to mitigate costs of shipping over time in part through achieving higher sales volumes, optimizing our fulfillment network, negotiating better terms with our suppliers, and achieving better operating efficiencies. We believe that offering low prices to our customers is fundamental to our future success, and one way we offer lower prices is through shipping offers.Costs to operate our AWS segment are primarily classified as “Technology and content” as we leverage a shared infrastructure that supports both our internal technology requirements and external sales to AWS customers.27Table of ContentsFulfillmentFulfillment costs primarily consist of those costs incurred in operating and staffing our North America and International fulfillment centers, physical stores, and customer service centers and payment processing costs. While AWS payment processing and related transaction costs are included in “Fulfillment,” AWS costs are primarily classified as “Technology and content.” Fulfillment costs as a percentage of net sales may vary due to several factors, such as payment processing and related transaction costs, our level of productivity and accuracy, changes in volume, size, and weight of units received and fulfilled, the extent to which third party sellers utilize Fulfillment by Amazon services, timing of fulfillment network and physical store expansion, the extent we utilize fulfillment services provided by third parties, mix of products and services sold, and our ability to affect customer service contacts per unit by implementing improvements in our operations and enhancements to our customer self-service features. Additionally, sales by our sellers have higher payment processing and related transaction costs as a percentage of net sales compared to our retail sales because payment processing costs are based on the gross purchase price of underlying transactions.The increase in fulfillment costs in absolute dollars in 2020, compared to the prior year, is primarily due to variable costs corresponding with increased product and service sales volume and inventory levels, costs from expanding our fulfillment network, and the COVID-19 related impact of lower productivity, increased employee hiring and benefits, and costs to maintain safe workplaces. We expect fulfillment costs as a percentage of net sales to continue to be negatively impacted through at least Q1 2021 by COVID-19 related costs.We seek to expand our fulfillment network to accommodate a greater selection and in-stock inventory levels and to meet anticipated shipment volumes from sales of our own products as well as sales by third parties for which we provide the fulfillment services. We regularly evaluate our facility requirements.Technology and ContentTechnology and content costs include payroll and related expenses for employees involved in the research and development of new and existing products and services, development, design, and maintenance of our stores, curation and display of products and services made available in our online stores, and infrastructure costs. Infrastructure costs include servers, networking equipment, and data center related depreciation and amortization, rent, utilities, and other expenses necessary to support AWS and other Amazon businesses. Collectively, these costs reflect the investments we make in order to offer a wide variety of products and services to our customers.We seek to invest efficiently in numerous areas of technology and content so we may continue to enhance the customer experience and improve our process efficiency through rapid technology developments, while operating at an ever increasing scale. Our technology and content investment and capital spending projects often support a variety of product and service offerings due to geographic expansion and the cross-functionality of our systems and operations. We expect spending in technology and content to increase over time as we continue to add employees and technology infrastructure. These costs are allocated to segments based on usage. The increase in technology and content costs in absolute dollars in 2020, compared to the prior year, is primarily due to increased payroll and related costs associated with technical teams responsible for expanding our existing products and services and initiatives to introduce new products and service offerings and an increase in spending on technology infrastructure, offset by a reduction in depreciation and amortization expense from our change in the estimated useful life of our servers. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 1 — Description of Business, Accounting Policies, and Supplemental Disclosures — Use of Estimates” for additional information on our change in estimated useful life of our servers.MarketingMarketing costs include advertising and payroll and related expenses for personnel engaged in marketing and selling activities, including sales commissions related to AWS. We direct customers to our stores primarily through a number of marketing channels, such as our sponsored search, third party customer referrals, social and online advertising, television advertising, and other initiatives. Our marketing costs are largely variable, based on growth in sales and changes in rates. To the extent there is increased or decreased competition for these traffic sources, or to the extent our mix of these channels shifts, we would expect to see a corresponding change in our marketing costs.The increase in marketing costs in absolute dollars in 2020, compared to the prior year, is primarily due to increased payroll and related expenses for personnel engaged in marketing and selling activities, partially offset by lower spending on marketing channels as a result of COVID-19.While costs associated with Amazon Prime membership benefits and other shipping offers are not included in marketing expense, we view these offers as effective worldwide marketing tools, and intend to continue offering them indefinitely.28Table of ContentsGeneral and AdministrativeThe increase in general and administrative costs in absolute dollars in 2020, compared to the prior year, is primarily due to increases in payroll and related expenses and professional service fees.Other Operating Expense (Income), NetOther operating expense (income), net was $201 million and $(75) million during 2019 and 2020, and was primarily related to a benefit from accelerated vesting of warrants to acquire equity of a vendor in Q4 2020, offset by a lease impairment in Q2 2020 and the amortization of intangible assets.Interest Income and ExpenseOur interest income was $832 million and $555 million during 2019 and 2020. We generally invest our excess cash in AAA-rated money market funds and investment grade short- to intermediate-term fixed income securities. Our interest income corresponds with the average balance of invested funds based on the prevailing rates, which vary depending on the geographies and currencies in which they are invested.Interest expense was $1.6 billion in 2019 and 2020 and was primarily related to debt and finance leases.Our long-term lease liabilities were $39.8 billion and $52.6 billion as of December 31, 2019 and 2020. Our long-term debt was $23.4 billion and $31.8 billion as of December 31, 2019 and 2020. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 4 — Leases and Note 6 — Debt” for additional information.Other Income (Expense), NetOther income (expense), net was $203 million and $2.4 billion during 2019 and 2020. The primary components of other income (expense), net are related to equity warrant valuations, equity securities valuations and adjustments, and foreign currency.Income TaxesOur effective tax rate is subject to significant variation due to several factors, including variability in our pre-tax and taxable income and loss and the mix of jurisdictions to which they relate, intercompany transactions, the applicability of special tax regimes, changes in how we do business, acquisitions, investments, audit-related developments, changes in our stock price, changes in our deferred tax assets and liabilities and their valuation, foreign currency gains (losses), changes in statutes, regulations, case law, and administrative practices, principles, and interpretations related to tax, including changes to the global tax framework, competition, and other laws and accounting rules in various jurisdictions, and relative changes of expenses or losses for which tax benefits are not recognized. Our effective tax rate can be more or less volatile based on the amount of pre-tax income or loss. For example, the impact of discrete items and non-deductible expenses on our effective tax rate is greater when our pre-tax income is lower. In addition, we record valuation allowances against deferred tax assets when there is uncertainty about our ability to generate future income in relevant jurisdictions, and the effects of the COVID-19 pandemic on our business make estimates of future income more challenging. We recorded a provision for income taxes of $2.4 billion and $2.9 billion in 2019 and 2020. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 9 — Income Taxes” for additional information.Non-GAAP Financial MeasuresRegulation G, Conditions for Use of Non-GAAP Financial Measures, and other SEC regulations define and prescribe the conditions for use of certain non-GAAP financial information. Our measures of free cash flows and the effect of foreign exchange rates on our consolidated statements of operations meet the definition of non-GAAP financial measures. We provide multiple measures of free cash flows because we believe these measures provide additional perspective on the impact of acquiring property and equipment with cash and through finance leases and financing obligations.29Table of ContentsFree Cash FlowFree cash flow is cash flow from operations reduced by “Purchases of property and equipment, net of proceeds from sales and incentives.” The following is a reconciliation of free cash flow to the most comparable GAAP cash flow measure, “Net cash provided by (used in) operating activities,” for 2019 and 2020 (in millions): Year Ended December 31, 20192020Net cash provided by (used in) operating activities$38,514 $66,064 Purchases of property and equipment, net of proceeds from sales and incentives(12,689)(35,044)Free cash flow$25,825 $31,020 Net cash provided by (used in) investing activities$(24,281)$(59,611)Net cash provided by (used in) financing activities$(10,066)$(1,104)Free Cash Flow Less Principal Repayments of Finance Leases and Financing ObligationsFree cash flow less principal repayments of finance leases and financing obligations is free cash flow reduced by “Principal repayments of finance leases” and “Principal repayments of financing obligations.” Principal repayments of finance leases and financing obligations approximates the actual payments of cash for our finance leases and financing obligations. The following is a reconciliation of free cash flow less principal repayments of finance leases and financing obligations to the most comparable GAAP cash flow measure, “Net cash provided by (used in) operating activities,” for 2019 and 2020 (in millions): Year Ended December 31, 20192020Net cash provided by (used in) operating activities$38,514 $66,064 Purchases of property and equipment, net of proceeds from sales and incentives(12,689)(35,044)Free cash flow25,825 31,020 Principal repayments of finance leases(9,628)(10,642)Principal repayments of financing obligations(27)(53)Free cash flow less principal repayments of finance leases and financing obligations$16,170 $20,325 Net cash provided by (used in) investing activities$(24,281)$(59,611)Net cash provided by (used in) financing activities$(10,066)$(1,104)30Table of ContentsFree Cash Flow Less Equipment Finance Leases and Principal Repayments of All Other Finance Leases and Financing Obligations Free cash flow less equipment finance leases and principal repayments of all other finance leases and financing obligations is free cash flow reduced by equipment acquired under finance leases, which is included in “Property and equipment acquired under finance leases,” principal repayments of all other finance lease liabilities, which is included in “Principal repayments of finance leases,” and “Principal repayments of financing obligations.” All other finance lease liabilities and financing obligations consists of property. In this measure, equipment acquired under finance leases is reflected as if these assets had been purchased with cash, which is not the case as these assets have been leased. The following is a reconciliation of free cash flow less equipment finance leases and principal repayments of all other finance leases and financing obligations to the most comparable GAAP cash flow measure, “Net cash provided by (used in) operating activities,” for 2019 and 2020 (in millions): Year Ended December 31, 20192020Net cash provided by (used in) operating activities$38,514 $66,064 Purchases of property and equipment, net of proceeds from sales and incentives(12,689)(35,044)Free cash flow25,825 31,020 Equipment acquired under finance leases (1)(12,916)(9,104)Principal repayments of all other finance leases (2)(392)(427)Principal repayments of financing obligations(27)(53)Free cash flow less equipment finance leases and principal repayments of all other finance leases and financing obligations$12,490 $21,436 Net cash provided by (used in) investing activities$(24,281)$(59,611)Net cash provided by (used in) financing activities$(10,066)$(1,104)___________________(1)For the year ended December 31, 2019 and 2020, this amount relates to equipment included in “Property and equipment acquired under finance leases” of $13,723 million and $11,588 million. (2)For the year ended December 31, 2019 and 2020, this amount relates to property included in “Principal repayments of finance leases” of $9,628 million and $10,642 million. All of these free cash flows measures have limitations as they omit certain components of the overall cash flow statement and do not represent the residual cash flow available for discretionary expenditures. For example, these measures of free cash flows do not incorporate the portion of payments representing principal reductions of debt or cash payments for business acquisitions. Additionally, our mix of property and equipment acquisitions with cash or other financing options may change over time. Therefore, we believe it is important to view free cash flows measures only as a complement to our entire consolidated statements of cash flows.31Table of ContentsEffect of Foreign Exchange RatesInformation regarding the effect of foreign exchange rates, versus the U.S. Dollar, on our net sales, operating expenses, and operating income is provided to show reported period operating results had the foreign exchange rates remained the same as those in effect in the comparable prior year periods. The effect on our net sales, operating expenses, and operating income from changes in our foreign exchange rates versus the U.S. Dollar is as follows (in millions): Year Ended December 31, 2019Year Ended December 31, 2020 AsReportedExchangeRateEffect (1)At PriorYearRates (2)AsReportedExchangeRateEffect (1)At PriorYearRates (2)Net sales$280,522 $2,560 $283,082 $386,064 $(1,438)$384,626 Operating expenses265,981 2,740 268,721 363,165 (989)362,176 Operating income14,541 (180)14,361 22,899 (449)22,450 ___________________(1)Represents the change in reported amounts resulting from changes in foreign exchange rates from those in effect in the comparable prior year period for operating results.(2)Represents the outcome that would have resulted had foreign exchange rates in the reported period been the same as those in effect in the comparable prior year period for operating results.GuidanceWe provided guidance on February 2, 2021, in our earnings release furnished on Form 8-K as set forth below. These forward-looking statements reflect Amazon.com’s expectations as of February 2, 2021, and are subject to substantial uncertainty. Our results are inherently unpredictable and may be materially affected by many factors, such as fluctuations in foreign exchange rates, changes in global economic conditions and customer spending, world events, the rate of growth of the Internet, online commerce, and cloud services, as well as those outlined in Item 1A of Part I, “Risk Factors.” This guidance reflects our estimates as of February 2, 2021 regarding the impact of the COVID-19 pandemic on our operations, including those discussed above, and is highly dependent on numerous factors that we may not be able to predict or control, including: the duration and scope of the pandemic, including any recurrence; actions taken by governments, businesses, and individuals in response to the pandemic; the impact of the pandemic on global and regional economies and economic activity, workforce staffing and productivity, and our significant and continuing spending on employee safety measures; our ability to continue operations in affected areas; and consumer demand and spending patterns, as well as the effects on suppliers, creditors, and third-party sellers, all of which are uncertain. This guidance also assumes the impacts on consumer demand and spending patterns, including impacts due to concerns over the current economic outlook, will be in line with those experienced during the first quarter of 2021 to date, and the additional assumptions set forth below. However, it is not possible to determine the ultimate impact on our operations for the first quarter of 2021, or whether other currently unanticipated direct or indirect consequences of the pandemic are reasonably likely to materially affect our operations.First Quarter 2021 Guidance•Net sales are expected to be between $100.0 billion and $106.0 billion, or to grow between 33% and 40% compared with first quarter 2020. This guidance anticipates a favorable impact of approximately 300 basis points from foreign exchange rates. •Operating income is expected to be between $3.0 billion and $6.5 billion, compared with $4.0 billion in first quarter 2020. This guidance assumes approximately $2.0 billion of costs related to COVID-19. •This guidance assumes, among other things, that no additional business acquisitions, investments, restructurings, or legal settlements are concluded.32Table of Contents Item 7A.Quantitative and Qualitative Disclosures About Market RiskWe are exposed to market risk for the effect of interest rate changes, foreign currency fluctuations, and changes in the market values of our investments. Information relating to quantitative and qualitative disclosures about market risk is set forth below and in Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”Interest Rate RiskOur exposure to market risk for changes in interest rates relates primarily to our investment portfolio and our long-term debt. Our long-term debt is carried at amortized cost and fluctuations in interest rates do not impact our consolidated financial statements. However, the fair value of our debt, which pays interest at a fixed rate, will generally fluctuate with movements of interest rates, increasing in periods of declining rates of interest and declining in periods of increasing rates of interest. We generally invest our excess cash in AAA-rated money market funds and investment grade short- to intermediate-term fixed income securities. Fixed income securities may have their fair market value adversely affected due to a rise in interest rates, and we may suffer losses in principal if forced to sell securities that have declined in market value due to changes in interest rates. The following table provides information about our cash equivalents and marketable fixed income securities, including principal cash flows by expected maturity and the related weighted-average interest rates as of December 31, 2020 (in millions, except percentages): 20212022202320242025ThereafterTotalEstimated Fair Value as of December 31, 2020Money market funds$27,430 $— $— $— $— $— $27,430 $27,430 Weighted average interest rate(0.16)%— %— %— %— %— %(0.16)%Corporate debt securities16,505 4,459 5,531 1,990 886 — 29,371 29,988 Weighted average interest rate0.42 %1.65 %1.32 %1.86 %1.84 % 0.92 %U.S. government and agency securities5,439 587 899 298 67 71 7,361 7,439 Weighted average interest rate0.30 %1.38 %1.12 %1.74 %1.13 %2.97 %0.58 %Asset-backed securities870 773 472 763 243 46 3,167 3,235 Weighted average interest rate2.08 %2.00 %1.53 %2.13 %1.57 %1.25 %1.94 %Foreign government and agency securities4,932 147 45 3 — — 5,127 5,131 Weighted average interest rate0.25 %0.74 %1.28 %1.76 %— %— %0.28 %Other fixed income securities109 156 230 160 43 — 698 710 Weighted average interest rate2.10 %1.85 %1.10 %0.84 %1.31 %— %1.38 %$55,285 $6,122 $7,177 $3,214 $1,239 $117 $73,154 Cash equivalents and marketable fixed income securities$73,933 As of December 31, 2020, we had long-term debt with a face value of $33.2 billion, including the current portion, primarily consisting of fixed rate unsecured senior notes. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 6 — Debt” for additional information.Foreign Exchange RiskDuring 2020, net sales from our International segment accounted for 27% of our consolidated revenues. Net sales and related expenses generated from our internationally-focused stores, including within Canada and Mexico (which are included in our North America segment), are primarily denominated in the functional currencies of the corresponding stores and primarily include Euros, British Pounds, and Japanese Yen. The results of operations of, and certain of our intercompany balances associated with, our internationally-focused stores and AWS are exposed to foreign exchange rate fluctuations. Upon consolidation, as foreign exchange rates vary, net sales and other operating results may differ materially from expectations, and we may record significant gains or losses on the remeasurement of intercompany balances. For example, as a result of fluctuations in foreign exchange rates throughout the year compared to rates in effect the prior year, International segment net sales increased by $1.7 billion in comparison with the prior year.33Table of ContentsWe have foreign exchange risk related to foreign-denominated cash, cash equivalents, and marketable securities (“foreign funds”). Based on the balance of foreign funds as of December 31, 2020, of $23.5 billion, an assumed 5%, 10%, and 20% adverse change to foreign exchange would result in fair value declines of $1.2 billion, $2.4 billion, and $4.7 billion. Fluctuations in fair value are recorded in “Accumulated other comprehensive income (loss),” a separate component of stockholders’ equity. Equity securities with readily determinable fair values are included in “Marketable securities” on our consolidated balance sheets and are measured at fair value with changes recognized in net income.We have foreign exchange risk related to our intercompany balances denominated in various foreign currencies. Based on the intercompany balances as of December 31, 2020, an assumed 5%, 10%, and 20% adverse change to foreign exchange rates would result in losses of $245 million, $485 million, and $970 million, recorded to “Other income (expense), net.”See Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations — Effect of Foreign Exchange Rates” for additional information on the effect on reported results of changes in foreign exchange rates.Equity Investment RiskAs of December 31, 2020, our recorded value in equity and equity warrant investments in public and private companies was $6.9 billion. Our equity and equity warrant investments in publicly traded companies represent $3.2 billion of our investments as of December 31, 2020, and are recorded at fair value, which is subject to market price volatility. We assess our equity investments in private companies for impairment. Valuations of private companies are inherently more complex due to the lack of readily available market data. The current global economic climate provides additional uncertainty. As such, we believe that market sensitivities are not practicable.34Table of Contents

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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThis report includes forward-looking statements based on the Company’s current assumptions, expectations and projections about future events. When used in this report, the words “believes,” “anticipates,” “may,” “expect,” “intend,” “estimate,” “project” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such words. In this report, the Company discloses important factors that could cause actual results to differ materially from management’s expectations. For more information on these and other factors, see “Forward-Looking Information” herein. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with “Item 1A. Risk Factors,” “Item 6. Selected Financial Data”, and the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. Business Overview AMETEK’s operations are affected by global, regional and industry economic factors. However, the Company’s strategic geographic and industry diversification, and its mix of products and services, have helped to mitigate the potential adverse impact of any unfavorable developments in any one industry or the economy of any single country on its consolidated operating results. In 2020, the Company was impacted by a weak global economy as a result of the COVID-19 pandemic, discussed below. In response to the weak global economy, the Company recorded 2020 realignment costs totaling $43.9 million (the “2020 realignment costs”). The 2020 realignment costs were composed of $35.5 million in severance costs for a reduction in workforce and $8.4 million of asset write-downs, primarily inventory. Contributions from the acquisitions of IntelliPower in January 2020, Pacific Design Technologies, Inc. (“PDT”) in September 2019, Gatan in October 2019, and a continued focus on and implementation of Operational Excellence initiatives, including the 2020 realignment actions, had a positive impact on the Company’s 2020 results.Highlights of 2020 were:•In January 2020, the Company spent $116.5 million, net of cash acquired, to acquire IntelliPower, a leading provider of high-reliability, ruggedized uninterruptible power systems serving a wide range of defense and industrial applications. •In March 2020, the Company completed the sale of its Reading Alloys business (“Reading”) to Kymera International for net proceeds of $245.3 million in cash. The sale resulted in a pre-tax gain of $141.0 million recorded in other income, net and income tax expense of $31.4 million.•Cash flow provided by operating activities for 2020 was a record $1,281.0 million, an increase of $166.6 million or 14.9%, compared with $1,114.4 million in 2019. •Free cash flow (cash flow provided by operating activities less capital expenditures) increased to a record $1,206.8 million in 2020, compared with $1,012.1 million in 2019.•EBITDA (earnings before interest, income taxes, depreciation, and amortization) was a record $1,421.6 million in 2020, compared with $1,388.3 million in 2019.•The Company continued its emphasis on investment in research, development and engineering, spending $246.2 million in 2020. Sales from products introduced in the past three years were $1,074.0 million or 23.7% of net sales. 22Table of ContentsImpact of COVID-19 Pandemic on our Business Our business, operations and end markets were negatively impacted in 2020 by the global outbreak and rapid spread of COVID-19. As the situation rapidly evolved, we remained focused on safely serving our customers and protecting the health and safety of our employees. All of our manufacturing locations remain operational with enhanced safety measures to help keep our employees, contractors, customers, and communities safe. In compliance with government protocols, certain of the Company's employees were instructed to work from home until government mandated restrictions allow for a safe return to the workplace. Those working at our sites are required to follow appropriate procedures, including completion of multiple training sessions and performance of self- and on-site screenings, as well as adhere to our personal protective equipment, social distancing, and personal hygiene protocols. We are committed to safely maintaining plant operations and focusing on business continuity, while reliably supplying critical products to our customers.During 2020, the COVID-19 pandemic resulted in a rapid decline in demand which impacted most of our end markets and geographies. We continue to experience end market volatility, however, orders have begun to return and stabilize in many of our end markets. Our financial position remains strong, however, we continue to closely monitor our fixed costs, capital expenditure plans, inventory, and capital resources to respond to changing conditions and to ensure we have the resources to meet our future needs. We believe that we will emerge from these events well positioned for long-term growth, though we cannot reasonably estimate the duration and severity of this global pandemic or its ultimate impact on the global economy and our business and results. Please refer to "Risk Factors", Part I, Item 1A of this Form 10-K for more information.Results of Operations The following table sets forth net sales and income by reportable segment and on a consolidated basis: Year Ended December 31,202020192018(In thousands)Net sales:Electronic Instruments$2,989,928 $3,322,881 $3,028,959 Electromechanical1,550,101 1,835,676 1,816,913 Consolidated net sales$4,540,029 $5,158,557 $4,845,872 Operating income and income before income taxes:Segment operating income:Electronic Instruments$770,620 $865,307 $782,144 Electromechanical324,962 387,931 363,765 Total segment operating income1,095,582 1,253,238 1,145,909 Corporate administrative expenses(67,698)(75,858)(70,369)Consolidated operating income1,027,884 1,177,380 1,075,540 Interest expense(86,062)(88,481)(82,180)Other income (expense), net140,487 (19,151)(5,615)Consolidated income before income taxes$1,082,309 $1,069,748 $987,745 ______________________The following “Results of Operations of the year ended December 31, 2020 compared with the year ended December 31, 2019” section presents an analysis of the Company’s consolidated operating results displayed in the Consolidated Statement of Income. A discussion regarding our financial condition and results of operations for the year ended December 31, 2019 compared to the year ended December 31, 2018 can be found under Item 7 in our 23Table of ContentsAnnual Report on Form 10-K for the fiscal year ended December 31, 2019, filed with the Securities and Exchange Commission on February 20, 2020.Results of Operations for the year ended December 31, 2020 compared with the year ended December 31, 2019 Net sales for 2020 were $4,540.0 million, a decrease of $618.6 million or 12.0%, compared with net sales of $5,158.6 million in 2019. The decrease in net sales for 2019 was due to a 13% organic sales decline driven by a weak economy as a result of the COVID-19 pandemic, an unfavorable 3% from the Reading divestiture, partially offset by a 4% increase from acquisitions. EIG net sales were $2,989.9 million in 2020, a decrease of 10.0%, compared with $3,322.9 million in 2019. EMG net sales were $1,550.1 million in 2020, a decrease of 15.6%, compared with $1,835.7 million in 2019. Total international sales for 2020 were $2,209.9 million or 48.7% of net sales, a decrease of $265.0 million or 10.7%, compared with international sales of $2,474.9 million or 48.0% of net sales in 2019. The decrease in international sales was primarily driven by lower sales in Europe as a result of the COVID-19 pandemic. Export shipments from the United States, which are included in total international sales, were $1,196.4 million in 2020, a decrease of $109.8 million or 8.4%, compared with $1,306.2 million in 2019. Orders for 2020 were $4,624.4 million, a decrease of $649.9 million or 12.3% compared with $5,274.3 million in 2019. The decrease in orders was due to an 11% organic order decline driven by a weak economy as a result of the COVID-19 pandemic, an unfavorable 3% from the Reading divestiture, partially offset by a favorable 1% from acquisitions, and a favorable 1% effect of foreign currency translation. The Company’s backlog of unfilled orders at December 31, 2020 was a record $1,802.2 million, an increase of $84.3 million or 4.9%, compared with $1,717.9 million at December 31, 2019. The Company recorded 2020 realignment costs totaling $43.9 million in the first quarter of 2020 (the “2020 realignment costs”). The 2020 realignment costs were composed of $35.5 million in severance costs for a reduction in workforce and $8.4 million of asset write-downs, primarily inventory, in response to the impact of a weak global economy as a result of the COVID-19 pandemic. See Note 18 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details.The 2020 realignment costs (in millions) reported in the consolidated statement of income as well as the impact on segment operating margins (in basis points) in 2020 are as follows:2020RealignmentCostsOperatingMarginsEIG$22.8 (70)EMG20.9 (130)Total reported in segment operating income43.7 (100)Selling, general and administrative expenses0.2 Total reported in the consolidated statement of income$43.9 (100)Segment operating income for 2020 was $1,095.6 million, a decrease of $157.6 million or 12.6%, compared with segment operating income of $1,253.2 million in 2019. The decrease in segment operating income was primarily due to the lower sales discussed above and the $43.7 million of 2020 realignment costs, partially offset by the benefits of the Company's Operational Excellence initiatives. Segment operating income, as a percentage of net sales, decreased to 24.1% in 2020, compared with 24.3% in 2019. The segment operating margins were negatively impacted by 100 basis points due to the 2020 realignment costs discussed above, partially offset by the benefits of the Company’s Operational Excellence initiatives. Cost of sales for 2020 was $2,996.5 million or 66.0% of net sales, a decrease of $374.4 million or 11.1%, compared with $3,370.9 million or 65.3% of net sales for 2019. The cost of sales decrease was primarily due to the net sales decrease discussed above, partially offset by the increase from the 2020 realignment costs discussed above.24Table of ContentsSelling, general and administrative expenses for 2020 were $515.6 million or 11.4% of net sales, a decrease of $94.7 million or 15.5%, compared with $610.3 million or 11.8% of net sales in 2019. Selling, general and administrative expenses decreased primarily due to the decrease in net sales discussed above as well as lower discretionary spending as a result of the COVID-19 pandemic.Consolidated operating income was $1,027.9 million or 22.6% of net sales for 2020, a decrease of $149.5 million or 12.7%, compared with $1,177.4 million or 22.8% of net sales in 2019. The consolidated operating income margins were negatively impacted by 100 basis points due to the 2020 realignment costs discussed above, partially offset by the benefits of the Company's Operational Excellence initiatives.Other income, net was $140.5 million for 2020, an increase of $159.7 million, compared with $19.2 million of other expense in 2019. The increase in other income was primarily due to the gain on the sale of Reading of $141.0 million, higher defined benefit pension income of $7.5 million, and lower acquisition-related expenses. The effective tax rate for 2020 was 19.4%, compared with 19.5% in 2019. See Note 9 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details.Net income for 2020 was a record $872.4 million, an increase of $11.1 million or 1.3%, compared with $861.3 million in 2019. The net of tax gain of $109.6 million on the sale of Reading and net of tax expense of $33.6 million on the 2020 realignment costs are included in net income in 2020.Diluted earnings per share for 2020 were a record $3.77, an increase of $0.02 or 0.5%, compared with $3.75 per diluted share in 2019. The net of tax gain of $0.47 per diluted share on the sale of Reading and net of tax expense of $0.15 per diluted share on the 2020 realignment costs are included in diluted earnings per share in 2020.Segment Results EIG’s net sales totaled $2,989.9 million for 2020, a decrease of $333.0 million or 10.0%, compared with $3,322.9 million in 2019. The net sales decrease was due to a 15% organic sales decline driven by a weak global economy as a result of the COVID-19 pandemic, partially offset by the acquisitions of Gatan and IntelliPower.EIG’s operating income was $770.6 million for 2020, a decrease of $94.7 million or 10.9%, compared with $865.3 million in 2019. EIG’s operating margins were 25.8% of net sales for 2020, compared with 26.0% of net sales in 2019. EIG’s decrease in operating income was primarily due to the decrease in sales discussed above as well as the $22.8 million of 2020 realignment costs, partially offset by the benefits of the Company's Operational Excellence initiatives. EIG’s 2020 operating margins were negatively impacted by 70 basis points due to the 2020 realignment costs discussed above.EMG’s net sales totaled $1,550.1 million for 2020, a decrease of $285.6 million or 15.6%, compared with $1,835.7 million in 2019. The net sales decrease was due to a 10% organic sales decline driven by a weak global economy as a result of the COVID-19 pandemic, a favorable 2% impact from the PDT acquisition as well as an unfavorable 8% impact from the Reading divestiture.EMG’s operating income was $325.0 million for 2020, a decrease of $62.9 million or 16.2%, compared with $387.9 million in 2019. EMG’s operating margins were 21.0% of net sales for 2020, compared with 21.1% of net sales in 2019. EMG’s decrease in operating income was primarily due to the decrease in sales discussed above as well as the $20.9 million of 2020 realignment costs, partially offset by benefits from the Group’s Operating Excellence initiatives. EMG’s 2020 operating margins were negatively impacted by 130 basis points due to the 2020 realignment costs discussed above.25Table of ContentsLiquidity and Capital Resources Cash provided by operating activities totaled a record $1,281.0 million in 2020, an increase of $166.6 million or 14.9%, compared with $1,114.4 million in 2019. The increase in cash provided by operating activities for 2020 was primarily due to strong working capital management. Free cash flow (cash flow provided by operating activities less capital expenditures) was a record $1,206.8 million in 2020, compared with $1,012.1 million in 2019. EBITDA (earnings before interest, income taxes, depreciation and amortization) was $1,421.6 million in 2020, compared with $1,388.3 million in 2019. Free cash flow and EBITDA are presented because the Company is aware that they are measures used by third parties in evaluating the Company. (See the “Notes to Selected Financial Data” included in Item 6 in this Annual Report on Form 10-K for a reconciliation of U.S. GAAP measures to comparable non-GAAP measures).Cash provided by investing activities totaled $61.6 million in 2020, compared with cash used by investing activities of $1,150.9 million in 2019. In 2020, the Company paid $116.5 million, net of cash acquired, to purchase IntelliPower in January 2020 and received proceeds of $245.3 million from the sale of its Reading business. Additions to property, plant and equipment totaled $74.2 million in 2020, compared with $102.3 million in 2019.Cash used by financing activities totaled $539.4 million in 2020, compared with $72.9 million of cash provided by financing activities in 2019. At December 31, 2020, total debt, net was $2,413.7 million, compared with $2,768.7 million at December 31, 2018. In 2020, short-term borrowings decreased $328.0 million, compared with an increase of $130.7 million in 2019. Long-term borrowings decreased $102.9 million in 2020, compared to no change in long-term borrowings in 2019. In October 2018, the Company along with certain of its foreign subsidiaries amended and restated its Credit Agreement. The Credit Agreement amends and restates the Company’s existing $850 million revolving credit facility, which was due to expire in March 2021. The amended Credit Agreement consists of a five-year revolving credit facility in an aggregate principal amount of $1.5 billion with a final maturity date in October 2023. The revolving credit facility total borrowing capacity excludes an accordion feature that permits the Company to request up to an additional $500 million in revolving credit commitments at any time during the life of the Credit Agreement under certain conditions. The revolving credit facility provides the Company with additional financial flexibility to support its growth plans, including its acquisition strategy. At December 31, 2020, the Company had available borrowing capacity of $1,897.7 million under its revolving credit facility, including the $500 million accordion feature. In the third quarter of 2020, an 80 million British pound ($102.9 million) 4.68% senior note matured and was paid. In the fourth quarter of 2019, $100 million of 6.30% senior notes matured and were paid. The debt-to-capital ratio was 28.9% at December 31, 2020, compared with 35.1% at December 31, 2019. The net debt-to-capital ratio (total debt, net less cash and cash equivalents divided by the sum of net debt and stockholders’ equity) was 16.8% at December 31, 2020, compared with 31.7% at December 31, 2019. The net debt-to-capital ratio is presented because the Company is aware that this measure is used by third parties in evaluating the Company. (See the “Notes to Selected Financial Data” included in Item 6 in this Annual Report on Form 10-K for a reconciliation of U.S. GAAP measures to comparable non-GAAP measures).In 2020, the Company repurchased approximately 55,000 shares of its common stock for $4.7 million, compared with $11.9 million used for repurchases of approximately 133,000 shares in 2019. At December 31, 2020, $484.4 million was available under the Company’s Board of Directors authorization for future share repurchases. On February 12, 2019, the Company’s Board of Directors approved an increase of $500 million in the authorization for the repurchase of the Company’s common stock. Additional financing activities for 2020 included cash dividends paid of $165.0 million, compared with $127.5 million in 2019. On February 12, 2020, the Company’s Board of Directors approved a 29% increase in the quarterly cash dividend on the Company’s common stock to $0.18 per common share from $0.14 per common share. 26Table of ContentsProceeds from the exercise of employee stock options were $64.9 million in 2020, compared with $90.4 million in 2019. As a result of all of the Company’s cash flow activities in 2020, cash and cash equivalents at December 31, 2019 totaled $1,212.8 million, compared with $393.0 million at December 31, 2019. At December 31, 2020, the Company had $344.0 million in cash outside the United States, compared with $357.9 million at December 31, 2019. The Company utilizes this cash to fund its international operations, as well as to acquire international businesses. The Company is in compliance with all covenants, including financial covenants, for all of its debt agreements. The Company believes it has sufficient cash-generating capabilities from domestic and unrestricted foreign sources, available credit facilities and access to long-term capital funds to enable it to meet its operating needs and contractual obligations in the foreseeable future. Subsequent EventEffective February 11, 2021, the Company's Board of Directors approved an 11% increase in the quarterly cash dividend on the Company's common stock to $0.20 per common share from $0.18 per common share.The following table summarizes AMETEK’s contractual cash obligations and the effect such obligations are expected to have on the Company’s liquidity and cash flows in future years at December 31, 2020. Payments DueContractual Obligations (1)TotalLess ThanOne YearMore Than One Year(In millions)Long-term debt borrowings(2)$2,347.6 $62.2 $2,285.4 Revolving credit loans(3)72.1 72.1 — Total debt(4)2,419.7 134.3 2,285.4 Interest on long-term fixed-rate debt454.4 71.4 383.0 Non-cancellable operating leases(5)190.1 50.3 139.8 Purchase obligations(6)526.1 462.1 32.0 Total$3,590.3 $718.1 $2,840.2 ______________________(1)The liability for uncertain tax positions was not included in the table of contractual obligations as of December 31, 2020 because the timing of the settlements of these uncertain tax positions cannot be reasonably estimated at this time. See Note 9 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details.(2)See Note 10 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details.(3)Although not contractually obligated, the Company expects to have the capability to repay the revolving credit loan within one year as permitted in the Credit Agreement. Accordingly, $72.1 million was classified as short-term debt at December 31, 2020.(4)Excludes debt issuance costs of $6.0 million, of which $2.0 million is classified as current and $4.0 million is classified as long-term. See Note 10 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details.(5)The leases expire over a range of years from 2021 to 2035, except for a single land lease with 63 years remaining. Most of the leases contain renewal or purchase options, subject to various terms and conditions.(6)Purchase obligations primarily consist of contractual commitments to purchase certain inventories at fixed prices.27Table of ContentsOther CommitmentsThe Company has standby letters of credit and surety bonds of $46.8 million related to performance and payment guarantees at December 31, 2020. Based on experience with these arrangements, the Company believes that any obligations that may arise will not be material to its financial position. Internal Reinvestment Capital Expenditures Capital expenditures were $74.2 million or 1.6% of net sales in 2020, compared with $102.3 million or 2.0% of net sales in 2019. In 2020, approximately 73% of capital expenditures were for improvements to existing equipment or additional equipment to increase productivity and expand capacity. Capital expenditures in 2021 are expected to be approximately 2% of net sales, with a continued emphasis on spending to improve productivity. Research, Development and Engineering The Company is committed to, and has consistently invested in, research, development and engineering activities to design and develop new and improved products and solutions. Research, development and engineering costs before customer reimbursement were $246.2 million in 2020, $260.3 million in 2019 and $230.2 million in 2018. These amounts included research and development expenses of $158.9 million, $161.9 million and $141.0 million in 2020, 2019, and 2018, respectively. All such expenditures were directed toward the development of new products and solutions and the improvement of existing products and solutions.Environmental MattersInformation with respect to environmental matters is set forth in Note 13 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.Critical Accounting Policies and EstimatesCritical accounting policies are those policies that can have a significant impact on the presentation of the Company’s financial condition and results of operations and that require the use of complex and subjective estimates based on the Company’s historical experience and management’s judgment. Because of the uncertainty inherent in such estimates, actual results may differ materially from the estimates used. Below are the policies used in preparing the Company's financial statements that management believes are the most dependent upon the application of estimates and assumptions. A complete list of the Company’s significant accounting policies is in Note 1 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. •Business Combinations. The Company allocates the purchase price of an acquired company, including when applicable, the acquisition date fair value of contingent consideration between tangible and intangible assets acquired and liabilities assumed from the acquired business based on their estimated fair values, with the residual of the purchase price recorded as goodwill. Third party appraisal firms and other consultants are engaged to assist management in determining the fair values of certain assets acquired and liabilities assumed. Estimating fair values requires significant judgments, estimates and assumptions, including but not limited to: discount rates, future cash flows and the economic lives of trade names, technology, and customer relationships. These estimates are based on historical experience and information obtained from the management of the acquired companies and are inherently uncertain.•Goodwill and Other Intangible Assets. Goodwill and other intangible assets with indefinite lives, primarily trademarks and trade names, are not amortized; rather, they are tested for impairment at least annually. The Company can elect to perform a qualitative analysis to determine if it is more likely than not that the fair values of its reporting units are less than the respective carrying values of those reporting units. The 28Table of ContentsCompany elected to bypass performing the qualitative screen and performed the first step quantitative analysis of the goodwill impairment test in the current year. The Company may elect to perform the qualitative analysis in future periods.The Company principally relies on a discounted cash flow analysis to determine the fair value of each reporting unit, which considers forecasted cash flows discounted at an appropriate discount rate. The Company believes that market participants would use a discounted cash flow analysis to determine the fair value of its reporting units in a sale transaction. The annual goodwill impairment test requires the Company to make a number of assumptions and estimates concerning future levels of revenue growth, operating margins, depreciation, amortization and working capital requirements, which are based on the Company’s long-range plan and are considered level 3 inputs. The Company’s long-range plan is updated as part of its annual planning process and is reviewed and approved by management. The discount rate is an estimate of the overall after-tax rate of return required by a market participant whose weighted average cost of capital includes both equity and debt, including a risk premium. While the Company uses the best available information to prepare its cash flow and discount rate assumptions, actual future cash flows or market conditions could differ significantly resulting in future impairment charges related to recorded goodwill balances. While there are always changes in assumptions to reflect changing business and market conditions, the Company’s overall methodology and the population of assumptions used have remained unchanged. In order to evaluate the sensitivity of the goodwill impairment test to changes in the fair value calculations, the Company applied a hypothetical 10% decrease in fair values of each reporting unit. The 2020 results (expressed as a percentage of carrying value for the respective reporting unit) showed that, despite the hypothetical 10% decrease in fair value, the fair values of the Company’s reporting units still exceeded their respective carrying values by 40% to 779%.The impairment test for indefinite-lived intangibles other than goodwill (primarily trademarks and trade names) consists of a comparison of the fair value of the indefinite-lived intangible asset to the carrying value of the asset as of the impairment testing date. The Company can elect to perform a qualitative analysis to determine if it is more likely than not that the fair values of its indefinite-lived intangible assets are less than the respective carrying values of those assets. The Company elected to bypass performing the qualitative screen. The Company may elect to perform the qualitative analysis in future periods. The Company estimates the fair value of its indefinite-lived intangibles using the relief from royalty method using level 3 inputs, which is a widely used valuation technique for such assets. The fair value derived from the relief from royalty method is determined by applying a royalty rate to a projection of net revenues discounted using an appropriate discount rate. Each royalty rate is determined based on the profitability of the trade name to which it relates and observed market royalty rates. Certain impairment models have discount rates calculated based on a debt/equity cost of capital. While the Company uses the best available information to prepare its cash flow and discount rate assumptions, actual future cash flows or market conditions could differ significantly resulting in future impairment charges related to recorded intangible balances. While there are always changes in assumptions to reflect changing business and market conditions, the Company’s overall methodology and the population of assumptions used have remained unchanged.The Company’s acquisitions have generally included a significant goodwill component and the Company expects to continue to make acquisitions. At December 31, 2020, goodwill and other indefinite-lived intangible assets totaled $4,977.9 million or 48.1% of the Company’s total assets. The Company completed its required annual impairment tests in the fourth quarter of 2020 and determined that the carrying values of the Company’s goodwill and indefinite-lived intangibles were not impaired. There can be no assurance that goodwill or indefinite-lived intangibles impairment will not occur in the future.•Pensions. The Company has U.S. and foreign defined benefit and defined contribution pension plans. The most significant elements in determining the Company’s pension income or expense are the assumed pension liability discount rate and the expected return on plan assets. The pension discount rate reflects the current interest rate at which the pension liabilities could be settled at the valuation date. At the end of each year, the Company determines the assumed discount rate to be used to discount plan liabilities. In 29Table of Contentsestimating this rate for 2020, the Company considered rates of return on high-quality, fixed-income investments that have maturities consistent with the anticipated funding requirements of the plan. In estimating the U.S. and foreign discount rates, the Company’s actuaries developed a customized discount rate appropriate to the plans’ projected benefit cash flow based on yields derived from a database of long-term bonds at consistent maturity dates. The Company determines the expected long-term rate of return based primarily on its expectation of future returns for the pension plans’ investments. Additionally, the Company considers historical returns on comparable fixed-income and equity investments and adjusts its estimate as deemed appropriate.•Income Taxes. The process of providing for income taxes and determining the related balance sheet accounts requires management to assess uncertainties, make judgments regarding outcomes and utilize estimates. The Company conducts a broad range of operations around the world and is therefore subject to complex tax regulations in numerous international taxing jurisdictions, resulting at times in tax audits, disputes and potential litigation, the outcome of which is uncertain. Management must make judgments currently about such uncertainties and determine estimates of the Company’s tax assets and liabilities. To the extent the final outcome differs, future adjustments to the Company’s tax assets and liabilities may be necessary.The Company assesses the realizability of its deferred tax assets, taking into consideration the Company’s forecast of future taxable income, available net operating loss carryforwards and available tax planning strategies that could be implemented to realize the deferred tax assets. Based on this assessment, management must evaluate the need for, and the amount of, valuation allowances against the Company’s deferred tax assets. To the extent facts and circumstances change in the future, adjustments to the valuation allowances may be required.The Company assesses the uncertainty in its tax positions, by applying a minimum recognition threshold which a tax position is required to meet before a tax benefit is recognized in the financial statements. Once the minimum threshold is met, using a more likely than not standard, a series of probability estimates is made for each item to properly measure and record a tax benefit. The tax benefit recorded is generally equal to the highest probable outcome that is more than 50% likely to be realized after full disclosure and resolution of a tax examination. The underlying probabilities are determined based on the best available objective evidence such as recent tax audit outcomes, published guidance, external expert opinion, or by analogy to the outcome of similar issues in the past. There can be no assurance that these estimates will ultimately be realized given continuous changes in tax policy, legislation and audit practice. The Company recognizes interest and penalties accrued related to uncertain tax positions in income tax expense.Recent Accounting Pronouncements See Note 2, Recent Accounting Pronouncements, to the Company’s Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for information regarding recently issued accounting pronouncements.Forward-Looking Information Certain matters discussed in this Form 10-K are “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995 (“PSLRA”), which involve risk and uncertainties that exist in the Company’s operations and business environment and can be affected by inaccurate assumptions, or by known or unknown risks and uncertainties. Many such factors will be important in determining the Company’s actual future results. The Company wishes to take advantage of the “safe harbor” provisions of the PSLRA by cautioning readers that numerous important factors in some cases have caused, and in the future could cause, the Company’s actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. Some, but not all, of the factors or uncertainties that could cause actual results to differ from present expectations are set forth above and under Item 1A. Risk Factors. The Company undertakes no obligation to 30Table of Contentspublicly update any forward-looking statements, whether as a result of new information, subsequent events or otherwise, unless required by the securities laws to do so.Item 7A. Quantitative and Qualitative Disclosures About Market RiskThe Company’s primary exposures to market risk are fluctuations in interest rates, foreign currency exchange rates and commodity prices, which could impact its financial condition and results of operations. The Company addresses its exposure to these risks through its normal operating and financing activities. The Company’s differentiated and global business activities help to reduce the impact that any particular market risk may have on its operating income as a whole. The Company’s short-term debt carries variable interest rates and generally its long-term debt carries fixed rates. These financial instruments are more fully described in the Notes to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. The foreign currencies to which the Company has the most significant exchange rate exposure are the Euro, the British pound, the Japanese yen, the Chinese renminbi, the Canadian dollar, and the Mexican peso. Exposure to foreign currency rate fluctuation is modest, monitored, and when possible, mitigated through the use of local borrowings and occasional derivative financial instruments in the foreign currency affected. The effect of translating foreign subsidiaries’ balance sheets into U.S. dollars is included in other comprehensive income within stockholders’ equity. Foreign currency transactions have not had a significant effect on the operating results reported by the Company because revenues and costs associated with the revenues are generally transacted in the same foreign currencies.The primary commodities to which the Company has market exposure are raw material purchases of nickel, aluminum, copper, steel, titanium, and gold. Exposure to price changes in these commodities are generally mitigated through adjustments in selling prices of the ultimate product and purchase order pricing arrangements, although forward contracts are sometimes used to manage some of those exposures. Based on a hypothetical ten percent adverse movement in interest rates, commodity prices or foreign currency exchange rates, the Company’s best estimate is that the potential losses in future earnings, fair value of risk-sensitive financial instruments and cash flows are not material, although the actual effects may differ materially from the hypothetical analysis.31Table of Contents

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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A")Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is designed to provide a reader of our consolidated financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A should be read in conjunction with the other sections of this Annual Report on Form 10-K, including Part I, Item 1A: “Risk Factors” and Part II, Item 8: “Financial Statements and Supplementary Data.” The various sections of this MD&A contain a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risk factors described throughout this filing. The tables in the MD&A sections below are derived from exact numbers and may have immaterial rounding differences.This section discusses our results of operations for the year ended December 31, 2020 as compared to the year ended December 31, 2019. For a discussion and analysis of the year ended December 31, 2019, compared to the same period in 2018 please refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations included in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2019, filed with the SEC on February 27, 2020.OverviewAxon is a global network of devices, apps and people that helps public safety personnel become smarter and safer. With a mission of protecting life, our technologies give law enforcement the confidence, focus and time they need to protect their communities. Our products impact every aspect of a public safety officer’s day-to-day experience with the goal of helping everyone get home safe. Our revenues for the year ended December 31, 2020 were $681.0 million, an increase of $150.1 million, or 28.2%, from the prior year. We had a loss from operations of $14.2 million compared to $6.4 million in the prior year. The higher loss from operations was primarily the result of increased stock compensation expense for our CEO Performance Award and XSPP awards and an increase in legal expenses. Remaining cost increases were primarily attributable to the increase in unit sales and an increase in headcount. These cost increases were largely offset by higher revenue and improved gross margin. For the year ended December 31, 2020, we recorded net loss of $1.7 million compared to net income of $0.9 million for the prior year.2021 OutlookFor the year ending December 31, 2021, we expect revenue of $740 million to $780 million. We anticipate that revenue for the three months ending March 31, 2021 will reflect approximately 12% growth as compared to the three months ended March 31, 2020. We anticipate capital expenditures of approximately $65 million to $70 million in 2021, including approximately $25 million in support of capacity expansion and automation of TASER device and cartridge manufacturing, approximately $20 million for development of our planned new manufacturing and office facility in Scottsdale, Arizona, and the remainder on investments to support our continued growth.COVID-19In late 2019, COVID-19 was first detected in Wuhan, China. In March 2020 the World Health Organization declared COVID-19 a global pandemic. This contagious disease outbreak, which has continued to spread throughout the United States and world, has adversely affected workforces, economies, and financial markets globally, leading to an economic downturn. As an essential provider of products and services for law enforcement and other first responders, we remain focused on protecting the health and wellbeing of our employees while assuring the continuity of our business operations.In response to the pandemic, Axon has taken a number of actions:Customer support:●Free access to Axon Citizen cloud software to all public law enforcement agencies in 2020 to enable social distancing;28 Table of Contents●A partnership with the National Police Foundation to provide personal protective equipment (“PPE”) for first responders;●An online support center for our customers, www.axon.com/covid-19-support-center; and●Our annual Axon Accelerate user conference was held virtually in late August 2020.​Employee safety and manufacturing:●Curbed all non-essential travel at the beginning of March;●We continue to allow for a remote work model for the majority of our office staff, with medical screening for any employees who do work in our offices; and●Mitigating contamination risk in our facilities through staggered shifts, the use of PPE, increased distancing, cleaning standards that exceed CDC guidance, and paying or subsidizing certain high-risk employees while they stay at home.​Supply chain:●We previously took steps to diversify our supply chain and global manufacturing footprint, which have positioned us well to manage through the pandemic. Thus far, we have been able to produce and ship our critical core products with little to no interruption.●We have proactively built up a safety stock of raw and finished goods inventory aligned to our strategic model to help meet strong product demand while also preparing us to stagger factory work schedules. We continue to adjust strategic inventory levels based on areas of risk to mitigate potential supply disruptions.●In light of our broad geographic supplier base both domestic and international, we are continuously monitoring our supply chain to manage through potential impacts, finding alternate sources as well as shipping / logistic options as available or working with foreign regulators to ensure that our suppliers can provide parts.​Shareholder engagement:●We have pivoted our shareholder engagement to a virtual format.oOur annual meeting was held virtually on May 29, 2020, and we anticipate holding our 2021 annual meeting virtually;oWe completed a follow-on equity offering in June 2020 for which all related marketing was conducted virtually; andoWe will continue to participate in several upcoming investor conferences utilizing video conferencing. All investor materials and events are available at investor.axon.com.​We are in a strong liquidity position, with substantial cash and investments on hand, which are discussed in more detail under Liquidity and Capital Resources. We believe that our existing liquidity and other sources of funding will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions or strategic investments and other liquidity requirements through at least the next 12 months. Our expenses for the year ended December 31, 2020 increased by approximately $4.1 million for costs related to the pandemic. We expect ongoing increased costs related to the mitigation of contamination risk at our facilities. We expect these incremental costs will continue to be partially offset by savings on travel and events and other cost-savings measures. ​We have elected to participate in the social security deferral program offered under the Coronavirus Aid, Relief, and Economic Security Act, whereby we deferred payment of the employer portion of all social security taxes that would otherwise have been payable from March 27, 2020 through December 31, 2020. Payment of the deferred amount is due 50% on December 31, 2021 and 50% on December 31, 2022.29 Table of Contents​Results of OperationsThe following table presents data from our consolidated statements of operations as well as the percentage relationship to total net sales of items included in our statements of operations (dollars in thousands):​​​​​​​​​​​​​​​​Year Ended December 31, ​​2020 ​2019 Net sales from products $ 500,250 73.5% ​$ 399,474 75.3%Net sales from services​ 180,753 26.5​​ 131,386 24.7​Net sales​ 681,003 100.0​​ 530,860 100.0​Cost of product sales​ 224,131 32.9​​ 190,683 35.9​Cost of service sales​ 40,541 6.0​​ 32,891 6.2​Cost of sales​ 264,672 38.9​​ 223,574 42.1​Gross margin​ 416,331 61.1​​ 307,286 57.9​Operating expenses:​​​​​​​​​​​​Sales, general and administrative​ 307,286 45.1​​ 212,959 40.1​Research and development​ 123,195 18.1​​ 100,721 19.0​Total operating expenses​ 430,481 63.2​​ 313,680 59.1​Income (loss) from operations​ (14,150) (2.1)​​ (6,394) (1.2)​Interest and other income, net​ 7,859 1.1​​ 8,464 1.6​Income (loss) before provision for income taxes​ (6,291) (1.0)​​ 2,070 0.4​Provision for (benefit from) income taxes​ (4,567) (0.7)​​ 1,188 0.2​Net income (loss) $ (1,724) (0.3)% ​$ 882 0.2%​Net sales to the U.S. and other countries are summarized as follows (dollars in thousands):​​​​​​​​​​​​​​​​Year Ended December 31, ​​2020​​2019 United States $ 535,079 79% ​$ 446,100 84%Other Countries​ 145,924 21​​ 84,760 16​Total​$ 681,003 100% ​$ 530,860 100%​International revenue in 2020 increased substantially compared to 2019, driven by strength in all of our international regions and most notably within EMEA.Our operations are comprised of two reportable segments: the manufacture and sale of CEDs, batteries, accessories and extended warranties and other products and services (collectively, the “TASER” segment); and software and sensors, which includes the sale of devices, wearables, applications, cloud and mobile products, and services (collectively, the "Software and Sensors" segment). In both segments, we report sales of products and services. Service revenue in both segments includes sales related to Axon Evidence. In the TASER segment, service revenue also includes digital subscription training content. In the Software and Sensors segment, service revenue also includes other recurring cloud-hosted software revenue and related professional services. Collectively, this revenue is sometimes referred to as "Axon Cloud revenue." Revenue from our “products” in the Software and Sensors segment are generally from sales of sensors, including on-officer body cameras, Axon Fleet cameras, other hardware sensors, warranties on sensors, and other products, and is sometimes referred to as "Sensors and Other revenue." Within the Software and Sensors segment, we include only revenues and costs attributable to that segment which costs include: costs of sales for both products and services, direct labor, and product management and R&D for products included, or to be included, within the Software and Sensors segment. All other costs are included in the TASER segment.30 Table of ContentsFor the Years Ended December 31, 2020 and 2019Net SalesNet sales by product line were as follows for the years ended December 31, 2020 and 2019 (dollars in thousands):​​​​​​​​​​​​​​​​​​​​Year Ended December 31, Dollar Percent ​​2020​2019​Change​Change TASER segment: ​ ​ ​ ​TASER 7​$ 107,506 15.8% $ 56,652 10.7% $ 50,854 89.8%TASER X26P​ 41,724 6.1​ 52,524 9.9​ (10,800) (20.6)​TASER X2​ 60,107 8.8​ 55,920 10.5​ 4,187 7.5​TASER Pulse​ 9,407 1.4​ 4,089 0.8​ 5,318 130.1​Cartridges​ 115,193 16.9​ 85,987 16.2​ 29,206 34.0​Axon Evidence and cloud services​ 2,935 0.4​ 704 0.1​ 2,231 316.9​Extended warranties​ 20,754 3.0​ 18,074 3.4​ 2,680 14.8​Other​ 8,926 1.3​ 7,711 1.5​ 1,215 15.8​TASER segment​ 366,552 53.7​ 281,661 53.1​ 84,891 30.1​Software and Sensors segment:​ ​ ​​ ​ ​​ ​Axon Body​ 57,150 8.4​ 44,039 8.3​ 13,111 29.8​Axon Flex​ 4,082 0.6​ 5,928 1.1​ (1,846) (31.1)​Axon Fleet​ 20,108 3.0​ 16,182 3.0​ 3,926 24.3​Axon Dock​ 19,723 2.9​ 20,449 3.9​ (726) (3.6)​Axon Evidence and cloud services​ 176,797 26.0​ 130,265 24.5​ 46,532 35.7​Extended warranties​ 24,408 3.6​ 19,188 3.6​ 5,220 27.2​Other​ 12,183 1.8​ 13,148 2.5​ (965) (7.3)​Software and Sensors segment​ 314,451 46.3​ 249,199 46.9​ 65,252 26.2​Total net sales​$ 681,003 100.0% $ 530,860 100.0% $ 150,143 28.3%​Net unit sales were as follows:​​​​​​​​​​​​​Year Ended December 31, ​Unit​Percent​ 2020 2019 Change ChangeTASER 7 77,451 49,221 28,230 57.4%TASER X26P 37,391 48,798 (11,407) (23.4)%TASER X2 43,407 40,973 2,434 5.9%TASER Pulse 33,158 11,785 21,373 181.4%Cartridges 3,714,291 2,751,603 962,688 35.0%Axon Body 182,538 151,499 31,039 20.5%Axon Flex 8,962 15,586 (6,624) (42.5)%Axon Fleet 11,304 10,467 837 8.0%Axon Dock 25,422 22,275 3,147 14.1%​Net sales for the TASER segment increased $84.9 million, or 30.1%, primarily as a result of a net increase of $49.6 million in TASER device sales and a $29.2 million increase in cartridge revenue. Cartridge revenue increased due to increased unit sales, partially offset by a slight decrease in average selling price. We continue to see a shift to purchases of our latest generation device, TASER 7, from legacy devices, especially X26P devices. Sales of our TASER 7 device also drove the increase in revenue from Axon Evidence and cloud services. Revenue was also impacted by higher average selling prices for TASER 7, X2, and X26P. Revenue from consumer TASER Pulse devices increased due to a substantial increase in volume, partially offset by lower average selling prices. Net sales for the Software and Sensors segment increased $65.3 million, or 26.2%. Revenue from Axon Evidence and cloud services increased $46.5 million as we continued to add users and associated devices to our network during 31 Table of Contentsthe year ended December 31, 2020. The increase in the aggregate number of users and devices also resulted in increased extended warranty revenues of $5.2 million. Revenue from Axon Body cameras increased $13.1 million following the introduction of our Axon Body 3 camera during the third quarter of 2019. Backlog - As of December 31, 2020 compared to December 31, 2019Our backlog for products and services includes all orders that have been received and are believed to be firm.In the TASER segment, we define backlog as equal to deferred revenue. Deferred revenue represents amounts invoiced to customers for goods and services to be delivered in subsequent periods. We process orders within the TASER segment quickly, and our best estimate of firm orders outstanding as of period end represents those that have been invoiced but remain undelivered. The TASER segment backlog balance was $61.8 million as of December 31, 2020. We expect to realize $28.9 million of this deferred revenue balance as revenue during the next 12 months. This represents cash received and accounts receivable from customers on or prior to December 31, 2020 for products and services expected to be delivered in the next 12 months.In the Software and Sensors segment, we define backlog as cumulative bookings, net of cancellations, less product and service revenue recognized to date. Bookings are generally realized as revenue over multiple years. The Software and Sensors backlog balance was $1.4 billion as of December 31, 2020. This backlog balance includes $213.4 million of deferred revenue, and $1.2 billion that has been recorded as bookings but not yet invoiced, all as of December 31, 2020. We expect to realize approximately $370.0 million of the December 31, 2020 backlog balance as revenue during the next 12 months.​​​​​​​​​​​​ TASER Software and Sensors Total​​(in thousands)Balance, beginning of period​$ 55,189​$ 1,026,192​$ 1,081,381Add: additions to backlog, net of cancellations​​ 373,119​​ 716,145​​ 1,089,264Less: revenue recognized during period​​ (366,552)​​ (314,451)​​ (681,003)Balance end of period​$ 61,756 $ 1,427,886 $ 1,489,642​Our backlog of $1.5 billion as of December 31, 2020 has increased significantly from $1.1 billion as of December 31, 2019. The increase in TASER segment backlog is not expected to have a material impact on revenue or operating margins. Our significant increase in backlog, primarily in the Software and Sensors segment is indicative of expected revenue growth in this segment.Cost of Product and Service SalesCost of product and services sales in dollars and as a percent of related segment sales (dollars in thousands):​​​​​​​​​​​​​​​​​​​​Year Ended December 31, ​Dollar​Percent ​​2020​2019​Change​Change TASER segment: ​​ ​ ​​ ​ ​​ ​ Cost of product sales​$ 136,925​ 37.4% $ 107,188​ 38.1% $ 29,737​ 27.7%Software and Sensors segment:​​​​​​​​​​​​​​​ Cost of product sales​​ 87,206 27.7% 83,495 33.5% 3,711 4.4%Cost of service sales​​ 40,541 12.9% 32,891 13.2% 7,650 23.3%Total cost of sales​​ 127,747 40.6% 116,386 46.7% 11,361 9.8%Total cost of product and service sales​$ 264,672 38.9% $ 223,574 42.1% $ 41,098 18.4%​Within the TASER segment, cost of product and service sales was $136.9 million, an increase of $29.7 million, or 27.7%, from 2019. Cost as a percentage of sales decreased to 37.4% from 38.1%. The increase in cost of sales was primarily a result of increased sales, with improvement to the cost as a percentage of sales primarily a result of 32 Table of Contentsincreased leverage on manufacturing overhead expenses and higher expense in the prior year for TASER 7 ramp-up and optimization costs related to scrap, obsolete inventory, and higher labor costs.Within the Software and Sensors segment, cost of product and service sales was $127.7 million, an increase of $11.4 million, or 9.8%, from 2019. As a percentage of net sales, cost of product and service sales decreased to 40.6% in 2020 from 46.7% in 2019. Cost of product sales increased $3.7 million primarily driven by the impact of increased units, but decreased as a percentage of total segment net sales, reflecting higher average selling prices on Axon cameras and docks, overall product mix, and relatively stable unit costs. Cost of service sales increased $7.7 million driven primarily by a $3.9 million increase in third party cloud data cost, and an increase in professional services expense due to increased deployments in 2020. Gross MarginGross Margin (dollars in thousands):​​​​​​​​​​​​​​​​​​​​​​​​​​​​​Year Ended December 31, ​Dollar​Percent​​ 2020 2019 Change Change​TASER segment​$ 229,627​$ 174,473​$ 55,154​ 31.6%Software and Sensors segment​​ 186,704​​ 132,813​​ 53,891​ 40.6%Total gross margin​$ 416,331​$ 307,286​$ 109,045 35.5%Gross margin as % of net sales​​ 61.1% 57.9% ​​​​​​Gross margin increased $109.0 million to $416.3 million for the year ended December 31, 2020 compared to $307.3 million for 2019. As a percentage of net sales, gross margin increased to 61.1% for 2020 from 57.9% for 2019.As a percentage of net sales, gross margin for the TASER segment increased to 62.6% for the year ended December 31, 2020 from 61.9% for the year ended December 31, 2019.Within the Software and Sensors segment, gross margin as a percentage of total segment net sales was 59.4% and 53.3% for the years ended 2020 and 2019, respectively. Within the Software and Sensors segment, product gross margin was 36.6% for the year ended December 31, 2020 and 29.8% for the same period in 2019, while the service margins were 77.1% and 74.8% during those same periods, respectively.Sales, General and Administrative ExpensesSales, General and Administrative ("SG&A") Expenses (dollars in thousands):​​​​​​​​​​​​​​​​Year Ended December 31, ​Dollar​Percent​ 2020 2019 Change ChangeSalaries, benefits and bonus​$ 83,287​$ 67,582​$ 15,705​ 23.2% Stock-based compensation​​ 103,860​​ 59,341​​ 44,519​ 75.0​Professional, consulting and lobbying​​ 45,541​​ 21,590​​ 23,951​ 110.9​Sales and marketing​​ 32,464​​ 28,961​​ 3,503​ 12.1​Office and building​​ 9,076​​ 6,650​​ 2,426​ 36.5​Travel and meals​​ 5,630​​ 11,407​​ (5,777)​ (50.6)​Depreciation and amortization���​ 6,079​​ 5,739​​ 340​ 5.9​Other​​ 21,349​​ 11,689​​ 9,660​ 82.6​Total sales, general and administrative expenses​$ 307,286​$ 212,959​$ 94,327 44.3%SG&A expenses as a percentage of net sales​​ 45.1% ​ 40.1% ​​​​​​SG&A expenses increased $94.3 million, or 44.3%. Stock-based compensation expense increased $44.5 million in comparison to the prior year comparable period, which was primarily attributable to an increase of $41.5 33 Table of Contentsmillion in expense related to the CEO Performance Award and XSPP. As of December 31, 2020, eleven operational goals for the CEO Performance Award and XSPP are considered probable of attainment or have been attained; during the prior year comparable period, nine operational goals were considered probable. Refer to Note 13 of the notes to our consolidated financial statements within this Annual Report on Form 10-K for additional discussion of the CEO Performance Award and XSPP. Stock-based compensation expense also increased over the prior year comparable period due to an increase in headcount.Professional, consulting and lobbying expenses increased $24.0 million, driven primarily by an increase of $19.1 million in expenses related to the FTC litigation. As discussed in Note 10 of the notes to our consolidated financial statements within this Annual Report on Form 10-K, on January 3, 2020, we sued the FTC in the District of Arizona, and the FTC filed an enforcement action regarding our May 2018 acquisition of Vievu LLC. Also contributing to the increase were higher expenses related to our enterprise resource planning system conversion.Salaries, benefits and bonus expense increased $15.7 million, primarily due to an increase in headcount. Salaries, benefits and bonus expense decreased as a percentage of sales from 12.7% for 2019 to 12.2% for 2020. Sales and marketing expenses increased $3.5 million, driven by a $4.8 million increase in commissions tied to higher revenues. The increase was partially offset by savings driven by the cancellation of in-person events, including our annual Axon Accelerate user conference.Other SG&A expenses increased by $9.7 million, primarily driven by the following:●Supplies expense increased $3.0 million, including a $2.4 million increase in computer licenses and maintenance supporting increased headcount, and a $0.7 million increase for PPE and other COVID-19 related expenses.●Charitable contributions increased $1.8 million, primarily reflecting our donations of PPE under our Got You Covered campaign. ●Insurance expense increased $1.4 million primarily as a result of increases in the cost of comparable policies. ●Recruiting expense increased $0.9 million as a result of increased hiring needs in 2020. ​Partially offsetting the noted increases was a $5.8 million decrease in travel expenses following the suspension of all non-essential travel in mid-March 2020 in response to the COVID-19 pandemic.Research and Development ExpensesResearch and Development ("R&D") Expenses (dollars in thousands):​​​​​​​​​​​​​​​​Year Ended December 31, ​Dollar​Percent​ 2020 2019 Change ChangeSalaries, benefits and bonus​$ 71,488​$ 63,763​$ 7,725​ 12.1% Stock-based compensation​​ 26,248​​ 17,588​​ 8,660​ 49.2​Professional and consulting​​ 10,503​​ 4,525​​ 5,978​ 132.1​Travel and meals​​ 594​​ 2,247​​ (1,653)​ (73.6)​Other​​ 14,362​​ 12,598​​ 1,764​ 14.0​Total research and development expenses​$ 123,195​$ 100,721​$ 22,474 22.3%R&D expenses as a percentage of net sales​​ 18.1%​ 19.0%​​​​​​The increase in R&D expense was primarily attributable to our Software and Sensors segment. Within the TASER segment, R&D expenses increased $0.9 million or 6.3%, reflecting increased consulting expense and supplies in the current year related to the development of next generation products. The increase was partially offset by lower compensation and benefits resulting from decreased headcount.34 Table of ContentsR&D expense for the Software and Sensors segment increased $21.6 million or 25.0% but remained relatively consistent at 34.3% of sales as compared to 34.6% in the prior year. Of the increase, $9.1 million related to salaries, benefits, and bonus attributable to increased headcount.Stock-based compensation expense increased $8.7 million. Contributing to the increase was expense of $3.8 million related to our XSPP. As of December 31, 2020, eleven operational goals for the XSPP are considered probable of attainment or have been attained; during the prior year comparable period, nine operational goals were considered probable. Stock-based compensation expense also increased over the prior year comparable period due to an increase in headcount.Professional and consulting expenses increased $6.0 million related to development of next generation products. The increases were partially offset by a decrease of $1.7 million in travel and meals expense following the suspension of all non-essential travel in mid-March 2020 due to the COVID-19 pandemicWe expect R&D expense to continue to increase in absolute dollars as we focus on growing the Software and Sensors segment as we add headcount and additional resources to develop new products and services to further advance our scalable cloud-connected device platform. We believe that these investments will result in an increase in our subscription revenue base, which over time will result in revenue increasing faster than the increase in SG&A expenses as we reach economies of scale.Interest and Other Income, NetInterest and other income, net was $7.9 million and $8.5 million for the years ended December 31, 2020 and 2019, respectively.For the year ended December 31, 2020, we earned interest income of $5.1 million, other income, net of $0.6 million, had losses from foreign currency transaction adjustments of $0.2 million, and interest expense of $0.1 million. Additionally, we recorded a net gain of $2.1 million related to an observable price change for our investment in Flock Group, Inc. and related warrants. The decrease in interest income was a result of decreased interest rates during the current period, partially offset by higher balances of cash, cash equivalents, and investments. For the year ended December 31, 2019, we earned interest income of $8.7 million and had losses from foreign currency transaction adjustments of $0.3 million, other income, net of $0.1 million, and interest expense of less than $0.1 million.Provision for Income TaxesThe provision for income taxes was a benefit of $4.6 million for the year ended December 31, 2020. The effective income tax rate for 2020 was 72.6%. The benefits related to excess stock-based compensation of $9.0 million, research and development credits of $10.2 million, and a deduction for foreign derived intangible income (“FDII”) of $0.9 million were partially offset by the tax effects of permanently non-deductible expenses for executive compensation of $15.5 million, an increase in uncertain tax benefits of $1.0 million, other permanently non-deductible expenses of $0.8 million and state tax expense of $0.9 million. Additionally, we recorded a $0.2 million increase to our valuation allowance as of December 31, 2020 related to research and development tax credits that may not be utilized prior to expiration, partially offset by changes in certain foreign jurisdictions.The provision for income taxes was $1.2 million for the year ended December 31, 2019. The effective income tax rate for 2019 was 57.4%. The benefits related to excess stock-based compensation of $5.0 million and research and development credits of $4.9 million were partially offset by the tax effects of permanently non-deductible expenses for executive compensation of $7.6 million, an increase in uncertain tax benefits of $1.2 million and other permanently non-deductible expenses of $1.1 million and state tax expense of $0.5 million. Additionally, we recorded 35 Table of Contentsa $0.4 million increase to our valuation allowance as of December 31, 2019 related to research and development tax credits that may not be utilized prior to expiration, partially offset by changes in certain foreign jurisdictions.Net IncomeWe recorded net loss of $1.7 million for the year ended December 31, 2020 compared to net income of $0.9 million in 2019. Net loss per basic and diluted share was $0.03 for 2020, compared to net income per basic and diluted share of $0.01 for 2019.Three Months Ended December 31, 2020 Compared to September 30, 2020Net sales by product line were as follows (dollars in thousands):​​​​​​​​​​​​​​​​​​​ Three Months Ended Three Months Ended Dollar Percent​​December 31, 2020​September 30, 2020​Change​ChangeTASER segment:​​​​​​​​​​​​​​​​TASER 7​$ 58,890 26.0% $ 21,702 13.0% $ 37,188 171.4%TASER X26P​ 11,386 5.0​ 9,766 5.9​ 1,620 16.6​TASER X2​ 14,706 6.5​ 14,494 8.7​ 212 1.5​TASER Pulse​ 3,033 1.4​ 2,981 1.8​ 52 1.7​Cartridges​​ 38,461​ 17.0​​ 26,335​ 15.8​​ 12,126​ 46.0​Axon Evidence and cloud services​ 1,159 0.5​ 692 0.4​ 467 67.5​Extended warranties​ 5,414 2.4​ 5,265 3.2​ 149 2.8​Other​ 2,712 1.2​ 3,171 1.9​ (459) (14.5)​TASER segment​ 135,761 60.0​ 84,406 50.7​ 51,355 60.8​Software and Sensors segment:​ ​ ​ ​Axon Body​ 16,505 7.3​ 15,978 9.6​ 527 3.3​Axon Flex​ 630 0.3​ 1,589 1.0​ (959) (60.4)​Axon Fleet​ 7,020 3.1​ 4,215 2.5​ 2,805 66.5​Axon Dock​ 5,009 2.2​ 5,708 3.4​ (699) (12.2)​Axon Evidence and cloud services​ 50,302 22.2​ 45,450 27.3​ 4,852 10.7​Extended warranties​ 6,701 3.0​ 6,514 3.9​ 187 2.9​Other​ 4,212 1.9​ 2,582 1.6​ 1,630 63.1​Software and Sensors segment​ 90,379 40.0​ 82,036 49.3​ 8,343 10.2​Total net sales​$ 226,140 100.0% $ 166,442 100.0% $ 59,698 35.9%​Net unit sales were as follows:​​​​​​​​​​​​ Three Months Ended ​ ​ ​​​​​​Unit​Percent​​December 31, 2020​September 30, 2020​Change​ChangeTASER 7 41,099 15,908 25,191 158.4% TASER X26P 10,611 8,119 2,492 30.7% TASER X2 9,751 10,078 (327) (3.2)% TASER Pulse 11,657 12,811 (1,154) (9.0)% Cartridges 1,272,679 852,980 419,699 49.2% Axon Body 44,735 62,873 (18,138) (28.8)% Axon Flex 749 3,175 (2,426) (76.4)% Axon Fleet 3,905 2,396 1,509 63.0% Axon Dock 6,326 9,165 (2,839) (31.0)% ​Net sales for the TASER segment increased $51.4 million, or 60.8%, on a sequential basis primarily due to a $37.2 million increase in revenue from TASER 7 devices and a $12.1 million increase in cartridge revenue. The 36 Table of Contentsincrease in TASER 7 revenues was a result of both increased unit sales and a higher average selling price, driven by greater adoption of TASER 7, especially internationally.Net sales for the Software and Sensors segment increased $8.3 million, or 10.2%, on a sequential basis primarily due to a $4.9 million increase in Axon Evidence and cloud services revenue and a $2.8 million increase in Axon Fleet revenue. The increase in Axon Evidence and cloud services revenue was a result of the increase in the aggregate number of users on our network. Axon Fleet revenue was driven primarily by increased unit sales, as well as an increase in the average selling price. International sales were $59.5 million in for the three months ended December 31, 2020 as compared to $23.1 million for the three months ended September 30, 2020, an increase of $36.4 million, primarily driven by increased sales in Europe.Non-GAAP Financial MeasuresTo supplement our financial results presented in accordance with accounting principles generally accepted in the U.S. ("GAAP"), we present the non-GAAP financial measures of EBITDA and Adjusted EBITDA (CEO Performance Award). Our management uses these non-GAAP financial measures in evaluating our performance in comparison to prior periods. We believe that both management and investors benefit from referring to these non-GAAP financial measures in assessing our performance, and when planning and forecasting our future periods. A reconciliation of GAAP to the non-GAAP financial measures is presented below.●EBITDA (Most comparable GAAP Measure: Net income) - Earnings before interest expense, investment interest income, taxes, depreciation and amortization.●Adjusted EBITDA (CEO Performance Award) (Most comparable GAAP Measure: Net income) - Earnings before interest expense, investment interest income, taxes, depreciation, amortization and non-cash stock-based compensation expense.Although these non-GAAP financial measures are not consistent with GAAP, management believes investors will benefit by referring to these non-GAAP financial measures when assessing our operating results, as well as when forecasting and analyzing future periods. However, management recognizes that:●these non-GAAP financial measures are limited in their usefulness and should be considered only as a supplement to our GAAP financial measures;●these non-GAAP financial measures should not be considered in isolation from, or as a substitute for, our GAAP financial measures;●these non-GAAP financial measures should not be considered to be superior to our GAAP financial measures; and●these non-GAAP financial measures were not prepared in accordance with GAAP and investors should not assume that the non-GAAP financial measures presented in this Annual Report on Form 10-K were prepared under a comprehensive set of rules or principles.37 Table of ContentsEBITDA and Adjusted EBITDA (CEO Performance Award) reconcile to net income as follows (dollars in thousands):​​​​​​​​​​For the Years Ended December 31, ​ December 31, December 31, ​​2020​2019Net income (loss)​$ (1,724)​$ 882Depreciation and amortization​ 12,475​ 11,361Interest expense​ 55​ 46Investment interest income​ (4,086)​ (7,040)Provision for (benefit from) income taxes​ (4,567)​ 1,188EBITDA​$ 2,153​$ 6,437​​​​​​​Adjustments:​ ​ Stock-based compensation expense​ 133,572​ 78,495Adjusted EBITDA (CEO Performance Award)​$ 135,725​$ 84,932​Liquidity and Capital ResourcesSummaryAs of December 31, 2020, we had $155.4 million of cash and cash equivalents, a decrease of $16.8 million from December 31, 2019. Cash and cash equivalents and investments totaled $652.6 million, an increase of $256.4 million from December 31, 2019.Cash FlowsThe following table summarizes our cash flows from operating, investing and financing activities (in thousands):​​​​​​​​​​Year Ended December 31, ​ 2020 2019Operating activities​$ 38,481​$ 65,673Investing activities​​ (356,526)​​ (240,737)Financing activities​​ 299,265​​ (3,937)Effect of exchange rate changes on cash and cash equivalents​ 1,976​ 329Net decrease in cash and cash equivalents and restricted cash​$ (16,804)​$ (178,672)​Operating activitiesNet cash provided by operating activities in 2020 of $38.5 million consisted of $1.7 million in net loss, the net add-back of non-cash income statement items totaling $141.0 million and a $100.8 million net change in operating assets and liabilities. Included in the non-cash items were $12.5 million in depreciation and amortization expense, $133.6 million in stock-based compensation expense, and a $16.5 million increase in deferred income tax assets. The most significant increase to the portion of cash provided by operating activities related to the changes in operating assets and liabilities was a $107.8 million increase in accounts and notes receivable and contract assets. The increase in accounts and notes receivable and contract assets was attributable to increased sales in 2020, primarily sales made under subscription plans. Operating cash flows were also negatively impacted by increased inventory of $52.2 million, as we proactively built up a safety stock of inventory to help meet strong product demand while also preparing us to stagger factory work schedules, and increased prepaid expenses and other assets of $14.9 million resulting primarily from an increase in deferred commissions expense. Operating cash flows were positively impacted by an increase in deferred revenue of $65.1 million. The increase in deferred revenue was primarily attributable to increased prepayments for Software and Sensors hardware and services, and a smaller increase in hardware deferred revenue from TASER subscription sales. 38 Table of ContentsInvesting activitiesWe used $356.5 million for investing activities in 2020. Purchases of investments, net of calls and maturities, were $276.7 million. We also invested $72.6 million in the purchase of property and equipment and intangibles, including $54.1 million for land on which we intend to construct our new manufacturing and office facility, and $7.1 million for equity investments in unconsolidated affiliates. Financing activitiesNet cash used provided by financing activities was $299.3 million for the year ended December 31, 2020. During 2020, we completed an equity offering that generated net proceeds of $306.8 million. Certain RSUs that vested in the year ended December 31, 2020 were net-share settled, such that we withheld shares to cover the employees’ tax obligation for the applicable income and other employment taxes, and remitted the cash, which totaled $7.8 million, to the appropriate taxing authorities.Liquidity and Capital ResourcesOur most significant source of liquidity continues to be funds generated by operating activities and available cash and cash equivalents. In addition, our $50.0 million revolving credit facility is available for additional working capital needs or investment opportunities. Under the terms of the line of credit, available borrowings are reduced by outstanding letters of credit. Advances under the line of credit bear interest at LIBOR plus 1.0 to 1.5% per year determined in accordance with a pricing grid based on our funded debt to earnings before interest, taxes, depreciation and amortization ("EBITDA") ratio.As of December 31, 2020, we had letters of credit outstanding of $6.1 million, leaving the net amount available for borrowing of $43.9 million. The facility matures on December 31, 2021 and has an accordion feature which allows for an increase in the total line of credit up to $100.0 million, subject to certain conditions, including the availability of additional bank commitments. There can be no assurance that we will continue to generate cash flows at or above current levels or that we will be able to maintain our ability to borrow under our revolving credit facility. At December 31, 2020 and 2019, there were no borrowings under the line.Our agreement with the bank requires us to comply with a maximum funded debt to EBITDA ratio, as defined, of no greater than 2.50 to 1.00 based upon a trailing four fiscal quarter period. At December 31, 2020, the Company’s funded debt to EBITDA ratio was 0.0000 to 1.00.On January 29, 2021, we entered into an amendment to the credit agreement which extends the maturity date to December 31, 2023 and increases the amount of the unsecured revolving line of credit which is available for letters of credit from $10 million to $20 million.TASER subscription and installment purchase arrangements typically involve amounts invoiced in five equal installments at the beginning of each year of the five-year term. This is in contrast to a traditional CED sale in which the entire amount being charged for the hardware is invoiced upon shipment. This impacts liquidity in a commensurate fashion, with the cash for the subscription or installment purchase received in five annual installments rather than up front. It is our strategic intent to shift an increasing amount of our business to a subscription model, to better match the municipal budgeting process of our customers as well as to allow for multiple product offerings to be bundled into existing subscriptions. We carefully considered the cash flow impacts of this strategic shift and regularly revisit our cash flow forecast with the goal of maintaining a comfortable level of liquidity as we introduce commercial offerings in which we incur upfront cash costs to produce and fulfill hardware sales ahead of the cash inflows from our customers. Based on our strong balance sheet and the fact that we had no long-term debt or financing lease obligations at December 31, 2020, we believe financing will be available, both through our existing credit line and possible 39 Table of Contentsadditional financing. However, there is no assurance that such funding will be available on terms acceptable to us, or at all.We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions or strategic investments and other liquidity requirements through at least the next 12 months. We and our Board of Directors may consider repurchases of our common stock. Further repurchases of our common stock would take place on the open market, would be financed with available cash and are subject to authorization as well as market and business conditions.Contractual ObligationsThe following table outlines our future contractual financial obligations by period in which payment is expected, as of December 31, 2020 (dollars in thousands):​​​​​​​​​​​​​​​​​​​​​​Less than​​​​​​​More than​ Total 1 Year 1 - 3 Years 3 - 5 Years 5 YearsOperating lease obligations​$ 26,409​$ 6,277​$ 12,069​$ 7,860​$ 203Purchase obligations​​ 209,258​​ 192,826​​ 4,169​​ 5,003​​ 7,260Total contractual obligations $ 235,667 $ 199,103 $ 16,238 $ 12,863 $ 7,463​Purchase obligations in the table above represent $169.3 million of open purchase orders and $40.0 million of other purchase obligations. The open purchase orders represent both cancelable and non-cancelable purchase orders with key vendors, which are included in this table due to our strategic relationships with these vendors.We are subject to U.S. federal income tax as well as income taxes imposed by state and foreign jurisdictions. As of December 31, 2020, we had $7.7 million of gross unrecognized tax benefits related to uncertain tax positions. The settlement period for these long-term income tax liabilities cannot be determined; however, the liabilities are expected to increase by approximately $0.1 million within the next 12 months.Off-Balance Sheet ArrangementsThe discussion of off-balance sheet arrangements in Note 10 to the consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K is incorporated by reference herein.Critical Accounting EstimatesWe have identified the following accounting estimates as critical to our business operations and the understanding of our results of operations. The preparation of this Annual Report on Form 10-K requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. While we do not believe that a change in these estimates is reasonably likely, there can be no assurance that our actual results will not differ from these estimates. The effect of these estimates on our business operations is discussed below.Product WarrantiesWe warranty our CEDs, Axon cameras and certain related accessories from manufacturing defects on a limited basis for a period of one year after purchase and, thereafter, will replace any defective unit for a fee. Estimated costs for the standard warranty are charged to cost of products sold when revenue is recorded for the related product. Future warranty costs are estimated based on historical data related to warranty claims on a quarterly basis and this rate is applied to current product sales. Historically, reserve amounts have been increased if management becomes aware of a component failure or other issue that could result in larger than anticipated warranty claims from customers. The warranty reserve is reviewed quarterly to verify that it sufficiently reflects the remaining warranty obligations based 40 Table of Contentson the anticipated expenditures over the balance of the warranty obligation period, and adjustments are made when actual warranty claim experience differs from estimates. As of December 31, 2020 and 2019, our warranty reserve was approximately $0.8 million and $1.5 million, respectively. Warranty expense for the years ended December 31, 2020, 2019 and 2018 was $0.0 million, $1.6 million and $0.7 million, respectively. Warranty expense for the year ended December 31, 2020, was impacted by lower than expected warranty claims for the Axon Body 3 on-officer body camera. Warranty expense for the year ended December 31, 2019 was impacted by higher than initially expected warranty claims for the Axon Flex 2 on-officer body camera. Warranty expense for the year ended December 31, 2018, was impacted by lower than expected warranty claims for the Axon Body 2 on-officer body camera.Revenue related to separately-priced extended warranties is initially recorded as deferred revenue at its allocated amount and subsequently recognized as net sales on a straight-line basis over the warranty service period. Costs related to extended warranties are charged to cost of product and service sales when incurred.InventoryInventories are stated at the lower of cost and net realizable value. Cost is determined using the weighted average cost of raw materials, which approximates the first-in, first-out (“FIFO”) method and includes allocations of manufacturing labor and overhead. Provisions are made to reduce potentially excess, obsolete or slow-moving inventories, as well as trial and evaluation inventories to their net realizable value. These provisions are based on management’s best estimate after considering historical demand, projected future demand, inventory purchase commitments, industry and market trends and conditions among other factors. We evaluate inventory costs for abnormal costs due to excess production capacity and treat such costs as period costs.During the year ended December 31, 2020, we recorded provisions to reduce inventories to their lower of cost and net realizable value of approximately $3.8 million compared to $1.3 million during the year ended December 31, 2019. The largest driver of the increase in the provision in 2020 compared to 2019 was a $2.2 million reduction in the carrying amount of our trial and evaluation inventory to zero which is our estimate of its net realizable value. The provision in 2020 and in 2019 was driven by analyses of projected sales data for existing products resulting in adjustments to state inventories at their lower of cost and net realizable value.Revenue Recognition, Deferred Revenue and Accounts and Notes ReceivableWe derive revenue from two primary sources: (1) the sale of physical products, including CEDs, Axon cameras, Axon Signal enabled devices, corresponding hardware extended warranties, and related accessories such as Axon docks, cartridges and batteries, among others, and (2) subscriptions to our Axon Evidence digital evidence management SaaS (including data storage fees and other ancillary services), which includes varying levels of support. To a lesser extent, we also recognize training, professional services and revenue related to other software and SaaS services. We apply the five-step model outlined in Accounting Standards Codification ("ASC") Topic 606, Revenue from Contracts with Customers ("Topic 606").A performance obligation is a promise in a contract to transfer a distinct good or service to the customer, and is the unit of account in Topic 606. For contracts with multiple performance obligations, we allocate the contract transaction price to each performance obligation using our estimate of the standalone selling price ("SSP") of each distinct good or service in the contract.Revenues are recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We enter into contracts that can include various combinations of products and services, each of which is generally distinct and accounted for as a separate performance obligation. Revenue is recognized net of allowances for returns.Performance obligations to deliver products, including CEDs, cameras and related accessories such as cartridges, batteries and docks, are generally satisfied at the point in time we ship the product, as this is when the customer obtains control of the asset under our standard terms and conditions. In certain contracts with non-standard terms and 41 Table of Contentsconditions, these performance obligations may not be satisfied until formal customer acceptance occurs. Performance obligations to fulfill service-type extended warranties and provide our SaaS offerings, including Axon Evidence and other cloud services, are generally satisfied over time as the customer receives and consumes the benefits of these services over the stated service period.Many of our products and services are sold on a standalone basis. We also bundle our hardware products and services together and sell them to our customers in single transactions, where the customer can make payments over a multi-year period. For the years ended December 31, 2020, 2019 and 2018, the composition of revenue recognized from contracts containing multiple performance obligations and those not containing multiple performance obligations was as follows (dollars in thousands):​​​​​​​​​​​​​​​​​​​​For the Year Ended December 31, 2020​​​TASER Software and Sensors Total Contracts with Multiple Performance Obligations $ 186,427 50.9% $ 311,187 99.0% $ 497,614 73.1%Contracts without Multiple Performance Obligations​​ 180,125​ 49.1​​ 3,264​ 1.0​​ 183,389​ 26.9 Total​$ 366,552​ 100.0% $ 314,451​ 100.0% $ 681,003​ 100.0%​​​​​​​​​​​​​​​​​​​​For the Year Ended December 31, 2019​​ TASER Software and Sensors Total Contracts with Multiple Performance Obligations $ 130,761 46.4% $ 245,416 98.5% $ 376,177 70.9%Contracts without Multiple Performance Obligations​​ 150,900​ 53.6​​ 3,783​ 1.5​​ 154,683​ 29.1 Total​$ 281,661​ 100.0% $249,199​ 100.0% $ 530,860​ 100.0%​​​​​​​​​​​​​​​​​​​​For the Year Ended December 31, 2018​​ TASER Software and Sensors Total Contracts with Multiple Performance Obligations $ 72,355 28.6% $ 159,318 95.4% $ 231,673 55.2%Contracts without Multiple Performance Obligations​​ 180,760​ 71.4​​ 7,635​ 4.6​​ 188,395​ 44.8 Total​$ 253,115​ 100.0% $ 166,953​ 100.0% $ 420,068​ 100.0%​Additionally, we offer customers the ability to purchase CED cartridges and certain services on an unlimited basis over the contractual term. Due to the unlimited nature of these arrangements whereby we are obligated to deliver unlimited products at the customer’s request, we account for these arrangements as stand-ready obligations, and recognize revenue ratably over the contract period. Cost of product sales is recognized as the products are shipped to the customer.We have elected to recognize shipping costs as an expense in cost of product sales when the control of hardware products or accessories have transferred to the customer.Sales tax collected on sales is netted against government remittances and thus, recorded on a net basis.Deferred revenue consists of payments received in advance related to products and services for which the criteria for revenue recognition have not yet been met. Deferred revenue that will be recognized during the subsequent twelve month period from the balance sheet date is recorded as current deferred revenue and the remaining portion is recorded as long-term. Generally, customers are billed in annual installments.Sales are typically made on credit, and we generally do not require collateral. 42 Table of ContentsValuation of Goodwill, Intangible and Long-lived AssetsWe do not amortize goodwill and intangible assets with indefinite useful lives; rather, such assets are required to be tested for impairment at least annually, or sooner whenever events or changes in circumstances indicate that the assets may be impaired. We perform our annual impairment assessment in the fourth quarter of each year. Finite-lived intangible assets and other long-lived assets are amortized over their estimated useful lives. Management evaluates whether events and circumstances have occurred that indicate the remaining estimated useful life of long-lived assets and intangible assets may warrant revision or that the remaining balance of these assets, including intangible assets with indefinite lives, may not be recoverable.Circumstances that might indicate long-lived assets might not be recoverable could include, but are not limited to, a change in the product mix, a change in the way products and services are created, produced or delivered, or a significant change in the way our products are branded and marketed. When performing a review for recoverability, management estimates the future undiscounted cash flows expected to result from the use of the assets and their eventual disposition. The amount of the impairment loss, if impairment exists, is calculated based on the excess of the carrying amounts of the assets over their estimated fair value computed using discounted cash flows. During the year ended December 31, 2020, we abandoned certain planning and site development activities related to our planned new headquarters, resulting in an impairment charge of $0.7 million. Additionally, we recognized impairment charges totaling $0.5 million related to improvements and remodeling of certain of our offices. Both charges were included in sales, general and administrative expense in the accompanying consolidated statements of operations. During the year ended December 31, 2019, we abandoned certain capitalized software related to implementation work on an enterprise resource planning system conversion, resulting in an impairment charge of $1.3 million, and certain planning and site development activities related to our planned new headquarters, resulting in an impairment charge of $0.7 million, both of which were included in sales, general and administrative expense in the accompanying consolidated statements of operations and comprehensive income (loss). During the year ended December 31, 2018, we abandoned certain developed technology acquired in a business combination resulting in an impairment charge of $2.0 million.Income TaxesWe recognize federal, state and foreign current tax liabilities or assets based on our estimate of taxes payable or refundable in the current fiscal year by tax jurisdiction. We also recognize federal, state and foreign deferred tax assets or liabilities, as appropriate, for our estimate of future tax effects attributable to temporary differences and carry forwards.We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution. We must also assess whether uncertain tax positions as filed could result in the recognition of a liability for possible interest and penalties if any. We have completed research and development tax credit studies for each year a tax credit was claimed for federal, Arizona, and California income tax purposes. We determined that it was more likely than not that the full benefit of the research and development tax credit would not be sustained on examination and accordingly, have established a liability for unrecognized tax benefits of $7.7 million as of December 31, 2020. We expect the amount of the unrecognized tax benefit to increase by approximately $0.1 million within the next 12 months. Should the unrecognized tax benefit of $7.7 million be recognized, our effective tax rate would be favorably impacted. Our estimates are based on information available to us at the time we prepare the income tax provision. Our income tax returns are subject to audit by federal, state, and local governments, generally years after the returns are filed. These returns could be subject to material adjustments or differing interpretations of the tax laws. During 2020, we completed an audit of our 2016 U.S. federal income tax return by the Internal Revenue Service and began an audit of our 2016 and 2017 California income tax returns for which we are currently in the closing phase with the Franchise Tax Board. Additionally, we have been notified that an audit will commence for Axon Public Safety Southeast Asia LLC, our entity in Vietnam. The tax period has not yet been defined.43 Table of ContentsOur calculation of current and deferred tax assets and liabilities is based on certain estimates and judgments and involves dealing with uncertainties in the application of complex tax laws. Our estimates of current and deferred tax assets and liabilities may change based, in part, on added certainty or finality to an anticipated outcome, changes in accounting or tax laws in the U.S. and internationally, or changes in other facts or circumstances. In addition, we recognize liabilities for potential tax contingencies based on our estimate of whether, and the extent to which, additional taxes may be due. If we determine that payment of these amounts is unnecessary, or if the recorded tax liability is greater than our current assessment, we may be required to recognize an income tax benefit, or additional income tax expense, respectively, in our consolidated financial statements.In preparing our consolidated financial statements, we assess the likelihood that our deferred tax assets will be realized from future taxable income. In evaluating our ability to recover our deferred income tax assets, we consider all available positive and negative evidence, including operating results, ongoing tax planning and forecasts of future taxable income on a jurisdiction by jurisdiction basis. A valuation allowance is established if we determine that it is more likely than not that some portion or all of the net deferred tax assets will not be realized. Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgments that could become subject to audit by tax authorities in the ordinary course of business.We anticipate sufficient future pre-tax book income to realize a large portion of our deferred tax assets. However, based on expected income for years in which Arizona R&D tax credits are set to expire, and certain identified intangibles with an indefinite life, a reserve of $7.3 million has been recorded as a valuation allowance against deferred tax assets as of December 31, 2020.Stock-Based CompensationWe have historically granted stock-based compensation to key employees and non-employee directors as a means of attracting and retaining highly qualified personnel. Stock-based compensation awards primarily consist of service-based RSUs, performance-based RSUs, and performance-based stock options. Our stock-based compensation awards are classified as equity and measured at the fair market value of the underlying stock at the grant date. For service-based awards, we recognize RSU expense using the straight-line attribution method over the requisite service period. Vesting of performance-based RSUs is contingent upon the achievement of certain performance criteria related to our operating performance, as well as successful and timely development and market acceptance of future product introductions. For performance-based RSUs containing only performance conditions, compensation cost is recognized using the graded attribution model over the explicit or implicit service period. For awards containing multiple service, performance or market conditions, where all conditions must be satisfied prior to vesting, compensation expense is recognized over the requisite service period, which is defined as the longest explicit, implicit or derived service period, based on management’s estimate of the probability and timing of the performance criteria being satisfied, adjusted at each balance sheet date. For both service-based and performance-based RSUs, we account for forfeitures as they occur as a reduction to stock-based compensation expense and additional paid-in-capital.For performance-based options, stock-based compensation expense is recognized over the expected performance achievement period of individual performance goals when the achievement of each individual performance goal becomes probable. For performance-based awards with a vesting schedule based entirely on the attainment of both performance and market conditions, stock-based compensation expense is recognized over the longer of the expected achievement period of the performance and market conditions, beginning at the point in time that the relevant performance condition is considered probable of achievement. The fair value of such awards is estimated on the grant date using Monte Carlo simulations. Refer to Note 13 of the notes to our consolidated financial statements within this Annual Report on Form 10-K.We have granted a total of approximately 15.0 million performance-based awards (options and restricted stock units) of which approximately 12.0 million are outstanding as of December 31, 2020, the vesting of which is contingent upon the achievement of certain performance criteria including the successful development and market acceptance of future product introductions as well as our future sales targets and operating performance and market capitalization. Compensation expense for performance awards will be recognized based on management’s best 44 Table of Contentsestimate of the probability of the performance criteria being satisfied using the most currently available projections of future product adoption and operating performance, adjusted at each balance sheet date. Changes in the subjective and probability-based assumptions can materially affect the estimates of the fair value of the awards and timing of recognition of stock-based compensation and consequently, the related amount recognized in our statements of operations and comprehensive income.Contingencies and Accrued Litigation ExpenseWe are subject to the possibility of various loss contingencies arising in the ordinary course of business, including product-related and other litigation. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required. Refer to Note 10 of our consolidated financial statements within this Annual Report on Form 10-K.Reserve for Expected Credit LossesWe are exposed to the risk of credit losses primarily through sales of products and services. Our expected credit loss allowance for accounts receivable, notes receivable, and contract assets represents management’s best estimate and application of judgment considering a number of factors, including historical collection experience, published or estimated credit default rates for entities that represent our customer base, current and future economic and market conditions and a review of the current status of customers' trade accounts receivables. Additionally, specific reserve amounts are established to record the appropriate provision for customers that have a higher probability of default. Our monitoring activities include account reconciliation, dispute resolution, payment confirmation, consideration of customers' financial condition and macroeconomic conditions. Balances are written off when determined to be uncollectible.​We review receivables for U.S. and international customers separately to better reflect different published credit default rates and economic and market conditions.A majority of our customers are governmental agencies. Due to municipal government funding rules, certain of our contracts are subject to appropriation, termination for convenience, or similar cancellation clauses, which could allow our customers to cancel or not exercise options to renew contracts in the future. Economic slowdowns that negatively affect municipal tax collections and put pressure on law enforcement may increase this risk and negatively impact the realizability of our accounts and notes receivable and contract assets. We considered the current and expected future economic and market conditions surrounding the COVID-19 pandemic and increased our reserve for expected credit losses by approximately $0.9 million during the year ended December 31, 2020.Based on the balances of our financial instruments as of December 31, 2020, a hypothetical 25 percent increase in expected credit loss rates across all pools would result in a $0.7 million increase in the allowance for expected credit losses.​Item 7A. Quantitative and Qualitative Disclosures About Market RiskInterest Rate RiskWe typically invest in a limited number of financial instruments, consisting principally of investments in money market accounts, certificates of deposit, corporate and municipal bonds with a typical long-term debt rating of “A” or better by any nationally recognized statistical rating organization, denominated in U.S. dollars. All of our cash equivalents and investments are treated as “held-to-maturity.” Investments in fixed-rate interest-earning instruments carry a degree of interest rate risk as their market value may be adversely impacted due to a rise in interest rates. As a result, we may suffer losses in principal if we sell securities that have declined in market value due to changes in 45 Table of Contentsinterest rates. However, because we classify our debt securities as “held-to-maturity” based on our intent and ability to hold these instruments to maturity, no gains or losses are recognized due to changes in interest rates. These securities are reported at amortized cost. Based on investment positions as of December 31, 2020, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $1.7 million decline in the fair market value of the portfolio. Such losses would only be realized if we sold the investments prior to maturity.Additionally, we have access to a $50.0 million line of credit borrowing facility which bears interest at LIBOR plus 1.0 to 1.5% per year determined in accordance with a pricing grid based on our funded debt to EBITDA ratio. Under the terms of the line of credit, available borrowings are reduced by outstanding letters of credit, which totaled $6.1 million at December 31, 2020. At December 31, 2020, there was no amount outstanding under the line of credit, and the available borrowing under the line of credit was $43.9 million. We have not borrowed any funds under the line of credit since its inception; however; should we need to do so in the future, such borrowings could be subject to adverse or favorable changes in the underlying interest rate.Exchange Rate RiskOur results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, in each case compared to the U.S. dollar, related to transactions by our foreign subsidiaries. The majority of our sales to international customers are transacted in foreign currencies and therefore are subject to exchange rate fluctuations on these transactions. The cost of our products to our customers increases when the U.S. dollar strengthens against their local currency, and we may have more sales and expenses denominated in foreign currencies in future years which could increase our foreign exchange rate risk. Additionally, intercompany sales to our non-U.S. dollar functional currency international subsidiaries are transacted in U.S. dollars which could increase our foreign exchange rate risk caused by foreign currency transaction gains and losses.To date, we have not engaged in any currency hedging activities. However, we may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. However, we may choose not to hedge certain foreign exchange exposures for a variety of reasons, including but not limited to the prohibitive economic cost of hedging particular exposures. As such, fluctuations in currency exchange rates could harm our business in the future.​46 Table of Contents

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+ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following is a discussion and analysis of the financial condition of AbbVie Inc. (AbbVie or the company). This commentary should be read in conjunction with the consolidated financial statements and accompanying notes appearing in Item 8, "Financial Statements and Supplementary Data." This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in “Management's Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019.EXECUTIVE OVERVIEWCompany OverviewAbbVie is a global, research-based biopharmaceutical company formed in 2013 following separation from Abbott Laboratories (Abbott). AbbVie uses its expertise, dedicated people and unique approach to innovation to develop and market advanced therapies that address some of the world's most complex and serious diseases. On May 8, 2020, AbbVie completed the acquisition of Allergan plc (Allergan). The acquisition of Allergan creates a diversified biopharmaceutical company positioned for success with a comprehensive product portfolio that has leadership positions in key therapeutic areas of immunology, hematologic oncology, aesthetics, neuroscience, eye care and women's health. AbbVie's existing product portfolio and pipeline is enhanced with numerous Allergan assets and Allergan's product portfolio benefits from AbbVie's commercial strength, expertise and international infrastructure. See Note 5 to the Consolidated Financial Statements for additional information on the acquisition. Subsequent to the acquisition date, AbbVie's consolidated financial statements include the assets, liabilities, operating results and cash flows of Allergan.AbbVie's products are generally sold worldwide directly to wholesalers, distributors, government agencies, health care facilities, specialty pharmacies and independent retailers from AbbVie-owned distribution centers and public warehouses. Certain products (including aesthetic products and devices) are also sold directly to physicians and other licensed healthcare providers. In the United States, AbbVie distributes pharmaceutical products principally through independent wholesale distributors, with some sales directly to retailers, pharmacies and patients. Outside the United States, AbbVie sells products primarily to customers or through distributors, depending on the market served. Certain products are co-marketed or co-promoted with other companies. AbbVie has approximately 47,000 employees. AbbVie operates as a single global business segment. 2020 Financial ResultsAbbVie's strategy has focused on delivering strong financial results, maximizing the benefits of the Allergan acquisition, advancing and investing in its pipeline and returning value to shareholders while ensuring a strong, sustainable growth business over the long term. The company's financial performance in 2020 included delivering worldwide net revenues of $45.8 billion, operating earnings of $11.4 billion, diluted earnings per share of $2.72 and cash flows from operations of $17.6 billion. Worldwide net revenues increased by 38% on a reported basis and on a constant currency basis, which included $10.3 billion of contributed revenues from the Allergan acquisition, growth in the immunology portfolio from Skyrizi, Rinvoq and the continued strength of Humira in the U.S. as well as revenue growth from Imbruvica and Venclexta.Diluted earnings per share in 2020 was $2.72 and included the following after-tax costs: (i) $5.7 billion for the change in fair value of contingent consideration liabilities; (ii) $4.8 billion related to the amortization of intangible assets; (iii) $3.0 billion of Allergan acquisition and integration expenses; (iv) $1.2 billion for acquired in-process research and development (IPR&D); and $241 million for milestones and other research and development (R&D) expenses. These costs were partially offset by $1.7 billion of certain tax benefits. Additionally, financial results reflected continued funding to support all stages of AbbVie’s pipeline assets and continued investment in AbbVie’s on-market brands.In October 2020, AbbVie's board of directors declared a quarterly cash dividend of $1.30 per share of common stock payable in February 2021. This reflects an increase of approximately 10.2% over the previous quarterly dividend of $1.18 per share of common stock.Following the closing of the Allergan acquisition, AbbVie implemented an integration plan designed to reduce costs, integrate and optimize the combined organization. The integration plan is expected to realize more than $2 billion of expected annual cost synergies over a three-year period, with approximately 50% realized in R&D, 40% in selling, general and administrative (SG&A) and 10% in cost of products sold.2020 Form 10-K | 32To achieve these integration objectives, AbbVie expects to incur approximately $2 billion of charges through 2022. These costs will consist of severance and employee benefit costs (cash severance, non-cash severance, including accelerated equity award compensation expense, retention and other termination benefits) and other integration expenses.Impact of the Coronavirus Disease 2019 (COVID-19)In March 2020, the World Health Organization declared the outbreak of a novel coronavirus (COVID-19) as a pandemic, which continues to spread throughout the United States and around the world. In response to the growing public health crisis, AbbVie has partnered with global authorities to support the experimental use of multiple AbbVie assets to determine their efficacy in the treatment of COVID-19. In June 2020, AbbVie announced that it entered into a collaboration with Harbour BioMed, Utrecht University and Erasmus Medical Center to develop a novel antibody therapeutic to prevent and treat COVID-19. Additionally, AbbVie donated $35 million to increase healthcare capacity, supply critical equipment and deliver food and essential supplies during the crisis. AbbVie continues to closely manage manufacturing and supply chain resources around the world to help ensure that patients continue to receive an uninterrupted supply of their medicines. Clinical trial sites are being monitored locally to protect the safety of study participants, staff and employees. While the impact of COVID-19 on AbbVie's operations to date has not been material, AbbVie has experienced lower new patient starts across the therapeutic portfolio. AbbVie expects this matter could continue to negatively impact its results of operations throughout the duration of the outbreak. The extent to which COVID-19 may impact AbbVie's financial condition and results of operations remains uncertain.2021 Strategic ObjectivesAbbVie's mission is to discover and develop innovative medicines and products that solve serious health issues today and address the medical challenges of tomorrow while achieving top-tier financial performance through outstanding execution. AbbVie intends to continue to advance its mission in a number of ways, including: (i) maximizing the benefits of the Allergan acquisition to create a more diversified revenue base with multiple long-term growth drivers; (ii) growing revenues by leveraging AbbVie's commercial strength and international infrastructure across Allergan's therapeutic areas and ensuring strong commercial execution of new product launches; (iii) continuing to invest in and expand its pipeline in support of opportunities in immunology, oncology, aesthetics, neuroscience, eye care and women's health as well as continued investment in key on-market products; (iv) expanding operating margins; and (v) returning cash to shareholders via a strong and growing dividend while also reducing debt. In addition, AbbVie anticipates several regulatory submissions and key data readouts from key clinical trials in the next 12 months.AbbVie expects to achieve its strategic objectives through:•Immunology revenue growth driven by increasing market share and expanding patient access of Skyrizi and Rinvoq, as well as Humira U.S. sales growth. •Hematologic oncology revenue growth from both Imbruvica and Venclexta.•Expansion of the company’s revenue base from additional Allergan products contributing to key aesthetics and neuroscience portfolios.•Effective management of Humira international biosimilar erosion.•Optimization of combined AbbVie and Allergan research and development, commercial, and manufacturing operations while maintaining key growth portfolios.•The favorable impact of pipeline products and indications recently approved or currently under regulatory review where approval is expected in 2021. These products are described in greater detail in the section labeled "Research and Development" included as part of this Item 7.AbbVie remains committed to driving continued expansion of operating margins and expects to achieve this objective through continued leverage from revenue growth, realization of expense synergies from the Allergan acquisition, productivity initiatives in supply chain and ongoing efficiency programs to optimize manufacturing, commercial infrastructure, administrative costs and general corporate expenses.The combination of AbbVie and Allergan creates a diverse entity with leadership positions across immunology, hematologic oncology, aesthetics, neuroscience, women's health, eye care and virology. AbbVie's existing product portfolio and pipeline is enhanced with numerous Allergan assets and Allergan's product portfolio benefits from AbbVie's commercial strength, expertise and international infrastructure.33 | 2020 Form 10-KResearch and DevelopmentResearch and innovation are the cornerstones of AbbVie's business as a global biopharmaceutical company. AbbVie's long-term success depends to a great extent on its ability to continue to discover and develop innovative products and acquire or collaborate on compounds currently in development by other biotechnology or pharmaceutical companies.AbbVie's pipeline currently includes more than 90 compounds, devices or indications in development individually or under collaboration or license agreements and is focused on such important specialties as immunology, oncology, aesthetics, neuroscience, eye care and women's health along with targeted investments in cystic fibrosis. Of these programs, more than 50 are in mid- and late-stage development.The following sections summarize transitions of significant programs from mid-stage development to late-stage development as well as developments in significant late-stage and registration programs. AbbVie expects multiple mid-stage programs to transition into late-stage programs in the next 12 months.Significant Programs and DevelopmentsImmunologySkyrizi•In January 2021, AbbVie announced top-line results from its Phase 3 KEEPsAKE-1 and KEEPsAKE-2 clinical trials of Skyrizi in adults with active psoriatic arthritis (PsA) met the primary and ranked secondary endpoints.•In January 2021, AbbVie announced top-line results from its Phase 3 ADVANCE and MOTIVATE induction studies of Skyrizi in patients with Crohn’s Disease met the primary and key secondary endpoints.Rinvoq•In February 2020, AbbVie announced top-line results from its second Phase 3 clinical trial of Rinvoq in adult patients with active PsA. Results from the SELECT-PsA 1 study, which evaluated Rinvoq versus placebo in patients who did not adequately respond to treatment with one or more non-biologic disease-modifying anti-rheumatic drugs (DMARDs), showed that both doses of Rinvoq met the primary and key secondary endpoints. The safety profile was consistent with that of previous studies across indications, with no new safety risks detected.•In May 2020, AbbVie submitted a supplemental New Drug Application (sNDA) to the U.S. Food and Drug Administration (FDA) and, in June 2020, submitted a marketing authorization application (MAA) to the European Medicines Agency (EMA) for Rinvoq for the treatment of adult patients with active PsA.•In June 2020, AbbVie announced top-line results from its Phase 3 Measure Up 1 study and, in July 2020, announced top-line results from its Phase 3 Measure Up 2 and AD Up studies of Rinvoq for the treatment of moderate to severe atopic dermatitis (AD) met all primary and secondary endpoints versus placebo.•In August 2020, AbbVie submitted an sNDA to the FDA and, earlier this year, submitted an MAA to the EMA for Rinvoq for the treatment of adult patients with active ankylosing spondylitis (AS).•In October 2020, AbbVie submitted an sNDA to the FDA and an MAA to the EMA for Rinvoq for the treatment of adult and adolescent patients with moderate to severe AD.•In December 2020, AbbVie announced its Phase 3 U-ACHIEVE induction study of Rinvoq for the treatment of adult patients with moderate to severe ulcerative colitis met the primary and all ranked secondary endpoints.•In January 2021, AbbVie announced that the European Commission (EC) approved Rinvoq for the treatment of adults with active PsA and active AS.2020 Form 10-K | 34OncologyImbruvica•In April 2020, AbbVie received FDA approval for the use of Imbruvica in combination with rituximab for the treatment of previously untreated patients with chronic lymphocytic leukemia (CLL) or small lymphocytic lymphoma (SLL). •In August 2020, the EC granted marketing authorization for Imbruvica in combination with rituximab for the treatment of adult patients with previously untreated CLL.Venclexta•In February 2020, AbbVie announced that the Phase 3 VIALE-C trial of Venclexta in combination with low-dose cytarabine in newly-diagnosed patients with acute myeloid leukemia (AML) did not meet its primary endpoint. •In March 2020, AbbVie announced that top-line results from its Phase 3 VIALE-A trial of Venclexta in combination with azacitidine in patients with AML met its primary endpoints. •In March 2020, AbbVie received EC approval of Venclyxto in combination with obinutuzumab for patients with previously untreated CLL. •In June 2020, AbbVie submitted an MAA to the EMA for Venclyxto for the treatment of patients with AML.•In October 2020, AbbVie received FDA full approval of Venclexta for the treatment of patients with AML. The approval is supported by data from a series of trials including the Phase 3 VIALE-A and VIALE-C studies.AestheticsJuvederm Collection•In June 2020, AbbVie received FDA approval of Juvederm Voluma XC for the augmentation of the chin region to improve the chin profile in adults over the age of 21.NeuroscienceBotox Therapeutic•In June 2020, the FDA accepted the company's supplemental Biologics License Application (sBLA) to expand the Botox prescribing information for the treatment of detrusor (bladder muscle) overactivity associated with an underlying neurologic condition in certain pediatric patients. In February 2021, AbbVie received FDA approval of Botox for the treatment of detrusor overactivity associated with a neurological condition in certain pediatric patients 5 years of age and older.•In July 2020, AbbVie received FDA approval of Botox for the treatment of lower limb spasticity caused by cerebral palsy in pediatric patients over the age of 2.Atogepant•In July 2020, AbbVie announced that the Phase 3 ADVANCE trial evaluating atogepant, an orally administered calcitonin gene-related peptide receptor antagonist, for migraine prevention met its primary endpoint for all doses (10mg, 30mg, and 60mg) compared to placebo, all secondary endpoints with 30mg and 60mg doses, and four out of six secondary endpoints with the 10mg dose. •In January 2021, AbbVie submitted a New Drug Application to the FDA for atogepant for the prevention of episodic migraine.Elezanumab•In September 2020, AbbVie announced that the FDA granted Orphan Drug and Fast Track designations for elezanumab, an investigational treatment for patients following spinal cord injury.35 | 2020 Form 10-KVirology/Liver DiseaseMavyret•In March 2020, AbbVie announced that the EC granted marketing authorization for Maviret to shorten once-daily treatment duration from 12 to 8 weeks in treatment-naïve, compensated cirrhotic, chronic hepatitis C virus (HCV) patients with genotype 3 infection.Eye CareAGN-190584•In October 2020, AbbVie announced that top-line results from its Phase 3 GEMINI 1 and 2 studies of AGN-190584, an investigational ophthalmic solution, for the treatment of presbyopia met their primary endpoint and majority of the secondary endpoints.Abicipar pegol•In June 2020, AbbVie announced that the FDA issued a Complete Response Letter (CRL) to the Biologics License Application (BLA) for abicipar pegol, a novel, investigational DARPin therapy for patients with neovascular (wet) age-related macular degeneration (nAMD). The CRL indicated that the rate of intraocular inflammation observed following administration of abicipar pegol results in an unfavorable benefit-risk ratio in the treatment of nAMD. In July 2020, AbbVie withdrew the regulatory application with the EMA for abicipar pegol for the treatment of nAMD.Women's HealthOriahnn•In May 2020, the FDA approved Oriahnn (elagolix, estradiol, and norethindrone acetate capsules; elagolix capsules) for the management of heavy menstrual bleeding due to uterine fibroids in pre-menopausal women.RESULTS OF OPERATIONSNet RevenuesThe comparisons presented at constant currency rates reflect comparative local currency net revenues at the prior year's foreign exchange rates. This measure provides information on the change in net revenues assuming that foreign currency exchange rates had not changed between the prior and current periods. AbbVie believes that the non-GAAP measure of change in net revenues at constant currency rates, when used in conjunction with the GAAP measure of change in net revenues at actual currency rates, may provide a more complete understanding of the company's operations and can facilitate analysis of the company's results of operations, particularly in evaluating performance from one period to another.Percent changeAt actual currency ratesAt constant currency ratesyears ended (dollars in millions)2020201920182020201920202019United States$34,879 $23,907 $21,524 45.9 %11.1 %45.9 %11.1 %International10,925 9,359 11,229 16.7 %(16.7)%17.8 %(13.6)%Net revenues$45,804 $33,266 $32,753 37.7 %1.6 %38.0 %2.6 %2020 Form 10-K | 36The following table details AbbVie's worldwide net revenues:Percent changeAt actual currency ratesAt constant currency ratesyears ended December 31 (dollars in millions)2020201920182020201920202019ImmunologyHumiraUnited States$16,112 $14,864 $13,685 8.4 %8.6 %8.4 %8.6 %International3,720 4,305 6,251 (13.6)%(31.1)%(12.5)%(27.8)%Total$19,832 $19,169 $19,936 3.5 %(3.9)%3.7 %(2.9)%SkyriziUnited States$1,385 $311 $— >100.0%n/m>100.0%n/mInternational205 44 — >100.0%n/m>100.0%n/mTotal$1,590 $355 $— >100.0%n/m>100.0%n/mRinvoqUnited States$653 $47 $— >100.0%n/m>100.0%n/mInternational78 — — >100.0%n/m>100.0%n/mTotal$731 $47 $— >100.0%n/m>100.0%n/mHematologic OncologyImbruvicaUnited States$4,305 $3,830 $2,968 12.4 %29.1 %12.4 %29.1 %Collaboration revenues1,009 844 622 19.5 %35.8 %19.5 %35.8 %Total$5,314 $4,674 $3,590 13.7 %30.2 %13.7 %30.2 %VenclextaUnited States$804 $521 $247 54.4 %>100.0%54.4 %>100.0%International533 271 97 97.0 %>100.0%97.8 %>100.0%Total$1,337 $792 $344 69.0 %>100.0%69.3 %>100.0%AestheticsBotox Cosmetic (a)United States$687 $— $— n/mn/mn/mn/mInternational425 — — n/mn/mn/mn/mTotal$1,112 $— $— n/mn/mn/mn/mJuvederm Collection (a)United States$318 $— $— n/mn/mn/mn/mInternational400 — — n/mn/mn/mn/mTotal$718 $— $— n/mn/mn/mn/mOther Aesthetics (a)United States$666 $— $— n/mn/mn/mn/mInternational94 — — n/mn/mn/mn/mTotal$760 $— $— n/mn/mn/mn/mNeuroscienceBotox Therapeutic (a)United States$1,155 $— $— n/mn/mn/mn/mInternational232 — — n/mn/mn/mn/mTotal$1,387 $— $— n/mn/mn/mn/mVraylar (a)United States$951 $— $— n/mn/mn/mn/mDuodopaUnited States$103 $97 $80 5.9 %20.4 %5.9 %20.4 %International391 364 350 7.4 %4.2 %6.3 %9.8 %Total$494 $461 $430 7.1 %7.2 %6.2 %11.7 %Ubrelvy (a)United States$125 $— $— n/mn/mn/mn/mOther Neuroscience (a)United States$528 $— $— n/mn/mn/mn/mInternational11 — — n/mn/mn/mn/mTotal$539 $— $— n/mn/mn/mn/m37 | 2020 Form 10-KPercent changeAt actual currency ratesAt constant currency ratesyears ended December 31 (dollars in millions)2020201920182020201920202019Eye CareLumigan/Ganfort (a)United States$165 $— $— n/mn/mn/mn/mInternational213 — — n/mn/mn/mn/mTotal$378 $— $— n/mn/mn/mn/mAlphagan/Combigan (a)United States$223 $— $— n/mn/mn/mn/mInternational103 — — n/mn/mn/mn/mTotal$326 $— $— n/mn/mn/mn/mRestasis (a)United States$755 $— $— n/mn/mn/mn/mInternational32 — — n/mn/mn/mn/mTotal$787 $— $— n/mn/mn/mn/mOther Eye Care (a)United States$305 $— $— n/mn/mn/mn/mInternational388 — — n/mn/mn/mn/mTotal$693 $— $— n/mn/mn/mn/mWomen's HealthLo Loestrin (a)United States$346 $— $— n/mn/mn/mn/mInternational10 — — n/mn/mn/mn/mTotal$356 $— $— n/mn/mn/mn/mOrilissa/OriahnnUnited States$121 $91 $11 33.3 %>100.0%33.3 %>100.0%International4 2 — 96.1 %n/m97.7 %n/mTotal$125 $93 $11 34.6 %>100.0%34.6 %>100.0%Other Women's Health (a)United States$181 $— $— n/mn/mn/mn/mInternational11 — — n/mn/mn/mn/mTotal$192 $— $— n/mn/mn/mn/mOther Key ProductsMavyretUnited States$785 $1,473 $1,614 (46.7)%(8.8)%(46.7)%(8.8)%International1,045 1,420 1,824 (26.4)%(22.1)%(26.8)%(19.6)%Total$1,830 $2,893 $3,438 (36.7)%(15.9)%(36.9)%(14.6)%CreonUnited States$1,114 $1,041 $928 6.9 %12.2 %6.9 %12.2 %LupronUnited States$600 $720 $726 (16.6)%(0.8)%(16.6)%(0.8)%International152 167 166 (9.1)%0.8 %(5.4)%6.0 %Total$752 $887 $892 (15.2)%(0.5)%(14.5)%0.5 %Linzess/Constella (a)United States$649 $— $— n/mn/mn/mn/mInternational18 — — n/mn/mn/mn/mTotal$667 $— $— n/mn/mn/mn/mSynthroidUnited States$771 $786 $776 (1.9)%1.3 %(1.9)%1.3 %All other$2,923 $2,068 $2,408 41.3 %(14.1)%42.4 %(11.5)%Total net revenues$45,804 $33,266 $32,753 37.7 %1.6 %38.0 %2.6 %n/m – Not meaningful(a)Net revenues include Allergan product revenues from the date of the acquisition, May 8, 2020, through December 31, 2020.The following discussion and analysis of AbbVie's net revenues by product is presented on a constant currency basis.Global Humira sales increased 4% in 2020 primarily driven by market growth across therapeutic categories, offset by direct biosimilar competition in certain international markets. In the United States, Humira sales increased 8% in 2020 driven by market growth across all indications and favorable pricing, partially offset by lower new patient starts due to the COVID-19 pandemic. Internationally, Humira revenues decreased 12% in 2020 primarily driven by direct biosimilar competition in certain international markets. Biosimilar competition for Humira is not expected in the United States until 2023. AbbVie continues to pursue strategies intended to maintain market leadership among its installed patient base and add to the sustainability of Humira.Net revenues for Skyrizi increased more than 100% in 2020 primarily driven by market growth and market share gains over the prior year following the April 2019 regulatory approvals for the treatment of moderate to severe plaque psoriasis.Net revenues for Rinvoq increased more than 100% in 2020 primarily driven by the August 2019 FDA approval and December 2019 EC approval for the treatment of moderate to severe rheumatoid arthritis.2020 Form 10-K | 38Net revenues for Imbruvica represent product revenues in the United States and collaboration revenues outside of the United States related to AbbVie's 50% share of Imbruvica profit. AbbVie's global Imbruvica revenues increased 14% in 2020 as a result of continued penetration of Imbruvica for patients with CLL, partially offset by lower new patient starts due to the COVID-19 pandemic in 2020.Net revenues for Venclexta increased 69% in 2020 primarily due to continued expansion of Venclexta for the treatment of patients with first-line CLL, relapsed/refractory CLL and first-line AML.Net revenues for Botox Cosmetic used in facial aesthetics were $1.1 billion in 2020 for the period subsequent to the completion of the Allergan acquisition.Net revenues for Juvederm Collection (including Juvederm Ultra XC, Juvederm Voluma XC and other Juvederm products) used in facial aesthetics were $718 million in 2020 for the period subsequent to the completion of the Allergan acquisition.Net revenues for Botox Therapeutic used primarily in neuroscience and urology therapeutic areas were $1.4 billion in 2020 for the period subsequent to the completion of the Allergan acquisition.Net revenues for Vraylar for the treatment of schizophrenia, bipolar I disorder and bipolar depression were $951 million in 2020 for the period subsequent to the completion of the Allergan acquisition.Global Mavyret sales decreased 37% in 2020 primarily driven by lower global new patient starts due to the COVID-19 pandemic as well as competitive dynamics in the U.S.Net revenues for Creon increased 7% in 2020 primarily driven by continued market growth, partially offset by lower new patient starts due to the COVID-19 pandemic. Creon maintains market leadership in the pancreatic enzyme market with approximately 80% total market share.Net revenues for Lupron decreased 14% in 2020 primarily due to a near-term supply issue which has impacted product availability of certain formulations.Gross MarginPercent changeyears ended December 31 (dollars in millions)20202019201820202019Gross margin$30,417 $25,827 $25,035 18 %3 %as a percent of net revenues66 %78 %76 %Gross margin as a percentage of net revenues in 2020 decreased from 2019 primarily due to the unfavorable impacts of higher amortization of intangible assets and inventory fair value step-up adjustments associated with the Allergan acquisition as well as collaboration profit sharing arrangements for Imbruvica and Venclexta.Selling, General and AdministrativePercent changeyears ended December 31 (dollars in millions)20202019201820202019Selling, general and administrative$11,299 $6,942 $7,399 63 %(6)%as a percent of net revenues25 %21 %23 %Selling, general and administrative (SG&A) expenses as a percentage of net revenues in 2020 increased from 2019 primarily due to the unfavorable impacts of incremental SG&A expenses of Allergan, including transaction and integration costs resulting from the acquisition.Research and Development and Acquired In-Process Research and DevelopmentPercent changeyears ended December 31 (dollars in millions)20202019201820202019Research and development$6,557 $6,407 $10,329 2 %(38)%as a percent of net revenues14 %19 %32 %Acquired in-process research and development$1,198 $385 $424 >100%(9)%Research and Development (R&D) expenses as a percentage of net revenues decreased in 2020 primarily due to the $1.0 billion intangible asset impairment charge in 2019, which represented the remaining value of the IPR&D acquired as part 39 | 2020 Form 10-Kof the 2016 Stemcentrx acquisition following the decision to terminate the Rova-T R&D program. See Note 7 to the Consolidated Financial Statements for additional information regarding the impairment charge. R&D expenses as a percentage of net revenues in 2020 were also favorably impacted by increased scale of the combined company for the period subsequent to the completion of the Allergan acquisition.Acquired IPR&D expenses reflect upfront payments related to various collaborations. Acquired IPR&D expense in 2020 included a charge of $750 million as a result of entering a collaboration agreement with Genmab A/S (Genmab) to research, develop and commercialize investigational bispecific antibody therapeutics for the treatment of cancer. Acquired IPR&D expense in 2020 also included a charge of $200 million as a result of a collaboration agreement with I-Mab Biopharma (I-Mab) for the development and commercialization of lemzoparlimab for the treatment of multiple cancers. See Note 5 to the Consolidated Financial Statements for additional information regarding the Genmab and I-Mab agreements. There were no individually significant transactions or cash flows during 2019.Other Operating Expenses and IncomeOther operating income in 2019 included $550 million of income from a legal settlement related to an intellectual property dispute with a third party and $330 million of income related to an amended and restated license agreement between AbbVie and Reata. See Note 5 to the Consolidated Financial Statements for additional information on the Reata agreement. Other Non-Operating Expensesyears ended December 31 (in millions)202020192018Interest expense$2,454 $1,784 $1,348 Interest income(174)(275)(204)Interest expense, net$2,280 $1,509 $1,144 Net foreign exchange loss$71 $42 $24 Other expense, net5,614 3,006 18 Interest expense in 2020 increased compared to 2019 primarily due to a higher average debt balance associated with the financing of the Allergan acquisition as well as the incremental Allergan debt acquired, partially offset by the favorable impact of lower interest rates on the company’s debt obligations.Interest income in 2020 decreased compared to 2019 primarily due to a lower average cash and cash equivalents balance as a result of the cash paid for the Allergan acquisition and the unfavorable impact of lower interest rates.Other expense, net included charges related to the change in fair value of the contingent consideration liabilities of $5.8 billion in 2020 and $3.1 billion in 2019. The fair value of contingent consideration liabilities is impacted by the passage of time and multiple other inputs, including the probability of success of achieving regulatory/commercial milestones, discount rates, the estimated amount of future sales of the acquired products and other market-based factors. In 2020, the change in fair value primarily included the increase in the Skyrizi contingent consideration liability due to higher estimated future sales driven by stronger market share uptake and favorable clinical trial results as well as lower interest rates. In 2019, the Skyrizi contingent consideration liability increased due to higher probabilities of success, higher estimated future sales, declining interest rates and passage of time. The higher probabilities of success primarily resulted from the April 2019 regulatory approvals of Skyrizi for the treatment of moderate to severe plaque psoriasis. These changes were partially offset by a $91 million decrease in the Stemcentrx contingent consideration liability due to the termination of the Rova-T R&D program.Income Tax ExpenseThe effective income tax rate was negative 36% in 2020, 6% in 2019 and negative 9% in 2018. The effective tax rate in each period differed from the statutory tax rate principally due to the impact of foreign operations which reflects the impact of lower income tax rates in locations outside the United States, tax incentives in Puerto Rico and other foreign tax jurisdictions, business development activities, changes in enacted tax rates and laws and related restructuring, the cost of repatriation decisions, tax audit settlements and Boehringer Ingelheim accretion on contingent consideration. The decrease in the effective tax rate for 2020 over the prior year was principally due to the recognition of a net tax benefit of $1.7 billion related to changes in tax laws and related restructuring, including certain intra-group transfers of intellectual property and deferred tax remeasurement.2020 Form 10-K | 40FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCESyears ended December 31 (in millions)202020192018Cash flows from:Operating activities$17,588 $13,324 $13,427 Investing activities(37,557)596 (1,006)Financing activities(11,501)18,708 (14,396)Operating cash flows in 2020 increased from 2019 and included the results of Allergan subsequent to the May 8 acquisition date. Operating cash flows in 2020 were favorably impacted by higher net revenues of the combined company and the timing of working capital cash flows, partially offset by acquisition-related cash expenses. Operating cash flows also reflected AbbVie’s contributions to its defined benefit plans of $367 million in 2020 and $727 million in 2019.Investing cash flows in 2020 primarily included $39.7 billion cash consideration paid to acquire Allergan offset by cash acquired of $1.5 billion. Investing cash flows also included net sales and maturities of investments totaling $1.5 billion, payments made for other acquisitions and investments of $1.4 billion and capital expenditures of $798 million. Investing cash flows in 2019 included net sales and maturities of investment securities totaling $2.1 billion resulting from the sale of substantially all of the company's investments in debt securities, payments made for other acquisitions and investments of $1.1 billion and capital expenditures of $552 million.Financing cash flows in 2020 included the issuance of term loans totaling $3.0 billion under the existing $6.0 billion term loan credit agreement which were used to finance the acquisition of Allergan. Subsequent to these borrowings, AbbVie terminated the unused commitments of the lenders under the term loan. Additionally, financing cash flows included the May 2020 repayment of $3.8 billion aggregate principal amount of the company's 2.50% senior notes at maturity, the September 2020 repayment of $650 million aggregate principal amount of 3.375% Allergan exchange notes at maturity, and the November 2020 repayments of €700 million aggregate principal amount of floating rate Allergan exchange notes at maturity and $450 million aggregate principal amount of 4.875% Allergan exchange notes due February 2021. Financing cash flows in 2019 included the issuance of $30.0 billion aggregate principal amount of floating rate and fixed rate unsecured senior notes which were used to finance the acquisition of Allergan. Additionally, financing cash flows in 2019 included the issuance of €1.4 billion aggregate principal amount of unsecured senior Euro notes which the company used to redeem €1.4 billion aggregate principal amount of 0.38% senior Euro notes that were due to mature in November 2019, as well as the repayment of a $3.0 billion 364-day term loan credit agreement that was scheduled to mature in June 2019. Cash dividend payments totaled $7.7 billion in 2020 and $6.4 billion in 2019. The increase in cash dividend payments was primarily driven by higher outstanding shares following the 286 million shares of AbbVie common stock issued to Allergan shareholders in May 2020 as well as an increase in the dividend rate. On October 30, 2020, AbbVie announced that its board of directors declared an increase in the quarterly cash dividend from $1.18 per share to $1.30 per share beginning with the dividend payable on February 16, 2021 to stockholders of record as of January 15, 2021. This reflects an increase of approximately 10.2% over the previous quarterly rate. The timing, declaration, amount of and payment of any dividends by AbbVie in the future is within the discretion of its board of directors and will depend upon many factors, including AbbVie's financial condition, earnings, capital requirements of its operating subsidiaries, covenants associated with certain of AbbVie's debt service obligations, legal requirements, regulatory constraints, industry practice, ability to access capital markets and other factors deemed relevant by its board of directors.The company's stock repurchase authorization permits purchases of AbbVie shares from time to time in open-market or private transactions at management’s discretion. The program has no time limit and can be discontinued at any time. Under this authorization, AbbVie repurchased 8 million shares for $757 million in 2020 and 4 million shares for $300 million in 2019. AbbVie cash-settled $201 million of its December 2018 open market purchases in January 2019. AbbVie's remaining stock repurchase authorization was $3.2 billion as of December 31, 2020.In 2020 and 2019, the company issued and redeemed commercial paper. There were no commercial paper borrowings outstanding as of December 31, 2020 or December 31, 2019. AbbVie may issue additional commercial paper or retire commercial paper to meet liquidity requirements as needed.Credit RiskAbbVie monitors economic conditions, the creditworthiness of customers and government regulations and funding, both domestically and abroad. AbbVie regularly communicates with its customers regarding the status of receivable balances, including their payment plans and obtains positive confirmation of the validity of the receivables. AbbVie establishes an 41 | 2020 Form 10-Kallowance for credit losses equal to the estimate of future losses over the contractual life of outstanding accounts receivable. AbbVie may also utilize factoring arrangements to mitigate credit risk, although the receivables included in such arrangements have historically not been a significant amount of total outstanding receivables.Credit Facility, Access to Capital and Credit RatingsCredit FacilityAbbVie currently has a $4.0 billion five-year revolving credit facility that matures in August 2024. This amended facility enables the company to borrow funds on an unsecured basis at variable interest rates and contains various covenants. At December 31, 2020, the company was in compliance with all covenants, and commitment fees under the credit facility were insignificant. No amounts were outstanding under the company's credit facility as of December 31, 2020 and 2019.Access to CapitalThe company intends to fund short-term and long-term financial obligations as they mature through cash on hand, future cash flows from operations or has the ability to issue additional debt. The company's ability to generate cash flows from operations, issue debt or enter into financing arrangements on acceptable terms could be adversely affected if there is a material decline in the demand for the company's products or in the solvency of its customers or suppliers, deterioration in the company's key financial ratios or credit ratings, or other material unfavorable changes in business conditions. At the current time, the company believes it has sufficient financial flexibility to issue debt, enter into other financing arrangements and attract long-term capital on acceptable terms to support the company's growth objectives.Credit RatingsFollowing the acquisition of Allergan, S&P Global Ratings revised its ratings outlook to stable from negative and lowered the issuer credit rating by one notch to BBB+ from A- and the short-term rating to A-2 from A-1. There were no changes in Moody's Investor Service of its Baa2 senior unsecured long-term rating and Prime-2 short-term rating with a stable outlook.Unfavorable changes to the ratings may have an adverse impact on future financing arrangements; however, they would not affect the company’s ability to draw on its credit facility and would not result in an acceleration of scheduled maturities of any of the company’s outstanding debt.Contractual ObligationsThe following table summarizes AbbVie's estimated contractual obligations as of December 31, 2020:(in millions)TotalLess than one yearOne to three yearsThree to five yearsMore than five yearsShort-term borrowings$34 $34 $— $— $— Long-term debt, including current portion84,948 8,422 16,643 16,197 43,686 Interest on long-term debt(a)33,664 2,752 4,652 3,898 22,362 Non-cancelable operating and finance lease payments1,154 229 323 208 394 Purchase obligations and other(b)5,432 5,040 249 112 31 Other long-term liabilities (c) (d) (e)18,478 1,029 3,036 4,144 10,269 Total$143,710 $17,506 $24,903 $24,559 $76,742 (a)Includes estimated future interest payments on long-term debt. Interest payments on debt are calculated for future periods using forecasted interest rates in effect at the end of 2020. Projected interest payments include the related effects of interest rate swap agreements. Certain of these projected interest payments may differ in the future based on changes in floating interest rates or other factors or events. The projected interest payments only pertain to obligations and agreements outstanding at December 31, 2020. See Note 10 to the Consolidated Financial Statements for additional information regarding the company's debt instruments and Note 11 for additional information on the interest rate swap agreements outstanding at December 31, 2020.(b)Includes the company's significant unconditional purchase obligations. These commitments do not exceed the company's projected requirements and are made in the normal course of business.(c)Excludes liabilities associated with the company's unrecognized tax benefits as it is not possible to reliably estimate the timing of the future cash outflows related to these liabilities. See Note 14 to the Consolidated Financial Statements for additional information on these unrecognized tax benefits.2020 Form 10-K | 42(d)Includes $13.0 billion of contingent consideration liabilities which are recorded at fair value on the consolidated balance sheet. Potential contingent consideration payments that exceed the fair value recorded on the consolidated balance sheet are not included in the table of contractual obligations. See Note 11 to the Consolidated Financial Statements for additional information regarding these liabilities.(e)Includes a one-time transition tax liability on a mandatory deemed repatriation of previously untaxed earnings of foreign subsidiaries resulting from U.S. tax reform enacted in 2017. The one-time transition tax is generally payable in eight annual installments. AbbVie enters into R&D collaboration arrangements with third parties that may require future milestone payments to third parties contingent upon the achievement of certain development, regulatory, or commercial milestones. Individually, these arrangements are insignificant in any one annual reporting period. However, if milestones for multiple products covered by these arrangements would happen to be reached in the same reporting period, the aggregate charge to expense could be material to the results of operations in that period. From a business perspective, the payments are viewed as positive because they signify that the product is successfully moving through development and is now generating or is more likely to generate future cash flows from product sales. It is not possible to predict with reasonable certainty whether these milestones will be achieved or the timing for achievement. As a result, these potential payments are not included in the table of contractual obligations. See Note 5 to the Consolidated Financial Statements for additional information on these collaboration arrangements.CRITICAL ACCOUNTING POLICIES AND ESTIMATESThe preparation of financial statements in accordance with generally accepted accounting principles in the United States requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenue and expenses. A summary of the company's significant accounting policies is included in Note 2 to the Consolidated Financial Statements. Certain of these policies are considered critical as these most significantly impact the company's financial condition and results of operations and require the most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Actual results may vary from these estimates.Revenue RecognitionAbbVie recognizes revenue when control of promised goods or services is transferred to the company’s customers, in an amount that reflects the consideration AbbVie expects to be entitled to in exchange for those goods or services. Sales, value add and other taxes collected concurrent with revenue-producing activities are excluded from revenue. AbbVie generates revenue primarily from product sales. For the majority of sales, the company transfers control, invoices the customer and recognizes revenue upon shipment to the customer. Rebates AbbVie provides rebates to pharmacy benefit managers, state government Medicaid programs, insurance companies that administer Medicare drug plans, wholesalers, group purchasing organizations and other government agencies and private entities.Rebate and chargeback accruals are accounted for as variable consideration and are recorded as a reduction to revenue in the period the related product is sold. Provisions for rebates and chargebacks totaled $27.0 billion in 2020, $18.8 billion in 2019 and $16.4 billion in 2018. Rebate amounts are typically based upon the volume of purchases using contractual or statutory prices, which may vary by product and by payer. For each type of rebate, the factors used in the calculations of the accrual for that rebate include the identification of the products subject to the rebate, the applicable price terms and the estimated lag time between sale and payment of the rebate, which can be significant.In order to establish its rebate and chargeback accruals, the company uses both internal and external data to estimate the level of inventory in the distribution channel and the rebate claims processing lag time for each type of rebate. To estimate the rebate percentage or net price, the company tracks sales by product and by customer or payer. The company evaluates inventory data reported by wholesalers, available prescription volume information, product pricing, historical experience and other factors in order to determine the adequacy of its reserves. AbbVie regularly monitors its reserves and records adjustments when rebate trends, rebate programs and contract terms, legislative changes, or other significant events indicate that a change in the reserve is appropriate. Historically, adjustments to rebate accruals have not been material to net earnings.43 | 2020 Form 10-KThe following table is an analysis of the three largest rebate accruals and chargeback allowances, which comprise approximately 89% of the total consolidated rebate and chargebacks recorded as reductions to revenues in 2020. Remaining rebate provisions charged against gross revenues are not significant in the determination of operating earnings.(in millions)Medicaid and Medicare RebatesManaged Care RebatesWholesalerChargebacksBalance at December 31, 2017$1,340 $1,195 $522 Provisions3,493 4,729 6,659 Payments(3,188)(4,485)(6,525)Balance at December 31, 20181,645 1,439 656 Provisions4,035 5,772 7,947 Payments(3,915)(5,275)(7,917)Balance at December 31, 20191,765 1,936 686 Additions(a)1,266 649 71 Provisions6,715 8,656 8,677 Payments(6,801)(8,334)(8,693)Balance at December 31, 2020$2,945 $2,907 $741 (a)Represents rebate accruals and chargeback allowances assumed in the Allergan acquisition.Cash Discounts and Product ReturnsCash discounts and product returns, which totaled $2.4 billion in 2020, $1.6 billion in 2019 and $1.6 billion in 2018, are accounted for as variable consideration and are recorded as a reduction to revenue in the same period the related product is sold. The reserve for cash discounts is readily determinable because the company's experience of payment history is fairly consistent. Product returns can be reliably estimated based on the company's historical return experience.Pension and Other Post-Employment BenefitsAbbVie engages outside actuaries to assist in the determination of the obligations and costs under the pension and other post-employment benefit plans that are direct obligations of AbbVie. The valuation of the funded status and the net periodic benefit cost for these plans are calculated using actuarial assumptions. The significant assumptions, which are reviewed annually, include the discount rate, the expected long-term rate of return on plan assets and the health care cost trend rates, and are disclosed in Note 12 to the Consolidated Financial Statements.The discount rate is selected based on current market rates on high-quality, fixed-income investments at December 31 each year. AbbVie employs a yield-curve approach for countries where a robust bond market exists. The yield curve is developed using high-quality bonds. The yield-curve approach reflects the plans' specific cash flows (i.e. duration) in calculating the benefit obligations by applying the corresponding individual spot rates along the yield curve. AbbVie reflects the plans' specific cash flows and applies them to the corresponding individual spot rates along the yield curve in calculating the service cost and interest cost portions of expense. For other countries, AbbVie reviews various indices such as corporate bond and government bond benchmarks to estimate the discount rate. AbbVie's assumed discount rates have a significant effect on the amounts reported for defined benefit pension and other post-employment plans as of December 31, 2020. A 50 basis point change in the assumed discount rate would have had the following effects on AbbVie's calculation of net periodic benefit costs in 2021 and projected benefit obligations as of December 31, 2020:50 basis point(in millions) (brackets denote a reduction)IncreaseDecreaseDefined benefit plansService and interest cost$(89)$101 Projected benefit obligation(1,000)1,140 Other post-employment plansService and interest cost$(6)$7 Projected benefit obligation(56)63 2020 Form 10-K | 44The expected long-term rate of return is based on the asset allocation, historical performance and the current view of expected future returns. AbbVie considers these inputs with a long-term focus to avoid short-term market influences. The current long-term rate of return on plan assets for each plan is supported by the historical performance of the trust's actual and target asset allocation. AbbVie's assumed expected long-term rate of return has a significant effect on the amounts reported for defined benefit pension plans as of December 31, 2020 and will be used in the calculation of net periodic benefit cost in 2021. A one percentage point change in assumed expected long-term rate of return on plan assets would increase or decrease the net period benefit cost of these plans in 2021 by $94 million.The health care cost trend rate is selected by reviewing historical trends and current views on projected future health care cost increases. The current health care cost trend rate is supported by the historical trend experience of each plan. Assumed health care cost trend rates have a significant effect on the amounts reported for health care plans as of December 31, 2020 and will be used in the calculation of net periodic benefit cost in 2021. Income TaxesAbbVie accounts for income taxes under the asset and liability method. Provisions for federal, state and foreign income taxes are calculated on reported pretax earnings based on current tax laws. Deferred taxes are provided using enacted tax rates on the future tax consequences of temporary differences, which are the differences between the financial statement carrying amount of assets and liabilities and their respective tax bases and the tax benefits of carryforwards. A valuation allowance is established or maintained when, based on currently available information, it is more likely than not that all or a portion of a deferred tax asset will not be realized.LitigationThe company is subject to contingencies, such as various claims, legal proceedings and investigations regarding product liability, intellectual property, commercial, securities and other matters that arise in the normal course of business. See Note 15 to the Consolidated Financial Statements for additional information. Loss contingency provisions are recorded for probable losses at management's best estimate of a loss, or when a best estimate cannot be made, a minimum loss contingency amount within a probable range is recorded. Accordingly, AbbVie is often initially unable to develop a best estimate of loss and therefore, the minimum amount, which could be zero, is recorded. As information becomes known, either the minimum loss amount is increased, resulting in additional loss provisions, or a best estimate can be made, also resulting in additional loss provisions. Occasionally, a best estimate amount is changed to a lower amount when events result in an expectation of a more favorable outcome than previously expected.Valuation of Goodwill and Intangible AssetsAbbVie has acquired and may continue to acquire significant intangible assets in connection with business combinations that AbbVie records at fair value. Transactions involving the purchase or sale of intangible assets occur with some frequency between companies in the pharmaceuticals industry and valuations are usually based on a discounted cash flow analysis incorporating the stage of completion. The discounted cash flow model requires assumptions about the timing and amount of future net cash flows, risk, cost of capital, terminal values and market participants. Each of these factors can significantly affect the value of the intangible asset. IPR&D acquired in a business combination is capitalized as an indefinite-lived intangible asset until regulatory approval is obtained, at which time it is accounted for as a definite-lived asset and amortized over its estimated useful life, or discontinuation, at which point the intangible asset will be written off. IPR&D acquired in transactions that are not business combinations is expensed immediately, unless deemed to have an alternative future use. Payments made to third parties subsequent to regulatory approval are capitalized and amortized over the remaining useful life.AbbVie reviews the recoverability of definite-lived intangible assets whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. Goodwill and indefinite-lived intangible assets are reviewed for impairment annually or when an event occurs that could result in an impairment. See Note 2 to the Consolidated Financial Statements for further information.Annually, the company tests its goodwill for impairment by first assessing qualitative factors to determine whether it is more likely than not that the fair value is less than its carrying amount. Some of the factors considered in the assessment include general macro-economic conditions, conditions specific to the industry and market, cost factors, the overall financial performance and whether there have been sustained declines in the company's share price. If the company concludes it is more likely than not that the fair value of the reporting unit is less than its carrying amount, a quantitative impairment test is performed. AbbVie tests indefinite-lived intangible assets for impairment by first assessing qualitative factors to determine whether it is more likely than not that the fair value is less than its carrying amount. If the company concludes it is more likely than not that the fair value is less than its carrying amount, a quantitative impairment test is performed. 45 | 2020 Form 10-KFor its quantitative impairment tests, the company uses an estimated future cash flow approach that requires significant judgment with respect to future volume, revenue and expense growth rates, changes in working capital use, the selection of an appropriate discount rate, asset groupings and other assumptions and estimates. The estimates and assumptions used are consistent with the company's business plans and a market participant's views. The use of alternative estimates and assumptions could increase or decrease the estimated fair value of the assets and could potentially impact the company's results of operations. Actual results may differ from the company's estimates.Contingent ConsiderationThe fair value measurements of contingent consideration liabilities are determined as of the acquisition date based on significant unobservable inputs, including the discount rate, estimated probabilities and timing of achieving specified development, regulatory and commercial milestones and the estimated amount of future sales of the acquired products. Contingent consideration liabilities are revalued to fair value at each subsequent reporting date until the related contingency is resolved. The potential contingent consideration payments are estimated by applying a probability-weighted expected payment model for contingent milestone payments and a Monte Carlo simulation model for contingent royalty payments, which are then discounted to present value. Changes to the fair value of the contingent consideration liabilities can result from changes to one or a number of inputs, including discount rates, the probabilities of achieving the milestones, the time required to achieve the milestones and estimated future sales. Significant judgment is employed in determining the appropriateness of certain of these inputs. Changes to the inputs described above could have a material impact on the company's financial position and results of operations in any given period. The fair value of the company's contingent consideration liabilities as of December 31, 2020 was calculated using the following significant unobservable inputs:RangeWeighted Average(a)Discount rate0.1% - 2.2%1.1%Probability of payment for unachieved milestones56% - 92%64%Probability of payment for royalties by indication(b)56% - 100%91%Projected year of payments2021 - 20342027(a)Unobservable inputs were weighted by the relative fair value of the contingent consideration liabilities.(b)Excludes early stage indications with 0% estimated probability of payment and includes approved indications with 100% probability of payment. Excluding approved indications, the estimated probability of payment ranged from 56% to 89% at December 31, 2020. Recent Accounting PronouncementsSee Note 2 to the Consolidated Financial Statements for additional information on recent accounting pronouncements.2020 Form 10-K | 46ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKThe company is exposed to risk that its earnings, cash flows and equity could be adversely impacted by changes in foreign exchange rates and interest rates. Certain derivative instruments are used when available on a cost-effective basis to hedge the company's underlying economic exposures. See Note 11 to the Consolidated Financial Statements for additional information regarding the company's financial instruments and hedging strategies.Foreign Currency RiskAbbVie's primary net foreign currency exposures are the Euro, Japanese yen, Canadian dollar and British pound. The following table reflects the total foreign currency forward exchange contracts outstanding at December 31, 2020 and 2019:20202019as of December 31 (in millions)Contract amountWeighted average exchange rateFair and carrying value receivable/(payable)Contract amountWeighted average exchange rateFair and carrying value receivable/(payable)Receive primarily U.S. dollars in exchange for the following currencies:Euro$7,818 1.213 $(39)$6,217 1.116 $(12)Japanese yen837 103.9 (7)820 108.7 — Canadian dollar591 1.328 (23)504 1.324 (6)British pound275 1.341 3 427 1.305 (6)All other currencies1,706 n/a(15)1,508 n/a(10)Total$11,227 $(81)$9,476 $(34)The company estimates that a 10% appreciation in the underlying currencies being hedged from their levels against the U.S. dollar, with all other variables held constant, would decrease the fair value of foreign exchange forward contracts by $1.14 billion at December 31, 2020. If realized, this appreciation would negatively affect earnings over the remaining life of the contracts. However, gains and losses on the hedging instruments offset losses and gains on the hedged transactions and reduce the earnings and stockholders' equity volatility relating to foreign exchange. A 10% appreciation is believed to be a reasonably possible near-term change in foreign currencies.As of December 31, 2020, the company has €6.6 billion aggregate principal amount of unsecured senior Euro notes outstanding, which are exposed to foreign currency risk. The company designated these foreign currency denominated notes as hedges of its net investments in certain foreign subsidiaries and affiliates. As a result, any foreign currency translation gains or losses related to the Euro notes will be included in accumulated other comprehensive loss. See Note 10 to the Consolidated Financial Statements for additional information regarding to the senior Euro notes and Note 11 to the Consolidated Financial Statements for additional information regarding to the net investment hedging program. Interest Rate RiskThe company estimates that an increase in interest rates of 100 basis points would adversely impact the fair value of AbbVie's interest rate swap contracts by approximately $111 million at December 31, 2020. If realized, the fair value reduction would affect earnings over the remaining life of the contracts. The company estimates that an increase of 100 basis points in long-term interest rates would decrease the fair value of long-term debt by $5.7 billion at December 31, 2020. A 100 basis point change is believed to be a reasonably possible near-term change in interest rates. 47 | 2020 Form 10-K

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+Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause a difference include, but are not limited to, those discussed under Item 1A. Risk Factors in this Annual Report on Form 10-K. The following section is qualified in its entirety by the more detailed information, including our consolidated financial statements and the notes thereto, which appears elsewhere in this Annual Report.OverviewOrganizationWe are a leading global provider of security products and solutions operating in three geographic regions: Americas, EMEA and Asia Pacific. We sell a wide range of security products and solutions for end-users in commercial, institutional and residential markets worldwide, including the education, healthcare, government, hospitality, commercial office and single and multi-family residential markets. Our leading brands include CISA, Interflex, LCN, Schlage, SimonsVoss and Von Duprin. Recent DevelopmentsCOVID-19 PandemicIn March 2020, a global pandemic was declared by the WHO related to COVID-19. The impacts of the COVID-19 pandemic negatively affected the global economy, disrupted supply chains and created significant volatility and disruption in financial markets. The outbreak and spread of COVID-19 also resulted in a substantial curtailment of business activities worldwide, including the major geographic markets we serve. As part of the efforts to contain the spread of COVID-19, federal, state and local governments have imposed various restrictions on the conduct of business and travel, such as stay-at-home orders, travel restrictions and quarantines. These measures, as well as changes in employee health and safety concerns and consumer spending patterns, trends and preferences, have led to widespread business closures and lower demand for our products, with the most pronounced negative impacts of these measures on our results of operations occurring during the second quarter of 2020. Further, changes in commercial real estate occupancy, constraints on government and institutional budgets and the uncertain business climate have led to declines and delays in new construction activity and discretionary projects, including in many of the commercial and institutional construction markets we serve. As the pandemic and resulting economic challenges have adversely impacted, and will likely continue to adversely impact us, we continue to closely monitor their effects on all aspects of our business and the markets in which we operate. Throughout the pandemic, our primary focus has been, and continues to be, the health and safety of employees, our business continuity plan, meeting the evolving needs of our customers and the well-being of the many communities around the world in which we operate. During the early months of the pandemic, we experienced temporary production shut-downs due either to government mandate or to help ensure employee safety, most notably in Italy and the Baja region of Mexico. However, the vast majority of our manufacturing facilities have remained open and operational throughout 2020, in part due to the numerous health and safety measures we adopted to promote the health and safety of our workforce and because many of our global operations have been deemed essential businesses. All of our global production and assembly facilities were operational as of December 31, 2020, and while we currently expect they will remain operational for the foreseeable future, such expectation is dependent upon future governmental actions, demand for our products, the stability of our global supply chain and our ability to continue to operate in a safe manner. We remain focused on business continuity and ensuring our facilities remain operational where safe and appropriate to do so. We will also continue to serve our customers when needed through our channel partners or inventory on hand. To the extent any additional temporary closures or adjustments to production are necessary, such measures will be implemented in a way that allows us to resume operations in an efficient and safe manner, while also minimizing disruption to customers and our overall business, including prudent measures to mitigate, to the extent possible, any financial impacts, although any additional local orders or decrees resulting in new temporary shut-downs will drive further unfavorable impacts to our operations, ability to serve our customers and potentially, our financial position and liquidity. The pandemic will likely continue to impact us in numerous and evolving ways that we may not be able to accurately predict; however, we will continue to closely monitor its impact on our business, employees, customers, suppliers, distribution channels and other business partners, and we believe that our actions taken to date, our financial flexibility and potential measures within our control will allow us to maintain a sound financial position and provide for adequate resources to fund our ongoing operating and financing needs.32Table of ContentsAdditionally, as a response to the COVID-19 pandemic, on March 27, 2020, the Coronavirus Aid, Relief and Economic Security Act (the "CARES Act") was enacted and signed into law, which included measures to assist companies in response to the COVID-19 pandemic. One measure allowed companies to defer the remittance of the employer portion of the social security tax through December 31, 2020, with half the amount deferred required to be paid by December 31, 2021, and the other half by December 31, 2022. Through December 31, 2020, we have elected to defer approximately $13 million under this provision, which is classified in Accrued expenses and other current liabilities and Other noncurrent liabilities within our Consolidated Balance Sheet. A second measure of the CARES Act raised the limit on business interest deductions from 30% to 50% of adjusted taxable income for tax years 2019 and 2020. This increased interest limitation resulted in approximately $20 million of reduced cash tax payments in 2020. Each of these two measures has resulted in a benefit to our cash flows from operations for the year ended December 31, 2020; however, neither measure is expected to materially impact our effective tax rate, and no income tax effects have been recorded during the year ended December 31, 2020.The challenges and uncertainties related to the COVID-19 pandemic and its potential impact on our business, results of operations, financial condition and cash flows, as well as a number of other challenges and uncertainties that could affect our businesses are described further under Part I, Item 1A. "Risk Factors."2020 and 2019 Significant Events AcquisitionsIn December 2020, we acquired Yonomi, Inc. ("Yonomi), a U.S. based smart home integration platform provider and innovation leader in IoT Cloud platforms. Yonomi has been integrated into our Americas segment. Impairment of Goodwill and Intangible AssetsAs a result of the global economic disruption and uncertainty due to the COVID-19 pandemic, we performed interim impairment tests on the goodwill balances of our EMEA and Asia Pacific reporting units, as well as on certain indefinite-lived trade name assets in these two regions, during the first quarter of 2020. As discussed in Notes 5 and 6 to the Consolidated Financial Statements, the results of these interim impairment tests indicated that the estimated fair value of our Asia Pacific reporting unit and three indefinite-lived trade names were impaired. Consequently, goodwill and intangible asset impairment charges totaling $96.3 million were recorded. Further impairment charges were recorded in our Asia Pacific segment during the year ended December 31, 2020, including $2.6 million related to supply chain disruptions that reduced a brand's expected future cash flows and $2.8 million related to declines in volumes and pricing pressure for a separate subsidiary in the region. Loss on Assets Held for SaleThe assets and liabilities of our QMI business met the criteria to be classified as held for sale as of December 31, 2020. Accordingly, QMI's net assets, which primarily included working capital and long-lived assets, were written down to fair value, estimated based on expected sales proceeds, less cost to sell, resulting in a Loss on assets held for sale of $37.9 million. Turkey and Colombia DivestituresIn 2019, we closed our production facility in Turkey to help streamline our footprint in EMEA and subsequently sold certain of the production assets, which represented a business, for total proceeds of approximately $4.1 million. We recorded a loss on divestiture of $24.2 million ($25.5 million, net of tax), primarily driven by the reclassification of $25.0 million of accumulated foreign currency translation adjustments to earnings upon sale. We also sold our interests in our Colombia operations in 2019 for a nominal amount, recording a net loss on divestiture of $5.9 million, of which $1.2 million related to the reclassification of accumulated foreign currency translation adjustments to earnings upon sale.2020 Dividends and Share RepurchasesWe paid quarterly dividends of $0.32 per ordinary share to shareholders on record as of March 17, 2020, June 16, 2020, September 16, 2020, and December 16, 2020. We paid a total of $117.3 million in cash for dividends to ordinary shareholders and repurchased approximately 1.9 million shares for approximately $208.8 million during the year ended December 31, 2020.33Table of ContentsOther Financing ActivitiesIn 2019, we issued $400.0 million of 3.500% Senior Notes due 2029 (the "3.500% Senior Notes"). Net proceeds from the issuance of the 3.500% Senior Notes, along with cash on hand, were utilized to make a $400.0 million principal payment to partially pay down the Company's outstanding term loan facility (the "Term Facility") balance. As a result of this payment, we have satisfied our obligation to make quarterly installments on the Term Facility up to its maturity date, with the remaining outstanding balance of $238.8 million due on September 12, 2022.Subsequent EventEffective January 1, 2021, we have combined our EMEA and Asia Pacific operations into a new segment named Allegion International, in addition to renaming our Americas segment "Allegion Americas". The new Allegion International segment has been created to drive speed and efficiency, simplify our operating segments and optimize our non-U.S. operations.34Table of ContentsResults of Operations - For the years ended December 31Dollar amounts in millions, except per share amounts2020% of Netrevenues2019% of NetrevenuesNet revenues$2,719.9 $2,854.0 Cost of goods sold1,541.1 56.7 %1,601.7 56.1 %Selling and administrative expenses635.7 23.4 %681.3 23.9 %Impairment of goodwill and intangible assets101.7 3.7 %5.9 0.2 %Loss on assets held for sale37.9 1.4 %— — %Operating income403.5 14.8 %565.1 19.8 %Interest expense51.1 56.0 Loss on divestitures— 30.1 Other (income) expense, net(13.0) 3.8 Earnings before income taxes365.4 475.2 Provision for income taxes50.9 73.1 Net earnings314.5 402.1 Less: Net earnings attributable to noncontrolling interests0.2 0.3 Net earnings attributable to Allegion plc$314.3 $401.8 Diluted net earnings per ordinary share attributable to Allegion plc ordinary shareholders:$3.39 $4.26 The discussions that follow describe the significant factors contributing to the changes in our results of operations for the years presented and form the basis used by management to evaluate the financial performance of the business. For a discussion of our results of operations for the year ended December 31, 2019, compared to the year ended December 31, 2018, see “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our 2019 Annual Report on Form 10-K filed with the SEC on February 18, 2020.Net RevenuesNet revenues for the year ended December 31, 2020, decreased by 4.7%, or $134.1 million, compared to the same period in 2019, due to the following:Pricing1.0 %Volume(5.8)%Divestitures(0.3)%Currency exchange rates0.4 %Total(4.7)%The decrease in Net revenues was principally driven by lower volumes across all regions, primarily due to the economic challenges stemming from the ongoing COVID-19 pandemic, particularly during the second quarter of 2020. The decrease was, to a lesser degree, due to the impact of the divestitures of our Colombia and Turkey businesses in 2019, as discussed above. These decreases were slightly offset by improved pricing and the impact of foreign currency exchange rate movements.Pricing includes increases or decreases of price, including discounts, surcharges and/or other sales deductions, on our existing products and services. Volume includes increases or decreases of revenue due to changes in unit volume of existing products and services, as well as new products and services.Cost of Goods SoldFor the year ended December 31, 2020, Cost of goods sold as a percentage of Net revenues increased to 56.7% from 56.1%, due to the following:35Table of ContentsInflation in excess of pricing and productivity0.2 %Volume / product mix0.8 %Divestitures(0.1)%Currency exchange rates(0.2)%Restructuring expenses(0.1)%Total0.6 %Costs of goods sold as a percentage of Net revenues for the year ended December 31, 2020, increased primarily due to the impact of reduced volumes and product mix and, to a lesser extent, inflation in excess of pricing and productivity. Inflation in excess of pricing and productivity was driven by productivity challenges stemming from the temporary closures during the second quarter discussed above; labor inefficiencies, such as increased absenteeism; and, increased costs related to ensuring a safe and healthy work environment in light of the COVID-19 pandemic. These increases were partially offset by certain non-U.S. government incentives, which were included within inflation in excess of pricing and productivity, as well as the impacts of the divestitures discussed above, foreign currency exchange rate movements and a year-over-year decrease in restructuring expenses. The year-over-year decrease in restructuring expenses impacting Costs of goods sold is due to the prior year restructuring costs related to the closure of our production facility in Turkey in 2019. Inflation in excess of pricing and productivity includes the impact to Cost of goods sold from pricing, as defined above, in addition to productivity and inflation. Productivity represents improvements in unit costs of materials and cost reductions related to improvements to our manufacturing design and processes. Inflation includes unit costs for the current period compared to the average actual cost for the prior period, multiplied by current year volumes. Volume/product mix represents the impact due to increases or decreases of revenue due to changes in unit volume, including new products and services, including the effect of changes in the mix of products and services sold on Cost of goods sold.Selling and Administrative ExpensesFor the year ended December 31, 2020, Selling and administrative expenses as a percentage of Net revenues decreased to 23.4% from 23.9%, due to the following:Productivity in excess of inflation(2.3)%Volume leverage1.4 %Investment spending0.1 %Currency exchange rates(0.1)%Restructuring / acquisition expenses0.4 %Total(0.5)%Selling and administrative expenses as a percentage of Net revenues for the year ended December 31, 2020, decreased primarily due to productivity benefits in excess of inflation and foreign currency exchange rate movements. These decreases were partially offset by unfavorable leverage due to lower volumes, increased investment spending and a year-over-year increase in restructuring and acquisition expenses.Productivity in excess of inflation includes the impact from reductions in selling and administrative expenses due to productivity projects and current period costs of ongoing selling and administrative functions compared to the same ongoing expenses in the prior period. Productivity in excess of inflation also reflects the benefits of certain non-U.S. government incentives, reductions in variable compensation and reductions or delays of other business spending in the current year, in response to the COVID-19 pandemic.Volume leverage represents the contribution margin related to changes in sales volume, excluding the impact of price, productivity, mix and inflation. Expenses related to increased head count for strategic initiatives, new facilities or significant improvements for strategic initiatives and new product development, are captured in Investment spending in the table above. Operating Income/MarginOperating income for the year ended December 31, 2020, decreased $161.6 million from the same period in 2019, and Operating margin decreased to 14.8% from 19.8%, due to the following: 36Table of ContentsIn millionsOperating IncomeOperating MarginDecember 31, 2019$565.1 19.8 %Pricing and productivity in excess of inflation66.7 2.1 %Volume / product mix(94.9)(2.3)%Currency exchange rates8.6 0.2 %Investment spending(2.1)(0.1)%Divestitures0.6 0.1 %Restructuring / acquisition expenses(6.8)(0.3)%Impairment of goodwill and intangible assets(95.8)(3.4)%Loss on assets held for sale(37.9)(1.3)%December 31, 2020$403.5 14.8 %The decreases in Operating income and Operating margin were largely driven by our current year goodwill and intangible asset impairment charges and loss on assets held for sale related to our QMI business. As a result of the global economic disruption and uncertainty due to the COVID-19 pandemic, we determined a triggering event had occurred as of March 31, 2020, and performed interim impairment testing on the goodwill balances of our EMEA and Asia Pacific reporting units, as well as on certain indefinite-lived trade name assets in these two regions, which resulted in impairment charges totaling $96.3 million. Additional intangible asset impairments of $2.6 million and $2.8 million were recorded in our Asia Pacific segment in the third and fourth quarters of 2020, respectively. Further, as we concluded that the net assets of our QMI business met the criteria to be classified as held for sale as of December 31, 2020, they were written down to fair value, estimated based on expected sales proceeds, less cost to sell, which resulted in a loss of $37.9 million. The decreases in Operating income and Operating margin were also attributable to unfavorable volume/product mix, a year-over-year increase in restructuring and acquisition expenses and increased investment spending. These decreases were partially offset by pricing improvements and productivity in excess of inflation, foreign currency exchange rate movements and the impact of the divestitures discussed above. Interest ExpenseInterest expense for the year ended December 31, 2020, decreased $4.9 million compared to 2019, which is due to a lower weighted-average interest rate during the current year on our outstanding indebtedness and a $2.7 million prior year charge for the write-off of previously deferred financing costs related to the Term Facility, which did not recur in the current period.Loss on DivestituresIn 2019, we closed our production facility in Turkey and subsequently sold certain of the production assets thereof, which represented a business, for total proceeds of approximately $4.1 million. We recorded a loss on divestiture of $24.2 million ($25.5 million, net of tax), primarily driven by the reclassification of $25.0 million of accumulated foreign currency translation adjustments to earnings upon sale. We also sold our interests in our Colombia operations in 2019 for a nominal amount, recording a net loss on divestiture of $5.9 million, of which $1.2 million related to the reclassification of accumulated foreign currency translation adjustments to earnings upon sale. Other (Income) Expense, netThe components of Other (income) expense, net, for the years ended December 31 were as follows:In millions20202019Interest income$(0.9)$(1.8)Foreign currency exchange loss0.7 1.8 (Earnings) loss from equity method investments(0.3)0.1 Net periodic pension and postretirement benefit (income) cost, less service cost(2.2)6.8 Other(10.3)(3.1)Other (income) expense, net$(13.0)$3.8 37Table of ContentsFor the year ended December 31, 2020, Other (income) expense, net was favorable $16.8 million compared to 2019, primarily due to gains of $12.8 million related to the reclassification to earnings of accumulated foreign currency translation adjustments upon the liquidation of two legal entities in our EMEA region, which are included within Other in the table above, as well as favorable net periodic pension and postretirement benefit (income) cost, less service cost in 2020 compared to 2019. Provision for Income TaxesFor the year ended December 31, 2020, our effective tax rate was 13.9%, compared to 15.4% for the year ended December 31, 2019. The decrease in the effective tax rate was primarily due to the favorable mix of income earned in lower tax rate jurisdictions, partially offset by the unfavorable tax impact related to goodwill and intangible asset impairment charges and the unfavorable year-over-year change in the amounts recognized for valuation allowances. Review of Business SegmentsWe operate in and report financial results for three segments: Americas, EMEA and Asia Pacific. Beginning in the second quarter of 2020, results for the Company's India operations have been included within the Asia Pacific segment results, due to an operational change. This change did not result in a material impact to Segment results of operations for either the EMEA or Asia Pacific segment. These segments represent the level at which our chief operating decision maker reviews company financial performance and makes operating decisions.Segment operating income (loss) is the measure of profit and loss that our chief operating decision maker uses to evaluate the financial performance of the business and as the basis for resource allocation, performance reviews and compensation. For these reasons, we believe that Segment operating income (loss) represents the most relevant measure of Segment profit and loss. Our chief operating decision maker may exclude certain charges or gains, such as corporate charges and other special charges, to arrive at a Segment operating income (loss) that is a more meaningful measure of profit and loss upon which to base our operating decisions. We define Segment operating margin as Segment operating income (loss) as a percentage of the segment's Net revenues.The segment discussions that follow describe the significant factors contributing to the changes in results for each segment included in Net earnings. Segment Results of Operations - For the years ended December 31In millions20202019% ChangeNet revenuesAmericas$2,016.7 $2,114.5 (4.6)%EMEA554.6 572.5 (3.1)%Asia Pacific148.6 167.0 (11.0)%Total$2,719.9 $2,854.0 Segment operating income (loss)Americas$580.2 $611.6 (5.1)%EMEA(5.4)34.3 (115.7)%Asia Pacific(96.7)0.5 N/MTotal$478.1 $646.4 Segment operating marginAmericas28.8 %28.9 %EMEA(1.0)%6.0 %Asia Pacific(65.1)%0.3 %"N/M" = not meaningful38Table of ContentsAmericasOur Americas segment is a leading provider of security products and solutions in approximately 30 countries throughout North America, Central America, the Caribbean and South America. The segment sells a broad range of products and solutions including, locks, locksets, portable locks, key systems, door closers, exit devices, doors and door systems, electronic products and access control systems to end-users in commercial, institutional and residential facilities, including the education, healthcare, government, hospitality, commercial office and single and multi-family residential markets. This segment’s primary brands are LCN, Schlage, Steelcraft, Technical Glass Products ("TGP") and Von Duprin.Net revenuesNet revenues for the year ended December 31, 2020, decreased by 4.6%, or $97.8 million, compared to the same period in 2019, due to the following: Pricing1.1 %Volume(5.3)%Divestitures(0.4)%Total(4.6)%The decrease in Net revenues was principally driven by lower volumes due to the economic challenges stemming from the ongoing COVID-19 pandemic, as well as the impact of the divestiture of our Colombia business in 2019. These decreases were partially offset by improved pricing. Net revenues from residential products for the year ended December 31, 2020, increased mid-single digits compared to the same period in the prior year, primarily driven by higher volumes. Net revenues from non-residential products for the year ended December 31, 2020, decreased high single digits compared to the prior year, primarily driven by lower volumes. As a result of the COVID-19 pandemic, there have been changes in commercial real estate occupancy, constraints on government and institutional budgets and an overall uncertain business climate, which have led to declines and delays in new construction activity and discretionary projects in the non-residential construction markets we serve. These challenges are expected to continue in 2021, but the long-term impacts of the pandemic and related market disruption are not yet known. Additionally, as end-users have continued to adopt newer technologies in their facilities and homes, accelerated by the increasing adoption of the Internet of Things ("IoT"), growth in electronic security products and solutions has become an increased metric monitored by management and of focus to our investors. For the year ended December 31, 2020, Net revenues from the sale of electronic products in the Americas segment decreased mid-single digits compared to the same period in the prior year, primarily driven by lower volumes due to delays in discretionary projects. Electronic products include all electrified product categories including, but not limited to, electronic locks, access controls and electrified exit devices.Operating income/marginSegment operating income for the year ended December 31, 2020, decreased $31.4 million, and Segment operating margin decreased to 28.8% from 28.9% compared to the same period in 2019, due to the following: In millionsOperating IncomeOperating MarginDecember 31, 2019$611.6 28.9 %Pricing and productivity in excess of inflation31.0 1.1 %Volume / product mix(64.8)(1.5)%Currency exchange rates5.9 0.3 %Investment spending(2.0)(0.1)%Divestitures0.7 0.2 %Restructuring / acquisition expenses(2.2)(0.1)%December 31, 2020$580.2 28.8 %The decreases in Segment operating income and Segment operating margin were primarily due to unfavorable volume/product mix, as well as increased investment spending and year-over-year increases in restructuring and acquisition expenses. These decreases were partially offset by pricing improvements and productivity in excess of inflation, foreign currency exchange rate movements and the impact of the divestiture of our Colombia business in 2019. As a result of the ongoing COVID-19 pandemic, certain of our facilities in the Americas experienced productivity challenges due to temporary closures and lower volume and demand, particularly during the second quarter; however, these productivity decreases were more than offset by reductions in variable compensation and reductions or delays of other business spending.39Table of ContentsEMEAOur EMEA segment provides security products, services and solutions in approximately 80 countries throughout Europe, the Middle East and Africa. The segment offers end-users a broad range of products, services and solutions including, locks, locksets, portable locks, key systems, door closers, exit devices, doors and door systems, electronic products and access control systems, as well as time and attendance and workforce productivity solutions. This segment’s primary brands are AXA, Bricard, Briton, CISA, Interflex and SimonsVoss. This segment also resells LCN, Schlage and Von Duprin products, primarily in the Middle East. Net revenuesNet revenues for the year ended December 31, 2020, decreased by 3.1%, or $17.9 million, compared to the same period in 2019, due to the following:Pricing0.9 %Volume(6.0)%Divestitures(0.2)%Currency exchange rates2.2 %Total(3.1)%The decrease in Net revenues was principally driven by lower volumes due to the economic challenges stemming from the ongoing COVID-19 pandemic, particularly during the second quarter, as well as the divestiture of our Turkey business in 2019. These decreases were partially offset by improved pricing and favorable foreign currency exchange rate movements.Operating income (loss)/marginSegment operating income (loss) for the year ended December 31, 2020, was unfavorable $39.7 million, and Segment operating margin decreased to (1.0)% from 6.0% compared to the same period in 2019, due to the following:In millionsOperating Income (Loss)Operating MarginDecember 31, 2019$34.3 6.0 %Pricing and productivity in excess of inflation15.0 2.6 %Volume / product mix(22.4)(3.8)%Currency exchange rates2.8 0.4 %Investment spending(0.3)(0.1)%Divestitures(0.1)— %Restructuring / acquisition expenses3.1 0.5 %Impairment of intangible assets0.1 — %Loss on assets held for sale(37.9)(6.6)%December 31, 2020$(5.4)(1.0)%Segment operating income (loss) was unfavorable primarily due to the loss on assets held for sale related to our QMI business, unfavorable volume/product mix and, to a lesser extent, increased investment spending and the impact of the divestiture of our Turkey business in 2019. These decreases were partially offset by pricing improvements and productivity in excess of inflation, foreign currency exchange rate movements, year-over-year decreases in restructuring and acquisition expenses and intangible asset impairment charges. Certain of our facilities in EMEA did experience productivity challenges as a result of the COVID-19 pandemic due to temporary closures and lower volume and demand, particularly during the second quarter in Italy; however, this was more than offset by the benefits of certain government incentives and reductions in variable compensation and other business spending. Pricing and productivity in excess of inflation also includes the impact of a $5.1 million environmental remediation charge incurred during the fourth quarter of 2020. Segment operating margin decreased primarily due to the loss on assets held for sale, unfavorable volume/product mix and increased investment spending. These decreases were partially offset by pricing improvements and productivity in excess of inflation, foreign currency exchange rate movements and year-over-year decreases in restructuring and acquisition expenses.40Table of ContentsAsia PacificOur Asia Pacific segment provides security products, services and solutions in approximately 15 countries throughout the Asia Pacific region. The segment offers end-users a broad range of products, services and solutions including, locks, locksets, portable locks, key systems, door closers, exit devices, electronic products and access control systems. This segment’s primary brands are Brio, Briton, FSH, Gainsborough, Legge, Milre and Schlage.Net revenuesNet revenues for the year ended December 31, 2020, decreased by 11.0%, or $18.4 million, compared to the same period in 2019, due to the following: Pricing(0.7)%Volume(9.9)%Currency exchange rates(0.4)%Total(11.0)%The decrease in Net revenues was principally driven by lower volumes in our Korea business, declines attributable to the economic challenges stemming from the ongoing COVID-19 pandemic and weakness in end markets throughout the region. Unfavorable foreign currency exchange rate movements and lower pricing also contributed to the decrease in Net revenues during the current year.Operating income (loss)/marginSegment operating income (loss) for the year ended December 31, 2020, was unfavorable $97.2 million, and Segment operating margin decreased to (65.1)% from 0.3% compared to the same period in 2019, due to the following: In millionsOperating Income (Loss)Operating MarginDecember 31, 2019$0.5 0.3 %Pricing and productivity in excess of inflation8.2 4.9 %Volume / product mix(7.7)(4.9)%Currency exchange rates(0.1)(0.1)%Investment spending0.8 0.5 %Restructuring / acquisition expenses(2.5)(1.5)%Impairment of goodwill and intangible assets(95.9)(64.3)%December 31, 2020$(96.7)(65.1)%The decreases to Segment operating income (loss) and Segment operating margin were both primarily due to an $88.1 million goodwill impairment charge in the first quarter of 2020 and increased year-over-year intangible asset impairment charges, as well as unfavorable volume/product mix, year-over-year increases in restructuring and acquisition expenses and foreign currency exchange rate movements. These decreases were partially offset by productivity improvements in excess of lower pricing and inflation and decreased investment spending. Pricing and productivity in excess of inflation includes the impact of a $4.0 million gain on the sale of a building within the region during the fourth quarter of 2020.Liquidity and Capital ResourcesSources and uses of liquidityOur primary source of liquidity is cash provided by operating activities. Cash provided by operating activities is used to invest in new product development and fund capital expenditures and working capital requirements and is expected to be adequate to service any future debt, pay any declared dividends and potentially fund acquisitions and share repurchases. Our ability to fund these capital needs depends on our ongoing ability to generate cash from our operating activities and to access our borrowing facilities (including unused availability under our Revolving Facility) and capital markets. Throughout 2020, we have closely monitored the developments related to the COVID-19 pandemic, including the resulting uncertainties around customer demand, supply chain disruption, the availability and cost of materials, customer and supplier financial condition, levels of liquidity and our ongoing compliance with debt covenants. While our business and results of 41Table of Contentsoperations have been negatively impacted by the pandemic and the resulting global economic slowdown, we have no required principal payments on our long-term debt until September 2022, maintain cash and cash equivalents of $480.4 million and have unused availability of $485.0 million under our Revolving Facility as of December 31, 2020. Further, our business operates with low capital intensity, providing financial flexibility during this time of continued uncertainty. We believe that our actions taken to date, future cash provided by operating activities, availability under our Revolving Facility, access to funds on hand and capital markets, as well as other potential measures within our control to maintain a sound financial position and liquidity, will provide adequate resources to fund our operating and financing needs.The following table reflects the major categories of cash flows for the years ended December 31. For additional details, please see the Consolidated Statements of Cash Flows in the Consolidated Financial Statements.In millions20202019Net cash provided by operating activities$490.3 $488.2 Net cash used in investing activities(56.7)(77.6)Net cash used in financing activities$(321.9)$(342.2)Operating activitiesNet cash provided by operating activities for the year ended December 31, 2020, increased $2.1 million compared to 2019. As discussed above, Net cash provided by operating activities for the year ended December 31, 2020, included benefits totaling approximately $30 million due to measures included in the CARES Act.Investing activitiesNet cash used in investing activities for the year ended December 31, 2020, decreased $20.9 million compared to 2019, primarily due to a decrease in capital expenditures.Financing activitiesNet cash used in financing activities for the year ended December 31, 2020, decreased $20.3 million compared to 2019. The year over-year reductions in debt repayments and cash used to repurchase shares of $17.7 million and $17.2 million, respectively, were partially offset by a year-over-year increase in dividend payments to ordinary shareholders of $16.7 million. CapitalizationAt December 31, long-term debt and other borrowings consisted of the following:In millions20202019Term Facility$238.8 $238.8 Revolving Facility— — 3.200% Senior Notes due 2024400.0 400.0 3.550% Senior Notes due 2027400.0 400.0 3.500% Senior Notes due 2029400.0 400.0 Other debt0.6 0.7 Total borrowings outstanding1,439.4 1,439.5 Less discounts and debt issuance costs, net(9.8)(11.8)Total debt1,429.6 1,427.7 Less current portion of long-term debt0.2 0.1 Total long-term debt$1,429.4 $1,427.6 As of December 31, 2020, we have an unsecured Credit Agreement in place, consisting of a $700.0 million term loan facility (the “Term Facility”), of which $238.8 million is outstanding, and a $500.0 million revolving credit facility (the “Revolving Facility” and, together with the Term Facility, the “Credit Facilities”). The Credit Facilities mature on September 12, 2022. At inception, the Term Facility was scheduled to amortize in quarterly installments at the following rates: 1.25% per quarter starting December 31, 2017 through December 31, 2020, 2.5% per quarter from March 31, 2021 through June 30, 2022, with the balance due on September 12, 2022. Principal amounts repaid on the Term Facility may not be reborrowed. During the third 42Table of Contentsquarter of 2019, we made a $400.0 million principal payment to partially pay down the outstanding Term Facility balance. As a result of this payment, we have satisfied our obligation to make quarterly installments on the Term Facility up to the maturity date, with the remaining outstanding balance due on September 12, 2022.The Revolving Facility provides aggregate commitments of up to $500.0 million, which includes up to $100.0 million for the issuance of letters of credit. At December 31, 2020, there were no borrowings outstanding on the Revolving Facility, and we had $15.0 million of letters of credit outstanding. Commitments under the Revolving Facility may be reduced at any time without premium or penalty, and amounts repaid may be reborrowed.Outstanding borrowings under the Credit Facilities accrue interest at our option of (i) a LIBOR rate plus the applicable margin or (ii) a base rate plus the applicable margin. The applicable margin ranges from 1.125% to 1.500% depending on our credit ratings. At December 31, 2020, outstanding borrowings under the Credit Facilities accrue interest at LIBOR plus a margin of 1.250%, resulting in an interest rate of 1.51%. As of December 31, 2020, we also have $400.0 million outstanding of 3.200% Senior Notes due 2024 (the "3.200% Senior Notes"), $400.0 million outstanding of 3.550% Senior Notes due 2027 (the "3.550% Senior Notes") and $400.0 million outstanding of 3.500% Senior Notes due 2029 (the "3.500% Senior Notes", and all three senior notes collectively, the "Senior Notes"). The Senior Notes require semi-annual interest payments on April 1 and October 1 of each year, and will mature on October 1, 2024, October 1, 2027, and October 1, 2029, respectively. Historically, the majority of our earnings were considered to be permanently reinvested in jurisdictions where we have made, and intend to continue to make, substantial investments to support the ongoing development and growth of our global operations. At December 31, 2020, we have analyzed our working capital requirements and the potential tax liabilities that would be incurred if certain subsidiaries made distributions and concluded that no material changes to our historic permanent reinvestment assertions are required.Defined Benefit PlansOur investment objective in managing defined benefit plan assets is to ensure that all present and future benefit obligations are met as they come due. We seek to achieve this goal while trying to mitigate volatility in plan funded status, contributions and expense by better matching the characteristics of the plan assets to that of the plan liabilities. Global asset allocation decisions are based on a dynamic approach whereby a plan's allocation to fixed income assets increases as the funded status increases. We monitor plan funded status, asset allocation and the impact of market conditions on our defined benefit plans regularly in addition to investment manager performance. None of our defined benefit pension plans have experienced a significant impact on their liquidity due to volatility in the markets. For further details on pension plan activity, see Note 12 to the Consolidated Financial Statements.Contractual ObligationsThe following table summarizes our contractual cash obligations by required payment periods:In millions20212022-20232024-2025ThereafterTotalLong-term debt (including current maturities)$0.2 $239.1 $400.1 $800.0 $1,439.4 Interest payments on long-term debt45.6 85.4 66.0 77.3 274.3 Purchase obligations462.5 ———462.5 Operating leases30.4 38.2 16.8 19.5 104.9 Total contractual cash obligations$538.7 $362.7 $482.9 $896.8 $2,281.1 Future interest payments on variable rate long-term debt are estimated based on the rate in effect as of December 31, 2020. As the timing and amounts of our future expected obligations under our defined benefit plans, income taxes, environmental and product liability matters are uncertain, they have not been included in the contractual cash obligations table above, but rather, are discussed below:Defined Benefit Pension and Postretirement ("OPEB") PlansAt December 31, 2020, we had net pension liabilities of $20.2 million, which consist of plan assets of $796.9 million and benefit obligations of $817.1 million. It is our objective to contribute to our pension plans in order to ensure adequate funds are available in the plans to make benefit payments to plan participants and beneficiaries when required. At December 31, 2020, the funded status of our qualified pension plan for U.S. employees increased to 98.7% from 93.5% at December 31, 2019. The 43Table of Contentsfunded status for our non-U.S. pension plans increased to 101.8% at December 31, 2020 from 101.1% at December 31, 2019. The funded status for all of our pension plans at December 31, 2020 increased to 97.5% from 95.3% at December 31, 2019. We currently project that approximately $11.4 million will be contributed to our plans worldwide in 2021. At December 31, 2020, we also had OPEB obligations of $5.2 million. We fund OPEB costs principally on a pay-as-you-go basis as medical costs are incurred by covered retiree populations. Benefit payments, which are net of expected plan participant contributions and Medicare Part D subsidies, are not expected to be material in 2021. See Note 12 to the Consolidated Financial Statements for additional information related to our pension and OPEB obligations.Income TaxesAt December 31, 2020, we have total unrecognized tax benefits for uncertain tax positions of $41.2 million and $7.6 million of related accrued interest and penalties, net of tax. These liabilities have been excluded from the preceding table as we are unable to reasonably estimate the amount and period in which these liabilities might be paid. See Note 18 to the Consolidated Financial Statements for additional information regarding matters relating to income taxes, including unrecognized tax benefits and tax authority disputes. Contingent LiabilitiesWe are involved in various litigation, claims and administrative proceedings, including those related to environmental, asbestos-related and product liability matters. We believe that these liabilities are subject to the uncertainties inherent in estimating future costs for contingent liabilities and will likely be resolved over an extended period of time. See Note 21 to the Consolidated Financial Statements for additional information.Guarantor Financial InformationIn March 2020, the SEC adopted amendments to the financial disclosure requirements applicable to registered debt offerings that include credit enhancements, such as subsidiary guarantees, in Rule 3-10 of Regulation S-X. The amended rules focus on providing material, relevant and decision-useful information regarding guarantees and other credit enhancements, while eliminating certain prescriptive requirements. We adopted these amendments on March 31, 2020. Accordingly, summarized financial information has been presented only for the issuers and guarantors of our registered securities for the most recent fiscal year, and the location of the required disclosures has been moved outside the Notes to the Consolidated Financial Statements and is provided below.Allegion US Holding Company Inc. ("Allegion US Hold Co") is the issuer of the 3.200% Senior Notes and 3.550% Senior Notes and is the guarantor of the 3.500% Senior Notes. Allegion plc (the “Parent”) is the issuer of the 3.500% Senior Notes and is the guarantor of the 3.200% Senior Notes and 3.550% Senior Notes. Allegion US Hold Co is 100% owned by the Parent and each of the guarantees of Allegion US Hold Co and the Parent is full and unconditional and joint and several.The 3.200% Senior Notes and the 3.550% Senior Notes are senior unsecured obligations of Allegion US Hold Co and rank equally with all of Allegion US Hold Co’s existing and future senior unsecured and unsubordinated indebtedness. The guarantee of the 3.200% Senior Notes and the 3.550% Senior Notes is the senior unsecured obligation of the Parent and ranks equally with all of Allegion plc’s existing and future senior unsecured and unsubordinated indebtedness. The 3.500% Senior Notes are senior unsecured obligations of the Parent, are guaranteed by Allegion US Hold Co and rank equally with all of Allegion plc’s existing and future senior unsecured indebtedness. Each guarantee is effectively subordinated to any secured indebtedness of the Guarantor to the extent of the value of the assets securing such indebtedness. The Senior Notes are structurally subordinated to indebtedness and other liabilities of the subsidiaries of the Guarantor, none of which guarantee the notes. The obligations of the Guarantor under its Guarantee are limited as necessary to prevent such Guarantee from constituting a fraudulent conveyance under applicable law and, therefore, are limited to the amount that the Guarantor could guarantee without such Guarantee constituting a fraudulent conveyance; this limitation, however, may not be effective to prevent such Guarantee from constituting a fraudulent conveyance. If the Guarantee was rendered voidable, it could be subordinated by a court to all other indebtedness (including guarantees and other contingent liabilities) of the Guarantor, and, depending on the amount of such indebtedness, the Guarantor’s liability on its Guarantee could be reduced to zero. In such an event, the notes would be structurally subordinated to the indebtedness and other liabilities of the Guarantor. For further details, terms and conditions of the Senior Notes refer to the Company’s Form 8-K filed October 2, 2017 and Form 8-K filed September 27, 2019.44Table of ContentsThe following tables present the summarized financial information specified in Rule 1-02(bb)(1) of Regulation S-X for each issuer and guarantor. The summarized financial information has been prepared in accordance with Rule 13-01 of Regulation S-X.Selected Condensed Statement of Comprehensive Income InformationYear ended December 31, 2020In millionsAllegion plcAllegion US Hold CoNet revenues$— $— Gross profit— — Operating loss(7.5)(0.2)Equity earnings in affiliates, net of tax358.8 216.5 Transactions with related parties and subsidiaries(a)(15.3)(39.3)Net earnings314.3 164.7 Net earnings attributable to the entity314.3 164.7 (a) Transactions with related parties and subsidiaries include intercompany interest and fees.Selected Condensed Balance Sheet InformationDecember 31, 2020In millionsAllegion plcAllegion US Hold CoCurrent assets:Amounts due from related parties and subsidiaries$— $20.0 Total current assets19.0 38.7 Noncurrent assets:Amounts due from related parties and subsidiaries— 1,644.2 Total noncurrent assets1,793.3 1,671.8 Current liabilities:Amounts due to related parties and subsidiaries$197.5 $183.9 Total current liabilities204.4 190.7 Noncurrent liabilities:Amounts due to related parties and subsidiaries507.3 2,463.9 Total noncurrent liabilities1,143.2 3,267.3 Critical Accounting PoliciesManagement’s Discussion and Analysis of Financial Condition and Results of Operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of financial statements in conformity with those accounting principles requires management to use judgment in making estimates and assumptions based on the relevant information available at the end of each period. These estimates and assumptions have a significant effect on reported amounts of assets and liabilities, revenues and expenses as well as the disclosure of contingent assets and liabilities because they result primarily from the need to make estimates and assumptions on matters that are inherently uncertain. Actual results may differ from estimates. If updated information or actual amounts are different from previous estimates, the revisions are included in our results for the period in which they become known.The following is a summary of certain accounting estimates and assumptions made by management that we consider critical:•Goodwill – Goodwill is tested annually during the fourth quarter for impairment or when there is a significant change in events or circumstances that indicate the fair value of a reporting unit is more likely than not less than its carrying amount. Recoverability of goodwill is measured at the reporting unit level and starts with a comparison of the carrying amount of a reporting unit to its estimated fair value. If the estimated fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not impaired. To the extent that the carrying value of a reporting unit exceeds its estimated fair value, a goodwill impairment charge will be recognized for the amount by which the carrying value of the reporting unit exceeds its fair value, not to exceed the carrying amount of the reporting unit's goodwill. 45Table of ContentsAs quoted market prices are not available for our reporting units, the calculation of their estimated fair values is based on two valuation techniques, a discounted cash flow model (income approach) and a market multiple of earnings (market approach), with each method being weighted in the calculation. The income approach relies on the Company’s estimates of revenue growth rates, terminal growth rates, margin assumptions and discount rates to estimate future cash flows and explicitly addresses factors such as timing, with due consideration given to forecasting risk. The market approach requires determining an appropriate peer group, which is utilized to derive estimated fair values of our reporting units based on selected market multiples. The market approach reflects the market’s expectations for future growth and risk, with adjustments to account for differences between the selected peer group companies and the subject reporting units. As a result of the global economic disruption and uncertainty due to the COVID-19 pandemic, we concluded a triggering event had occurred as of March 31, 2020, and accordingly, performed interim impairment testing on the goodwill balances of our EMEA and Asia Pacific reporting units. Given the high degree of market volatility and lack of reliable market data that existed as of March 31, 2020, we determined a discounted cash flow model (income approach) provided the best approximation of fair value of the EMEA and Asia Pacific reporting units for the purpose of performing these interim tests. This was a change in estimate, as historically our determination of reporting unit fair values has been estimated based on both an income and a market approach, as discussed above, with each method being weighted in the calculation. The results of the interim impairment testing indicated the estimated fair value of the Asia Pacific reporting unit was less than its carrying value, and consequently, a goodwill impairment charge of $88.1 million was recorded. As markets stabilized throughout the year, we reverted to utilizing both an income and market approach while performing our annual impairment test in the fourth quarter. The estimated fair values for each of our reporting units exceeded their carrying values by more than 20% for the annual 2020 goodwill impairment test, completed in the fourth quarter. Assessing the fair value of our reporting units includes, among other things, making key assumptions for estimating future cash flows and appropriate market multiples. These assumptions are subject to a high degree of judgment and complexity. We make every effort to estimate future cash flows as accurately as possible with the information available at the time the forecast is developed. However, changes in assumptions and estimates may affect the estimated fair value of the reporting unit and could result in impairment charges in future periods. Factors that have the potential to create variances in the estimated fair value of the reporting unit include, but are not limited to, the following:•Decreases in estimated market sizes or market growth rates due to greater-than-expected declines in volumes, pricing pressures or disruptive technology;•Declines in our market share and penetration assumptions due to increased competition or an inability to develop or launch new products;•The impacts of market volatility, including greater-than-expected declines in pricing, reductions in volumes or fluctuations in foreign exchange rates;•The level of success of on-going and future research and development efforts, including those related to acquisitions, and increases in the research and development costs necessary to obtain regulatory approvals and launch new products;•Increases in the price or decreases in the availability of key commodities and the impact of higher energy prices; and•Increases in our market-participant risk-adjusted weighted-average cost of capital.•Indefinite-lived intangible assets – Similar to goodwill, indefinite-lived intangible assets are tested annually during the fourth quarter for impairment or when there is a significant change in events or circumstances that indicate the fair value of the asset is more likely than not less than its carrying amount. Recoverability of indefinite-lived intangible assets is determined on a relief from royalty methodology, which is based on the implied royalty paid, at an appropriate discount rate, to license the use of an asset rather than owning the asset. The present value of the after-tax cost savings (i.e. royalty relief) indicates the estimated fair value of the asset. Any excess of the carrying value over the estimated fair value is recognized as an impairment loss equal to that excess. During the first quarter of 2020, we concluded the global economic disruption and uncertainty due to the COVID-19 pandemic to be a triggering event. Accordingly, interim impairment tests on certain indefinite-lived trade names were performed as of March 31, 2020. Based on these tests, it was determined that three of our indefinite-lived trade names in the EMEA and Asia Pacific segments were impaired, and impairment charges totaling $8.2 million were recorded.A significant increase in the discount rate, decrease in the terminal growth rate, decrease in the royalty rate or substantial reductions in future revenue projections could have a negative impact on the estimated fair values of any of our indefinite-lived intangible assets. 46Table of Contents•Income taxes – We account for income taxes in accordance with ASC Topic 740. Deferred tax assets and liabilities are determined based on temporary differences between financial reporting and tax bases of assets and liabilities, applying enacted tax rates expected to be in effect for the year in which the differences are expected to reverse. We recognize future tax benefits, such as net operating losses and non-U.S. tax credits, to the extent that realizing these benefits is considered in our judgment to be more likely than not. We regularly review the recoverability of our deferred tax assets considering our historic profitability, projected future taxable income, timing of the reversals of existing temporary differences and the feasibility of our tax planning strategies. Where appropriate, we record a valuation allowance with respect to future tax benefits. The provision for income taxes involves a significant amount of management judgment regarding interpretation of relevant facts and laws in the jurisdictions in which we operate. Future changes in applicable laws, projected levels of taxable income and tax planning could change the effective tax rate and tax balances recorded by us. In addition, tax authorities periodically review income tax returns filed by us and can raise issues regarding our filing positions, timing and amount of income or deductions and the allocation of income among the jurisdictions in which we operate. A significant period of time may elapse between the filing of an income tax return and the ultimate resolution of an issue raised by a revenue authority with respect to that return. We believe that we have adequately provided for any reasonably foreseeable resolution of these matters. We will adjust our estimates if significant events so dictate. To the extent that the ultimate results differ from our original or adjusted estimates, the effect will be recorded in the provision for income taxes in the period that the matter is finally resolved.•Defined benefit plans – We provide several U.S. and non-U.S. defined benefit pension plan benefits to eligible employees and retirees. Our noncontributory defined benefit pension plans covering non-collectively bargained U.S. employees provide benefits on an average pay formula while most plans for collectively bargained U.S. employees provide benefits on a flat dollar benefit formula. The non-U.S. pension plans generally provide benefits based on earnings and years of service. Determining the costs associated with such plans is dependent on various actuarial assumptions including discount rates, expected return on plan assets, employee mortality and turnover rates. Actuarial valuations are performed to determine expense in accordance with GAAP. Actual results may differ from the actuarial assumptions and are generally recorded to Accumulated other comprehensive loss and amortized into earnings over future periods. We review our actuarial assumptions at each measurement date and make modifications to the assumptions as appropriate. The discount rate and expected return on plan assets are determined as of each measurement date. Discount rates for all plans are established using hypothetical yield curves based on the yields of corporate bonds rated AA quality. Spot rates are developed from the yield curve and used to discount future benefit payments. The expected return on plan assets reflects the average rate of returns expected on the funds invested or to be invested to provide for the benefits included in the projected benefit obligation. The expected return on plan assets is based on what is achievable given the plan’s investment policy, the types of assets held and the target asset allocation. We believe the assumptions utilized in recording our defined benefit obligations are reasonable based on input from our actuaries, outside investment advisors and information as to assumptions used by plan sponsors.Changes in any of the assumptions can have an impact on the net periodic pension benefit cost. An estimated 0.25% rate decline in the discount rate would increase net periodic pension benefit cost by approximately $1.1 million in 2021, while a 0.25% rate decline in the estimated return on assets would increase net periodic pension benefit cost by approximately $1.9 million. •Business combinations – The fair value of consideration paid in a business combination is allocated to the tangible and identifiable intangible assets acquired, liabilities assumed and goodwill. Acquired intangible assets primarily include indefinite-lived trade names, customer relationships and completed technologies. The accounting for business combinations involves a considerable amount of judgment and estimation, including the fair value of acquired intangible assets involving projections of future revenues and cash flows that are either discounted at an estimated discount rate or measured at an estimated royalty rate; fair value of other acquired assets and assumed liabilities, including potential contingencies; and the useful lives of the acquired assets. The assumptions used to determine the fair value of acquired intangible assets include projections developed using internal forecasts, available industry and market data, estimates of long-term growth rates, profitability, customer attrition and royalty rates, which are determined at the time of acquisition. An income approach or market approach (or both) is utilized in accordance with accepted valuation models for each acquired intangible asset to determine fair value. The impact of prior or future business combinations on our financial condition or results of operations may be materially impacted by the change in or initial selection of assumptions and estimates.47Table of ContentsRecent Accounting PronouncementsSee Note 2 to our Consolidated Financial Statements included in Item 8 herein for a discussion of recently issued and adopted accounting pronouncements.Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKWe are exposed to fluctuations in currency exchange rates, interest rates and commodity prices which could impact our results of operations and financial condition. Foreign Currency ExposuresWe have operations throughout the world that manufacture and sell products in various international markets. As a result, we are exposed to movements in exchange rates of various currencies against the U.S. dollar as well as against other currencies throughout the world. We actively manage material currency exposures that are associated with purchases and sales and other assets and liabilities at the legal entity level; however, we do not hedge currency translation risk. We attempt to hedge exposures that cannot be naturally offset to an insignificant amount with foreign currency derivatives. Derivative instruments utilized by us in our hedging activities are viewed as risk management tools, involve little complexity and are not used for trading or speculative purposes. To minimize the risk of counter party non-performance, derivative instrument agreements are made only through major financial institutions with significant experience in such derivative instruments.We evaluate our exposure to changes in currency exchange rates on our foreign currency derivatives using a sensitivity analysis. The sensitivity analysis is a measurement of the potential loss in fair value based on a percentage change in exchange rates. Based on the firmly committed currency derivative instruments in place at December 31, 2020, a hypothetical change in fair value of those derivative instruments assuming a 10% adverse change in exchange rates would result in an additional unrealized loss of approximately $16.9 million. This amount, when realized, would be partially offset by changes in the fair value of the underlying transactions.Commodity Price ExposuresWe are exposed to volatility in the prices of commodities used in some of our products and we use fixed price contracts to manage this exposure. We do not have committed commodity derivative instruments in place at December 31, 2020.Interest Rate ExposureOutstanding borrowings under our Credit Facilities accrue interest at our option of (i) a LIBOR rate plus the applicable margin or (ii) a base rate plus the applicable margin. The applicable margin ranges from 1.125% to 1.500% depending on our credit ratings. At December 31, 2020, the outstanding borrowings of $238.8 million under the Term Facility accrue interest at LIBOR plus a margin of 1.250%. We are also exposed to the risk of rising interest rates to the extent that we fund our operations with short-term or variable-rate borrowings, as we currently have unused availability of $485.0 million under our Revolving Facility as of December 31, 2020. If LIBOR or other applicable base rates of our Credit Facilities increase in the future, our Interest expense could increase.48Table of Contents

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+ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSPlease read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included under Part II, Item 8 of this Annual Report on Form 10-K. We have omitted discussion of 2018 results where it would be redundant to the discussion previously included in Part II, Item 7 of our 2019 Annual Report on Form 10-K.Trends in Our BusinessThe following long-term trends have contributed to the results of our consolidated operations, and we anticipate that they will continue to affect our future results:•Users' behaviors and advertising continue to shift online as the digital economy evolves.The continuing shift from an offline to online world has contributed to the growth of our business since inception, contributing to revenue growth, and we expect that this online shift will continue to benefit our business.•Users are increasingly using diverse devices and modalities to access our products and services, and our advertising revenues are increasingly coming from new formats.Our users are accessing the Internet via diverse devices and modalities, such as smartphones, wearables and smart home devices, and want to feel connected no matter where they are or what they are doing. We seek to expand our products and services to stay in front of these trends in order to maintain and grow our business.We generate our advertising revenues increasingly from different channels, including mobile, and newer advertising formats, and the margins from the advertising revenues from these channels and newer products have generally been lower than those from traditional desktop search. Additionally, as the market for a particular device type or modality matures, our revenues may be affected. For example, growth in the global smartphone market has slowed due to various factors, including increased market saturation in developed countries, which can affect our mobile advertising revenue growth rates. We expect TAC paid to our distribution partners and Google Network Members to increase as our revenues grow and to be affected by changes in device mix; geographic mix; partner mix; partner agreement terms; the percentage of queries channeled through paid access points; product mix; the relative revenue growth rates of advertising revenues from different channels; and revenue share terms. We expect these trends to continue to affect our revenue growth rates and put pressure on our overall margins.•As online advertising evolves, we continue to expand our product offerings which may affect our monetization.As interactions between users and advertisers change and as online user behavior evolves, we continue to expand and evolve our product offerings to serve their changing needs. Over time, we expect our monetization trends to fluctuate. For example, we have seen an increase in YouTube ads and Google Play ads, which monetize at a lower rate than our traditional search ads.•As users in developing economies increasingly come online, our revenues from international markets continue to increase and movements in foreign exchange rates affect such revenues.The shift to online, as well as the advent of the multi-device world, has brought opportunities outside of the U.S., including in emerging markets, such as India, where we continue to invest heavily and develop localized versions of our products and relevant advertising programs useful to our users in these markets. This has led to a trend of increased revenues from international markets over time, as regions with emerging markets, such as APAC, have demonstrated higher revenue growth rates. We expect that our results will continue to be affected by our performance in these markets, particularly as low-cost mobile devices become more available. This trend could impact our margins as developing markets initially monetize at a lower rate than more mature markets.Our international revenues represent a significant portion of our revenues and are subject to fluctuations in foreign currency exchange rates relative to the U.S. dollar. While we have a foreign exchange risk management program designed to reduce our exposure to these fluctuations, this program does not fully offset their effect on our revenues and earnings.30Table of ContentsAlphabet Inc.•The portion of our revenues that we derive from non-advertising revenues is increasing and may affect margins.Non-advertising revenues have grown over time. We expect this trend to continue as we focus on expanding our offerings to our users through products and services like Google Cloud, Google Play, hardware products, and YouTube subscriptions. Across these initiatives, we currently derive non-advertising revenues primarily from sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees, including fees received for Google Cloud services and subscription and other services. The margins on these revenues vary significantly and may be lower than the margins on our advertising revenues. A number of our Other Bets initiatives are in their initial development stages, and as such, the sources of revenues from these businesses could change over time and the revenues could be volatile.•As we continue to serve our users and expand our businesses, we will invest heavily in operating and capital expenditures.We continue to make significant R&D investments in areas of strategic focus such as advertising, cloud, machine learning, and search, as well as in new products and services. In addition, we expect to continue to invest in land and buildings for data centers and offices, and information technology assets, which includes servers and network equipment, to support the long-term growth of our business.In addition, acquisitions and strategic investments are an important part of our strategy and use of capital, contributing to the breadth and depth of our offerings, expanding our expertise in engineering and other functional areas, and building strong partnerships around strategic initiatives. For example, in 2020 we announced our Google for India Digitization Fund to invest approximately $10 billion into India over the next 5-7 years through a mix of equity investments, partnerships, and operational, infrastructure and ecosystem investments.•We face continuing changes in regulatory conditions, laws and public policies, which could impact our business practices and financial results.Changes in social, political, economic, tax, and regulatory conditions or in laws and policies governing a wide range of topics and related legal matters have resulted in fines and caused us to change our business practices. As these global trends continue, for example the recent antitrust complaints filed by the U.S. Department of Justice and a number of state Attorneys General as well as the News Media Bargaining Code drafted by the Australian Competition and Consumer Commission, our cost of doing business may increase and our ability to pursue certain business models or offer certain products or services may be limited.•Our employees are critical to our success and we expect to continue investing in them.Our employees are among our best assets and are critical for our continued success. We expect to continue hiring talented employees around the globe and to provide competitive compensation programs to our employees.The Impact of COVID-19 on our Results and OperationsIn late 2019, an outbreak of COVID-19 emerged and by March 11, 2020 was declared a global pandemic by the World Health Organization. Across the United States and the world, governments and municipalities instituted measures in an effort to control the spread of COVID-19, including quarantines, shelter-in-place orders, school closings, travel restrictions and the closure of non-essential businesses. The macroeconomic impacts of COVID-19 are significant and continue to evolve, as exhibited by, among other things, a rise in unemployment, changes in consumer behavior, and market volatility. We began to observe the impact of COVID-19 and the related reductions in global economic activity on our financial results in March 2020 when, despite an increase in users' search activity, our advertising revenues declined compared to the prior year due to a shift of user search activity to less commercial topics and reduced spending by our advertisers. During the course of the quarter ended June 30, 2020, we observed a gradual return in user search activity to more commercial topics, followed by increased spending by our advertisers that continued throughout the second half of 2020.We continue to assess the realized and potential credit deterioration of our customers due to changes in the macroeconomic environment, which has been reflected in our allowance for credit losses for accounts receivable. Additionally, over the course of the year we experienced variability in our margins as many of our expenses are less variable in nature and/or may not correlate to changes in revenues, including costs associated with our data centers and facilities as well as employee compensation. Also, market volatility has contributed to fluctuations in the valuation of our equity investments.31Table of ContentsAlphabet Inc.While we continued to make investments in land and buildings for data centers, offices and information technology, in 2020 we slowed the pace of our investments, primarily as it relates to office facilities, as a result of COVID-19.The ongoing impact of COVID-19 on our business continues to evolve and be unpredictable. For example, to the extent the pandemic disrupts economic activity globally we, like other businesses, are not immune to continued adverse impacts to our business, operations and financial results from volatility in advertising spending, changes in user behavior and preferences, credit deterioration and liquidity of our customers, depressed economic activity, or volatility in capital markets. The ongoing impact will depend on a number of factors, including the duration and severity of the pandemic; the uneven impact to certain industries; advances in testing, treatment and prevention including vaccines; and the macroeconomic impact of government measures to contain the spread of the virus and related government stimulus measures. To address the potential impact to our business, over the near-term, we continue to evaluate the pace of our investment plans, including, but not limited to, our hiring, investments in data centers, servers, network equipment, real estate and facilities, marketing and travel spending, as well as taking certain measures to support our customers, our overall workforce, and communities we operate in. As we look to return our workforce in more locations back to the office in 2021, we may experience increased costs as we prepare our facilities for a safe return to work environment and experiment with hybrid work models. At the same time, we believe the current environment is accelerating digital transformation and we remain focused on innovating and investing in the services we offer to consumers and businesses. For example, as it relates to Google Cloud, we continue to invest aggressively around the globe in our go-to-market capabilities, product development and technical infrastructure to support long term growth. The ongoing impact of COVID-19 and the extent of these measures we have taken and the additional measures that we may implement could have a material impact on our financial results. Our past results may not be indicative of our future performance, and historical trends in our financial results may differ materially.Executive OverviewThe following table summarizes our consolidated financial results for the years ended December 31, 2019 and 2020 (in millions, except for per share information and percentages).Year Ended December 31,20192020Revenues$161,857 $182,527 Increase in revenues year over year18 %13 %Increase in constant currency revenues year over year20 %14 %Operating income(1)$34,231 $41,224 Operating margin(1)21 %23 %Other income (expense), net$5,394 $6,858 Net Income(1)$34,343 $40,269 Diluted EPS(1)$49.16 $58.61 (1) Results for 2019 include the effect of the $1.7 billion EC fine. See Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information.•Total revenues were $182.5 billion, an increase of 13% year over year, primarily driven by an increase in Google Services segment revenues of $16.8 billion or 11% and an increase in Google Cloud segment revenues of $4.1 billion or 46%. Revenues from the United States, EMEA, APAC, and Other Americas were $85.0 billion, $55.4 billion, $32.6 billion, and $9.4 billion, respectively.•Total cost of revenues was $84.7 billion, an increase of 18% year over year. TAC was $32.8 billion, an increase of 9% year over year, primarily driven by an increase in revenues subject to TAC. Other cost of revenues were $51.9 billion, an increase of 24% year over year, primarily driven by an increase in data centers and other operations costs and content acquisition costs.32Table of ContentsAlphabet Inc.•Operating expenses were $56.6 billion, an increase of 5% year over year primarily driven by headcount growth and partially offset by declines in advertising and promotional expenses and travel and entertainment expenses.Other information:•Operating cash flow was $65.1 billion.•Capital expenditures, which primarily included investments in technical infrastructure, were $22.3 billion.•Number of employees was 135,301 as of December 31, 2020. The majority of new hires during the year were engineers and product managers.Our SegmentsBeginning in the fourth quarter of 2020, we report our segment results as Google Services, Google Cloud, and Other Bets: •Google Services includes products and services such as ads, Android, Chrome, hardware, Google Maps, Google Play, Search, and YouTube. Google Services generates revenues primarily from advertising; sales of apps, in-app purchases, digital content products, and hardware; and fees received for subscription-based products such as YouTube Premium and YouTube TV.•Google Cloud includes Google’s infrastructure and data analytics platforms, collaboration tools, and other services for enterprise customers. Google Cloud generates revenues primarily from fees received for Google Cloud Platform ("GCP") services and Google Workspace (formerly known as G Suite) collaboration tools.•Other Bets is a combination of multiple operating segments that are not individually material. Revenues from the Other Bets are derived primarily through the sale of internet services as well as licensing and R&D services.Unallocated corporate costs primarily include corporate initiatives, corporate shared costs, such as finance and legal, including fines and settlements, as well as costs associated with certain shared research and development activities. Additionally, hedging gains (losses) related to revenue are included in corporate costs.Financial ResultsRevenuesThe following table presents our revenues by type (in millions).Year Ended December 31,20192020Google Search & other$98,115 $104,062 YouTube ads15,149 19,772 Google Network Members' properties21,547 23,090 Google advertising134,811 146,924 Google other17,014 21,711 Google Services total151,825 168,635 Google Cloud8,918 13,059 Other Bets659 657 Hedging gains (losses)455 176 Total revenues$161,857 $182,527 Google ServicesGoogle advertising revenuesOur advertising revenue growth, as well as the change in paid clicks and cost-per-click on Google Search & other properties and the change in impressions and cost-per-impression on Google Network Members' properties and the correlation between these items, have been affected and may continue to be affected by various factors, including:•advertiser competition for keywords;•changes in advertising quality, formats, delivery or policy;33Table of ContentsAlphabet Inc.•changes in device mix;•changes in foreign currency exchange rates;•fees advertisers are willing to pay based on how they manage their advertising costs;•general economic conditions including the impact of COVID-19;•seasonality; and•traffic growth in emerging markets compared to more mature markets and across various advertising verticals and channels.Our advertising revenue growth rate has been affected over time as a result of a number of factors, including challenges in maintaining our growth rate as revenues increase to higher levels; changes in our product mix; changes in advertising quality or formats and delivery; the evolution of the online advertising market; increasing competition; our investments in new business strategies; query growth rates; and shifts in the geographic mix of our revenues. We also expect that our revenue growth rate will continue to be affected by evolving user preferences, the acceptance by users of our products and services as they are delivered on diverse devices and modalities, our ability to create a seamless experience for both users and advertisers, and movements in foreign currency exchange rates.Google advertising revenues consist primarily of the following:•Google Search & other consists of revenues generated on Google search properties (including revenues from traffic generated by search distribution partners who use Google.com as their default search in browsers, toolbars, etc.) and other Google owned and operated properties like Gmail, Google Maps, and Google Play;•YouTube ads consists of revenues generated on YouTube properties; and•Google Network Members' properties consist of revenues generated on Google Network Members' properties participating in AdMob, AdSense, and Google Ad Manager.Google Search & otherGoogle Search & other revenues increased $5,947 million from 2019 to 2020. The overall growth was primarily driven by interrelated factors including increases in search queries resulting from ongoing growth in user adoption and usage, primarily on mobile devices, growth in advertiser spending primarily in the second half of the year, and improvements we have made in ad formats and delivery. This increase was partially offset by a decline in advertiser spending primarily in the first half of the year driven by the impact of COVID-19.YouTube adsYouTube ads revenues increased $4,623 million from 2019 to 2020. Growth was primarily driven by our direct response advertising products, which benefited from improvements to ad formats and delivery and increased advertiser spending. Brand advertising products also contributed to growth despite revenues being adversely impacted by a decline in advertiser spending primarily in the first half of the year driven by the impact of COVID-19.Google Network Members' propertiesGoogle Network Members' properties revenues increased $1,543 million from 2019 to 2020. The growth was primarily driven by strength in AdMob and Google Ad Manager. Use of Monetization MetricsPaid clicks for our Google Search & other properties represent engagement by users and include clicks on advertisements by end-users on Google search properties and other owned and operated properties including Gmail, Google Maps, and Google Play. Historically, we included certain viewed YouTube engagement ads and the related revenues in our paid clicks and cost-per-click monetization metrics. Over time, advertising on YouTube has expanded to multiple advertising formats and the type of viewed engagement ads historically included in paid clicks and cost-per-click metrics have increasingly covered a smaller portion of YouTube advertising revenues. As a result, we removed these ads and the related revenues from the paid clicks and cost-per-click metrics for the current and historical periods presented. The revised metrics provide a better understanding of monetization trends on the properties included within Google Search & other, as they now more closely correlate with the related changes in revenues.Impressions for our Google Network Members' properties include impressions displayed to users served on Google Network Members' properties participating primarily in AdMob, AdSense and Google Ad Manager.Cost-per-click is defined as click-driven revenues divided by our total number of paid clicks and represents the average amount we charge advertisers for each engagement by users.34Table of ContentsAlphabet Inc.Cost-per-impression is defined as impression-based and click-based revenues divided by our total number of impressions and represents the average amount we charge advertisers for each impression displayed to users.As our business evolves, we periodically review, refine and update our methodologies for monitoring, gathering, and counting the number of paid clicks on our Google Search & other properties and the number of impressions on Google Network Members’ properties and for identifying the revenues generated by click activity on our Google Search & other properties and the revenues generated by impression activity on Google Network Members’ properties. Paid clicks and cost-per-clickThe following table presents changes in our paid clicks and cost-per-click (expressed as a percentage): Year Ended December 31, 20192020Paid clicks change23 %19 %Cost-per-click change(6)%(10)%Paid clicks increased from 2019 to 2020 primarily due to an increase in clicks due to interrelated factors, resulting from ongoing growth in user adoption and usage, primarily on mobile devices; continued growth in advertiser activity; and improvements we have made in ad formats and delivery. Growth was also driven by an increase in clicks relating to ads on Google Play. The positive effect on our revenues from an increase in paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers. The decrease in cost-per-click was primarily driven by reduced advertiser spending in response to COVID-19 primarily during the first half of the year. The decrease in cost-per-click was also affected by changes in device mix, geographic mix, ongoing product changes, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies.Paid clicks increased from 2018 to 2019 primarily due to an increase in clicks due to interrelated factors, including an increase in search queries resulting from ongoing growth in user adoption and usage, primarily on mobile devices; continued growth in advertiser activity; and improvements we have made in ad formats and delivery. Growth was also driven by an increase in clicks relating to ads on Google Play. The positive effect on our revenues from an increase in paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers. The decrease in cost-per-click was driven by changes in device mix, geographic mix, ongoing product changes, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies.Impressions and cost-per-impressionThe following table presents changes in our impressions and cost-per-impression (expressed as a percentage): Year Ended December 31, 2020Impressions change15 %Cost-per-impression change(8)%Impressions increased from 2019 to 2020 primarily due to growth in Google Ad Manager. The positive effect on our revenues from an increase in impressions was partially offset by a decrease in the cost-per-impression paid by our advertisers which was driven by a reduction in advertiser spending in response to COVID-19, primarily during the first half of the year, as well as the effect of a combination of factors including ongoing product and policy changes and improvements we have made in ad formats and delivery, changes in device mix, geographic mix, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies.Google other revenuesGoogle other revenues consist primarily of revenues from: •Google Play, which includes revenues from sales of apps and in-app purchases (which we recognize net of payout to developers) and digital content sold in the Google Play store; •hardware, including Google Nest home products, Pixelbooks, Pixel phones and other devices; •YouTube non-advertising, including YouTube Premium and YouTube TV subscriptions and other services; and•other products and services.35Table of ContentsAlphabet Inc.Google other revenues increased $4,697 million from 2019 to 2020. The growth was primarily driven by Google Play and YouTube non-advertising. Growth for Google Play was primarily driven by sales of apps and in-app purchases, which benefited from elevated user engagement partially due to the impact of COVID-19. Growth for YouTube non-advertising was primarily driven by an increase in paid subscribers. Over time, our growth rate for Google other revenues may be affected by the seasonality associated with new product and service launches as well as market dynamics.Google CloudOur Google Cloud revenues increased $4,141 million from 2019 to 2020. The growth was primarily driven by GCP followed by our Google Workspace offerings. Our infrastructure and our data and analytics platform products were the largest drivers of growth in GCP.Over time, our growth rate for Google Cloud revenues may be affected by customer usage, market dynamics, as well as new product and service launches.Revenues by GeographyThe following table presents our revenues by geography as a percentage of revenues, determined based on the addresses of our customers: Year Ended December 31, 20192020United States46 %47 %EMEA31 %30 %APAC17 %18 %Other Americas6 %5 %For further details on revenues by geography, see Note 2 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.Use of Constant Currency Revenues and Constant Currency Revenue Percentage ChangeThe effect of currency exchange rates on our business is an important factor in understanding period to period comparisons. Our international revenues are favorably affected as the U.S. dollar weakens relative to other foreign currencies, and unfavorably affected as the U.S. dollar strengthens relative to other foreign currencies. Our revenues are also favorably affected by net hedging gains and unfavorably affected by net hedging losses.We use non-GAAP constant currency revenues and non-GAAP percentage change in constant currency revenues for financial and operational decision-making and as a means to evaluate period-to-period comparisons. We believe the presentation of results on a constant currency basis in addition to U.S. Generally Accepted Accounting Principles ("GAAP") results helps improve the ability to understand our performance because they exclude the effects of foreign currency volatility that are not indicative of our core operating results.Constant currency information compares results between periods as if exchange rates had remained constant period over period. We define constant currency revenues as total revenues excluding the effect of foreign exchange rate movements and hedging activities, and use it to determine the constant currency revenue percentage change on a year-on-year basis. Constant currency revenues are calculated by translating current period revenues using prior period exchange rates, as well as excluding any hedging effects realized in the current period.Constant currency revenue percentage change is calculated by determining the change in period revenues over prior period revenues where current period foreign currency revenues are translated using prior period exchange rates and hedging effects are excluded from revenues of both periods.These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP.36Table of ContentsAlphabet Inc.The following table presents the foreign exchange effect on our international revenues and total revenues (in millions, except percentages): Year Ended December 31,20192020EMEA revenues$50,645 $55,370 Exclude foreign exchange effect on current period revenues using prior year rates2,397 (111)EMEA constant currency revenues$53,042 $55,259 Prior period EMEA revenues$44,739 $50,645 EMEA revenue percentage change13 %9 %EMEA constant currency revenue percentage change19 %9 %APAC revenues$26,928 $32,550 Exclude foreign exchange effect on current period revenues using prior year rates388 11 APAC constant currency revenues$27,316 $32,561 Prior period APAC revenues$21,341 $26,928 APAC revenue percentage change26 %21 %APAC constant currency revenue percentage change28 %21 %Other Americas revenues$8,986 $9,417 Exclude foreign exchange effect on current period revenues using prior year rates541 964 Other Americas constant currency revenues$9,527 $10,381 Prior period Other Americas revenues$7,608 $8,986 Other Americas revenue percentage change18 %5 %Other Americas constant currency revenue percentage change25 %16 %United States revenues$74,843 $85,014 United States revenue percentage change18 %14 %Hedging gains (losses)455 176 Total revenues$161,857 $182,527 Total constant currency revenues$164,728 $183,215 Prior period revenues, excluding hedging effect(1)$136,957 $161,402 Total revenue percentage change18 %13 %Total constant currency revenue percentage change20 %14 %(1) Total revenues and hedging gains (losses) for the year ended December 31, 2018 were $136,819 million and $(138) million, respectively.EMEA revenue percentage change from 2019 to 2020 was not significantly affected by foreign currency exchange rates, primarily due to the U.S. dollar weakening relative to the Euro offset by the U.S. dollar strengthening relative to the Turkish lira and Russian ruble.APAC revenue percentage change from 2019 to 2020 was not significantly affected by foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Indian rupee, partially offset by the U.S. dollar weakening relative to the Japanese yen.Other Americas revenue percentage change from 2019 to 2020 was unfavorably affected by changes in foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Brazilian real and Argentine peso. 37Table of ContentsAlphabet Inc.Costs and Operating ExpensesCost of RevenuesCost of revenues includes TAC which are paid to our distribution partners who make available our search access points and services, and amounts paid to Google Network Members primarily for ads displayed on their properties. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers.The cost of revenues as a percentage of revenues generated from ads placed on Google Network Members' properties are significantly higher than the cost of revenues as a percentage of revenues generated from ads placed on Google properties (which includes Google Search & other and YouTube ads), because most of the advertiser revenues from ads served on Google Network Members’ properties are paid as TAC to our Google Network Members.Additionally, other cost of revenues (which is the cost of revenues excluding TAC) includes the following:•Content acquisition costs primarily related to payments to content providers from whom we license video and other content for distribution on YouTube advertising and subscription services and Google Play (we pay fees to these content providers based on revenues generated or a flat fee);•Expenses associated with our data centers (including bandwidth, compensation expenses including stock-based compensation ("SBC"), depreciation, energy, and other equipment costs) as well as other operations costs (such as content review and customer support costs). These costs are generally less variable in nature and may not correlate with related changes in revenues; and•Inventory related costs for hardware we sell. The following tables present our cost of revenues, including TAC (in millions, except percentages): Year Ended December 31, 20192020TAC$30,089 $32,778 Other cost of revenues41,807 51,954 Total cost of revenues$71,896 $84,732 Total cost of revenues as a percentage of revenues44.4 %46.4 %Cost of revenues increased $12,836 million from 2019 to 2020. The increase was due to increases in other cost of revenues and TAC of $10,147 million and $2,689 million, respectively. The increase in other cost of revenues from 2019 to 2020 was due to an increase in data center and other operations costs and an increase in content acquisition costs primarily for YouTube. This increase was partially offset by a decline in hardware costs.The increase in TAC from 2019 to 2020 was due to increases in TAC paid to distribution partners and to Google Network Members, driven by growth in revenues subject to TAC. The TAC rate was 22.3% in both 2019 and 2020. The TAC rate on Google properties revenues and the TAC rate on Google Network revenues were both substantially consistent from 2019 to 2020.Over time, cost of revenues as a percentage of total revenues may be affected by a number of factors, including the following:•The amount of TAC paid to distribution partners, which is affected by changes in device mix, geographic mix, partner mix, partner agreement terms such as revenue share arrangements, and the percentage of queries channeled through paid access points;•The amount of TAC paid to Google Network Members, which is affected by a combination of factors such as geographic mix, product mix, and revenue share terms;•Relative revenue growth rates of Google properties and Google Network Members' properties;•Certain costs that are less variable in nature and may not correlate with the related revenues;•Costs associated with our data centers and other operations to support ads, Google Cloud, Search, YouTube and other products;•Content acquisition costs, which are primarily affected by the relative growth rates in our YouTube advertising and subscription revenues; •Costs related to hardware sales; and•Increased proportion of non-advertising revenues, which generally have higher costs of revenues, relative to our advertising revenues.38Table of ContentsAlphabet Inc.Research and DevelopmentThe following table presents our R&D expenses (in millions, except percentages): Year Ended December 31, 20192020Research and development expenses$26,018 $27,573 Research and development expenses as a percentage of revenues16.1 %15.1 %R&D expenses consist primarily of:•Compensation expenses (including SBC) for engineering and technical employees responsible for R&D of our existing and new products and services; •Depreciation expenses; •Equipment-related expenses; and•Professional services fees primarily related to consulting and outsourcing services.R&D expenses increased $1,555 million from 2019 to 2020. The increase was primarily due to an increase in compensation expenses of $1,619 million, largely resulting from a 11% increase in headcount and partially offset by higher compensation charges in certain Other Bets in 2019. Additionally, the increase in R&D expenses was partially offset by a decrease in travel and entertainment expenses of $383 million. Over time, R&D expenses as a percentage of revenues may fluctuate due to certain expenses that are generally less variable in nature and may not correlate to the changes in revenues. In addition, R&D expenses may be affected by a number of factors including continued investment in ads, Android, Chrome, Google Cloud, Google Play, hardware, machine learning, Other Bets, Search and YouTube.Sales and MarketingThe following table presents our sales and marketing expenses (in millions, except percentages): Year Ended December 31, 20192020Sales and marketing expenses$18,464 $17,946 Sales and marketing expenses as a percentage of revenues11.4 %9.8 %Sales and marketing expenses consist primarily of:•Advertising and promotional expenditures related to our products and services; and•Compensation expenses (including SBC) for employees engaged in sales and marketing, sales support, and certain customer service functions.Sales and marketing expenses decreased $518 million from 2019 to 2020. The decrease was primarily due to a decrease in advertising and promotional expenses of $1,395 million, as we reduced spending and paused or rescheduled campaigns and changed some events to digital-only formats as a result of COVID-19, and a decrease in travel and entertainment expenses of $371 million. The decrease was partially offset by an increase in compensation expenses of $1,347 million, largely resulting from an 8% increase in headcount.Over time, sales and marketing expenses as a percentage of revenues may fluctuate due to certain expenses that are generally less variable in nature and may not correlate to the changes in revenues. In addition, sales and marketing expenses may be affected by a number of factors including the seasonality associated with new product and service launches and strategic decisions regarding the timing and extent of our spending.General and AdministrativeThe following table presents our general and administrative expenses (in millions, except percentages): Year Ended December 31, 20192020General and administrative expenses$9,551 $11,052 General and administrative expenses as a percentage of revenues5.9 %6.1 %General and administrative expenses consist primarily of:•Compensation expenses (including SBC) for employees in our finance, human resources, information technology, and legal organizations; •Depreciation;39Table of ContentsAlphabet Inc.•Equipment-related expenses; •Legal-related expenses; and•Professional services fees primarily related to audit, information technology consulting, outside legal, and outsourcing services.General and administrative expenses increased $1,501 million from 2019 to 2020. The increase was primarily due to an increase in compensation expenses of $887 million, largely resulting from a 16% increase in headcount. In addition, there was an increase of $440 million related to allowance for credit losses for accounts receivable. The increase was partially offset by a $554 million charge recognized in 2019 relating to a legal settlement.Over time, general and administrative expenses as a percentage of revenues may fluctuate due to certain expenses that are generally less variable in nature and may not correlate to the changes in revenues, the effect of discrete items such as legal settlements, or allowances for credit losses for accounts receivable.European Commission FinesIn March 2019, the EC announced its decision that certain contractual provisions in agreements that Google had with AdSense for Search partners infringed European competition law. The EC decision imposed a €1.5 billion ($1.7 billion as of March 20, 2019) fine, which was accrued in the first quarter of 2019.Please refer to Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information.Segment ProfitabilityThe following table presents our segment operating income (loss) (in millions). For comparative purposes, amounts in prior periods have been recast.Year Ended December 31,201820192020Operating income (loss):Google Services$43,137 $48,999 $54,606 Google Cloud(4,348)(4,645)(5,607)Other Bets(3,358)(4,824)(4,476)Corporate costs, unallocated(1)(7,907)(5,299)(3,299)Total income from operations$27,524 $34,231 $41,224 (1) Corporate costs, unallocated includes a fine of $5.1 billion for the year ended December 31, 2018 and a fine and legal settlement totaling $2.3 billion for the year ended December 31, 2019.Google ServicesGoogle services operating income increased $5,607 million from 2019 to 2020. The increase was primarily driven by an increase in revenues partially offset by increases in content acquisition costs primarily for YouTube, data center and other operations costs, and TAC. Additionally, there was an increase in operating expenses primarily driven by an increase in compensation expenses (including SBC) largely due to increases in headcount. Operating income benefited from a decline in hardware costs.Google services operating income increased $5,862 million from 2018 to 2019. The increase was primarily driven by an increase in revenues partially offset by increases in TAC, data center and other operations costs, and content acquisition costs primarily for YouTube. Additionally, there was an increase in operating expenses primarily driven by an increase in compensation expenses (including SBC) largely due to an increase in headcount.Google CloudGoogle Cloud operating loss increased $962 million from 2019 to 2020 and increased $297 million from 2018 to 2019. The increase in operating loss in both periods was driven by an increase in total expenses of $5,103 million from 2019 to 2020 and $3,377 million from 2018 to 2019. Operating expenses increased primarily due to compensation expenses (including SBC), largely driven by an increase in headcount. Additionally, data center and other operating costs increased in both periods.Other BetsOther Bets operating loss decreased $348 million from 2019 to 2020 and increased $1,466 million from 2018 to 2019. The fluctuations were primarily driven by compensation expenses (including SBC).40Table of ContentsAlphabet Inc.Other Income (Expense), NetThe following table presents other income (expense), net, (in millions): Year Ended December 31, 20192020Other income (expense), net$5,394 $6,858 Other income (expense), net, increased $1,464 million from 2019 to 2020. The change was primarily driven by an increase in net gains on equity and debt securities of $3,519 million, partially offset by a $902 million loss resulting from our equity derivatives, which hedged the changes in fair value of certain marketable equity securities, and a decrease in interest income of $562 million.Over time, other income (expense), net, may be affected by market dynamics and other factors. Equity values generally change daily for marketable equity securities and upon the occurrence of observable price changes or upon impairment of non-marketable equity securities. In addition, volatility in the global economic climate and financial markets, including the effects of COVID-19, could result in a significant change in the value of our investments. Fluctuations in the value of these investments has, and we expect will continue to, contribute to volatility of OI&E in future periods. For additional information about our investments, see Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.Provision for Income TaxesThe following table presents our provision for income taxes (in millions, except for effective tax rate): Year Ended December 31, 20192020Provision for income taxes$5,282 $7,813 Effective tax rate13.3 %16.2 %Our provision for income taxes and our effective tax rate increased from 2019 to 2020. The increase in the provision for income taxes and our effective tax rate is primarily due to benefits related to the resolution of multi-year audits in 2019 that did not recur in 2020, higher earnings in countries that have higher statutory rates resulting from the change in our corporate legal entity structure implemented as of December 31, 2019, and an increase in valuation allowance for net deferred tax assets that are not likely to be realized relating to certain of our Other Bets, partially offset by an increase in the U.S. federal Foreign-Derived Intangible Income tax deduction benefits. See Note 14 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information.We expect our future effective tax rate to be affected by the geographic mix of earnings in countries with different statutory rates. Additionally, our future effective tax rate may be affected by changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items.41Table of ContentsAlphabet Inc.Quarterly Results of OperationsThe following tables presenting our quarterly results of operations should be read in conjunction with the consolidated financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K. We have prepared the unaudited information on the same basis as our audited consolidated financial statements. Our operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year. The following table presents our unaudited quarterly results of operations for the eight quarters ended December 31, 2020. This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our consolidated financial position and operating results for the quarters presented. Seasonal fluctuations in internet usage and advertiser expenditures, underlying business trends such as traditional retail seasonality and macroeconomic conditions have affected, and are likely to continue to affect, our business (including developments and volatility arising from COVID-19). Commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates. Quarter Ended Mar 31,2019Jun 30,2019Sept 30,2019Dec 31,2019Mar 31,2020Jun 30,2020Sept 30,2020Dec 31,2020(In millions, except per share amounts) (unaudited)Consolidated Statements of Income Data:Revenues$36,339 $38,944 $40,499 $46,075 $41,159 $38,297 $46,173 56,898 Costs and expenses:Cost of revenues16,012 17,296 17,568 21,020 18,982 18,553 21,117 26,080 Research and development6,029 6,213 6,554 7,222 6,820 6,875 6,856 7,022 Sales and marketing3,905 4,212 4,609 5,738 4,500 3,901 4,231 5,314 General and administrative2,088 2,043 2,591 2,829 2,880 2,585 2,756 2,831 European Commission fines1,697 0 0 0 0 0 0 0 Total costs and expenses29,731 29,764 31,322 36,809 33,182 31,914 34,960 41,247 Income from operations6,608 9,180 9,177 9,266 7,977 6,383 11,213 15,651 Other income (expense), net1,538 2,967 (549)1,438 (220)1,894 2,146 3,038 Income before income taxes8,146 12,147 8,628 10,704 7,757 8,277 13,359 18,689 Provision for income taxes1,489 2,200 1,560 33 921 1,318 2,112 3,462 Net income$6,657 $9,947 $7,068 $10,671 $6,836 $6,959 $11,247 15,227 Basic net income per share of Class A and B common stock and Class C capital stock$9.58 $14.33 $10.20 $15.49 $9.96 $10.21 $16.55 $22.54 Diluted net income per share of Class A and B common stock and Class C capital stock$9.50 $14.21 $10.12 $15.35 $9.87 $10.13 $16.40 $22.30 Financial ConditionCash, Cash Equivalents, and Marketable SecuritiesAs of December 31, 2020, we had $136.7 billion in cash, cash equivalents, and short-term marketable securities. Cash equivalents and marketable securities are comprised of time deposits, money market funds, highly liquid government bonds, corporate debt securities, mortgage-backed and asset-backed securities and marketable equity securities.Sources, Uses of Cash and Related TrendsOur principal sources of liquidity are our cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from our operations. The primary use of capital continues to be to invest for the long term growth of the business. We regularly evaluate our cash and capital structure, including the size, pace and form of capital return to stockholders.42Table of ContentsAlphabet Inc.The following table presents our cash flows (in millions): Year Ended December 31, 20192020Net cash provided by operating activities$54,520 $65,124 Net cash used in investing activities$(29,491)$(32,773)Net cash used in financing activities$(23,209)$(24,408)Cash Provided by Operating ActivitiesOur largest source of cash provided by our operations are advertising revenues generated by Google Search & other properties, Google Network Members' properties and YouTube ads. Additionally, we generate cash through sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees including fees received for Google Cloud offerings and subscription-based products.Our primary uses of cash from our operating activities include compensation and related costs, payments to our distribution partners and Google Network Members, and payments for content acquisition costs. In addition, uses of cash from operating activities include hardware inventory costs, income taxes, and other general corporate expenditures.Net cash provided by operating activities increased from 2019 to 2020 primarily due to the net effect of increases in cash received from revenues and cash paid for cost of revenues and operating expenses, and changes in operating assets and liabilities.Cash Used in Investing ActivitiesCash provided by investing activities consists primarily of maturities and sales of our investments in marketable and non-marketable securities. Cash used in investing activities consists primarily of purchases of marketable and non-marketable securities, purchases of property and equipment, and payments for acquisitions.Net cash used in investing activities increased from 2019 to 2020 primarily due to a net increase in purchases of securities, partially offset by decreases in payments for acquisitions and purchases of property and equipment. The net decrease in purchases of property and equipment was driven by decreases in purchases of land and buildings for offices as well as data center construction, partially offset by increases in purchases of servers.Cash Used in Financing ActivitiesCash provided by financing activities consists primarily of proceeds from issuance of debt and proceeds from the sale of interest in consolidated entities. Cash used in financing activities consists primarily of repurchases of capital stock, net payments related to stock-based award activities, and repayments of debt.Net cash used in financing activities increased from 2019 to 2020 primarily due to an increase in cash payments for repurchases of capital stock, partially offset by increases in net proceeds from issuance of debt and proceeds from the sale of interest in consolidated entities.Liquidity and Material Cash RequirementsWe expect existing cash, cash equivalents, short-term marketable securities, cash flows from operations and financing activities to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities for at least the next 12 months and thereafter for the foreseeable future.As of December 31, 2020, we had long-term taxes payable of $6.5 billion related to a one-time transition tax payable incurred as a result of the U.S. Tax Cuts and Jobs Act ("Tax Act"). As permitted by the Tax Act, we will pay the transition tax in annual interest-free installments through 2025.In 2017, 2018 and 2019, the EC announced decisions that certain actions taken by Google infringed European competition law and imposed fines of €2.4 billion ($2.7 billion as of June 27, 2017), €4.3 billion ($5.1 billion as of June 30, 2018), and €1.5 billion ($1.7 billion as of March 20, 2019), respectively. While each EC decision is under appeal, we included the fines in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees (in lieu of a cash payment) for the fines. In January 2021, we closed the acquisition of Fitbit, a leading wearables brand, for $2.1 billion.We have a short-term debt financing program of up to $5.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. As of December 31, 2020, we had no commercial paper outstanding. As of December 31, 2020, we have $4.0 billion of revolving credit facilities expiring 43Table of ContentsAlphabet Inc.in July 2023 with no amounts outstanding. The interest rate for the credit facilities is determined based on a formula using certain market rates. In August 2020, we issued $10.0 billion of fixed-rate senior unsecured notes in six tranches: $1.0 billion due in 2025, $1.0 billion due in 2027, $2.25 billion due in 2030, $1.25 billion due in 2040, $2.5 billion due in 2050 and $2.0 billion due in 2060. The 2020 Notes had a weighted average duration of 21.5 years and weighted average coupon rate of 1.57%. Of the total issuance, $5.75 billion was designated as Sustainability Bonds, the net proceeds of which are used to fund environmentally and socially responsible projects in the following eight areas: energy efficiency, clean energy, green buildings, clean transportation, circular economy and design, affordable housing, commitment to racial equity, and support for small businesses and COVID-19 crisis response. The remaining net proceeds are used for general corporate purposes. As of December 31, 2020, we have senior unsecured notes outstanding with a total carrying value of $13.8 billion. Refer to Note 6 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information on the debts.In accordance with the authorizations of the Board of Directors of Alphabet, in 2020 we repurchased and subsequently retired 21.5 million shares of Alphabet Class C capital stock for an aggregate amount of $31.1 billion. As of December 31, 2020, $17.6 billion remains authorized and available for repurchase. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. Refer to Note 11 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.Capital Expenditures and LeasesWe make investments in land and buildings for data centers and offices and information technology assets through purchases of property and equipment and lease arrangements to provide capacity for the growth of our services and products. Our capital investments in property and equipment consist primarily of the following major categories:•Technical infrastructure, which consists of our investments in servers and network equipment for compute, storage and networking requirements for ongoing business activities, including machine learning, (collectively referred to as our information technology assets) and data center land and building construction; and•Office facilities, ground up development projects and related building improvements.Due to the integrated nature of Alphabet, our technical infrastructure and office facilities are managed centrally at a consolidated level. The associated costs, including depreciation and impairment, are allocated to operating segments as a service cost generally based on usage or headcount. Our technical infrastructure investments are designed to support all of Alphabet, including primarily ads, Google Cloud, Search, and YouTube.Construction in progress consists primarily of technical infrastructure and office facilities which have not yet been placed in service for our intended use. The time frame from date of purchase to placement in service of these assets may extend to multiple periods. For example, our data center construction projects are generally multi-year projects with multiple phases, where we acquire qualified land and buildings, construct buildings, and secure and install information technology assets. During the years ended December 31, 2019 and 2020, we spent $23.5 billion and $22.3 billion on capital expenditures and recognized total operating lease assets of $4.4 billion and $2.8 billion, respectively. As of December 31, 2020, the amount of total future lease payments under operating leases, which had a weighted average remaining lease term of 9 years, was $15.1 billion. As of December 31, 2020, we have entered into leases that have not yet commenced with future lease payments of $8.0 billion, excluding purchase options, that are not yet recorded on our Consolidated Balance Sheets. These leases will commence between 2021 and 2026 with non-cancelable lease terms of 1 to 25 years.Depreciation of our property and equipment commences when the deployment of such assets are completed and are ready for our intended use. Land is not depreciated. For the years ended December 31, 2019 and 2020, our depreciation and impairment expenses on property and equipment were $10.9 billion and $12.9 billion, respectively.For the years ended December 31, 2019 and 2020, our operating lease expenses (including variable lease costs), were $2.4 billion and $2.9 billion, respectively. Finance leases were not material for the years ended December 31, 2019 and 2020. Please refer to Note 4 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information on the leases.44Table of ContentsAlphabet Inc.Contractual Obligations as of December 31, 2020The following summarizes our contractual obligations as of December 31, 2020 (in millions): Payments Due By Period TotalLess than1 year1-3years3-5yearsMore than5 yearsOperating lease obligations(1)$15,091 $2,198 $4,165 $3,127 $5,601 Obligations for leases that have not yet commenced(1)8,049 370 1,198 1,469 5,012 Purchase obligations(2)10,656 7,368 1,968 354 966 Long-term debt obligations(3)19,840 1,357 634 2,587 15,262 Tax payable(4)7,359 834 1,916 4,609 0 Other long-term liabilities reflected on our balance sheet(5)1,421 532 616 185 88 Total contractual obligations$62,416 $12,659 $10,497 $12,331 $26,929 (1) For further information, refer to Note 4 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.(2) Represents non-cancelable contractual obligations primarily related to data center operations and build-outs; information technology assets; purchases of inventory; and digital media content licensing arrangements. The amounts included above represent the non-cancelable portion of agreements or the minimum cancellation fee. For those agreements with variable terms, we do not estimate the non-cancelable obligation beyond any minimum quantities and/or pricing as of December 31, 2020. Excluded from the table above are open orders for purchases that support normal operations, which are generally cancelable.(3) Represents our principal and interest payments. For further information on long-term debt, refer to Note 6 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.(4) Represents one-time transition tax payable incurred as a result of the Tax Act. For further information, refer to Note 14 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Excluded from the table above are long-term taxes payable of $2.3 billion as of December 31, 2020 primarily related to uncertain tax positions, for which we are unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing and outcomes of tax audits.(5) Represents cash obligations recorded on our Consolidated Balance Sheets, including the short-term portion of these long-term liabilities, primarily for certain commercial agreements. These amounts do not include the EC fines which are classified as current liabilities on our Consolidated Balance Sheets. For further information regarding the EC fines, refer to Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.Off-Balance Sheet ArrangementsAs of December 31, 2020, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. See Note 10 included in Part II, Item 8 of this annual report on Form 10-K for more information on our commitments and contingencies.Critical Accounting Policies and EstimatesWe prepare our consolidated financial statements in accordance with GAAP. In doing so, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, expenses, gains and losses, as well as related disclosure of contingent assets and liabilities. In some cases, we could reasonably have used different accounting policies and estimates. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. We have reviewed our critical accounting policies and estimates with the audit and compliance committee of our Board of Directors.Please see Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for a summary of significant accounting policies and the effect on our financial statements.45Table of ContentsAlphabet Inc.RevenuesFor the sale of third-party goods and services, we evaluate whether we are the principal, and report revenues on a gross basis, or an agent, and report revenues on a net basis. In this assessment, we consider if we obtain control of the specified goods or services before they are transferred to the customer, as well as other indicators such as the party primarily responsible for fulfillment, inventory risk, and discretion in establishing price.Income TaxesWe are subject to income taxes in the U.S. and foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes.Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes and the effective tax rate in the period in which such determination is made.The provision for income taxes includes the effect of reserve provisions and changes to reserves that are considered appropriate as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Services ("IRS") and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes.Loss ContingenciesWe are regularly subject to claims, suits, government investigations, and other proceedings involving competition, intellectual property, privacy, tax and related compliance, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury consumer protection, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the possible loss in the Notes to the Consolidated Financial Statements.We evaluate, on a regular basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments and changes to our disclosures as appropriate. Significant judgment is required to determine both the likelihood of there being, and the estimated amount of, a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Should any of our estimates and assumptions change or prove to have been incorrect, it could have a material effect on our business, consolidated financial position, results of operations, or cash flows.Long-lived AssetsLong-lived assets, including property and equipment, long-term prepayments, and intangible assets, excluding goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The evaluation is performed at the lowest level of identifiable cash flows independent of other assets. An impairment loss would be recognized when estimated undiscounted future cash flows generated from the assets are less than their carrying amount. Measurement of an impairment loss would be based on the excess of the carrying amount of the asset group over its fair value.Fair Value MeasurementsWe measure certain of our non-marketable equity and debt investments, certain other instruments including stock-based compensation awards settled in the stock of certain Other Bets, and certain assets and liabilities acquired in a business combination, at fair value on a nonrecurring basis. The determination of fair value involves the use of appropriate valuation methods and relevant inputs into valuation models. The fair value hierarchy prioritizes the inputs used to measure fair value whereby it gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. We maximize the use of relevant observable inputs and minimize the use of unobservable inputs. Our use of unobservable inputs reflects the assumptions that market participants would use and may include our own data adjusted based on reasonably available information. We apply judgment in assessing the relevance of observable market data to determine the priority of inputs under the fair value hierarchy, particularly in situations where there is very little or no market activity.46Table of ContentsAlphabet Inc.In determining the fair values of our non-marketable equity and debt investments, as well as assets acquired (especially with respect to intangible assets) and liabilities assumed in business combinations, we make significant estimates and assumptions, some of which include the use of unobservable inputs.Certain stock-based compensation awards may be settled in the stock of certain of our Other Bets or in cash. These awards are based on the equity values of the respective Other Bet, which requires use of unobservable inputs.We also have compensation arrangements with payouts based on realized investment returns, i.e. performance fees. We recognize compensation expense based on the estimated payouts, which may result in expense recognized before investment returns are realized, and may require the use of unobservable inputs.Non-marketable Equity SecuritiesOur non-marketable equity securities not accounted for under the equity method are carried either at fair value or under the measurement alternative. Under the measurement alternative, the carrying value is measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. Determining whether an observed transaction is similar to a security within our portfolio requires judgment based on the rights and obligations of the securities. Recording upward and downward adjustments to the carrying value of our equity securities as a result of observable price changes requires quantitative assessments of the fair value of our securities using various valuation methodologies and involves the use of estimates.Non-marketable equity securities are also subject to periodic impairment reviews. Our quarterly impairment analysis considers both qualitative and quantitative factors that may have a significant effect on the investment's fair value. Qualitative factors considered include the companies' financial and liquidity position, access to capital resources and the time since the last adjustment to fair value, among others. When indicators of impairment exist, we prepare quantitative assessments of the fair value of our equity investments using both the market and income approaches which require judgment and the use of estimates, including discount rates, investee revenues and costs, and comparable market data of private and public companies, among others. When our assessment indicates that an impairment exists, we write down the investment to its fair value.Change in Accounting EstimateIn January 2021, we completed an assessment of the useful lives of our servers and network equipment and determined we should adjust the estimated useful life of our servers from three years to four years and the estimated useful life of certain network equipment from three years to five years. This change in accounting estimate will be effective beginning fiscal year 2021. For assets that are in-service as of December 31, 2020, we expect operating results to be favorably impacted by approximately $2.1 billion for the full fiscal year 2021. The effect of the change may be different due to our capital investments during the fiscal year 2021.ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKWe are exposed to financial market risks, including changes in foreign currency exchange rates, interest rates, and equity investment risks. Foreign Currency Exchange RiskWe transact business globally in multiple currencies. Our international revenues, as well as costs and expenses denominated in foreign currencies, expose us to the risk of fluctuations in foreign currency exchange rates against the U.S. dollar. Principal currencies hedged included the Australian dollar, British pound, Canadian dollar, Euro and Japanese yen. For the purpose of analyzing foreign currency exchange risk, we considered the historical trends in foreign currency exchange rates and determined that it was reasonably possible that adverse changes in exchange rates of 10% could be experienced in the near term.We use foreign exchange forward contracts to offset the foreign exchange risk on our assets and liabilities denominated in currencies other than the functional currency of the subsidiary. These forward contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements on our assets and liabilities. The foreign currency gains and losses on the assets and liabilities are recorded in other income (expense), net, which are offset by the gains and losses on the forward contracts.If an adverse 10% foreign currency exchange rate change was applied to total monetary assets, liabilities, and commitments denominated in currencies other than the functional currencies at the balance sheet date, it would have resulted in an adverse effect on income before income taxes of approximately $8 million and $497 million as of 47Table of ContentsAlphabet Inc.December 31, 2019 and 2020, respectively, after consideration of the effect of foreign exchange contracts in place for the years ended December 31, 2019 and 2020.We use foreign currency forwards and option contracts, including collars (an option strategy comprised of a combination of purchased and written options) to protect our forecasted U.S. dollar-equivalent earnings from changes in foreign currency exchange rates. When the U.S. dollar strengthens, gains from foreign currency options and forwards reduce the foreign currency losses related to our earnings. When the U.S. dollar weakens, losses from foreign currency collars and forwards offset the foreign currency gains related to our earnings. These hedging contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements. We designate these contracts as cash flow hedges for accounting purposes. We reflect the gains or losses of foreign currency spot rate changes as a component of AOCI and subsequently reclassify them into revenues to offset the hedged exposures as they occur. If the U.S. dollar weakened by 10% as of December 31, 2019 and 2020, the amount recorded in AOCI related to our foreign exchange contracts before tax effect would have been approximately $1.1 billion and $912 million lower as of December 31, 2019 and 2020, respectively. The change in the value recorded in AOCI would be expected to offset a corresponding foreign currency change in forecasted hedged revenues when recognized.We use foreign exchange forward contracts designated as net investment hedges to hedge the foreign currency risks related to our investment in foreign subsidiaries. These forward contracts serve to offset the foreign currency translation risk from our foreign operations.If the U.S. dollar weakened by 10%, the amount recorded in cumulative translation adjustment ("CTA") within AOCI related to our net investment hedge would have been approximately $936 million and $1 billion lower as of December 31, 2019 and 2020, respectively. The change in value recorded in CTA would be expected to offset a corresponding foreign currency translation gain or loss from our investment in foreign subsidiaries.Interest Rate RiskOur Corporate Treasury investment strategy is to achieve a return that will allow us to preserve capital and maintain liquidity. We invest primarily in debt securities including those of the U.S. government and its agencies, corporate debt securities, mortgage-backed securities, money market and other funds, municipal securities, time deposits, asset backed securities, and debt instruments issued by foreign governments. By policy, we limit the amount of credit exposure to any one issuer. Our investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. Unrealized gains or losses on our marketable debt securities are primarily due to interest rate fluctuations as compared to interest rates at the time of purchase. For certain fixed and variable rate debt securities, we have elected the fair value option for which changes in fair value are recorded in other income (expense), net. We measure securities for which we have not elected the fair value option at fair value with gains and losses recorded in AOCI until the securities are sold, less any expected credit losses. We use value-at-risk ("VaR") analysis to determine the potential effect of fluctuations in interest rates on the value of our marketable debt security portfolio. The VaR is the expected loss in fair value, for a given confidence interval, for our investment portfolio due to adverse movements in interest rates. We use a variance/covariance VaR model with 95% confidence interval. The estimated one-day loss in fair value of our marketable debt securities as of December 31, 2019 and 2020 are shown below (in millions): As of December 31,12-Month Average As of December 31, 2019202020192020Risk Category - Interest Rate$104 $144 $90 $145 Actual future gains and losses associated with our marketable debt security portfolio may differ materially from the sensitivity analyses performed as of December 31, 2019 and 2020 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates and our actual exposures and positions. VaR analysis is not intended to represent actual losses but is used as a risk estimation.Equity Investment RiskOur marketable and non-marketable equity securities are subject to a wide variety of market-related risks that could substantially reduce or increase the fair value of our holdings.Our marketable equity securities are publicly traded stocks or funds and our non-marketable equity securities are investments in privately held companies, some of which are in the startup or development stages.48Table of ContentsAlphabet Inc.We record our marketable equity securities not accounted for under the equity method at fair value based on readily determinable market values, of which publicly traded stocks and mutual funds are subject to market price volatility, and represent $3.3 billion and $5.9 billion of our investments as of December 31, 2019 and 2020, respectively. A hypothetical adverse price change of 30% on our December 31, 2020 balance, which could be experienced in the near term, would decrease the fair value of our marketable equity securities by $1.8 billion. From time to time, we may enter into derivatives to hedge the market price risk on certain of our marketable equity securities.Our non-marketable equity securities not accounted for under the equity method are adjusted to fair value for observable transactions for identical or similar investments of the same issuer or impairment (referred to as the measurement alternative). The fair value measured at the time of the observable transaction is not necessarily an indication of the current fair value as of the balance sheet date. These investments, especially those that are in the early stages, are inherently risky because the technologies or products these companies have under development are typically in the early phases and may never materialize and they may experience a decline in financial condition, which could result in a loss of a substantial part of our investment in these companies. The success of our investment in any private company is also typically dependent on the likelihood of our ability to realize appreciation in the value of our investments through liquidity events such as public offerings, acquisitions, private sales or other market events. As of December 31, 2019 and 2020, the carrying value of our non-marketable equity securities, which were accounted for under the measurement alternative, was $11.4 billion and $18.9 billion, respectively. Valuations of our equity investments in private companies are inherently more complex due to the lack of readily available market data. Volatility in the global economic climate and financial markets could result in a significant impairment charge relating to our non-marketable equity securities. Changes in valuation of non-marketable equity securities may not directly correlate with changes in valuation of marketable equity securities. Additionally, observable transactions at lower valuations could result in significant losses on our non-marketable equity securities. The effect of COVID-19 on our impairment assessment requires significant judgment due to the uncertainty around the duration and severity of the impact.The carrying values of our equity method investments, which totaled approximately $1.3 billion and $1.4 billion as of December 31, 2019 and 2020, respectively, generally do not fluctuate based on market price changes, however these investments could be impaired if the carrying value exceeds the fair value and is not expected to recover.For further information about our equity investments, please refer to Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K.49Table of ContentsAlphabet Inc.

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+Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)•the announcement in November 2020 of the Company’s investment in the Health for Life Capital Fund II, a leading venture capital fund dedicated to health, nutrition, microbiota, and digital health;•the announcement in November 2020 of plans to collaborate with InnovaFeed, the world leader in producing premium insect ingredients for animal feed, on the construction and operation of the world’s largest insect protein production site in Decatur, Illinois; and•the announcement in December 2020 of the end of dry lysine production in early 2021.The Company executes its strategic vision through three pillars: Optimize the Core, Drive Efficiencies, and Expand Strategically, all supported by its Readiness effort. The Company launched Readiness to drive new efficiencies and improve the customer experience in the Company’s existing businesses through a combination of data and analytics, process simplification and standardization, and behavioral and cultural change, building upon its earlier 1ADM and operational excellence programs. Operating Performance IndicatorsThe Company’s Ag Services and Oilseeds operations are principally agricultural commodity-based businesses where changes in selling prices move in relationship to changes in prices of the commodity-based agricultural raw materials. As a result, changes in agricultural commodity prices have relatively equal impacts on both revenues and cost of products sold. Therefore, changes in revenues of these businesses do not necessarily correspond to the changes in margins or gross profit. Thus, gross margins per volume or metric ton are more meaningful than gross margins as percentage of revenues.The Company’s Carbohydrate Solutions operations and Nutrition businesses also utilize agricultural commodities (or products derived from agricultural commodities) as raw materials. However, in these operations, agricultural commodity market price changes do not necessarily correlate to changes in cost of products sold. Therefore, changes in revenues of these businesses may correspond to changes in margins or gross profit. Thus, gross margin rates are more meaningful as a performance indicator in these businesses.The Company has consolidated subsidiaries in more than 70 countries. For the majority of the Company’s subsidiaries located outside the United States, the local currency is the functional currency except certain significant subsidiaries in Switzerland where Euro is the functional currency, and Brazil and Argentina where U.S. dollar is the functional currency. Revenues and expenses denominated in foreign currencies are translated into U.S. dollars at the weighted average exchange rates for the applicable periods. For the majority of the Company’s business activities in Brazil and Argentina, the functional currency is the U.S. dollar; however, certain transactions, including taxes, occur in local currency and require remeasurement to the functional currency. Changes in revenues are expected to be correlated to changes in expenses reported by the Company caused by fluctuations in the exchange rates of foreign currencies, primarily the Euro, British pound, Canadian dollar, and Brazilian real, as compared to the U.S. dollar.The Company measures its performance using key financial metrics including net earnings, gross margins, segment operating profit, return on invested capital, EBITDA, economic value added, manufacturing expenses, and selling, general, and administrative expenses. The Company’s financial results can vary significantly due to changes in factors such as fluctuations in energy prices, weather conditions, crop plantings, government programs and policies, trade policies, changes in global demand, general global economic conditions, changes in standards of living, and global production of similar and competitive crops. Due to these unpredictable factors, the Company undertakes no responsibility for updating any forward-looking information contained within “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”33Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Market Factors Influencing Operations or Results in the Twelve Months Ended December 31, 2020 The Company is subject to a variety of market factors which affect the Company’s operating results. North American crushing margins were volatile due to slow farmer selling and COVID-19 impacts on demand for meal and oil earlier in 2020, but strengthened in the third quarter due to the increasingly tight soybean stocks in South America. South America saw record origination volumes in the first half of 2020 as it benefited from strong farmer selling in Brazil driven by the devaluation of the Brazilian Real. Record U.S. industry exports in the fourth quarter were driven by strong demand from China and the rest of the world. Demand and margins for biodiesel remained solid in North and South America. Margins for starches and sweeteners and wheat flour remained solid while demand was soft due to the impacts of COVID-19 in the food service sector. Ethanol margins were mixed as U.S. industry ethanol production exceeded demand and inventories remained high early in the year, but improved and stabilized the rest of the year as ADM and many ethanol producers idled some capacity due to the low demand. Nutrition benefited from growing demand for flavors, pet food, feed for livestock, plant-based proteins, edible beans, and probiotics. Lower out-of-home consumption caused by COVID-19 lockdown measures negatively impacted flavors and textured plant-based protein volumes, especially in the food service channel, as well as demand for aqua feed and amino acids. Global demand for amino acids was also negatively impacted by lower livestock counts following an African swine fever outbreak.Year Ended December 31, 2020 Compared to Year Ended December 31, 2019 Net earnings attributable to controlling interests increased 28% or $0.4 billion, to $1.8 billion. Segment operating profit increased 17% or $0.5 billion, to $3.5 billion, and included net income of $7 million consisting of gains on the sale of a portion of the Company’s shares in Wilmar and certain other assets, partially offset by asset impairment, restructuring, and settlement charges. Included in segment operating profit in the prior year was a net charge of $134 million consisting of asset impairment, restructuring, and settlement charges, gains on the sale of certain assets, and a step-up gain on an equity investment. Adjusted segment operating profit increased $0.4 billion to $3.4 billion due primarily to higher results in Ag Services, Vantage Corn Processors, Human and Animal Nutrition, and higher equity earnings from the Wilmar investment, partially offset by lower results in Crushing, Refined Products and Other, and Other Business. Refined Products and Other in the prior year included the $128 million 2018 portion of the two-year retroactive biodiesel tax credits. Corporate results in the current year were a net charge of $1.6 billion included early debt retirement charges of $409 million, a mark-to-market loss of $17 million on the conversion option of the exchangeable bonds issued in August 2020, impairment and restructuring charges of $16 million, acquisition-related expenses of $4 million, gains on the sale of certain assets of $7 million, and a credit of $91 million from the elimination of the last-in, first-out (LIFO) reserve in connection with the accounting change effective January 1, 2020. Corporate results in the prior year were a net charge of $1.4 billion and included restructuring and pension settlement and remeasurement charges of $159 million primarily related to early retirement and reorganization initiatives, a loss on sale of the Company's equity investment in CIP of $101 million, and a charge of $37 million from the effect of changes in agricultural commodity prices on LIFO inventory valuation reserves.Income taxes of $101 million decreased $108 million. The Company’s effective tax rate for 2020 was 5.4% compared to 13.2% for 2019. The change in rate was due primarily to changes in the geographic mix of earnings, foreign currency remeasurement, and adjustments to previously filed returns. The rates for 2020 and 2019 were also impacted by U.S. tax credits, mainly the railroad maintenance tax credit, which had an offsetting expense in cost of products sold.Analysis of Statements of EarningsProcessed volumes by product for the years ended December 31, 2020 and 2019 are as follows (in metric tons):(In thousands)20202019ChangeOilseeds36,565 36,271 294 Corn17,885 22,079 (4,194) Total54,450 58,350 (3,900)34Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)The Company generally operates its production facilities, on an overall basis, at or near capacity, adjusting facilities individually, as needed, to react to local supply and demand conditions. The overall increase in oilseeds is due to increased plant capacity utilization combined with downtime in the prior year due to weather-related issues. The overall decrease in corn processed is primarily related to the temporary idling of two dry mill facilities in the second quarter due to the low ethanol demand. The Company currently expects that the idled facilities will be restarted as demand for ethanol improves within the next 12 months.Revenues by segment for the years ended December 31, 2020 and 2019 are as follows:(In millions)20202019ChangeAg Services and Oilseeds Ag Services$32,726 $31,705 $1,021 Crushing9,593 9,479 114 Refined Products and Other7,397 7,557 (160)Total Ag Services and Oilseeds49,716 48,741 975 Carbohydrate Solutions Starches and Sweeteners6,387 6,854 (467)Vantage Corn Processors2,085 3,032 (947)Total Carbohydrate Solutions8,472 9,886 (1,414)NutritionHuman Nutrition2,812 2,745 67 Animal Nutrition2,988 2,932 56 Total Nutrition5,800 5,677 123 Other Business367 352 15 Total Other Business367 352 15 Total$64,355 $64,656 $(301)Revenues and cost of products sold in agricultural merchandising and processing businesses are significantly correlated to the underlying commodity prices and volumes. In periods of significant changes in market prices, the underlying performance of the Company is better evaluated by looking at margins since both revenues and cost of products sold, particularly in Ag Services and Oilseeds, generally have a relatively equal impact from market price changes which generally result in an insignificant impact to gross profit. Revenues decreased $0.3 billion to $64.4 billion due to lower sales volumes ($2.3 billion), partially offset by higher sales prices ($2.0 billion). Lower sales volumes of rice, ethanol, oils, and corn by-products and lower sales prices of biodiesel were partially offset by higher sales volumes of biodiesel and higher sales prices of soybeans, oils, and meal. Ag Services and Oilseeds revenues increased 2% to $49.7 billion due to higher sales prices ($1.9 billion), partially offset by lower sales volumes ($0.9 billion). Carbohydrate Solutions revenues decreased 14% to $8.5 billion due to lower sales volumes ($1.4 billion) primarily due to temporarily idled dry mill facilities. Nutrition revenues increased 2% to $5.8 billion due to higher sales prices ($0.1 billion). 35Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Cost of products sold decreased $0.6 billion to $59.9 billion due principally to lower sales volumes, partially offset by higher commodity prices. Included in cost of products sold in the current year was a credit of $91 million from the effect of the elimination of the LIFO reserve in connection with the accounting change in the current year compared to a charge of $37 million from the effect of changes in agricultural commodity prices on LIFO inventory valuation reserves in the prior year. Manufacturing expenses decreased $0.1 billion to $5.6 billion due principally to lower energy costs and decreased operating supplies, partially offset by increased railroad maintenance expenses. Foreign currency translation impacts decreased both revenues and cost of products sold by $0.3 billion.Gross profit increased $0.3 billion or 7%, to $4.5 billion. Higher results in Human and Animal Nutrition ($0.2 billion) and Ag Services ($0.3 billion) were partially offset by lower results in Refined Products and Other ($0.1 billion) and Crushing ($0.1 billion). These factors are explained in the segment operating profit discussion on page 38. In Corporate, the positive period-over-period impact from LIFO of $0.1 billion due to the elimination of the LIFO reserve in connection with the accounting change effective January 1, 2020 and the changes in agricultural commodity prices on LIFO inventory valuation reserves in the prior period, were offset by the increase in railroad maintenance expenses of $0.1 billion. Selling, general, and administrative expenses increased 8% to $2.7 billion due principally to higher variable performance related compensation expenses and increased IT and project-related expenses. Asset impairment, exit, and restructuring costs decreased $223 million to $80 million. Charges in the current year consisted primarily of $47 million of impairments related to certain intangible and other long-lived assets and $17 million of individually insignificant restructuring charges presented as specified items within segment operating profit, $7 million of individually insignificant impairments and $9 million of individually insignificant restructuring charges in Corporate. Prior year charges consisted of impairments of $131 million related to certain facilities, vessels, and other long lived assets and $11 million related to goodwill and other intangible assets presented as specified items within segment operating profit, $159 million of restructuring and pension settlement and remeasurement charges in Corporate primarily related to early retirement and reorganization initiatives, and several individually insignificant restructuring charges presented as specified items within segment operating profit.Interest expense decreased $63 million to $339 million due to lower interest rates and net interest savings from cross currency swaps, partially offset by the mark-to-market loss adjustment related to the conversion option of the exchangeable bonds issuedin August 2020.Equity in earnings of unconsolidated affiliates increased $125 million to $579 million due principally to higher earnings from the Company’s investment in Wilmar. Loss on debt extinguishment of $409 million in the current year related to multiple early debt redemptions including the $0.7 billion debt tender in September 2020.Interest income decreased $104 million to $88 million. Interest income on segregated funds in the Company’s futures commission and brokerage business declined due to lower interest rates.Other income - net of $278 million increased $285 million. Current year income included gains related to the sale of a portion of the Company’s shares in Wilmar and certain other assets, an investment revaluation gain, the non-service components of net pension benefit income, foreign exchange gains, and other income. Prior year expense included a loss on sale of the Company’s equity investment in CIP and foreign exchange losses, partially offset by gains on the sale of certain assets, step-up gains on equity investments, gains on disposals of individually insignificant assets in the ordinary course of business, and other income.36Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Segment operating profit, adjusted segment operating profit (a non-GAAP measure), and earnings before income taxes for the years ended December 31, 2020 and 2019 are as follows:Segment Operating Profit20202019Change(In millions)Ag Services and Oilseeds Ag Services$828 $502 $326 Crushing466 580 (114)Refined Products and Other439 586 (147)Wilmar372 267 105 Total Ag Services and Oilseeds2,105 1,935 170 Carbohydrate Solutions Starches and Sweeteners762 753 9 Vantage Corn Processors(45)(109)64 Total Carbohydrate Solutions717 644 73 NutritionHuman Nutrition 462 376 86 Animal Nutrition112 42 70 Total Nutrition574 418 156 Other Business52 85 (33)Total Other52 85 (33)Specified Items:Gain on sales of assets83 12 71 Impairment, restructuring, and settlement charges(76)(146)70 Total Specified Items7 (134)141 Total Segment Operating Profit$3,455 $2,948 $507 Adjusted Segment Operating Profit(1)$3,448 $3,082 $366 Segment Operating Profit$3,455 $2,948 $507 Corporate(1,572)(1,360)(212)Earnings Before Income Taxes$1,883 $1,588 $295 (1) Adjusted segment operating profit is segment operating profit excluding the listed specified items.37Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Ag Services and Oilseeds operating profit increased 9%. Ag Services results were higher than the prior year, which was negatively impacted by challenging weather conditions and the U.S.-China trade tensions. Strong performance in global trade was driven by strong results in destination marketing and increased trading volumes. Robust farmer selling in Brazil and strong margins in North America drove higher origination results. Current year results also included a $54 million settlement related to U.S. high water insurance claims in 2019. Crushing results were lower than the prior year. Although volumes were strong and execution margins were solid, negative timing impacts drove lower results in the current year compared to the favorable timing effects in the prior year. Refined Products and Other results were lower due to decreased biodiesel margins in North America and the $128 million 2018 portion of retroactive biodiesel tax credits that were recorded in the prior year. Equity earnings from Wilmar were higher year-over-year.Carbohydrate Solutions operating profit increased 11%. Starches and Sweeteners results were higher due to strong margins in corn wet milling and wheat milling in North America and improved conditions in EMEAI, partially offset by negative mark-to-market timing effects on corn oil and COVID-related impacts on volumes across the business. Vantage Corn Processors results improved from the prior year due to effective risk management and strong demand for industrial alcohol.Nutrition operating profit increased 37%. Human Nutrition delivered strong performance and growth across its broad portfolio. Strong execution to meet rising customer demand for plant-based proteins and edible beans drove higher results in Specialty Ingredients. Additional income from fermentation and strong sales for probiotics and fiber drove higher performance in Health & Wellness. Flavors continued to deliver strong results. Animal Nutrition results improved year-over-year driven by strong performance from Neovia, good margins in commercial and livestock premix, and improved margins in amino acids.Other Business operating profit decreased 39%. Lower results, including loss provisions related to the Company’s futures commission and brokerage business, were partially offset by improvements in underwriting performance at the captive insurance operations.Corporate results are as follows:(In millions)20202019ChangeLIFO credit (charge)$91 $(37)$128 Interest expense - net(313)(348)35 Unallocated corporate costs(857)(647)(210)Gain (loss) on sale of assets7 (101)108 Expenses related to acquisitions(4)(17)13 Loss on debt extinguishment(409)— (409)Loss on debt conversion option(17)— (17)Impairment, restructuring, and settlement charges(16)(159)143 Other charges(54)(51)(3)Total Corporate$(1,572)$(1,360)$(212)38Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Corporate results were a net charge of $1.6 billion in the current year compared to $1.4 billion in the prior year. The elimination of the LIFO reserve in connection with the accounting change effective January 1, 2020 resulted in a credit of $91 million in the current year compared to a charge of $37 million from the effect of changes in agricultural commodity prices on LIFO inventory valuation reserves in the prior year. Interest expense - net decreased $35 million due principally to lower interest rates and net interest savings from cross currency swaps. Unallocated corporate costs increased $210 million due principally to higher variable performance-related compensation expenses and increased IT and project-related expenses related to the business transformation program which includes the implementation of an Enterprise Resource Planning system. Loss on sale of assets in the prior year related to the sale of the Company’s equity investment in CIP. Expenses related to acquisitions in the prior year consisted of expenses primarily related to the Neovia acquisition. Loss on debt extinguishment was related to multiple early debt redemptions and the $0.7 billion debt tender in September 2020. Loss on debt conversion option was related to the mark-to-market adjustment of the conversion option of the exchangeable bonds issued in August 2020. Impairment and restructuring charges in the current year related to impairment of certain assets and individually insignificant restructuring charges. Impairment, restructuring, and settlement charges in the prior year included restructuring and pension settlement and remeasurement charges related to early retirement and reorganization initiatives. Other charges in the current year included railroad maintenance expenses of $138 million, partially offset by foreign exchange gains, an investment revaluation gain, and the non-service components of net pension benefit income. Other charges in the prior year included railroad maintenance expenses of $51 million. Non-GAAP Financial MeasuresThe Company uses adjusted earnings per share (EPS), adjusted earnings before taxes, interest, and depreciation and amortization (EBITDA), and adjusted segment operating profit, non-GAAP financial measures as defined by the SEC, to evaluate the Company’s financial performance. These performance measures are not defined by accounting principles generally accepted in the United States and should be considered in addition to, and not in lieu of, GAAP financial measures. Adjusted EPS is defined as diluted EPS adjusted for the effects on reported diluted EPS of specified items. Adjusted EBITDA is defined as earnings before taxes, interest, and depreciation and amortization, adjusted for specified items. The Company calculates adjusted EBITDA by removing the impact of specified items and adding back the amounts of interest expense and depreciation and amortization to earnings before income taxes. Adjusted segment operating profit is segment operating profit adjusted, where applicable, for specified items. Management believes that adjusted EPS, adjusted EBITDA, and adjusted segment operating profit are useful measures of the Company’s performance because they provide investors additional information about the Company’s operations allowing better evaluation of underlying business performance and better period-to-period comparability. Adjusted EPS, adjusted EBITDA, and adjusted segment operating profit are not intended to replace or be an alternative to diluted EPS, earnings before income taxes, and segment operating profit, respectively, the most directly comparable amounts reported under GAAP. 39Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)The table below provides a reconciliation of diluted EPS to adjusted EPS for the years ended December 31, 2020 and 2019.20202019In millionsPer shareIn millionsPer shareAverage number of shares outstanding - diluted563 565 Net earnings and reported EPS (fully diluted)$1,772 $3.15 $1,379 $2.44 Adjustments:LIFO charge (credit) (net of tax of $22 million in 2020 and $9 million in 2019) (1)(69)(0.12)28 0.05 (Gain) loss on sales of assets (net of tax of $10 million in 2020 and $35 million in 2019) (2)(80)(0.14)124 0.22 Asset impairment, restructuring, and settlement charges (net of tax of $23 million in 2020 and $56 million in 2019) (2)69 0.12 249 0.44 Expenses related to acquisitions (net of tax of $1 million in 2020 and $6 million in 2019) (2)3 0.01 11 0.02 Loss on debt extinguishment (net of tax of $99 million) (2)310 0.55 — — Loss on debt conversion option (net of tax of $0) (2)17 0.03 — — Tax adjustments(3)(0.01)39 0.07 Adjusted net earnings and adjusted EPS$2,019 $3.59 $1,830 $3.24 (1) Tax effected using the Company’s U.S. tax rate. LIFO accounting was discontinued effective January 1, 2020.(2) Tax effected using the applicable tax rates.The tables below provide a reconciliation of earnings before income taxes to adjusted EBITDA and adjusted EBITDA by segment for the years ended December 31, 2020 and 2019.(In millions)20202019ChangeEarnings before income taxes$1,883 $1,588 $295 Interest expense339 402 (63)Depreciation and amortization976 993 (17)LIFO charge (credit)(91)37 (128)(Gain) loss on sales of assets(90)89 (179)Asset impairment, restructuring, and settlement charges92 305 (213)Railroad maintenance expense138 51 87 Expenses related to acquisitions4 17 (13)Loss on debt extinguishment409 — 409 Adjusted EBITDA$3,660 $3,482 $178 (In millions)20202019ChangeAg Services and Oilseeds$2,469 $2,311 158 Carbohydrate Solutions1,029 974 55 Nutrition802 642 160 Other Business61 117 (56)Corporate(701)(562)(139)Adjusted EBITDA$3,660 $3,482 $178 40Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Market Factors Influencing Operations or Results in the Twelve Months Ended December 31, 2019 The Company is subject to a variety of market factors which affect the Company’s operating results. Sales volumes and margins in Ag Services and Oilseeds were negatively impacted by challenging North American weather conditions, in particular high water in the Mississippi river system in the first half of 2019, and the continuing global trade tensions with China. Handling volumes in North America were impacted by the late harvest as planting was delayed due to spring flooding. Continued good global meal demand resulted in strong global crushing volumes and solid margins. South American origination volumes benefited from the U.S.-China trade dispute but were also impacted by softer Chinese demand due to the African swine fever impact on local feed demand and intermittent farmer selling. Global demand and margins for refined oil and biodiesel remained solid. Demand and prices for sweeteners and starches remained solid in North America while co-product prices were stable. Although ethanol demand remained steady in North America, margins were severely pressured as U.S. industry ethanol production and stocks remained at high levels and U.S. exports to China ceased during the trade dispute. The severe weather conditions in North America also adversely impacted operations in the Carbohydrate Solutions business unit. Nutrition benefited from growing demand for flavors, flavors systems, human and pet health and wellness products, and plant-based proteins but was negatively impacted by the African swine fever in Asia Pacific, which also resulted in pricing pressures in the global lysine market. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018Net earnings attributable to controlling interests decreased 24% or $0.4 billion, to $1.4 billion. Segment operating profit decreased 10% or $0.3 billion, to $2.9 billion, and included a net charge of $134 million consisting of asset impairment, restructuring, and settlement charges, gains on sale of certain assets, and a step-up gain on an equity investment. Included in segment operating profit in 2018 was a net charge of $89 million consisting of asset impairment, restructuring, and settlement charges and a net gain on sales of assets and businesses. Adjusted segment operating profit decreased $0.3 billion to $3.1 billion due to lower results in Ag Services, Crushing, and Carbohydrate Solutions, and lower equity earnings from Wilmar, partially offset by higher results in Refined Products and Other and Nutrition. Refined Products and Other in 2019 included $270 million related to the biodiesel tax credit for 2018 and 2019 compared to $120 million for 2017 recorded in the prior year. Corporate results were a net charge of $1.4 billion in 2019, and included restructuring and pension settlement and remeasurement charges of $159 million primarily related to early retirement and reorganization initiatives, a loss on sale of the Company’s equity investment in CIP of $101 million, and a charge of $37 million from the effect of changes in agricultural commodity prices on LIFO inventory valuation reserves, compared to a credit of $18 million in 2018. Corporate results in 2018 of $1.2 billion included a pension settlement charge of $117 million, a $49 million charge related to a discontinued software project, and restructuring charges of $24 million primarily related to the reorganization of IT services.Income taxes of $209 million decreased $36 million. The Company’s effective tax rate for 2019 was 13.2% compared to 11.9% for 2018. The low 2019 tax rate was primarily due to the impact of U.S. tax credits, including the 2018 and 2019 biodiesel tax credit and the railroad maintenance tax credit, signed into law in December 2019. The effective tax rate for 2018 included the 2017 biodiesel tax credit recorded in the first quarter of 2018 and the additional true-up adjustments related to the 2017 U.S. tax reform, along with certain favorable discrete tax items netting to a favorable $74 million.Analysis of Statements of EarningsProcessed volumes by product for the years ended December 31, 2019 and 2018 are as follows (in metric tons):(In thousands)20192018ChangeOilseeds36,271 36,308 (37)Corn22,079 22,343 (264) Total58,350 58,651 (301)41Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)The Company generally operates its production facilities, on an overall basis, at or near capacity, adjusting facilities individually, as needed, to react to local supply and demand conditions. Processed volumes of Corn decreased slightly from the prior year levels primarily related to the production disruptions in the Columbus, Nebraska corn processing plant due to flooding and production issues in the Decatur, Illinois corn complex.Revenues by segment for the years ended December 31, 2019 and 2018 are as follows:(In millions)20192018ChangeAg Services and Oilseeds Ag Services$31,705 $31,766 $(61)Crushing9,479 10,319 (840)Refined Products and Other7,557 7,806 (249)Total Ag Services and Oilseeds48,741 49,891 (1,150)Carbohydrate Solutions Starches and Sweeteners6,854 6,922 (68)Vantage Corn Processors3,032 3,357 (325)Total Carbohydrate Solutions9,886 10,279 (393)NutritionHuman Nutrition2,745 2,571 174 Animal Nutrition2,932 1,219 1,713 Total Nutrition5,677 3,790 1,887 Other Business352 381 (29)Total Other Business352 381 (29)Total$64,656 $64,341 $315 Revenues and cost of products sold in agricultural merchandising and processing businesses are significantly correlated to the underlying commodity prices and volumes. In periods of significant changes in market prices, the underlying performance of the Company is better evaluated by looking at margins since both revenues and cost of products sold, particularly in Ag Services and Oilseeds, generally have a relatively equal impact from market price changes which generally result in an insignificant impact to gross profit. Revenues increased $315 million to $64.7 billion due to overall higher sales volumes ($3.2 billion), partially offset by lower sales prices ($2.9 billion). The increase in sales volumes was due principally to soybeans, wheat, cotton, and higher sales volumes of feed ingredients related to acquisitions. The decrease in sales prices was due principally to soybeans, meal, and wheat. Ag Services and Oilseeds revenues decreased 2% to $48.7 billion due to lower sales prices ($3.0 billion), partially offset by higher sales volumes ($1.8 billion). Carbohydrate Solutions revenues decreased 4% to $9.9 billion due to lower sales volumes ($0.4 billion). Nutrition revenues increased 50% to $5.7 billion due to higher sales volumes ($1.8 billion), primarily related to acquisitions and higher sales prices ($0.1 billion). Cost of products sold increased $0.3 billion to $60.5 billion due to overall higher sales volumes, partially offset by lower prices of commodities. Included in cost of products sold in 2019 was a charge of $37 million from the effect of changes in agricultural commodity prices on LIFO inventory valuation reserves compared to a credit of $18 million in 2018. Manufacturing expenses increased $0.3 billion to $5.7 billion due principally to new acquisitions. Foreign currency translation impacts decreased both revenues and cost of products sold by $0.8 billion.42Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Gross profit decreased $34 million or 1%, to $4.1 billion. Lower results in Ag Services and Oilseeds ($40 million), Carbohydrate Solutions ($301 million), and Other ($6 million) were offset by higher results in Nutrition ($400 million). These factors are explained in the discussions of segment operating profit on page 45. The effect of changes in agricultural commodity prices on LIFO inventory valuation reserves had a negative impact on gross profit of $37 million in 2019 compared to a positive impact of $18 million in 2018.Selling, general, and administrative expenses increased 15% to $2.5 billion due principally to new acquisitions, primarily in the Nutrition segment, and higher spending on IT, business transformation, growth-related investments, and Readiness-related projects, partially offset by lower variable performance-related and stock compensation expenses. Asset impairment, exit, and restructuring costs increased $132 million to $303 million. Charges in 2019 consisted of asset impairments of $131 million related to certain facilities, vessels, and other long-lived assets and $11 million related to goodwill and other intangible assets presented as specified items within segment operating profit, and $159 million of restructuring and pension settlement and remeasurement charges in Corporate primarily related to early retirement and reorganization initiatives and several individually insignificant restructuring charges presented as specified items within segment operating profit. Charges in 2018 totaling $171 million consisted of $56 million of impairment of certain long-lived assets, a $12 million impairment of an equity investment, a $21 million impairment related to a long-term financing receivable, and $9 million of other individually insignificant impairment and restructuring charges presented as specified items within segment operating profit, and a $49 million charge related to a discontinued software project, $18 million of restructuring charges related to the reorganization of IT services and $6 million individually insignificant restructuring charges in Corporate. Interest expense increased $38 million to $402 million due to higher borrowings to fund recent acquisitions, partially offset by lower interest rates.Equity in earnings of unconsolidated affiliates decreased $64 million to $454 million due to lower earnings from the Company’s investments in Wilmar and CIP, partially offset by higher earnings from the Company’s investments in Olenex and other equity investees.Other expense - net of $7 million decreased $94 million. Expense in 2019 included a loss on sale of the Company’s equity investment in CIP and foreign exchange loss, partially offset by gains on the sale of certain assets, step-up gains on equity investments, gains on disposals of individually insignificant assets in the ordinary course of business, and other income. Expense in 2018 included foreign exchange losses and a non-cash pension settlement charge of $117 million related to the purchase of a group annuity contract that irrevocably transferred the future benefit obligations and annuity administration for certain U.S. salaried retirees under the Company’s ADM Retirement Plan. These expenses were partially offset by gains on disposals of businesses, an equity investment, and individually insignificant assets in the ordinary course of business, and other income. 43Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Operating profit by segment and earnings before income taxes for the years ended December 31, 2019 and 2018 are as follows:Segment Operating Profit20192018Change(In millions)Ag Services and Oilseeds Ag Services$502 $657 $(155)Crushing580 650 (70)Refined Products and Other586 370 216 Wilmar267 343 (76)Total Ag Services and Oilseeds1,935 2,020 (85)Carbohydrate Solutions Sweeteners and Starches753 905 (152)Vantage Corn Processors(109)40 (149)Total Carbohydrate Solutions644 945 (301)NutritionHuman Nutrition376 318 58 Animal Nutrition42 21 21 Total Nutrition418 339 79 Other Business85 58 27 Total Other Business85 58 27 Specified Items:Gain on sales of assets and businesses12 13 (1)Impairment, restructuring, and exit charges(146)(102)(44)Total Specified Items(134)(89)(45)Total Segment Operating Profit2,948 3,273 (325)Adjusted Segment Operating Profit(1)3,082 3,362 (280)Segment Operating Profit2,948 3,273 (325)Corporate(1,360)(1,213)(147)Earnings Before Income Taxes$1,588 $2,060 $(472)(1) Adjusted segment operating profit is segment operating profit excluding the above specified items.44Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Ag Services and Oilseeds operating profit decreased 4%. Ag Services results were lower due to weaker North American grain margins and lower volumes, in part due to challenging weather conditions and the U.S.-China trade tensions. Results in 2019 were negatively impacted by high water conditions in the first half of the year, which limited grain movement and sales in North America. Slow farmer selling and lower Chinese demand for South American origination, in part due to African swine fever, also impacted results. Crushing results were strong but down compared to 2018. Lower executed crush margins around the globe drove lower results, partially offset by favorable timing effects of approximately $102 million from hedges entered in 2018. Refined Products and Other results were up compared to 2018 primarily due to the retroactive biodiesel tax credit of $270 million for 2018 and 2019 recorded in 2019 compared to $120 million for 2017 recorded in 2018, strong demand, and higher results from equity investments. Wilmar results were lower year over year.Carbohydrate Solutions operating profit decreased 32%. Starches and Sweeteners results were down primarily due to lower results in EMEA where margins were pressured due to low sugar prices and the Turkish quota on starch-based sweeteners. Higher manufacturing costs at the Decatur, IL complex and weaker margins in flour milling also contributed to the decrease. Vantage Corn Processors results were down due to significantly lower ethanol margins amid a continued unfavorable ethanol industry environment, exacerbated by the lack of Chinese demand for ethanol due to the U.S.-China trade dispute.Nutrition operating profit increased 23%. Human Nutrition results were higher year over year on strong sales and margin growth in North America and Europe, Middle East, Africa, and India (EMEAI) and contributions from acquisitions. Animal Nutrition results were up driven largely by contributions from the acquisition of Neovia, partially offset by additional expenses related to inventory valuation of newly-acquired Neovia and weaker lysine results.Other Business operating profit increased 47% primarily due to improved results from the Company’s futures commission brokerage business and captive insurance underwriting performance.Corporate results are as follows:(In millions)20192018ChangeLIFO credit (charge)$(37)$18 $(55)Interest expense - net(348)(321)(27)Unallocated corporate costs(647)(660)13 Loss on sale of asset(101)— (101)Expenses related to acquisitions(17)(8)(9)Impairment, restructuring, and settlement charges(159)(190)31 Other charges(51)(52)1 Total Corporate$(1,360)$(1,213)$(147)Corporate results were a net charge of $1.4 billion in 2019 compared to $1.2 billion in 2018. The effect of changes in agricultural commodity prices on LIFO inventory valuation reserves resulted in a charge of $37 million in 2019 compared to a credit of $18 million in 2018. Interest expense - net increased $27 million due to higher borrowings to fund recent acquisitions, partially offset by interest savings from cross-currency swaps. Unallocated corporate costs decreased $13 million due principally to decreased performance-related compensation accruals partially offset by higher spending on IT, business transformation, growth-related investments, and Readiness-related projects. Loss on sale of asset related to the sale of the Company’s equity investment in CIP. Expenses related to acquisitions in 2019 consisted of expenses primarily related to the Neovia acquisition. Expenses related to acquisitions in 2018 consisted of expenses and losses on foreign currency derivative contracts entered into to economically hedge certain acquisitions. Impairment, restructuring, and settlement charges in 2019 included restructuring and pension settlement and remeasurement charges related to early retirement and reorganization initiatives. Impairment, restructuring, and settlement charges in 2018 included pension settlement charge of $117 million related to the purchase of a group annuity contract that irrevocably transferred the future benefit obligations and annuity administration for certain U.S. salaried retirees under the Company’s ADM Retirement Plan, a $49 million charge related to a discontinued software project, and restructuring charges of $24 million primarily related to the reorganization of IT services. Other charges in 2019 included railroad maintenance expenses of $51 million. Other charges in 2018 included foreign exchange losses which were partially offset by earnings from the Company’s equity investment in CIP.45Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Non-GAAP Financial MeasuresThe Company uses adjusted earnings per share (EPS), adjusted earnings before taxes, interest, and depreciation and amortization (EBITDA), and adjusted segment operating profit, non-GAAP financial measures as defined by the SEC, to evaluate the Company’s financial performance. These performance measures are not defined by accounting principles generally accepted in the United States and should be considered in addition to, and not in lieu of, GAAP financial measures. Adjusted EPS is defined as diluted EPS adjusted for the effects on reported diluted EPS of specified items. Adjusted EBITDA is defined as earnings before taxes, interest, and depreciation and amortization, adjusted for specified items. The Company calculates adjusted EBITDA by removing the impact of specified items and adding back the amounts of interest expense and depreciation and amortization to earnings before income taxes. Adjusted segment operating profit is segment operating profit adjusted, where applicable, for specified items. Management believes that adjusted EPS, adjusted EBITDA, and adjusted segment operating profit are useful measures of the Company’s performance because they provide investors additional information about the Company’s operations allowing better evaluation of underlying business performance and better period-to-period comparability. Adjusted EPS, adjusted EBITDA, and adjusted segment operating profit are not intended to replace or be an alternative to diluted EPS, earnings before income taxes, and segment operating profit, respectively, the most directly comparable amounts reported under GAAP. The table below provides a reconciliation of diluted EPS to adjusted EPS for the years ended December 31, 2019 and 2018.20192018In millionsPer shareIn millionsPer shareAverage number of shares outstanding - diluted565 567 Net earnings and reported EPS (fully diluted)$1,379 $2.44 $1,810 $3.19 Adjustments:LIFO charge (credit) (net of tax of $9 million in 2019 and $4 million in 2018) (1)28 0.05 (14)(0.02)(Gain) loss on sales of assets and businesses (net of tax of $35 million in 2019 and $0 million in 2018) (2)124 0.22 (13)(0.02)Asset impairment, restructuring, and settlement charges (net of tax of $56 million in 2019 and $66 million in 2018) (2)249 0.44 226 0.40 Expenses related to acquisitions (net of tax of $6 million in 2019 and $2 million in 2018) (2)11 0.02 6 0.01 Tax adjustments (3)39 0.07 (33)(0.06)Adjusted net earnings and adjusted EPS$1,830 $3.24 $1,982 $3.50 (1) Tax effected using the Company’s U.S. tax rate.(2) Tax effected using the applicable tax rates.(3) Includes tax adjustments related to the U.S. Tax Cuts and Jobs Act and other discrete items.46Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)The tables below provide a reconciliation of earnings before income taxes to adjusted EBITDA and adjusted EBITDA by segment for the years ended December 31, 2019 and 2018.(In millions)20192018ChangeEarnings before income taxes$1,588 $2,060 $(472)Interest expense402 364 38 Depreciation and amortization993 941 52 LIFO charge (credit)37 (18)55 Gain (loss) on sales of assets and businesses89 (13)102 Asset impairment, restructuring, and settlement charges305 292 13 Railroad maintenance expense51 — 51 Expenses related to acquisitions17 8 9 Adjusted EBITDA$3,482 $3,634 $(152)(In millions)20192018ChangeAg Services and Oilseeds$2,311 $2,410 (99)Carbohydrate Solutions974 1,282 (308)Nutrition642 486 156 Other Business117 92 25 Corporate(562)(636)74 Adjusted EBITDA$3,482 $3,634 $(152)47Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Liquidity and Capital ResourcesA Company objective is to have sufficient liquidity, balance sheet strength, and financial flexibility to fund the operating and capital requirements of a capital intensive agricultural commodity-based business. The Company depends on access to credit markets, which can be impacted by its credit rating and factors outside of ADM’s control, to fund its working capital needs and capital expenditures. The primary source of funds to finance ADM’s operations, capital expenditures, and advancement of its growth strategy is cash generated by operations and lines of credit, including a commercial paper borrowing facility and accounts receivable securitization programs. In addition, the Company believes it has access to funds from public and private equity and debt capital markets in both U.S. and international markets.Cash used in operating activities was $2.4 billion in 2020 compared to $5.5 billion in 2019. Working capital changes as described below, including the impact of deferred consideration, decreased cash by $5.5 billion in the current year compared to $7.7 billion in the prior year.Trade receivables increased $0.1 billion primarily due to lower receivables sold. Inventories increased $2.4 billion primarily due to higher inventory prices. Other current assets and accrued expenses and other payables increased $2.1 billion and $1.3 billion, respectively, primarily due to increases in contracts and futures gains and losses. Trade payables increased $0.7 billion principally reflecting seasonal cash payments for North American harvest-related grain purchases. Payables to brokerage customers increased $1.4 billion due to increased customer trading activity in the Company’s futures commission and brokerage business.Deferred consideration in securitized receivables of $4.6 billion and $7.7 billion in 2020 and 2019, respectively, was offset by the same amounts of net consideration received for beneficial interest obtained for selling trade receivables. Cash provided by investing activities was $4.5 billion this year compared to $5.3 billion last year. Capital expenditures of $0.8 billion in the current year were comparable to last year. Net assets of businesses acquired were $15 million this year compared to $1.9 billion last year due to the acquisition of Neovia in 2019. Proceeds from sales of business and assets of $0.7 billion in the current year related to the sale of a portion of the Company shares in Wilmar and certain other assets compared to $0.3 billion in the prior year. Net consideration received for beneficial interest obtained for selling trade receivables was $4.6 billion and $7.7 billion in 2020 and 2019, respectively.Cash used in financing activities was $0.4 billion this year compared to $0.7 billion last year. Long-term debt borrowings in the current year of $1.8 billion consisted of the $0.5 billion and $1.0 billion aggregate principal amounts of 2.75% Notes due in 2025 and 3.25% Notes due in 2030, respectively, issued on March 27, 2020 and the $0.3 billion aggregate principal amount of zero coupon exchangeable bonds due in 2023 issued on August 26, 2020. Proceeds from the borrowings in the current year were used for general corporate purposes, including the reduction of short-term debt. Commercial paper net borrowings were $0.8 billion in the current year compared to $0.9 billion in the prior year. Long-term debt payments in the current year of $2.1 billion related primarily to the early redemption of the $0.5 billion and $0.4 billion aggregate principal amounts of 4.479% debentures due in 2021 and 3.375% debentures due in 2022, respectively, the repurchase of $0.7 billion aggregate principal amount of certain outstanding notes and debentures, and the redemption of $0.2 billion aggregate principal amount of private placement notes due in 2021 and 2024. Long-term debt payments of $0.6 billion in the prior year related to the €500 million Floating Rate Notes that matured in June 2019. Share repurchases in the current year were $0.1 billion compared to $0.2 billion in the prior year. Dividends paid in the current year of $0.8 billion were comparable to the prior year. At December 31, 2020, ADM had $0.7 billion of cash, cash equivalents, and short-term marketable securities and a current ratio, defined as current assets divided by current liabilities, of 1.5 to 1. Included in working capital is $7.9 billion of readily marketable commodity inventories. At December 31, 2020, the Company’s capital resources included shareholders’ equity of $20.0 billion and lines of credit, including the accounts receivable securitization programs described below, totaling $10.2 billion, of which $6.6 billion was unused. ADM’s ratio of long-term debt to total capital (the sum of long-term debt and shareholders’ equity) was 28% and 29% at December 31, 2020 and 2019, respectively. The Company uses this ratio as a measure of ADM’s long-term indebtedness and an indicator of financial flexibility. The Company’s ratio of net debt (the sum of short-term debt, current maturities of long-term debt, and long-term debt less the sum of cash and cash equivalents and short-term marketable securities) to capital (the sum of net debt and shareholders’ equity) was 32% and 29% at December 31, 2020 and 2019, respectively. Of the Company’s total lines of credit, $5.0 billion supported the commercial paper borrowing programs, against which there was $1.7 billion of commercial paper outstanding at December 31, 2020.48Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)COVID-19 has not significantly impacted ADM’s capital and financial resources, and pricing on its revolving credit facility remains unchanged. However, in line with the overall markets, COVID-19 created dislocations in the credit markets during certain periods in the first half of 2020 with corporate spreads increasing, partially offset by a decline in benchmark yields. The Company has utilized its diversified sources of liquidity, including its inventory financing and bilateral bank facilities, to ensure it has ample cash and is prepared for possible unexpected credit market disruptions. Additionally, ADM has been accepted into the Federal Reserve’s Commercial Paper Financing Facility and the Bank of England’s COVID Corporate Financing Facility ensuring uninterrupted access to both the U.S. and European commercial paper markets. The Federal Reserve’s Commercial Paper Financing Facility and the Bank of England’s COVID Corporate Financing Facility expire in March and June 2021, respectively, unless renewed. To date, the Company has not utilized these facilities.During the second half of 2020, the global credit market stabilized with corporate credit spreads below pre-pandemic levels. Continued actions by central banks provided additional support in both the short-term and long-term funding markets further stabilizing corporate credit markets. Low benchmark yields and favorable credit spreads coupled with continued strong cash flow generation during the second half of the year presented opportunities for ADM to re-balance the company’s liability portfolio to pre-pandemic levels. Starting in June 2020, ADM began a series of liability management transactions including multiple early debt redemptions and the $0.7 billion debt tender in September 2020 to capitalize on all-time low interest rates. As of December 31, 2020, the Company had $0.7 billion of cash and cash equivalents, $0.3 billion of which is cash held by foreign subsidiaries whose undistributed earnings are considered indefinitely reinvested. Based on the Company’s historical ability to generate sufficient cash flows from its U.S. operations and unused and available U.S. credit capacity of $4.0 billion, the Company has asserted that these funds are indefinitely reinvested outside the U.S. The Company has accounts receivable securitization programs (the “Programs”) with certain commercial paper conduit purchasers and committed purchasers. The Programs provide the Company with up to $1.8 billion in funding against accounts receivable transferred into the Programs and expand the Company’s access to liquidity through efficient use of its balance sheet assets (see Note 19 in Item 8 for more information and disclosures on the Programs). As of December 31, 2020, the Company utilized $1.6 billion of its facility under the Programs. On November 5, 2014, the Company’s Board of Directors approved a stock repurchase program authorizing the Company to repurchase up to 100,000,000 shares of the Company’s common stock during the period commencing January 1, 2015 and ending December 31, 2019. On August 7, 2019, the Company’s Board of Directors approved the extension of the stock repurchase program through December 31, 2024 and the repurchase of up to an additional 100,000,000 shares under the extended program. The Company has acquired approximately 95.5 million shares under this program as of December 31, 2020.In 2021, the Company expects capital expenditures of $0.9 billion to $1.0 billion, and additional cash outlays of approximately $0.8 billion in dividends and up to $0.5 billion in share repurchases, subject to other strategic uses of capital.The Company’s credit facilities and certain debentures require the Company to comply with specified financial and non-financial covenants including maintenance of minimum tangible net worth as well as limitations related to incurring liens, secured debt, and certain other financing arrangements. The Company was in compliance with these covenants as of December 31, 2020.The three major credit rating agencies have maintained the Company’s credit ratings at solid investment grade levels with stable outlooks. 49Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Contractual ObligationsIn the normal course of business, the Company enters into contracts and commitments which obligate the Company to make payments in the future. The following table sets forth the Company’s significant future obligations by time period. Purchases include commodity-based contracts entered into in the normal course of business, which are further described in Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” energy-related purchase contracts entered into in the normal course of business, and other purchase obligations related to the Company’s normal business activities. The following table does not include unrecognized income tax benefits of $151 million as of December 31, 2020 as the Company is unable to reasonably estimate the timing of settlement. Where applicable, information included in the Company’s consolidated financial statements and notes is cross-referenced in this table. Payments Due by Period Item 8 Contractual Obligations and Note Less than1 - 33 - 5 More thanOther CommitmentsReferenceTotal1 YearYearsYears5 Years (In millions)Purchases Inventories $18,220 $17,915 $301 $4 $— Energy 537 184 166 187 — Other 940 553 158 41 188 Total purchases 19,697 18,652 625 232 188 Short-term debt 2,042 2,042 — — — Long-term debtNote 107,887 2 1,061 1 6,823 Estimated interest payments 5,370 319 632 598 3,821 One-time transition taxNote 13164 25 56 83 — Operating leasesNote 141,299 302 486 251 260 Estimated pension and other postretirement plan contributions (1)Note 15151 45 29 27 50 Total $36,610 $21,387 $2,889 $1,192 $11,142 (1) Includes pension contributions of $29 million for fiscal 2021. The Company is unable to estimate the amount of pension contributions beyond fiscal year 2021. For more information concerning the Company’s pension and other postretirement plans, see Note 15 in Item 8.At December 31, 2020, the Company estimates it will spend approximately $1.7 billion through fiscal year 2025 to complete currently approved capital projects which are not included in the table above. The Company also has outstanding letters of credit and surety bonds of $1.2 billion at December 31, 2020 which are not included in the table above.The Company has entered into agreements, primarily debt guarantee agreements related to equity-method investees, which could obligate the Company to make future payments. The Company’s liability under these agreements is immaterial and arises only if the primary entity fails to perform its contractual obligation. The Company has collateral for a portion of these contingent obligations. 50Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Off Balance Sheet ArrangementsAccounts Receivable Securitization ProgramsOn April 1, 2020 and October 1, 2020, the Company restructured its accounts receivable securitization programs (Programs) from a deferred purchase price to a pledge structure. Under the new structure, ADM Ireland Receivables and ADM Receivables transfer a portion of the purchased accounts receivable together with an equally proportional interest in all of its right, title and interest in the remaining purchased accounts receivable to each of the commercial paper conduit purchasers and committed purchasers. In exchange, ADM Ireland Receivables and ADM Receivables receive a cash payment for the accounts receivables transferred. See Note 19 of “Notes to Consolidated Financial Statements” included in Item 8 herein, “Financial Statements and Supplementary Data” for more information and disclosures on the ProgramsThere were no other material changes in the Company’s off balance sheet arrangements during the year. Critical Accounting PoliciesThe process of preparing financial statements requires management to make estimates and judgments that affect the carrying values of the Company’s assets and liabilities as well as the recognition of revenues and expenses. These estimates and judgments are based on the Company’s historical experience and management’s knowledge and understanding of current facts and circumstances. Certain of the Company’s accounting policies are considered critical, as these policies are important to the depiction of the Company’s financial statements and require significant or complex judgment by management. Management has discussed with the Company’s Audit Committee the development, selection, disclosure, and application of these critical accounting policies. Following are the accounting policies management considers critical to the Company’s financial statements.Fair Value Measurements - Inventories and Commodity DerivativesCertain of the Company’s inventory and commodity derivative assets and liabilities as of December 31, 2020 are valued at estimated fair values, including $7.9 billion of merchandisable agricultural commodity inventories, $2.8 billion of commodity derivative assets, $2.0 billion of commodity derivative liabilities, and $0.5 billion of inventory-related payables. Commodity derivative assets and liabilities include forward fixed-price purchase and sale contracts for agricultural commodities. Merchandisable agricultural commodities are freely traded, have quoted market prices, and may be sold without significant additional processing. Management estimates fair value for its commodity-related assets and liabilities based on exchange-quoted prices, adjusted for differences in local markets. The Company’s inventory and derivative commodity fair value measurements are mainly based on observable market quotations without significant adjustments and are therefore reported as Level 2 within the fair value hierarchy. Level 3 fair value measurements of approximately $3.0 billion of assets and $0.9 billion of liabilities represent fair value estimates where unobservable price components represent 10% or more of the total fair value price. For more information concerning amounts reported as Level 3, see Note 4 in

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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsYou should read the following discussion and analysis of our financial condition and results of operations together with the consolidated financial statements and related notes that are included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements based upon current plans, expectations and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and elsewhere in this Annual Report on Form 10-K.Overview Arista Networks pioneered software-driven, cognitive cloud networking for large-scale data center and campus workspace environments. Our industry-leading cloud networking platform is highly scalable and programmable, and purpose built to address the functional and performance requirements for cloud networks, including workflow automation, network visibility and analytics, and has further allowed us to integrate rapidly with a wide range of third-party applications for virtualization, management, automation, orchestration and network services. We generate revenue primarily from sales of our switching and routing platforms, which incorporate our EOS software, and related network applications. We also generate revenue from post contract support, or PCS, which end customers typically purchase in conjunction with our products, and renewals of PCS. We sell our products through both our direct sales force and our channel partners. Our end customers span a range of industries and include large internet companies, service providers, financial services organizations, government agencies, media and entertainment companies and others. Historically, large purchases by a relatively limited number of end customers have accounted for a significant portion of our revenue. We have experienced unpredictability in the timing of orders from these large end customers primarily due to changes in demand patterns specific to these customers, the time it takes these end customers to evaluate, test, qualify and accept our products, and the overall complexity of these large orders. We expect continued variability in our customer concentration and timing of sales on a quarterly and annual basis. For example, sales to our end customers Microsoft and Facebook in fiscal 2019 collectively represented 40% of our total revenue, whereas sales to our end customer Microsoft in fiscal 2020 amounted to 21.5% of our revenues, with our end customer Facebook representing less than 10% of our revenues in the period. These changes contributed to a year-over-year decline in our revenue for fiscal 2020. However, this decline in revenue from these large end customers was in part offset by stronger sales to our enterprise and other cloud and service provider customers. In addition, we typically provide pricing discounts to large end customers, which may result in lower margins for the period in which such sales occur. We believe that cloud networking will continue to replace legacy network technologies across data center and campus environments. Our cloud networking platforms are well positioned to address the growing cloud networking market, and to address increasing performance requirements driven by the growing number of connected devices, as well as the need for constant connectivity and access to data and applications.52Table of ContentsThe markets for cloud networking solutions are highly competitive and characterized by rapidly changing technology, changing end-customer needs, evolving industry standards, frequent introductions of new products and services and industry consolidation. We expect competition to intensify in the future as the market for cloud networking expands and existing competitors and new market entrants introduce new products or enhance existing products. Our future success is dependent upon our ability to continue to evolve and adapt to our rapidly changing environment. We must also continue to develop market leading products and features that address the needs of our existing and new customers, and increase sales in the enterprise data center switching, and campus workspace markets. We intend to continue expanding our sales force and marketing activities in key geographies, as well as our relationships with channel, technology and system-level partners in order to reach new end customers more effectively, increase sales to existing customers, and provide services and support. In addition, we intend to continue to invest in our research and development organization to enhance the functionality of our existing cloud networking platform, introduce new products and features, and build upon our technology leadership. We believe one of our greatest strengths lies in our ability to rapidly develop new features and applications.Our development model is focused on the development of new products based on our EOS software and enhancements to EOS. We engineer our products to be agnostic with respect to the underlying merchant silicon architecture. Today, we combine our EOS software with merchant silicon into a family of switching and routing products. This enables us to focus our research and development resources on our software core competencies and to leverage the investments made by merchant silicon vendors to achieve cost-effective solutions. We work closely with third party contract manufacturers to manufacture our products. Our contract manufacturers deliver our products to our third party direct fulfillment facilities. We and our fulfillment partners then perform labeling, final configuration, quality assurance testing and shipment to our customers.Recent Developments The global coronavirus (“COVID-19”) pandemic and related shelter in place, travel and social distancing restrictions imposed by governments around the world in an effort to contain or slow its spread have negatively impacted the global economy, disrupted business, sales activities, supply chains and workforce participation, including our own, and created significant volatility and disruption of financial markets, and we expect that the global health crisis caused by COVID-19 will continue to negatively impact business activity for the foreseeable future.We have taken numerous steps, and will continue to take further actions, in our approach to address COVID-19. We have prioritized the protection of our employees during this pandemic and, as a result, have closed our offices across the globe (including our corporate headquarters), limiting access to only those employees providing essential activities, instructed employees to work from home, and implemented travel restrictions. We continue to work closely with our contract manufacturers and supply chain partners who have experienced delays in component sourcing, workforce disruptions and governmental restrictions on the production and export of their products. Although we have worked diligently to drive improvements in these areas, including funding additional working capital and incremental purchase commitments, these delays have negatively impacted our ability to supply products to our customers on a timely basis. We expect to continue to invest in working capital as supply availability improves in order to address the risk of future COVID-19 related supply chain disruptions, but we cannot be certain that such disruptions will not occur. When the COVID-19 pandemic began, we initially experienced some volatility in customer demand, but sales activity subsequently stabilized and we experienced incremental improvements in overall demand as the year progressed. However, the supply chain disruptions outlined above and the earlier volatility in customer demand contributed in part to a year-over-year decline in total revenue for the year ended December 31, 2020. The extent of the impact of COVID-19 on our operational and financial performance, including our ability to execute our business strategies and initiatives in the expected time frame, will depend on future developments, including the duration and spread of the pandemic, the breadth and duration of governmental containment measures such as shelter in place, travel and social distancing restrictions as well as the reauthorization of or increase in such measures in the event of spikes in COVID-19 infection rates, the success of the COVID-19 vaccination deployment, and the impact on our customers, partners, contract manufacturers 53Table of Contentsand supply chain, all of which are uncertain and cannot be predicted. However, any continued or renewed disruption in manufacturing and supply resulting from the COVID-19 pandemic or related containment measures could negatively impact our business. We also believe that any extended or renewed COVID-19 related economic disruption could have a negative impact on demand from our customers in future periods. Accordingly, current results and financial condition discussed herein may not be indicative of future operating results and trends.In response to potential future COVID-19 related disruptions to our business, we have continued to carefully review our investment and spending plans, cautiously increasing incremental spending in the second half of fiscal 2020 as overall customer demand stabilized. Although management is actively monitoring the impact of COVID-19 on the Company’s financial condition, liquidity, operations, suppliers, industry, and workforce, the full impact of the pandemic continues to evolve as of the date of this report. As such, the Company is unable to estimate the effects of COVID-19 on its future results of operations, financial condition, or liquidity.AcquisitionsOn February 5, 2020, we acquired Big Switch Networks, Inc. (“Big Switch”), a network monitoring and software-defined networking pioneer headquartered in Santa Clara, California. With the acquisition of Big Switch, we expanded our data center networking solutions and further strengthen our network monitoring and observability suite delivered through Arista’s software platform CloudVision and DANZ (DataANalyZer) capabilities. In addition, on October 7, 2020, we completed the acquisition of Awake Security Inc. (“Awake Security”), a network detection and response (“NDR”) platform provider headquartered in Santa Clara, California. With the acquisition of Awake Security, we added an NDR platform to our product portfolio that combines artificial intelligence (AI) with human expertise to autonomously hunt for and respond to insider and external threats.Results of OperationsYear Ended December 31, 2020 Compared to Year Ended December 31, 2019 Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages) Year Ended December 31,20202019Change in$% ofRevenue$% ofRevenue$%RevenueProduct$1,830,842 79.0 %$2,021,150 83.8 %$(190,308)(9.4)%Service 486,670 21.0 389,556 16.2 97,114 24.9 Total revenue2,317,512 100.0 2,410,706 100.0 (93,194)(3.9)Cost of revenueProduct749,962 32.4 792,382 32.9 (42,420)(5.4)Service 85,664 3.7 73,986 3.0 11,678 15.8 Total cost of revenue835,626 36.1 866,368 35.9 (30,742)(3.5)Gross profit$1,481,886 63.9 %$1,544,338 64.1 %$(62,452)(4.0)%Gross margin63.9 %64.1 %54Table of ContentsRevenue by Geography (in thousands, except percentages)Year Ended December 31,2020% of Total2019% of TotalAmericas$1,771,992 76.5 %$1,833,163 76.1 %Europe, Middle East and Africa 326,729 14.1 381,651 15.8 Asia-Pacific 218,791 9.4 195,892 8.1 Total revenue $2,317,512 100.0 %$2,410,706 100.0 %Revenue Product revenue primarily consists of sales of our switching and routing products, and software licenses. Service revenue is primarily derived from sales of post-contract support, or PCS, which is typically purchased in conjunction with our products, and subsequent renewals of those contracts. We expect our revenue may vary from period to period based on, among other things, the timing, size, and complexity of orders, especially with respect to our large end customers. Product revenue decreased $190.3 million, or 9.4%, in the year ended December 31, 2020 compared to 2019. The decrease was primarily due to the recognition of $125.1 million of deferred product revenue in the year ended December 31, 2019 related to customer acceptance of products shipped in prior periods. In addition, we experienced reduced sales to our larger customers during fiscal 2020, combined with the impact of some COVID-19 related supply constraints. Service revenue increased $97.1 million, or 24.9% in the year ended December 31, 2020 compared to 2019 as a result of continued growth in initial and renewal support contracts as our customer installed base continued to expand. International revenues remained relatively constant at 23.5% of total revenues in the year ended December 31, 2020, compared to 23.9% in 2019, with a slight decrease in growth in our EMEA region, mostly offset by an increase in growth in our Asia-Pacific region. International revenue generally fluctuates based on the timing of deployments by certain of our large end customers. Cost of Revenue and Gross Margin Cost of product revenue primarily consists of amounts paid for inventory to our third-party contract manufacturers and merchant silicon vendors, overhead costs of our manufacturing operations, and other costs associated with manufacturing our products and managing our inventory. Cost of service revenue primarily consists of personnel and other costs associated with our global customer support and services organizations.Cost of revenue decreased $30.7 million or 3.5% for the year ended December 31, 2020 compared to 2019. The decrease in cost of revenue was primarily due to a corresponding decrease in product revenues, and was partially offset by incremental COVID-19 related supply chain costs and increased product transition costs. Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including pricing pressure on our products and services due to competition, the mix of sales to large end customers who generally receive lower pricing, manufacturing-related costs, including costs associated with supply chain sourcing activities, merchant silicon costs, the mix of products sold, and excess/obsolete inventory write-downs, including charges for excess/obsolete component inventory held by our contract manufacturers. We expect our gross margins to fluctuate over time, depending on the factors described above. Gross margin slightly decreased from 64.1% for the year ended December 31, 2019 to 63.9% in 2020. Gross margin was negatively impacted by incremental COVID-19 related supply chain costs and some increased product transition costs, combined with the impact of fixed overhead costs on a lower revenue base. These negative impacts were partially offset by a reduction in sales to our larger end customers who generally receive larger discounts, and improved service margins as we scale our services organization.55Table of ContentsOperating Expenses (in thousands, except percentages) Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of wages, benefits, bonuses and, with respect to sales and marketing expenses, sales commissions. Personnel costs also include stock-based compensation and travel expenses. Year Ended December 31, 20202019Change in $% ofRevenue$% ofRevenue$%Operating expenses:Research and development$486,594 20.9 %$462,759 19.2 %$23,835 5.2 %Sales and marketing229,366 9.9 213,907 8.9 15,459 7.2 General and administrative66,242 2.9 61,898 2.6 4,344 7.0 Total operating expenses$782,202 33.7 %$738,564 30.7 %$43,638 5.9 %Research and development. Research and development expenses consist primarily of personnel costs, prototype expenses, third-party engineering costs, and an allocated portion of facility and IT costs. Our research and development efforts are focused on new product development and maintaining and developing additional functionality for our existing products, including new releases and upgrades to our EOS software and applications. We expect our research and development expenses to increase in absolute dollars as we continue to invest in software development in order to expand the capabilities of our cloud networking platform, introduce new products and features, and build upon our technology leadership.Research and development expenses increased $23.8 million, or 5.2%, for the year ended December 31, 2020 compared to 2019. The increase was primarily due to a $26.8 million increase in stock-based compensation from new and refresh grants during the current fiscal year, and a $7.8 million increase in acquisition-related expenses and amortization of acquired intangible assets from our acquisition of Big Switch and Awake Security, partially offset by an $11.4 million decrease in new product introduction costs, including third-party engineering and other product development costs.Sales and marketing. Sales and marketing expenses consist primarily of personnel costs, marketing, trade shows, and other promotional activities, and an allocated portion of facility and IT costs. We expect our sales and marketing expenses to increase in absolute dollars as we continue to expand our sales and marketing efforts worldwide.Sales and marketing expenses increased $15.5 million, or 7.2%, for the year ended December 31, 2020 compared to 2019. The increase was driven by increased headcount, resulting in increased compensation costs, including salaries and stock-based compensation, partially offset by a decrease in travel and other sales and marketing activities due to COVID-19. General and administrative. General and administrative expenses consist primarily of personnel costs and professional services costs. General and administrative personnel costs include those for our executive, finance, human resources and legal functions. Our professional services costs are primarily related to external legal, accounting, and tax services. General and administrative expenses increased $4.3 million, or 7.0%, for the year ended December 31, 2020 compared to 2019. The increase was primarily driven by acquisition-related costs from our acquisitions of Big Switch and Awake Security in the current fiscal year. 56Table of ContentsOther Income, Net (in thousands, except percentages)Other income, net consists primarily of interest income from our cash, cash equivalents and marketable securities, gains and losses on our investments in privately-held companies, and foreign currency transaction gains and losses. We expect other income, net may fluctuate in the future as a result of the re-measurement of our private company equity investments upon the occurrence of observable price changes and/or impairments, changes in interest rates or returns on our cash and cash equivalents and marketable securities, and foreign currency exchange rate fluctuations. Year Ended December 31, 20202019Change in $% ofRevenue$% ofRevenue$%Other income, net:Interest income$27,139 1.2 %$51,144 2.2 %$(24,005)(46.9)%Gain on sale of marketable securities9,432 0.4 — — 9,432 100.0 Gain on investments in privately-held companies4,164 0.2 5,427 0.2 (1,263)(23.3)Other income (expense)(1,556)(0.1)(75)— (1,481)1,974.7 Total other income, net$39,179 1.7 %$56,496 2.4 %$(17,317)(30.7)%The unfavorable change in other income, net, during the year ended December 31, 2020 as compared to 2019 was driven by a $24.0 million decrease in interest income largely due to lower interest rates. This was partially offset by a realized gain of $9.4 million on the sale of marketable securities in the third quarter of the year ended December 31, 2020. Provision for Income Taxes (in thousands, except percentages) We operate in a number of tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may also be subject to U.S. income tax. Generally, our U.S. tax obligations are reduced by a credit for foreign income taxes paid on these foreign earnings, which avoids double taxation. Our tax expense to date consists of federal, state and foreign current and deferred income taxes. Year Ended December 31, 20202019Change in $% ofRevenue$% ofRevenue$%Provision for income taxes$104,306 4.5 %$2,403 0.1 %$101,903 4,240.7 Effective tax rate14.1 %0.3 %For the years ended December 31, 2020 and 2019, we recorded an expense of $104.3 million and $2.4 million for income taxes, respectively, and our effective tax rate increased from 0.3% in 2019 to 14.1% in 2020. The change in our income taxes was largely attributable to a net tax benefit of $86 million in 2019 resulting from an intra-entity transaction to sell our non-Americas economic and beneficial intellectual property rights. Further, while we experienced a decrease in worldwide profit before tax in 2020 compared to 2019, the tax benefits attributable to stock-based compensation also decreased, along with an increase in foreign earnings taxed in non-zero rate jurisdictions, resulting in overall higher tax expense. For further information regarding income taxes and the impact on our results of operations and financial position, refer to Note 10. Income Taxes of the Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages) 57Table of Contents Year Ended December 31, 20192018Change in $% ofRevenue$% ofRevenue$%RevenueProduct$2,021,150 83.8 %$1,841,100 85.6 %$180,050 9.8 %Service 389,556 16.2 310,269 14.4 79,287 25.6 Total revenue2,410,706 100.0 2,151,369 100.0 259,337 12.1 Cost of revenueProduct792,382 32.9 720,584 33.5 71,798 10.0 Service 73,986 3.0 57,408 2.7 16,578 28.9 Total cost of revenue866,368 35.9 777,992 36.2 88,376 11.4 Gross profit$1,544,338 64.1 %$1,373,377 63.8 %$170,961 12.4 %Gross margin64.1 %63.8 %Revenue by Geography (in thousands, except percentages)Year Ended December 31,2019% of Total2018% of TotalAmericas$1,833,163 76.1 %$1,550,453 72.1 %Europe, Middle East and Africa 381,651 15.8 414,069 19.2 Asia-Pacific 195,892 8.1 186,847 8.7 Total revenue $2,410,706 100.0 %$2,151,369 100.0 %Revenue Product revenue increased $180.1 million, or 9.8%, in the year ended December 31, 2019 compared to 2018. The increase was primarily driven by increased demand from both new and existing customers, and the recognition of product deferred revenue related to sales in the prior year for which revenue was recognized in 2019. Service revenue increased $79.3 million, or 25.6% in the year ended December 31, 2019 compared to 2018 as a result of continued growth in initial and renewal support contracts as our customer installed base has continued to expand. International revenues represented 23.9% of total revenues in the year ended December 31, 2019, compared to 27.9% in 2018, which was primarily due to a move toward U.S. deployments by certain of our large end customers during 2019. We continue to experience pricing pressure on our products and services due to competition, but demand for our products and growth in our installed base has more than offset this pricing pressure during the year. However, we have experienced reduced and volatile demand from certain of our large end customers during 2019.Cost of Revenue and Gross Margin Cost of revenue increased $88.4 million or 11.4% for the year ended December 31, 2019 compared to 2018. The increase in cost of revenue was primarily due to the corresponding increases in product and service revenues. Gross margin increased to 64.1% for the year ended December 31, 2019 compared to 63.8% in 2018. The increase in gross margin was primarily driven by an increase in product margins due to favorable customer mix, with lower discounts on smaller volume transactions, partially offset by increased product transition costs, including excess and obsolete inventory-related charges.Operating Expenses (in thousands, except percentages)58Table of Contents Year Ended December 31, 20192018Change in $% ofRevenue$% ofRevenue$%Operating expenses:Research and development $462,759 19.2 %$442,468 20.6 %$20,291 4.6 %Sales and marketing 213,907 8.9 187,142 8.7 26,765 14.3 General and administrative61,898 2.6 65,420 3.0 (3,522)(5.4)Legal settlement— — 405,000 18.8 (405,000)(100.0)Total operating expenses$738,564 30.7 %$1,100,030 51.1 %$(361,466)(32.9)%Research and development Research and development expenses increased $20.3 million, or 4.6%, for the year ended December 31, 2019 compared to 2018. The increase was primarily due to a $17.2 million increase in personnel costs driven primarily by headcount growth, and a $7.8 million increase in development-related facilities costs due to facilities expansion and headcount growth, partially offset by a $5.9 million decrease in new product introduction costs, including third-party engineering and other product development costs.Sales and marketing Sales and marketing expenses increased $26.8 million, or 14.3%, for the year ended December 31, 2019 compared to 2018. The increase primarily included a $23.4 million increase in personnel costs, which was driven by increased headcount as well as higher sales volumes, resulting in increased compensation costs, including commissions and stock-based compensation.General and administrativeGeneral and administrative expenses decreased $3.5 million, or 5.4%, for the year ended December 31, 2019 compared to 2018. The decrease was primarily related to a reduced level of litigation activity as a result of the settlement of our litigation with Cisco in August 2018.Legal settlementDuring the three months ended June 30, 2018, we recorded $405.0 million in legal settlement expenses in connection with the Term Sheet that was entered into on August 6, 2018 between the Company and Cisco, which included a $400.0 million payment and $5.0 million of legal fees associated with the settlement. Pursuant to the Term Sheet, the Company and Cisco obtained dismissals of all then ongoing district court and USITC litigation between us. On December 3, 2018, the parties entered into a mutual release and settlement agreement, which superseded the Term Sheet but did not substantially alter the terms. Other Income, Net (in thousands, except percentages) Year Ended December 31, 20192018Change in $% ofRevenue$% ofRevenue$%Other income, net:Interest income$51,144 2.2 %$31,666 1.4 %$19,478 61.5 %Interest expense— — (2,701)(0.1)2,701 (100.0)Gain (loss) on investments in privately-held companies5,427 0.2 (13,800)(0.6)19,227 (139.3)Other income (expense)(75)— 289 — (364)(126.0)Total other income, net$56,496 2.4 %$15,454 0.7 %$41,042 265.6 %59Table of ContentsThe favorable change in other income, net, during the year ended December 31, 2019 as compared to 2018 was driven by a $19.5 million increase in interest income, as we continued to generate cash and expand our marketable securities portfolios, and a $19.2 million favorable change on our investments in privately-held companies resulting from the gain on certain investments of $5.4 million in 2019, compared to a net loss of $13.8 million on these investments during 2018. Upon adoption of Accounting Standard Codification Topic 842 - Leases (“ASC 842”) on January 1, 2019, we derecognized the finance lease obligation associated with our build-to-suit lease, and therefore ceased to incur further interest expense as it relates to this obligation. Provision for (Benefit from) Income Taxes (in thousands, except percentages) Year Ended December 31, 20192018Change in $% ofRevenue$% ofRevenue$%Provision for (benefit from) income taxes$2,403 0.1 %$(39,314)(1.9)%$41,717 (106.1)%Effective tax rate0.3 %(13.6)%For the years ended December 31, 2019 and 2018, we recorded an expense of $2.4 million and a benefit of $39.3 million for income taxes, respectively. The change in our income taxes was largely attributable to a $96.9 million tax benefit from the Cisco settlement in 2018 and an overall increase in worldwide earnings in 2019, partially offset by a net tax benefit of $86 million in 2019 resulting from an intra-entity transaction to sell our non-Americas economic and beneficial intellectual property rights. Liquidity and Capital Resources Our principal sources of liquidity are cash, cash equivalents, marketable securities, and cash generated from operations. As of December 31, 2020, our total balance of cash, cash equivalents and marketable securities was $2.9 billion, of which approximately $421.0 million was held outside the U.S. in our foreign subsidiaries. Our cash, cash equivalents and marketable securities are held for general business purposes including the funding of working capital. Our marketable securities investment portfolio is primarily invested in highly-rated securities, with the primary objective of minimizing the potential risk of principal loss. We plan to continue to invest for long-term growth. We believe that our existing balances of cash, cash equivalents and marketable securities, together with cash generated from operations will be sufficient to meet our working capital requirements and our growth strategies for at least the next 12 months. Our future capital requirements will depend on many factors, including our growth rate, the timing and extent of our spending to support research and development activities, the timing and cost of establishing additional sales and marketing capabilities, the introduction of new and enhanced product and service offerings, our costs associated with supply chain activities, including access to outsourced manufacturing, our costs related to investing in or acquiring complementary or strategic businesses and technologies, the continued market acceptance of our products, and stock repurchases. If we require or elect to seek additional capital through debt or equity financing in the future, we may not be able to raise capital on terms acceptable to us or at all. If we are required and unable to raise additional capital when desired, our business, operating results and financial condition may be adversely affected.60Table of ContentsCash FlowsYear Ended December 31,202020192018(in thousands)Cash provided by operating activities$735,114 $963,034 $503,119 Cash (used in) investing activities (608,802)(284,072)(755,113)Cash (used in) provided by financing activities(346,339)(217,964)42,851 Effect of exchange rate changes1,966 353 (1,390)Net increase (decrease) in cash, cash equivalents and restricted cash$(218,061)$461,351 $(210,533)Cash Flows from Operating ActivitiesOur operating activities consist of net income, adjusted for certain non-cash items, and changes in assets and liabilities.During the year ended December 31, 2020, cash provided by operating activities was $735.1 million, primarily from net income of $634.6 million and net non-cash adjustments to net income of $186.2 million, partially offset by a net increase of $85.7 million in working capital requirements. The net non-cash adjustments primarily consist of $137.0 million of stock-based compensation expenses and $44.6 million of depreciation and amortization expenses. The increase in working capital primarily consisted of a $235.3 million increase in inventory to help mitigate the impact of COVID-19 related supply chain disruptions, partially offset by a $50.4 million increase in deferred revenue, a $41.1 million increase in accounts payable related to the timing of production receipts, and a $17.1 million increase in other liabilities primarily due to an increase in customer contract liabilities. During the year ended December 31, 2019, cash provided by operating activities was $963.0 million, primarily from net income of $859.9 million and net non-cash adjustments to net income of $62.4 million, partially offset by a net decrease of $40.8 million in cash from changes in our operating assets and liabilities. Cash outflows from operating activities consisted of an $11.9 million decrease in deferred revenue primarily due to the recognition of product deferred revenue related to contract acceptance terms, largely offset by increased service deferred revenue related to growth in customer service and support contracts, a $60.2 million increase in accounts receivable due to timing of shipments, and an $8.1 million increase in other assets resulting from increased spares inventory to support our customer base. These cash outflows were partially offset by cash inflows of $54.3 million in prepaid expenses and other current assets from a decrease in deferred cost of inventory due to the recognition of product deferred revenue, $23.5 million from an increase in income taxes payable, $20.9 million decrease in inventories due to timing of product shipments and receipts, and $16.4 million from increased accrued liabilities primarily due to an increase in supplier liability reserves for excess and obsolete component inventory.Cash Flows from Investing ActivitiesOur investing activities consist of our marketable securities investments, business combinations, investments in privately-held companies, and capital expenditures. During the year ended December 31, 2020, cash used in investing activities was $608.8 million, primarily consisting of purchases of available-for-sale securities of $2.7 billion, $227.4 million for the acquisition of Big Switch and Awake Security, and purchases of property, equipment and intangible assets of 15.4 million, partially offset by proceeds of $1.5 billion from maturities of marketable securities, proceeds from the sale of marketable securities of $773.0 million and proceeds from the sale of one of our investments in privately-held companies of $3.4 million.During the year ended December 31, 2019, cash used in investing activities was $284.1 million, primarily consisting of purchases of available-for-sale securities of $1.5 billion, and purchases of property and 61Table of Contentsequipment of 15.8 million, partially offset by proceeds of $1.2 billion from maturities of marketable securities and proceeds from the sale of one of our investments in privately-held companies of $28.2 million.Cash Flows from Financing ActivitiesOur financing activities consist of proceeds from the issuance of our common stock under employee equity incentive plans, offset by repurchases of our common stock.During the year ended December 31, 2020, cash used in financing activities was $346.3 million, consisting primarily of payments for repurchases of our common stock of $395.2 million and taxes paid of $8.7 million upon vesting of restricted stock units, offset partially by proceeds from the issuance of common stock under employee equity incentive plans of $57.6 million.During the year ended December 31, 2019, cash used in financing activities was $218.0 million, consisting primarily of payments for repurchases of our common stock of $266.1 million and taxes paid of $9.2 million upon vesting of restricted stock units, partially offset by proceeds from the issuance of common stock under employee equity incentive plans of $57.4 million.Stock Repurchase ProgramWe have periodically repurchased our common stock pursuant to our Repurchase Program authorized by our board of directors in April 2019. The Repurchase Program allows for stock repurchases of up to $1.0 billion over three years and these repurchases are to be funded from operating cash flows. The Repurchase Program, which expires in April 2022, does not obligate us to acquire any of our common stock, and may be suspended or discontinued by us at any time without prior notice. As of December 31, 2020, the remaining authorized amount for repurchases under the Repurchase Program was $338.7 million. Refer to Note 8. Stockholders' Equity and Stock-Based Compensation of the Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K for further discussion. Off-Balance Sheet ArrangementsAs of December 31, 2020, we did not have any relationships with any unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.Contractual Obligations and CommitmentsOur contractual commitments will have an impact on our future liquidity. Our contractual obligations represent material expected or contractually committed future payment obligations. We believe that we will be able to fund these obligations through cash generated from operations and from our existing balances of cash, cash equivalent and marketable securities. The following summarizes our contractual obligations and commitments as of December 31, 2020 (in thousands): Payments Due by PeriodTotalLess than1 Year1 to 3 Years3 to 5 YearsMore than5 YearsOperating lease obligations104,258 21,770 41,423 21,139 19,926 Purchase commitments with contract manufacturers and suppliers421,857 421,857 — — — Other non-cancellable purchase obligations32,103 32,103 — — Transition tax payable6,343 — — 6,343 — Total$564,561 $475,730 $41,423 $27,482 $19,926 62Table of ContentsThe contractual obligation table above excludes tax liabilities of $46.7 million related to uncertain tax positions because we are unable to make a reasonably reliable estimate of the timing of settlement, if any, of these future payments. In connection with the Tax Cuts and Jobs Act of 2017, we recorded a federal income tax payable for transition tax on the mandatory deemed repatriation of foreign earnings that will be payable over an eight-year period. The amounts included in the table above represent the remaining federal income tax payable after applying the first year's installment payment and early payments of future installments.Critical Accounting Policies and Estimates We have prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States ("GAAP" or "U.S. GAAP") and include our accounts and the accounts of our wholly owned subsidiaries. The preparation of these consolidated financial statements requires our management to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities at the date of the financial statements, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the applicable periods. We base our estimates, assumptions and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances. Different assumptions and judgments would change the estimates used in the preparation of our consolidated financial statements, which, in turn, could change the results from those reported. We evaluate our estimates, assumptions and judgments on an ongoing basis. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected. The critical accounting estimates, assumptions and judgments that we believe have the most significant impact on our consolidated financial statements are the following:Revenue RecognitionWe generate revenue from sales of our products, which incorporate our EOS software and accessories such as cables and optics, to direct customers and channel partners together with PCS. We typically sell products and PCS in a single contract. We recognize revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to be entitled to receive in exchange for those products or services. We apply the following five-step revenue recognition model:•Identification of the contract, or contracts, with a customer•Identification of the performance obligations in the contract•Determination of the transaction price•Allocation of the transaction price to the performance obligations in the contract•Recognition of revenue when (or as) we satisfy the performance obligationPost-Contract Customer SupportPCS, which includes technical support, hardware repair and replacement parts beyond standard warranty, bug fixes, patches and unspecified upgrades on a when-and-if-available basis, is offered under renewable, fee-based contracts. We initially defer PCS revenue and recognize it ratably over the life of the PCS contract as there is no discernible pattern of delivery related to these promises. We do not provide unspecified upgrades on a set schedule and address customer requests for technical support if and when they arise, with the related expenses recognized as incurred. PCS contracts generally have a term of one to three years. We include billed but unearned PCS revenue in deferred revenue. Contracts with Multiple Performance ObligationsMost of our contracts with customers, other than renewals of PCS, contain multiple performance obligations with a combination of products and PCS. Products and PCS generally qualify as distinct performance obligations. Our hardware includes EOS software, which together deliver the essential functionality of our products. For contracts which contain multiple performance obligations, we allocate revenue to each distinct performance obligation based on the standalone selling price (“SSP”). Judgment is 63Table of Contentsrequired to determine the SSP for each distinct performance obligation. We use a range of amounts to estimate SSP for products and PCS sold together in a contract to determine whether there is a discount to be allocated based on the relative SSP of the various products and PCS.If we do not have an observable SSP, such as when we do not sell a product or service separately, then SSP is estimated using judgment and considering all reasonably available information such as market conditions and information about the size and/or purchase volume of the customer. We generally use a range of amounts to estimate SSP for individual products and services based on multiple factors including, but not limited to, the sales channel (reseller, distributor or end customer), the geographies in which our products and services are sold, and the size of the end customer.We limit the amount of revenue recognition for contracts containing forms of variable consideration, such as future performance obligations, customer-specific returns, and acceptance or refund obligations. We include some or all of an estimate of the related at risk consideration in the transaction price only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recorded under each contract will not occur when the uncertainties surrounding the variable consideration are resolved. Most of our contracts with customers have payment terms of 30 days, with some large high volume customers having terms of up to 60 days. We have determined that our contracts generally do not include a significant financing component because the Company and the customer have specific business reasons other than financing for entering into such contracts. Specifically, both we and our customers seek to ensure the customer has a simplified way of purchasing our products and services.We account for multiple contracts with a single partner as one arrangement if the contractual terms and/or substance of those agreements indicate that they may be so closely related that they are, in effect, parts of a single contract.We may occasionally accept returns to address customer satisfaction issues even though there is generally no contractual provision for such returns. We estimate returns for sales to customers based on historical return rates applied against current-period shipments. Specific customer returns and allowances are considered when determining our sales return reserve estimate.Our policy applies to the accounting for individual contracts. However, we have elected a practical expedient to apply the guidance to a portfolio of contracts or performance obligations with similar characteristics so long as such application would not differ materially from applying the guidance to the individual contracts (or performance obligations) within that portfolio. Consequently, we have chosen to apply the portfolio approach when possible, which we do not believe will happen frequently. Additionally, we will evaluate a portfolio of data, when possible, in various situations, including accounting for commissions, rights of return and transactions with variable consideration.We report revenue net of sales taxes. We include shipping charges billed to customers in revenue and the related shipping costs are included in cost of product revenue.Inventory Valuation and Contract Manufacturer/Supplier LiabilitiesInventories primarily consist of finished goods and strategic components, primarily integrated circuits. Inventories are stated at the lower of cost (computed using the first-in, first-out method) and net realizable value. Manufacturing overhead costs and inbound shipping costs are included in the cost of inventory. We record a provision when inventory is determined to be in excess of anticipated demand, or obsolete, to adjust inventory to its estimated realizable value.Our contract manufacturers procure components and assemble products on our behalf based on our forecasts. We record a liability and a corresponding charge for non-cancellable, non-returnable purchase commitments with our contract manufacturers or suppliers for quantities in excess of our demand forecasts or that are considered obsolete due to manufacturing and engineering change orders resulting from design changes. 64Table of ContentsWe use significant judgment in establishing our forecasts of future demand and obsolete material exposures. These estimates depend on our assessment of current and expected orders from our customers, product development plans and current sales levels. If actual market conditions are less favorable than those projected by management, which may be caused by factors within and/or outside of our control, we may be required to increase our inventory write-downs and liabilities to our contract manufacturers and suppliers, which could have an adverse impact on our gross margins and profitability. We regularly evaluate our exposure for inventory write-downs and adequacy of our contract manufacturer/supplier liabilities.Income Taxes Income tax expense is an estimate of current income taxes payable in the current fiscal year based on reported income before income taxes. Deferred income taxes reflect the effect of temporary differences and carryforwards that we recognize for financial reporting and income tax purposes.We account for income taxes under the liability approach for deferred income taxes, which requires recognition of deferred income tax assets and liabilities for the expected future tax consequences of events that have been recognized in our consolidated financial statements, but have not been reflected in our taxable income. Estimates and judgments occur in the calculation of certain tax liabilities and in the determination of the recoverability of certain deferred income tax assets, which arise from temporary differences and carryforwards. Deferred income tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. We regularly assess the likelihood that our deferred income tax assets will be realized based on the positive and negative evidence available. We record a valuation allowance to reduce the deferred tax assets to the amount that we are more likely than not to realize. We believe that we have adequately reserved for our uncertain tax positions, although we can provide no assurance that the final tax outcome of these matters will not be materially different. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made and could have a material impact on our financial condition and results of operations. The provision for income taxes includes the effects of any reserves that we believe are appropriate, as well as the related net interest and penalties.We regularly review our tax positions and benefits to be realized. We recognize tax liabilities based upon our estimate of whether, and to the extent to which, additional taxes will be due when such estimates are more likely than not to be sustained. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. We recognize interest and penalties related to income tax matters as income tax expense.The U.S. tax rules require U.S. tax on foreign earnings, known as global intangible low taxed income (“GILTI”). Under U.S. GAAP, we are allowed to make an accounting policy choice of either (1) treating taxes due on future U.S. inclusions in taxable income related to GILTI as a current-period expense when incurred (the “period cost method”) or (2) factoring such amounts into a company’s measurement of its deferred taxes (the “deferred method”). We selected the deferred method of accounting and recorded the associated basis differences anticipated to influence prospective GILTI calculations.Loss ContingenciesIn the ordinary course of business, we are a party to claims and legal proceedings including matters relating to commercial, employee relations, business practices and intellectual property. In assessing loss contingencies, we use significant judgment and assumptions to estimate the likelihood of loss, impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss. We record a provision for contingent losses when it is both probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. We will record a charge equal to the minimum estimated liability for litigation costs or a loss contingency only when both of the following conditions are met: (i) information available prior to issuance of our consolidated financial statements indicates that it is probable that a liability had been incurred at the date of the financial statements and (ii) the range of loss can be 65Table of Contentsreasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required.Recent Accounting PronouncementsRefer to “Recent Accounting Pronouncements” in Note 1. Organization and Summary of Significant Accounting Policies of the Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K.Item 7A. Quantitative and Qualitative Disclosures About Market RiskWe are exposed to market risk in the ordinary course of our business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates, interest rates and investments in privately-held companies. The ongoing COVID-19 pandemic has increased the volatility of global financial markets, which may increase our foreign currency exchange risk and interest rate risk. For further discussion of the potential impacts of the COVID-19 pandemic on our business, operating results, and financial condition, see Risk Factors included in Part I, Item 1A of this Form 10-K. Foreign Currency Exchange Risk Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. Substantially all of our revenue is denominated in U.S. dollars, and therefore, our revenue is not directly subject to foreign currency risk. However, we are indirectly exposed to foreign currency risk. A stronger U.S. dollar could make our products and services more expensive in foreign countries and therefore reduce demand. A weaker U.S. dollar could have the opposite effect. Such economic exposure to currency fluctuations is difficult to measure or predict because our sales are also influenced by many other factors.Our expenses are generally denominated in the currencies in which our operations are located, which is primarily in the U.S. and to a lesser extent in Europe and Asia. Our results of operations and cash flows are, therefore, subject to fluctuations due to changes in foreign currency exchange rates and may be adversely affected in the future due to changes in foreign exchange rates. A hypothetical 10% change in foreign currency exchange rates on our monetary assets and liabilities would not be material to our financial condition or results of operations. To date, foreign currency transaction gains and losses and exchange rate fluctuations have not been material to our financial statements. While we have not engaged in the hedging of our foreign currency transactions to date and do not enter into any hedging contracts for trading or speculative purposes, we may in the future hedge selected significant transactions denominated in currencies other than the U.S. dollar.Interest Rate SensitivityAs of December 31, 2020 and 2019, we had cash, cash equivalents and available-for-sale marketable securities totaling $2.9 billion and $2.7 billion, respectively. Cash equivalents and marketable securities were invested primarily in money market funds, corporate bonds, U.S. agency mortgage-backed securities, U.S. treasury securities and commercial paper. Our primary investment objectives are to preserve capital and maintain liquidity requirements. In addition, our policy limits the amount of credit exposure to any single issuer. We do not enter into investments for trading or speculative purposes and have not used any derivative financial instruments to manage our interest rate risk exposure. Our primary exposure to market risk is interest income sensitivity, which is affected by changes in the general level of the interest rates in the U.S. A decline in interest rates would reduce our interest income on our cash, cash equivalents and marketable securities. For the years ended December 31, 2020, 2019 and 2018, the effect of a hypothetical 100 basis point increase or decrease in overall interest rates would not have had a material impact on our interest income. On the other hand, the fair market value of our investments in fixed income securities may be adversely impacted. We would incur unrealized losses on fixed income securities if there is an increase in interest rates compared to interest rates at the time of purchase. Under certain circumstances, if we are forced to sell our marketable securities prior to maturity, we may incur realized losses in such investments. However, 66Table of Contentsbecause of the conservative and short-term nature of the investments in our portfolio, a change in interest rates is not expected to have a material impact on our consolidated financial statements.Investments in Privately-Held CompaniesOur non-marketable equity investments in privately-held companies are recorded in “Investments” in our consolidated balance sheets. As of December 31, 2020 and 2019, the total carrying amount of our investments in privately-held companies was $8.3 million and $4.2 million. During fiscal 2020, we recorded a net gain of $4.1 million on certain investments, compared to a net gain of $5.4 million during fiscal 2019. See Note 5. Investments of the Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K for details. The privately-held companies in which we invested are in the startup or development stages. These investments are inherently risky because the markets for the technologies or products these companies are developing are typically in the early stages and may never materialize. We could lose our entire investment in these companies. Our evaluation of investments in privately-held companies is based on the fundamentals of the businesses invested in, including among other factors, the nature of their technologies and potential for financial return.67Table of Contents

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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.The following commentary should be read in conjunction with the consolidated financial statements and accompanying notes.EXECUTIVE OVERVIEWDescription of the Company and Business SegmentsWe manage our business based on three geographic segments: Americas (North and South America), EMEA (Europe, Middle East and Africa) and APAC (Asia-Pacific). Each of our segments provides a broad portfolio of essential healthcare products including acute and chronic dialysis therapies; sterile IV solutions; infusion systems and devices; parenteral nutrition therapies; inhaled anesthetics; generic injectable pharmaceuticals; and surgical hemostat and sealant products. These products are used by hospitals, kidney dialysis centers, nursing homes, rehabilitation centers, doctors’ offices and patients at home under physician supervision. Our global footprint and the critical nature of our products and services play a key role in expanding access to healthcare in emerging and developed countries. For financial information about our segments, see Note 16 in Item 8 of this Annual Report on Form 10-K.Recent Business Combinations and Asset AcquisitionsSeprafilm Adhesion BarrierIn February 2020, we completed the acquisition of the product rights to Seprafilm Adhesion Barrier (Seprafilm) from Sanofi for approximately $342 million in cash. Seprafilm is indicated for use in patients undergoing abdominal or pelvic laparotomy as an adjunct intended to reduce the incidence, extent and severity of postoperative adhesions between the abdominal wall and the underlying viscera such as omentum, small bowel, bladder, and stomach, and between the uterus and surrounding structures such as tubes and ovaries, large bowel, and bladder. Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for additional information regarding the acquisition of Seprafilm.Cheetah MedicalIn October 2019, we acquired 100 percent of Cheetah Medical, Inc. (Cheetah) for total cash consideration of $188 million, net of cash acquired, with the potential for additional cash consideration, up to $40 million, based on clinical and commercial milestones for which the acquisition date fair value was $18 million. Cheetah is a leading provider of hemodynamic monitoring technologies. Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for additional information regarding the acquisition of Cheetah.Recothrom and PreveleakIn March 2018, we acquired two hemostat and sealant products from Mallinckrodt plc: Recothrom Thrombin topical (Recombinant), the first and only stand-alone recombinant thrombin, and Preveleak Surgical Sealant, which is used in vascular reconstruction. The purchase price included an upfront payment of approximately $163 million and potential contingent payments in the future. Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for additional information regarding the acquisition of the Recothrom and Preveleak products.Transderm ScopIn February 2021, we agreed to acquire the rights to Transderm Scop from subsidiaries of GlaxoSmithKline for an upfront purchase price of $55 million plus the cost of acquired inventory and the potential for additional cash consideration of $30 million based upon a successful technology transfer by a specified date. We currently sell this product under a distribution license to the U.S. institutional market. Transderm Scop is indicated for post-operative nausea and vomiting in the U.S. and motion sickness in European markets. We expect the transaction to close late in the first quarter or early in the second quarter of 2021, subject to the satisfaction of closing conditions.Caelyx and DoxilIn December 2020, we agreed to acquire the rights to Caelyx and Doxil, the branded versions of liposomal doxorubicin, from a subsidiary of Johnson & Johnson for specified territories outside of the U.S for $325 million. We previously acquired the U.S. rights to this product in 2019. Liposomal doxorubicin is a chemotherapy medicine used 26to treat various types of cancer. We expect the transaction to close late in the first quarter or early in the second quarter of 2021, subject to the satisfaction of regulatory approvals and other closing conditions.Financial ResultsOur global net sales totaled $11.7 billion in 2020, an increase of 3% over 2019 on both a reported and constant currency basis. International sales totaled $6.8 billion in 2020, an increase of 4% compared to 2019 on a reported basis and 5% on a constant currency basis. Sales in the United States totaled $4.9 billion in 2020, an increase of 1% compared to 2019. Refer to the Net Sales discussion in the Results of Operations section below for more information related to changes in net sales on a constant currency basis. Our income from continuing operations totaled $1.1 billion, or $2.13 per diluted share, in 2020. Income from continuing operations in 2020 included special items which resulted in a net decrease to income from continuing operations of $495 million, or $0.96 per diluted share. Our special items are discussed in the Results of Operations section below.Our financial results included R&D expenses totaling $521 million in 2020, which reflects our focus on balancing investments to support our new product pipeline with efforts to optimize overall R&D spending.Our financial position remains strong, with operating cash flows from continuing operations totaling $1.9 billion in 2020. We have continued to execute on our disciplined capital allocation framework, which is designed to optimize stockholder value creation through reinvestment in our businesses, dividends and share repurchases, as well as acquisitions and other business development initiatives as discussed in the Strategic Objectives section below.Capital expenditures totaled $709 million in 2020 as we continue to invest across our businesses to support future growth, including additional investments in support of new and existing product capacity expansions. Our investments in capital expenditures in 2020 were focused on projects that improve production efficiency and enhance manufacturing capabilities to support our strategy of geographic expansion with select investments in growing markets.We also continued to return value to our stockholders in the form of dividends. During 2020, we paid cash dividends to our stockholders totaling $473 million. Additionally, in 2020 we repurchased 6.3 million shares through cash repurchases pursuant to a Rule 10b5-1 repurchase plan. For information on our share repurchase plans, see Note 8 in Item 8 of this Annual Report on Form 10-K.Strategic ObjectivesWe continue to focus on several key objectives to successfully execute our long-term strategy to achieve sustainable growth and deliver enhanced stockholder value. Our diversified and broad portfolio of medical products that treat life-threatening acute or chronic conditions and our global presence are core components of our strategy to achieve these objectives. We are focused on three strategic factors as part of our pursuit of industry leading performance: optimizing our core portfolio globally; operational excellence focused on streamlining our cost structure and enhancing operational efficiency; and maintaining a disciplined and balanced approach to capital allocation.Optimizing the Core Portfolio GloballyOur global product portfolio optimization strategy identifies products that we believe to have characteristics of core growth, products that we expect to provide us with a core return on capital, products that we intend to maintain or manage differently and products that we consider to be strategic bets. For products with core growth characteristics, we look to invest for long-term, higher margin growth. For products that we expect to generate a core return on capital, we seek to optimize our return on investment and to maintain or enhance our market position. For products that we intend to maintain or manage differently, we look to sustain or reposition our underlying investment. Finally, we are evaluating our market position and investment strategy for products that we consider to be strategic bets.As part of our portfolio management strategy, we seek to optimize our position in product areas where we have a stable, profitable business model, identify and alter investments in products that have reached the end of their life 27cycles or for which market positions have evolved unfavorably. In the course of doing so, we expect to continue to reallocate capital to more promising opportunities or business groupings, as described above.As part of this strategy, we are shifting our investments to drive innovation in product areas where we have compelling opportunities to serve patients and healthcare professionals while advancing our business and we are accelerating the pace in which we bring these advances to market. We are in the midst of launching several new products, geographic expansions and line extensions by 2023 including in such areas as chronic and acute renal care, smart pump technology, hospital pharmaceuticals and nutritionals, surgical sealants, and more. These comprise a mix of entirely new offerings, improvements on existing technologies, and the expansion of current products into new geographies.Operational ExcellenceWe have undertaken a comprehensive review of all aspects of our operations and are actively implementing changes in line with our business goals. As part of our pursuit of improved margin performance, we are working to optimize our cost structure and we are critically assessing optimal support levels in light of our ongoing portfolio optimization efforts. We intend to continue to actively manage our cost structure to help ensure that we are committing resources to the highest value uses. Such high value activities include supporting innovation, building out the portfolio, expanding patient access and accelerating growth for our stockholders.Maintaining Disciplined and Balanced Capital AllocationOur capital allocation strategies include the following:•reinvest in the business by funding opportunities that are positioned to deliver sustainable growth, support our innovation efforts and improve margin performance;•return capital to stockholders through dividends, which we expect to meaningfully increase with earnings growth;•share repurchases; and•identify and pursue accretive merger and acquisition (M&A) opportunities.Responsible Corporate CitizenWe strive for continued growth and profitability, while furthering our focus on acting as a responsible corporate citizen. To us, sustainability means creating lasting social, environmental and economic value by addressing the needs of our wide-ranging stakeholder base. Our comprehensive sustainability program is focused on areas in which we are uniquely positioned to make a positive impact. Priorities include providing employees a safe, healthy and inclusive workplace, fostering a culture that drives integrity, strengthening access to healthcare, enhancing math and science education, and driving environmental performance across the product life cycle, including development, manufacturing and transport. Along with the Baxter International Foundation, we provide financial support and product donations in support of critical needs, from assisting underserved communities to providing emergency relief for countries experiencing natural disasters.Throughout 2020, we continued to implement a range of water conservation strategies and facility-based energy saving initiatives. In the area of product stewardship and life cycle management, we are pursuing efforts such as sustainable design and reduced packaging. We are also responding to the challenges of climate change through innovative greenhouse gas emissions-reduction programs, such as shifting to less carbon-intensive energy sources in manufacturing and transport. Additionally, we monitor our progress against long-term goals to drive continued environmental stewardship while creating healthier, more sustainable communities where our employees work and live.Risk FactorsOur ability to sustain long-term growth and successfully execute the strategies discussed above depends in part on our ability to manage within an increasingly competitive and regulated environment and to address the other risk factors described in Item 1A of this Annual Report on Form 10-K.28RESULTS OF OPERATIONSSpecial ItemsThe following table provides a summary of our special items and the related impact by line item on our results of continuing operations for 2020, 2019 and 2018.years ended December 31 (in millions)202020192018Gross MarginIntangible asset amortization expense$(222)$(183)$(169)Intangible asset impairment1(17)(31)— Business optimization items2(53)(69)(49)Product-related items3(29)— 6 Acquisition and integration expenses4(11)(30)(27)Litigation5— — (8)Hurricane Maria insurance recoveries6— — 32 European medical devices regulation7(33)(25)(6)Investigation and related costs8(3)— — Total Special Items$(368)$(338)$(221)Impact on Gross Margin Ratio(3.1 pts)(3.0 pts)(2.0 pts)Selling, General and Administrative (SG&A) ExpensesBusiness optimization items2$78 $70 $145 Acquisition and integration expenses49 20 23 Litigation5— — 2 Investigation and related costs819 8 — Total Special Items$106 $98 $170 Impact on SG&A Expense Ratio1.0 pts0.9 pts1.5 ptsR&D ExpensesBusiness optimization items2$3 $45 $26 Acquisition and integration expenses422 8 7 European medical devices regulation7— — 3 Investigation and related costs81 — — Total Special Items$26 $53 $36 Impact on R&D Expense Ratio0.3 pts0.4 pts0.3 ptsOther Operating Income, netBusiness optimization items2$(17)$— $— Acquisition and integration expenses4(2)(4)— Hurricane Maria insurance recoveries6— (100)(10)Claris Settlement⁹— — (80)Insurance recoveries from a legacy product-related matter10— (37)— Total Special Items$(19)$(141)$(90)Other (Income) Expense, NetAcquisition and integration activities4$— $— $(24)Pension settlements1143 755 — Loss on debt extinguishment12110 — — Total Special Items$153 $755 $(24)Income Tax ExpenseTax effects of special items and impact of U.S. Tax Reform13$(139)$(387)$(277)Total Special Items$(139)$(387)$(277)Impact on Effective Tax Rate(2.6 pts)(20.9) pts(13.7) pts29Intangible asset amortization expense is identified as a special item to facilitate an evaluation of current and past operating performance and is consistent with how management and our Board of Directors internally assess performance. Additional special items are identified above because they are highly variable, difficult to predict and of a size that may substantially impact our results of operations for a period. Management believes that providing the separate impact of the above items on our results in accordance with U.S. GAAP may provide a more complete understanding of our operations and can facilitate a fuller analysis of our results of operations, particularly in evaluating performance from one period to another. 1In 2020 and 2019, our results included charges of $17 million and $31 million, respectively, for asset impairments related to developed-technology intangible assets. Refer to Note 4 in Item 8 of this Annual Report on Form 10-K for further information regarding these asset impairments.2In 2020, 2019 and 2018, our results were impacted by costs associated with our execution of programs to optimize our organization and cost structure. These actions included streamlining our international operations, rationalizing our manufacturing facilities, reducing our general and administrative infrastructure, re-aligning certain R&D activities and canceling certain R&D programs. Our results in 2020, 2019 and 2018 included business optimization charges of $134 million, $184 million and $220 million, respectively. Additionally, we recognized a gain of $17 million in 2020 for property we sold in conjunction with our business optimization initiatives. Refer to Note 10 in Item 8 of this Annual Report on Form 10-K for further information regarding these charges and related liabilities. 3Our results in 2020 included a charge of $29 million related to Sigma Spectrum infusion pump inspection and remediation activities. Our results in 2018 included a net benefit of $6 million related to an adjustment to our accrual for Sigma Spectrum infusion pump inspection and remediation activities. 4Our results in 2020 included $40 million of acquisition and integration expenses related to the acquisitions of Cheetah and Seprafilm and in-process R&D assets, partially offset by a benefit related to the change in the estimated fair value of contingent consideration liabilities. Our results in 2019 included $54 million of acquisition and integration expenses. This included integration expenses relate to our acquisitions of Claris Injectables Limited (Claris) and the Recothrom and Preveleak products in prior periods, as well as the 2019 acquisitions of Cheetah and in-process R&D assets, partially offset by a benefit related to the change in the estimated fair value of contingent consideration liabilities. Our results in 2018 included $33 million of acquisition and integration costs related to our acquisitions of Claris and the Recothrom and Preveleak products, upfront payments related to R&D collaborations and license agreements, and a gain from remeasuring our previously held investment to fair value upon acquisition of a controlling interest in our joint venture in Saudi Arabia. Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for further information regarding business development activities. 5Our results in 2018 included charges of $10 million related to certain product litigation. 6Our results in 2019 and 2018 included benefits of $100 million and $42 million, respectively, related to insurance recoveries as a result of losses incurred due to Hurricane Maria. Refer to Note 7 in Item 8 of this Annual Report on Form 10-K for further information.7Our results in 2020, 2019 and 2018 included costs of $33 million, $25 million and $9 million, respectively, related to updating our quality systems and product labeling to comply with the new medical device reporting regulation and other requirements of the European Union’s regulations for medical devices that are scheduled to become effective in 2021.8Our results in 2020 and 2019 included charges of $23 million and $8 million, respectively, for investigation and related costs. This included $15 million in 2020 and $8 million in 2019 related to our investigation of foreign exchange gains and losses associated with certain intra-company transactions and related legal matters. Additionally, we recorded incremental stock compensation expense of $8 million in 2020 as we extended the term of certain stock options that were scheduled to expire in the first quarter of 2020. Refer to Notes 7 and 8 in Item 8 of this Annual Report on Form 10-K for further information regarding the investigation and stock compensation expense.309Our results in 2018 included a benefit of $80 million for the settlement of certain claims related to the acquired operations of Claris. Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for further information.10Our results in 2019 included a benefit of $37 million for our allocation of insurance proceeds received pursuant to a settlement and cost-sharing arrangement for a legacy product-related matter. Refer to Note 7 in Item 8 of this Annual Report on Form 10-K for further information.11Our results in 2020 included a charge of $43 million related to lump-sum settlement distributions made to certain former U.S. employees with vested pension benefits. Our results in 2019 included a charge of $755 million related to the annuitization of a portion of our U.S. pension plan. Refer to Note 11 in Item 8 of this Annual Report on Form 10-K for further information regarding the lump-sum settlements and the pension annuitization.12Our results in 2020 included a loss of $110 million on the November 2020 early extinguishment of $750 million of 3.75% senior notes that were issued in March 2020. Refer to Note 5 in Item 8 of this Annual Report on Form 10-K for further information.13Reflected in this item is the income tax impact of the special items identified in this table. The tax effect of each special item is based on the jurisdiction in which the item was incurred and the tax laws in effect for each such jurisdiction. Additionally, our results in 2019 included a net tax benefit of $125 million related to income tax reform in Switzerland and India and an adjustment for U.S. federal tax reform. Our results in 2018 included a net tax benefit of $196 million related to updates to the estimated impact of U.S. federal tax reform previously made in 2017. Net Sales Percent changeAt actualcurrency ratesAt constantcurrency ratesyears ended December 31 (in millions)2020201920182020201920202019United States$4,878 $4,826 $4,723 1 %2 %1 %2 %International6,795 6,536 6,376 4 %3 %5 %7 %Total net sales$11,673 $11,362 $11,099 3 %2 %3 %5 %Net sales for the year ended December 31, 2020 increased 3% at actual and constant currency rates. Net sales for the year ended December 31, 2019 increased 2% at actual rates and 5% at constant currency rates.Foreign currency exchange rates had no net impact on 2020 net sales growth. Foreign currency exchange rates unfavorably impacted 2019 net sales growth by three percentage points principally due to the strengthening of the U.S Dollar relative to the Euro, Australian Dollar, British Pound, Chinese Yuan and Colombian Peso. The comparisons presented at constant currency rates reflect current year local currency sales at the prior year’s foreign exchange rates. This measure provides information on the change in net sales assuming that foreign currency exchange rates had not changed between the prior and the current period. We believe that the non-GAAP measure of change in net sales at constant currency rates, when used in conjunction with the U.S. GAAP measure of change in net sales at actual currency rates, may provide a more complete understanding and facilitate a fuller analysis of our results of operations, particularly in evaluating performance from one period to another.In 2020, the acquisition of Seprafilm contributed $94 million in revenue. In 2020 and 2019, the acquisition of Cheetah had an insignificant impact on reported revenues. The Recothrom and Preveleak products acquired in 2018 contributed $80 million and $52 million of revenues in 2019 and 2018, respectively. Our global operations expose us to risks associated with public health crises and epidemics/pandemics, such as the COVID-19 pandemic. COVID-19 has had, and we expect will continue to have, an adverse impact on our operations, supply chains and distribution systems and has increased and we expect will continue to increase our expenses, including as a result of impacts associated with preventive and precautionary measures that we, other businesses and governments are taking. These measures have led to unprecedented restrictions on, disruptions in, and other related impacts on businesses and personal activities. In addition to travel restrictions put in place in early 312020, governments have closed borders, imposed prolonged quarantines and may continue those measures or implement other restrictions and requirements in light of the continuing spread of the pandemic. We expect that these evolving restrictions and requirements, as well as the corresponding need to adapt to new methods of conducting business remotely, will continue to have an adverse effect on our business. For further discussion, refer to the Global Business Unit Net Sales Reporting section below and Item 1A of this Annual Report on Form 10-K.Global Business Unit Net Sales ReportingOur global business units (GBUs) include the following:•Renal Care includes sales of our peritoneal dialysis (PD), hemodialysis (HD) and additional dialysis therapies and services.•Medication Delivery includes sales of our intravenous (IV) therapies, infusion pumps, administration sets and drug reconstitution devices. •Pharmaceuticals includes sales of our premixed and oncology drug platforms, inhaled anesthesia and critical care products and pharmacy compounding services.•Clinical Nutrition includes sales of our parenteral nutrition (PN) therapies and related products.•Advanced Surgery includes sales of our biological products and medical devices used in surgical procedures for hemostasis, tissue sealing and adhesion prevention. •Acute Therapies includes sales of our continuous renal replacement therapies (CRRT) and other organ support therapies focused in the intensive care unit (ICU).•Other primarily includes sales of contract manufacturing services from our pharmaceutical partnering business.The following is a summary of net sales by GBU.Percent changeAt actualcurrency ratesAt constantcurrency ratesyears ended December 31 (in millions)2020201920182020201920202019Renal Care$3,757 $3,639 $3,651 3 %— %4 %3 %Medication Delivery2,735 2,799 2,664 (2)%5 %(2)%7 %Pharmaceuticals2,123 2,155 2,087 (1)%3 %(1)%6 %Clinical Nutrition922 872 875 6 %— %6 %3 %Advanced Surgery888 877 798 1 %10 %1 %12 %Acute Therapies740 535 515 38 %4 %39 %7 %Other508 485 509 5 %(5)%4 %(2)%Total Baxter$11,673 $11,362 $11,099 3 %2 %3 %5 %Renal Care net sales increased 3% in 2020 and were flat in 2019. The increase in 2020 was driven by global patient growth in PD, partially offset by a 1% negative impact from foreign exchange rate changes, as compared to the prior-year period. Global patient growth in PD in 2019 was offset by lower U.S. in-center HD sales and a 3% negative impact from foreign exchange rate changes, as compared to the prior-year period. Medication Delivery net sales decreased 2% in 2020 and increased 5% in 2019. The decrease in 2020 was primarily driven by lower demand for our infusion systems and related IV administration sets and solutions due to lower hospital admission rates and a reduction in elective surgeries resulting from the COVID-19 pandemic, including the impact from shelter in place initiatives as well as patient safety concerns related to potential COVID-19 infection risk. The increase in 2019 was attributable to increased sales of our Spectrum IQ Infusion System in the U.S. and EVO IQ Infusion System internationally and related IV access administration sets. Changes in foreign exchange rates had a negative impact on Medication Delivery net sales of 2% in 2019, compared to the prior-year period. Pharmaceuticals net sales decreased 1% in 2020 and increased 3% in 2019. The decrease in 2020 was driven by lower demand for inhaled anesthesia products resulting from the COVID-19 pandemic and new competitive entrants for TransDerm Scop. Those impacts were partially offset by increased demand for our international pharmacy compounding services along with certain generic injectables and a nonrecurring purchase from the U.S. 32government. The increase in 2019 was due to growth in international pharmacy compounding sales and increased sales of our generic injectables. Partially offsetting those increases were reduced sales of inhaled anesthetics as well as BREVIBLOC and U.S. cylophosphamide due to increased generic competition. Changes in foreign exchange rates had a negative impact on Pharmaceuticals net sales of 3% in 2019, compared to the prior-year period. Clinical Nutrition net sales increased 6% in 2020 and were flat in 2019. The increase in 2020 was driven by increased demand for our PN therapies and related products, recent product launches and competitor shortages of amino acids. A positive impact on net sales in 2019 from the launch of new products was offset by a 3% negative impact from foreign exchange rate changes, as compared to the prior-year period. Advanced Surgery net sales increased 1% and 10% in 2020 and 2019, respectively. The increase in 2020 was driven by the acquisition of Seprafilm, which contributed $94 million in net sales during 2020, and a benefit from increased demand for our hemostats and sealants early in the year due, in part, to competitive supply disruptions. Partially offsetting the increase was the impact of the COVID-19 pandemic as many elective surgeries were postponed. The increase in 2019 was primarily driven by higher sales as a result of a temporary supply disruption of a competitor, partially offset by a 2% negative impact from foreign exchange rate changes, as compared to the prior-year period. Acute Therapies net sales increased 38% and 4% in 2020 and 2019, respectively. The increase in 2020 was driven by increased global demand for our CRRT systems to treat acute kidney injuries during the COVID-19 pandemic, partially offset by a 1% negative impact from foreign exchange rate changes, as compared to the prior-year period. The increase in 2019 was due to higher global demand for our CRRT systems to treat acute kidney injuries, including the launch of PrisMax in several countries across the Americas, Europe and Asia. Partially offsetting the increase in 2019 was a 3% negative impact from foreign exchange rate changes, as compared to the prior-year period.Other net sales increased 5% in 2020 and decreased 5% in 2019. The increase in 2020 was driven by increased demand for our contract manufacturing services and a 1% positive impact from foreign exchange rate changes, as compared to the prior-year period. The decrease in 2019 was due to strong sales performance in 2018 and a 3% negative impact from foreign exchange rate changes, as compared to the prior-year period. Gross Margin and Expense Ratios20202019years ended December 312020% of net sales2019% of net sales2018% of net sales$ change% change$ change% changeGross margin$4,587 39.3 %$4,761 41.9 %$4,759 42.9 %$(174)(3.7)%$2 — %SG&A$2,469 21.2 %$2,535 22.3 %$2,620 23.6 %$(66)(2.6)%$(85)(3.2)%R&D$521 4.5 %$595 5.2 %$654 5.9 %$(74)(12.4)%$(59)(9.0)%Gross MarginThe gross margin ratio was 39.3%, 41.9% and 42.9% in 2020, 2019 and 2018, respectively. The special items identified above had an unfavorable impact of 3.1, 3.0 and 2.0 percentage points on the gross margin ratio in 2020, 2019 and 2018, respectively. Refer to the Special Items section above for additional detail.Excluding the impact of the special items, the gross margin ratio decreased 2.5 percentage points in 2020 compared to 2019 due to an unfavorable product mix, additional compensation costs, primarily for our manufacturing employees, reduced manufacturing efficiencies and incremental logistics costs, all resulting from the COVID-19 pandemic.Excluding the impact of the special items, the gross margin ratio was unchanged in 2019 compared to 2018. The gross margin ratio was impacted by an unfavorable product mix as well as inventory write-downs and incremental costs relating to improvements at a dialyzer facility in the U.S. that experienced manufacturing issues during the second quarter of 2019, offset by manufacturing efficiencies.33SG&AThe SG&A expenses ratio was 21.2%, 22.3% and 23.6% in 2020, 2019 and 2018, respectively. The special items identified above had an unfavorable impact of 1.0, 0.9 and 1.5 percentage points on the SG&A expenses ratio in 2020, 2019 and 2018, respectively. Refer to the Special Items section above for additional detail.Excluding the impact of the special items, the SG&A expenses ratio decreased 1.2 percentage points in 2020 primarily due to lower bonus accruals under our annual employee incentive compensation plans, actions we took to restructure our cost position and focus on expense management and reduced travel and related expenses due to the COVID-19 pandemic.Excluding the impact of the special items, the SG&A expenses ratio decreased 0.7 percentage points in 2019 primarily due to actions we took to restructure our cost position and focus on expense management.R&DThe R&D expenses ratio was 4.5%, 5.2% and 5.9% in 2020, 2019 and 2018, respectively. The special items identified above had an unfavorable impact of 0.3, 0.4 and 0.3 percentage points on the R&D expenses ratio in 2020, 2019 and 2018, respectively. Refer to the Special Items section above for additional detail.Excluding the impact of the special items, the R&D expenses ratio decreased 0.6 percentage points in 2020 as a result of reduced project-related expenditures compared to the prior year and actions we took to restructure our cost position and focus on expense management.Excluding the impact of the special items, the R&D expenses ratio decreased 0.8 percentage points in 2019 as a result of reduced project-related expenditures compared to the prior year and actions we took to restructure our cost position and focus on expense management.Business Optimization ItemsIn recent years, we have undertaken actions to transform our cost structure and enhance our operational efficiency. These efforts have included restructuring the organization, optimizing our manufacturing footprint, R&D operations and supply chain network, employing disciplined cost management, and centralizing and streamlining certain support functions. From the commencement of our business optimization actions in the second half of 2015 through December 31, 2020, we have incurred cumulative pre-tax costs of $1.1 billion related to these actions. The costs consisted primarily of employee termination costs, implementation costs, contract termination costs, asset impairments, and accelerated depreciation. We currently expect to incur additional pre-tax costs of approximately $14 million through the completion of the initiatives that are currently underway, primarily related to implementation costs. We continue to pursue cost savings initiatives and, to the extent further cost savings opportunities are identified, we may incur additional restructuring charges and costs to implement business optimization programs in future periods. The reductions in our cost base from these actions in the aggregate are expected to provide cumulative annual pretax savings of more than $1.2 billion once the remaining actions are complete. The savings from these actions will impact cost of sales, SG&A expenses, and R&D expenses. Approximately 95 percent of the expected annual pre-tax savings has been realized through December 31, 2020, with the remainder expected to be realized by the end of 2023. Refer to Note 10 in Item 8 of this Annual Report on Form 10-K for additional information regarding our business optimization programs.Other Operating Income, NetOther operating income, net was $19 million, $141 million and $99 million in 2020, 2019 and 2018, respectively. In 2020, we recognized a $17 million gain on the sale of property in conjunction with our business optimization initiatives. In 2020 and 2019, we recognized benefits of $2 million and $4 million, respectively, related to the change in the estimated fair value of contingent consideration liabilities. In 2019 and 2018, we recognized $100 million and $10 million, respectively, of insurance recoveries related to losses incurred due to Hurricane Maria within Other operating income, net. In 2019, we also recognized a benefit of $37 million when our share of the proceeds under a cost-sharing agreement became realizable following the resolution of a dispute with an insurer related to a legacy product-related matter. In 2018, we settled certain claims with the seller related to the acquired operations of Claris, which resulted in a benefit of $80 million. Additionally, included in other operating income in 2018 was $9 million of transition service income earned in connection with our separation of Baxalta in 2015. The agreement for these services terminated as of July 1, 2018.34Interest Expense, NetInterest expense, net was $134 million, $71 million and $45 million in 2020, 2019 and 2018, respectively. The increase in 2020 was primarily driven by higher average debt outstanding as a result of the March 2020 issuance of $750 million of 3.75% senior notes due October 2025 and $500 million of 3.95% senior notes due April 2030, and the May 2019 issuance of €750 million of 0.40% senior notes due May 2024 and €750 million of 1.3% senior notes due May 2029. The 3.75% senior notes due October 2025 were repaid in November 2020 with the proceeds from the issuance of $650 million of 1.73% senior notes due April 2031 and cash on hand. The increase in 2019 was primarily driven by higher average debt outstanding as a result of the issuance of €750 million of 0.40% senior notes due May 2024 and €750 million of 1.3% senior notes due May 2029. Refer to Note 5 in Item 8 of this Annual Report on Form 10-K for a summary of the components of interest expense, net for 2020, 2019 and 2018.Other (Income) Expense, NetOther (income) expense, net was an expense of $190 million in 2020, expense of $731 million in 2019 and income of $78 million in 2018. The net expense in 2020 was primarily driven by a $110 million loss on the early extinguishment of debt related to our November 2020 redemption of $750 million of senior notes that were issued in March 2020, foreign exchange net losses of $49 million and $46 million of pension settlement charges, which included a $43 million charge related to lump-sum settlement distributions made to certain former U.S. employees with vested pension benefits. These expenses in 2020 were partially offset by net unrealized gains of $13 million related to marketable equity securities. The net expense in 2019 was primarily driven by a $755 million pension settlement charge related to the transfer of U.S. pension plan liabilities to an insurance company and $37 million of foreign exchange net losses, partially offset by $53 million of pension and OPEB plan net benefits. The income in 2018 was primarily driven by $49 million of pension and OPEB plan net benefits, a $24 million gain from remeasuring our previously held investment to fair value upon acquisition of a controlling interest in our joint venture in Saudi Arabia and foreign exchange net gains of $14 million.We expect expenses from pension and OPEB plans to increase in 2021 primarily due to lower discount rates and a lower expected return on assets. Refer to Note 11 in Item 8 of this Annual Report on Form 10-K for further information regarding pension and OPEB plan expenses.Income Taxes The effective income tax rate for continuing operations was 14.1% in 2020, (4.2)% in 2019, and 4.0% in 2018. The special items identified above had a favorable impact of 2.6, 20.9 and 13.7 percentage points on the effective income tax rate in 2020, 2019 and 2018, respectively. Refer to the Special Items section above for additional detail. Our effective income tax rate can differ from the 21% U.S. federal statutory rate due to a number of factors, including foreign rate differences, tax incentives, increases or decreases in valuation allowances and liabilities for uncertain tax positions and excess tax benefits on stock compensation awards.For the twelve months ended December 31, 2020, the difference between our effective income tax rate and the U.S. federal statutory rate was primarily attributable to favorable geographic earnings mix and excess tax benefits on stock compensation awards. For the twelve months ended December 31, 2019, the difference between our effective income tax rate and the U.S. federal statutory rate was primarily due to special items, the most significant of which was the impact of recently enacted tax reform in Switzerland and India. We recognized a deferred tax benefit of $90 million to reflect a tax basis step-up, net of a valuation allowance, partially offset by a $5 million deferred tax revaluation to reflect an increase in the statutory tax rate, under the newly enacted Swiss tax laws. We also recognized a net deferred tax benefit of $24 million associated with deferred tax revaluation in India to reflect a decrease in the statutory tax rate. In addition to the Swiss and Indian tax reform impacts, our effective rate in 2019 was different from the U.S. federal statutory rate due to the recognition of tax benefits associated with a favorable tax ruling, a benefit related to a notional interest deduction on the share capital of a foreign subsidiary, and excess tax benefits on stock compensation awards. For the twelve months ended December 31, 2018, the difference between our effective income tax rate and the U.S. federal statutory rate was primarily due to special items, the most significant of which was our finalization of our provisional adjustments resulting from the 2017 Tax Act. SEC Staff Accounting Bulletin 118 (SAB 118) allowed a one-year measurement period from the December 22, 2017 Tax Act enactment date to refine the provisional amounts recognized in the 2017 financial statements. 35 We recorded several SAB 118 measurement period provisional adjustments in 2018. First, after further studying the 2017 Tax Act and related U.S. Treasury Regulations, we refined our provisional estimate of a full valuation allowance against our U.S. foreign tax credit deferred tax assets and released a $194 million valuation allowance due to our ability to utilize a portion of our U.S. foreign tax credit deferred tax assets. Second, the 2017 Tax Act requires us to pay U.S. income taxes on accumulated foreign subsidiary earnings not previously subject to U.S. income tax at a rate of 15.5% to the extent of foreign cash and certain other net current assets and 8% on the remaining earnings. During 2018, we refined our estimated one-time transition tax expense, recognizing a benefit of $5 million. Third, the 2017 Tax Act lowered the U.S. federal rate from 35% to 21% and generally exempts foreign income from U.S. taxation. We finalized our provisional revaluation of U.S. deferred tax assets, recording an additional $8 million benefit. Refer to Note 12 in Item 8 of this Annual Report on Form 10-K for further information related to the 2017 Tax Act and the finalization of associated SAB 118 provisional adjustments. Additionally, our effective rate in 2018 was different from the U.S. federal statutory rate due to excess tax benefits on stock compensation. Our tax provisions for 2020, 2019 and 2018 do not include any tax charges related to either the Base Erosion and Anti-Abuse Tax (BEAT) or Global Intangible Low Taxed Income (GILTI) provisions, except for the inability to fully utilize foreign tax credits against such GILTI. We anticipate that our effective income tax rate from continuing operations, calculated in accordance with U.S. GAAP, will be approximately 18% in 2021. This rate may be further impacted by a number of factors including discrete items, such as tax windfalls or deficiencies attributable to stock compensation awards, additional audit developments, or the tax effects of any future special items.Income from Continuing Operations and Earnings per Diluted ShareIncome from continuing operations was $1.1 billion in 2020, $1.0 billion in 2019 and $1.6 billion in 2018. Diluted earnings per share from continuing operations was $2.13 in 2020, $1.93 in 2019 and $2.84 in 2018. The significant factors and events causing the net changes from 2019 to 2020 and 2018 to 2019 are discussed above. Additionally, earnings per share from continuing operations was positively impacted by the repurchase of 35.8 million shares in 2018 through Rule 10b5-1 purchase plans, an accelerated share repurchase plan and otherwise and the repurchase of 16.5 million shares in 2019 through Rule 10b5-1 purchase plans, an accelerated share repurchase plan and otherwise. Refer to Note 8 in Item 8 of this Annual Report on Form 10-K for further information regarding our stock repurchases.Loss from Discontinued OperationsLoss from discontinued operations, net of tax was $6 million in 2018 and related to Baxalta.Segment resultsWe use operating income on a segment basis to make resource allocation decisions and assess the ongoing performance of our segments. Refer to Note 16 in Item 8 of this Annual Report on Form 10-K for additional details regarding our segments. The following is a summary of significant factors impacting our reportable segments’ financial results.Net salesOperating incomeyears ended December 31 (in millions)202020192018202020192018Americas$6,069 $6,094 $5,951 $2,235 $2,374 $2,411 EMEA3,129 2,968 2,946 677 652 666 APAC2,475 2,300 2,202 591 549 532 Corporate and other— — — (1,887)(1,803)(2,025)Total$11,673 $11,362 $11,099 $1,616 $1,772 $1,584 AmericasSegment operating income was $2.2 billion, $2.4 billion and $2.4 billion in 2020, 2019 and 2018, respectively. The decrease in 2020 was primarily driven by decreased sales and gross margin in multiple GBUs, particularly Medication Delivery, Pharmaceuticals and Advanced Surgery, and lower gross profit as a result of an unfavorable product mix and incremental logistics costs due primarily to the impact of the COVID-19 pandemic. The decreases 36were partially offset by favorable performance in Acute Therapies and Clinical Nutrition as well as the acquisition of Seprafilm. The decrease in 2019 was primarily driven by lower sales and gross margin in Pharmaceuticals and lower U.S. in-center HD sales, partially offset by favorable performance in Medication Delivery and Advanced Surgery, primarily due to a temporary supply disruption of a competitor. Additionally, results in 2019 were adversely impacted by unfavorable foreign exchange rates. EMEASegment operating income was $677 million, $652 million and $666 million in 2020, 2019 and 2018, respectively. The increase in 2020 was primarily driven by increased sales and gross margin in Acute Therapies, Clinical Nutrition, Pharmaceuticals and Renal Care, partially offset by decreased sales in Advanced Surgery. The decrease in 2019 was primarily driven by unfavorable foreign exchange rates, partially offset by increased local currency sales and gross margin in Renal Care and Pharmaceuticals. APACSegment operating income was $591 million, $549 million and $532 million in 2020, 2019 and 2018, respectively. The increase in 2020 was primarily driven by increased sales and gross margin in multiple GBUs, particularly Renal Care, Acute Therapies and Pharmaceuticals. The acquisition of Seprafilm also positively contributed to results in 2020. Results in 2019 were driven by higher sales and gross margin, primarily from China and Australia, in Renal Care and Pharmaceuticals. Corporate and otherCertain items are maintained at Corporate and are not allocated to a segment. They primarily include certain foreign currency hedging activities, corporate headquarters costs, certain R&D costs, certain GBU support costs, stock compensation expense, certain employee benefit plan costs, and certain gains, losses, and other charges (such as business optimization, acquisition and integration costs, intangible asset amortization and asset impairments). The operating loss in 2020 was higher than 2019 due to insurance recoveries received in 2019 from a legacy product-related matter and Hurricane Maria, as well as the Sigma Spectrum infusion pump inspection and remediation charge in 2020 and higher investigation and related costs and intangible asset amortization in 2020. Partially offsetting the increase in 2020 was lower business optimization charges, lower intangible asset impairment charges, lower bonus accruals under our annual employee incentive compensation plans and reduced travel and related expenses. The operating loss in 2019 decreased due to higher Hurricane Maria insurance recoveries in 2019, a benefit for our allocation of insurance proceeds received pursuant to a settlement and cost-sharing arrangement for a legacy product-related matter in 2019, lower SG&A and R&D expenses in 2019 and lower business optimization charges in 2019, partially offset by an impairment of a developed-technology intangible asset in 2019 and the benefit from the Claris settlement in 2018. LIQUIDITY AND CAPITAL RESOURCESCash Flows from Operations — Continuing OperationsIn 2020, 2019 and 2018, cash provided by operating activities was $1.9 billion, $2.1 billion and $2.0 billion, respectively. Operating cash flows decreased in 2020 primarily due to payments of $173 million to settle interest rate derivative contracts in 2020, an increase in inventory levels in 2020 and insurance recoveries received in 2019 from a legacy product-related matter and Hurricane Maria, partially offset by the timing of vendor payments and lower restructuring and employee incentive compensation payments in 2020. Operating cash flows increased in 2019 primarily due to an increase in our operating income, which included the insurance recoveries related to Hurricane Maria and a legacy product-related matter. Cash Flows from Investing ActivitiesIn 2020, cash used for investing activities included payments for acquisitions of $494 million, primarily related to Seprafilm and multiple product acquisitions, and capital expenditures of $709 million. In 2019, cash used for investing activities included payments for acquisitions of $418 million, primarily related to Cheetah and multiple product acquisitions, and capital expenditures of $696 million. In 2018, cash used in investing activities included 37payments for acquisitions of $268 million, primarily related to Recothrom and Preveleak and multiple product acquisitions, and capital expenditures of $659 million.We expect that our capital expenditures will increase in 2021 as we make investments in our manufacturing capacity in response to proposed regulatory changes of the U.S. Department of Health and Human Services in kidney health policy and reimbursement, which may substantially change the U.S. end stage renal disease market and demand for our peritoneal dialysis products.In February 2021, we agreed to acquire the rights to Transderm Scop from subsidiaries of GlaxoSmithKline for an upfront purchase price of $55 million plus the cost of acquired inventory and the potential for additional cash consideration of $30 million based upon a successful technology transfer by a specified date. We expect the transaction to close late in the first quarter or early in the second quarter of 2021, subject to the satisfaction of closing conditions.In December 2020, we agreed to acquire the rights to Caelyx and Doxil, the branded versions of liposomal doxorubicin, from a subsidiary of Johnson & Johnson for specified territories outside of the U.S for $325 million. We expect the transaction to close late in the first quarter or early in the second quarter of 2021, subject to the satisfaction of regulatory approvals and other closing conditions.Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for further information about our significant acquisitions and other arrangements.Cash Flows from Financing ActivitiesIn 2020, cash generated from financing activities included $1.2 billion of net proceeds from the March 2020 issuance of $750 million of senior notes due in 2025 and $500 million of senior notes due in 2030. In November 2020, we issued $650 million of senior notes due in 2031 and used the proceeds, along with cash on hand, to redeem the $750 million senior notes due in 2025 that were issued in March 2020 for $854 million, which included a $104 million make-whole premium. We have used the net proceeds from the senior notes issuances and redemptions for general corporate purposes, including to strengthen our balance sheet as a precautionary measure in light of the COVID-19 pandemic. In 2020, we also repaid $322 million of variable rate notes that matured and the borrowings under our Euro-denominated credit facility of €200 million ($225 million). Financing activities in 2020 also included payments for stock repurchases of $500 million, dividend payments of $473 million and receipts from stock issued under employee benefit plans of $202 million.In 2019, cash generated from financing activities included $1.7 billion in net proceeds from the issuance of €750 million of senior notes due in 2024 and €750 million of senior notes due in 2029, €200 million ($222 million) of borrowings under our Euro-denominated credit facility and stock issued under employee benefit plans of $356 million, partially offset by payments for stock repurchases of $1.3 billion and dividend payments of $423 million. In 2018, cash used for financing activities included payments for stock repurchases of $2.5 billion and dividend payments of $376 million, partially offset by the proceeds from stock issued under employee benefit plans of $258 million.As authorized by the Board of Directors, we repurchase our stock depending upon our cash flows, net debt levels and market conditions. In July 2012, the Board of Directors authorized the repurchase of up to $2.0 billion of our common stock. The Board of Directors increased this authority by an additional $1.5 billion in each of November 2016 and February 2018, by an additional $2.0 billion in November 2018 and by an additional $1.5 billion in October 2020. We paid $500 million in cash to repurchase approximately 6.3 million shares under this authority pursuant to a Rule 10b5-1 plan in 2020 and had $1.9 billion remaining available under this authorization as of December 31, 2020.In December 2018, we entered into a $300 million accelerated share repurchase agreement (ASR Agreement) with an investment bank. We funded the ASR Agreement with available cash. Under the ASR Agreement, we received 3.6 million shares upon execution. Based on the volume-weighted average price of our common stock during the term of the ASR Agreement, we received an additional 0.6 million shares from the investment bank at settlement in May 2019.38Credit Facilities and Access to Capital and Credit RatingsCredit FacilitiesAs of December 31, 2020, our U.S. dollar-denominated revolving credit facility had capacity of $2.0 billion. As of December 31, 2020, our Euro-denominated revolving credit facility had a capacity of approximately €200 million. Each of the facilities matures in 2024. There were no amounts outstanding under our credit facilities as of December 31, 2020. There was no amount outstanding under our U.S. dollar-denominated credit facility as of December 31, 2019 and €200 million ($224 million) was outstanding at a 0.91% interest rate under our Euro-denominated credit facility as of December 31, 2019. As of December 31, 2020, we were in compliance with the financial covenants in these agreements. The non-performance of any financial institution supporting either of the credit facilities would reduce the maximum capacity of these facilities by the institution’s respective commitment. We also maintain other credit arrangements, as described in Note 5 in Item 8 of this Annual Report on Form 10-K.Access to Capital and Credit RatingsWe intend to fund short-term and long-term obligations as they mature through cash on hand and future cash flows from operations or by issuing additional debt. We had $3.7 billion of cash and cash equivalents as of December 31, 2020, with adequate cash available to meet operating requirements in each jurisdiction in which we operate. We invest our excess cash in money market and other funds and diversify the concentration of cash among different financial institutions. As of December 31, 2020, we had approximately $6.2 billion of long-term debt and finance lease obligations, including current maturities. Subject to market conditions, we regularly evaluate opportunities with respect to our capital structure.Our ability to generate cash flows from operations, issue debt, including commercial paper, or enter into other financing arrangements on acceptable terms could be adversely affected if there is a material decline in the demand for our products or in the solvency of our customers or suppliers, deterioration in our key financial ratios or credit ratings or other significantly unfavorable changes in conditions. However, we believe we have sufficient financial flexibility to issue debt, enter into other financing arrangements and attract long-term capital on acceptable terms to support our growth objectives. Our credit ratings at December 31, 2020 were as follows:Standard & Poor’sFitchMoody’sRatingsSenior debtA-A-Baa1Short-term debtA2F2P2OutlookStableStableStableLIBOR ReformIn 2017, the United Kingdom’s Financial Conduct Authority announced that after 2021 it would no longer compel banks to submit the rates required to calculate the London Interbank Offered Rate (LIBOR) and other interbank offered rates, which have been widely used as reference rates for various securities and financial contracts, including loans, debt and derivatives. This announcement indicated that the continuation of LIBOR on the current basis was not guaranteed after 2021. Regulators in the U.S. and other jurisdictions have been working to replace these rates with alternative reference interest rates that are supported by transactions in liquid and observable markets, such as the Secured Overnight Financing Rate (SOFR). In 2020, it was announced that certain U.S. dollar LIBOR tenors would not cease until 2023. Currently, our credit facilities reference LIBOR-based rates. The discontinuation of LIBOR will require these arrangements to be modified in order to replace LIBOR with an alternative reference interest rate, which could impact our cost of funds. Our credit facilities include a provision specifying that we and the lenders will negotiate in good faith for the determination of a successor LIBOR rate.39Contractual ObligationsAs of December 31, 2020, we had contractual obligations, excluding accounts payable and accrued liabilities, payable or maturing in the following periods.(in millions)TotalLess thanone yearOne tothree yearsThree tofive yearsMore thanfive yearsLong-term debt and finance lease obligations, including current maturities6,233 406 212 1,664 3,951 Interest on short- and long-term debt and finance lease obligations 11,627 142 267 251 967 Operating leases673 121 186 126 240 Other non-current liabilities2408 — 84 48 276 Purchase obligations31,209 485 352 198 174 Contractual obligations2$10,150 $1,154 $1,101 $2,287 $5,608 1.Interest payments on debt and finance lease obligations are calculated for future periods using interest rates in effect at the end of 2020. Certain of these projected interest payments may differ in the future based on foreign currency fluctuations or other factors or events. The projected interest payments only pertain to obligations and agreements outstanding at December 31, 2020. Refer to Note 5 and Note 6, respectively, in Item 8 of this Annual Report on Form 10-K for further discussion regarding our debt instruments outstanding and finance lease obligations at December 31, 2020.2.The primary components of other non-current liabilities in our consolidated balance sheet as of December 31, 2020 are pension and other postretirement benefits, deferred tax liabilities, long-term tax liabilities, and litigation and environmental reserves. We projected the timing of the related future cash payments based on contractual maturity dates (where applicable) and estimates of the timing of payments (for liabilities with no contractual maturity dates). The actual timing of payments could differ from our estimates. We contributed $74 million, $69 million, and $51 million to our defined benefit pension plans in 2020, 2019, and 2018, respectively. The timing of funding in future periods is uncertain and is dependent on future movements in interest rates, investment returns, changes in laws and regulations, and other variables. Therefore, the table above excludes cash outflows related to our pension plans. The amount included within other non-current liabilities (and excluded from the table above) related to our pension plan liabilities was $1.0 billion as of December 31, 2020. In 2021, we have no obligation to fund our principal plans in the United States and we expect to make contributions of at least $45 million to our foreign pension plans. Additionally, we have excluded long-term tax liabilities, which include liabilities for unrecognized tax positions, and deferred tax liabilities from the table above because we are unable to estimate the timing of the related cash outflows. The amounts of long-term tax liabilities and deferred tax liabilities included within other non-current liabilities (and excluded from the table above) were $84 million and $143 million, respectively, as of December 31, 2020. 3.Includes our significant contractual unconditional purchase obligations. For cancellable agreements, any penalty due upon cancellation is included. These commitments do not exceed our projected requirements and are in the normal course of business. Examples include firm commitments for raw material purchases, utility agreements and service contracts.Off-Balance Sheet ArrangementsWe periodically enter into off-balance sheet arrangements. Certain contingencies arise in the normal course of business and are not recorded in the consolidated balance sheets in accordance with U.S. GAAP (such as contingent joint development and commercialization arrangement payments). Also, upon resolution of uncertainties, we may incur charges in excess of presently established liabilities for certain matters (such as contractual indemnifications). For a discussion of our significant off-balance sheet arrangements, refer to Note 14 in Item 8 of this Annual Report on Form 10-K for information regarding receivable transactions, and Note 2 and Note 7 in Item 8 of this Annual Report on Form 10-K regarding joint development and commercialization arrangements, indemnifications and legal contingencies.40FINANCIAL INSTRUMENT MARKET RISKWe operate on a global basis and are exposed to the risk that our earnings, cash flows and equity could be adversely impacted by fluctuations in foreign exchange and interest rates. Our hedging policy attempts to manage these risks to an acceptable level based on our judgment of the appropriate trade-off between risk, opportunity and costs. Refer to Note 14 and Note 15 in Item 8 of this Annual Report on Form 10-K for further information regarding our financial instruments and hedging strategies.Currency RiskWe are primarily exposed to foreign exchange risk with respect to revenues generated outside of the United States denominated in the Euro, British Pound, Chinese Yuan, Korean Won, Australian Dollar, Canadian Dollar, Japanese Yen, Colombian Peso, Brazilian Real, Mexican Peso, Indian Rupee and Swedish Krona. We manage our foreign currency exposures on a consolidated basis, which allows us to net exposures and take advantage of any natural offsets. In addition, we use derivative and nonderivative financial instruments to further reduce the net exposure to foreign exchange. Gains and losses on the hedging instruments offset losses and gains on the hedged transactions and reduce the earnings and stockholders’ equity volatility relating to foreign exchange. However, we don't hedge our entire foreign exchange exposure and are still subject to earnings and stockholders' equity volatility relating to foreign exchange risk. Financial market and currency volatility may limit our ability to cost-effectively hedge these exposures.We use options and forwards to hedge the foreign exchange risk to earnings relating to forecasted transactions and recognized assets and liabilities denominated in foreign currencies. The maximum term over which we have cash flow hedge contracts in place related to foreign exchange risk on forecasted transactions as of December 31, 2020 is 12 months. We also enter into derivative instruments to hedge foreign exchange risk on certain intra-company and third-party receivables and payables and debt denominated in foreign currencies.As part of our risk-management program, we perform sensitivity analyses to assess potential changes in the fair value of our foreign exchange instruments relating to hypothetical and reasonably possible near-term movements in foreign exchange rates.A sensitivity analysis of changes in the fair value of foreign exchange contracts outstanding as of December 31, 2020, while not predictive in nature, indicated that if the U.S. Dollar uniformly weakened by 10% against all currencies, the net pre-tax liability balance of $8 million with respect to those contracts would increase by $32 million, resulting in a net asset position. A similar analysis performed with respect to contracts outstanding as of December 31, 2019 indicated that, on a pre-tax basis, the net asset balance of $9 million would decrease by $18 million, resulting in a net liability position.The sensitivity analysis model recalculates the fair value of the foreign exchange contracts outstanding as of December 31, 2020 by replacing the actual exchange rates as of December 31, 2020 with exchange rates that are 10% weaker compared to the actual exchange rates for each applicable currency. All other factors are held constant. These sensitivity analyses disregard the possibility that currency exchange rates can move in opposite directions and that gains from one currency may or may not be offset by losses from another currency. The analyses also disregard the offsetting change in value of the underlying hedged transactions and balances.Our operations in Argentina are reported using highly inflationary accounting effective July 1, 2018. Changes in the value of the Argentine peso applied to our peso-denominated net monetary asset positions are recorded in income at the time of the change. As of December 31, 2020, our net monetary assets denominated in Argentine pesos are not significant.Interest Rate RiskWe are also exposed to the risk that our earnings and cash flows could be adversely impacted by fluctuations in interest rates. Our policy is to manage interest costs using the mix of fixed- and floating-rate debt that we believe is appropriate at that time. To manage this mix in a cost-efficient manner, we periodically enter into interest rate swaps in which we agree to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated by reference to an agreed-upon notional amount. We also periodically use forward-starting interest rate swaps and treasury rate locks to hedge the risk to earnings associated with fluctuations in interest rates relating to anticipated issuances of term debt. As of December 31, 2020, all of our outstanding debt obligations were at fixed interest rates and no interest rate derivative instruments were outstanding.41CHANGES IN ACCOUNTING STANDARDSRefer to Note 1 in Item 8 of this Annual Report on Form 10-K for information on changes in accounting standards.RECENT ACCOUNTING PRONOUNCEMENTSThere are no accounting standards issued but not yet effective that we believe will have a material impact on our condensed consolidated financial statements. CRITICAL ACCOUNTING POLICIESThe preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. A summary of our significant accounting policies is included in Note 1 in Item 8 of this Annual Report on Form 10-K. Certain of our accounting policies are considered critical, as these policies are the most important to the depiction of our financial statements and require significant, difficult or complex judgments by us, often employing the use of estimates about the effects of matters that are inherently uncertain. Actual results that differ from our estimates could have an unfavorable effect on our results of operations and financial position. The following is a summary of accounting policies that we consider critical to the consolidated financial statements.Revenue Recognition and Related Provisions and AllowancesRevenues from product sales are recorded at the net sales price (transaction price), which includes estimates of variable consideration primarily related to rebates and wholesaler chargebacks. These reserves are based on estimates of the amounts earned or to be claimed on the related sales. Our estimates take into consideration historical experience, current contractual and statutory requirements, specific known market events and trends, industry data, and forecasted customer buying and payment patterns. Overall, these reserves reflect our best estimates of the amount of consideration to which we are entitled based on the terms of the contract. The amount of variable consideration included in the net sales price is limited to the amount that is probable not to result in a significant reversal in the amount of the cumulative revenue recognized in a future period. Additionally, our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately and determining the allocation of the transaction price may require significant judgment.Pension and OPEB PlansWe provide pension and other postretirement benefits to certain of our employees. The service component of employee benefit expenses is reported in the same line items in the consolidated income statements as the applicable employee’s compensation expense. All other components of these employee benefit expenses are reported in other (income) expense, net in our consolidated statements of income. The valuation of the funded status and net periodic benefit cost for the plans is calculated using actuarial assumptions. These assumptions are reviewed annually and revised if appropriate. The significant assumptions include the following:•interest rates used to discount pension and OPEB plan liabilities;•the long-term rate of return on pension plan assets;•rates of increases in employee compensation (used in estimating liabilities);•anticipated future healthcare trend rates (used in estimating the OPEB plan liability); and•other assumptions involving demographic factors such as retirement, mortality and turnover (used in estimating liabilities).Selecting assumptions involves an analysis of both short-term and long-term historical trends and known economic and market conditions at the time of the valuation (also called the measurement date). The use of different assumptions would result in different measures of the funded status and net cost. Actual results in the future could differ from expected results.Our key assumptions are listed in Note 11 in Item 8 of this Annual Report on Form 10-K. The most critical assumptions relate to the plans covering U.S. and Puerto Rico employees, because these plans are the most significant to our consolidated financial statements.42Discount Rate AssumptionEffective for the December 31, 2020 measurement date, we utilized discount rates of 2.73% and 2.33% to measure our benefit obligations for the U.S. and Puerto Rico pension plans and OPEB plan, respectively. We used a broad population of approximately 200 Aa-rated corporate bonds as of December 31, 2020 to determine the discount rate assumption. All bonds were denominated in U.S. dollars, with a minimum amount outstanding of $50 million. This population of bonds was narrowed from a broader universe of approximately 700 Moody’s Aa rated, non-callable (or callable with make-whole provisions) bonds by eliminating the top 10th percentile and bottom 40th percentile to adjust for any pricing anomalies and to represent the bonds we would most likely select if we were to actually annuitize our pension and OPEB plan liabilities. This portfolio of bonds was used to generate a yield curve and associated spot rate curve to discount the projected benefit payments for the U.S. and Puerto Rico plans. The discount rate is the single level rate that produces the same result as the spot rate curve.For plans in Canada, Japan, the United Kingdom and other European countries, we use a method essentially the same as that described for the U.S. and Puerto Rico plans. For our other international plans, the discount rate is generally determined by reviewing country- and region-specific government and corporate bond interest rates.To understand the impact of changes in discount rates on pension and OPEB plan cost, we perform a sensitivity analysis. Holding all other assumptions constant, for each 50 basis point (i.e., one-half of one percent) increase in the discount rate, global pre-tax pension and OPEB plan cost would decrease by approximately $25 million, and for each 50 basis point decrease in the discount rate, global pre-tax pension and OPEB plan cost would increase by approximately $30 million.Return on Plan Assets AssumptionIn measuring the net periodic cost for 2020, we used a long-term expected rate of return of 6.5% for the pension plans covering U.S. and Puerto Rico employees. This assumption will decrease to 5.5% in 2021. This assumption is not applicable to our OPEB plan because it is not funded.We establish the long-term asset return assumption based on a review of historical compound average asset returns, both company-specific and relating to the broad market (based on our asset allocation), as well as an analysis of current market and economic information and future expectations. The current asset return assumption is supported by historical market experience for both our actual and targeted asset allocation. In calculating net pension cost, the expected return on assets is applied to a calculated value of plan assets, which recognizes changes in the fair value of plan assets in a systematic manner over five years. The difference between this expected return and the actual return on plan assets is a component of the total net unrecognized gain or loss and is subject to amortization in the future.To understand the impact of changes in the expected asset return assumption on net cost, we perform a sensitivity analysis. Holding all other assumptions constant, for each 50 basis point increase (decrease) in the asset return assumption, global pre-tax pension plan cost would decrease (increase) by approximately $15 million.Other AssumptionsFor the U.S. and Puerto Rico plans, we used the Pri-2012 combined mortality table with improvements projected using the MP-2019 projection scale adjusted to a long-term improvement of 0.8% as of December 31, 2020. For all other pension plans, we utilized country- and region-specific mortality tables to calculate the plans’ benefit obligations. We periodically analyze and update our assumptions concerning demographic factors such as retirement, mortality and turnover, considering historical experience as well as anticipated future trends.The assumptions relating to employee compensation increases and future healthcare costs are based on historical experience, market trends, and anticipated future company actions. Deferred Tax Asset Valuation Allowances, Reserves for Uncertain Tax Positions and Tax ReformWe maintain valuation allowances unless it is more likely than not that all or a portion of the deferred tax asset will be realized. Changes in valuation allowances are included in our tax provision in the period of change. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, 43expected future earnings, carryback and carryforward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. The realizability assessments made at a given balance sheet date are subject to change in the future, particularly if earnings of a subsidiary are significantly higher or lower than expected, or if we take operational or tax planning actions that could impact the future taxable earnings of a subsidiary.In the normal course of business, we are audited by federal, state and foreign tax authorities, and are periodically challenged regarding the amount of taxes due. These challenges relate to the timing and amount of deductions and the allocation of income among various tax jurisdictions. We believe our tax positions comply with applicable tax law and we intend to defend our positions. In evaluating the exposure associated with various tax filing positions, we record reserves for uncertain tax positions in accordance with U.S. GAAP based on the technical support for the positions, our past audit experience with similar situations, and potential interest and penalties related to the matters. Our results of operations and effective tax rate in a given period could be impacted if, upon final resolution with taxing authorities, we prevail in positions for which reserves have been established, or we are required to pay amounts in excess of established reserves.On December 22, 2017, the 2017 Tax Act was enacted into law and the new legislation contains several key tax provisions that affected us, including a one-time mandatory transition tax on accumulated foreign earnings and a reduction of the U.S. corporate income tax rate to 21% effective January 1, 2018, among others. We were required to recognize the effect of the tax law changes in the period of enactment, such as determining the transition tax, remeasuring our U.S. deferred tax assets and liabilities and reassessing the realizability of our deferred tax assets. In December 2017, the SEC staff issued SAB 118 which allowed us to record provisional amounts during a measurement period not to extend beyond one year of the enactment date. We updated our accounting for the initial impact of the 2017 Tax Act in 2018 in accordance with the guidance in SAB 118. Refer to Note 12 within Item 8 of this Annual Report on Form 10-K for further information.Valuation of Intangible Assets, Including IPR&D We record acquired intangible assets at fair value in business combinations and at cost in asset acquisitions. Valuations are generally completed for intangible assets acquired in business acquisitions using a discounted cash flow analysis, incorporating the stage of completion and consideration of market participant assumptions. The most significant estimates and assumptions inherent in a discounted cash flow analysis include the amount and timing of projected future cash flows, the discount rate used to measure the risks inherent in the future cash flows, the assessment of the asset’s life cycle, and the competitive and other trends impacting the asset, including consideration of technical, legal, regulatory, economic and other factors. Each of these factors and assumptions can significantly affect the value of the intangible asset.Acquired in-process R&D (IPR&D) is the value assigned to acquired technology or products under development which have not received regulatory approval and have no alternative future use. IPR&D acquired in a business combination is capitalized as an indefinite-lived intangible asset. Development costs incurred after the acquisition are expensed as incurred. Upon receipt of regulatory approval of the related technology or product, the indefinite-lived intangible asset is then accounted for as a finite-lived intangible asset and amortized on a straight-line basis over its estimated useful life. If the R&D project is abandoned, the indefinite-lived intangible asset is charged to expense.IPR&D acquired in transactions that are not business combinations is expensed immediately. For such transactions, payments made to third parties on or after regulatory approval are capitalized as intangible assets and amortized over the remaining useful life of the related asset.Due to the inherent uncertainty associated with R&D projects, there is no assurance that actual results will not differ materially from the underlying assumptions used to prepare discounted cash flow analyses, nor that the R&D project will result in a successful commercial product.Due to a change in the timing and amount of projected cash flows associated with $140 million of acquired in-process R&D intangible assets from a historical acquisition, we updated the estimated fair values of these assets in 2020. While no impairment has been recorded because the estimated fair values of those assets exceeded their carrying values, the estimated excess of fair value over carrying value of these assets declined in 2020 and are at risk of future impairment should the estimated timing or amount of projected cash flows further deteriorate. 44CERTAIN REGULATORY MATTERS The U.S. Food and Drug Administration (FDA) commenced an inspection of Claris’ facilities in Ahmedabad, India in July 2017, immediately prior to the closing of the Claris acquisition. FDA completed the inspection and subsequently issued a Warning Letter based on observations identified in the 2017 inspection (Claris Warning Letter).¹ FDA has not yet re-inspected the facilities and management cannot speculate on when the Claris Warning Letter will be lifted. However, we are continuing to implement corrective and preventive actions to address FDA’s prior observations and other items we identified and management continues to pursue and implement other manufacturing locations, including contract manufacturing organizations, to support the production of new products for distribution in the U.S. As of December 31, 2020, we have secured alternative locations to produce a majority of the planned new products to be manufactured in Ahmedabad for distribution into the U.S.On May 6, 2019, we received a Show Cause Notice under the Drugs & Cosmetics Act, 1940 and Rules thereunder (Show Cause Notice) from the Commissioner of the Food & Drugs Control Administration in the Gujarat State in Gandhinagar, India (Commissioner). The Show Cause Notice was issued regarding an April 9, 2019 inspection of our Claris facilities in Ahmedabad, India by the Commissioner. The Show Cause Notice contained a number of observations of alleged Good Manufacturing Practice related issues across a variety of areas, some of which overlap with the areas covered in the Claris Warning Letter. We responded to the Show Cause Notice and a follow up inspection occurred in July 2019. This matter resulted in a two-day suspension order for certain manufacturing operations, which occurred on March 19 and 20, 2020. This matter is now closed.Refer to Item 1A of this Annual Report on Form 10-K for additional discussion of regulatory matters and how they may impact us.1 Available online at https://www.fda.gov/ICECI/EnforcementActions/WarningLetters/ucm613538.htmFORWARD-LOOKING INFORMATIONThis annual report includes forward-looking statements. Use of the words “may,” “will,” “would,” “could,” “should,” “believes,” “estimates,” “projects,” “potential,” “expects,” “plans,” “seeks,” “intends,” “evaluates,” “pursues,” “anticipates,” “continues,” “designs,” “impacts,” “affects,” “forecasts,” “target,” “outlook,” “initiative,” “objective,” “designed,” “priorities,” “goal,” or the negative of those words or other similar expressions is intended to identify forward-looking statements that represent our current judgment about possible future events. These forward-looking statements may include statements with respect to accounting estimates and assumptions, impacts of the COVID-19 pandemic, litigation-related matters including outcomes, impacts of the internal investigation related to foreign exchange gains and losses, future regulatory filings and our R&D pipeline, strategic objectives, sales from new product offerings, credit exposure to foreign governments, potential developments with respect to credit ratings, investment of foreign earnings, estimates of liabilities including those related to uncertain tax positions, contingent payments, future pension plan contributions, costs, discount rates and rates of return, our exposure to financial market volatility and foreign currency and interest rate risks, potential tax liabilities associated with the separation of our biopharmaceuticals business from our medical products businesses, the impact of competition, future sales growth, business development activities (including the acquisitions of Cheetah and Seprafilm and the proposed acquisitions of Caelyx and Doxil and Transderm Scop), business optimization initiatives, cost saving initiatives, future capital and R&D expenditures, future debt issuances, manufacturing expansion, the sufficiency of our facilities and financial flexibility, the adequacy of credit facilities, tax provisions and reserves, the effective tax rate and all other statements that do not relate to historical facts.These forward-looking statements are based on certain assumptions and analyses made in light of our experience and perception of historical trends, current conditions, and expected future developments as well as other factors that we believe are appropriate in the circumstances. While these statements represent our judgment on what the future may hold, and we believe these judgments are reasonable, these statements are not guarantees of any events or financial results. Whether actual future results and developments will conform to expectations and predictions is subject to a number of risks and uncertainties, including the following factors, many of which are beyond our control:45•demand for, market acceptance risks for and competitive pressures related to new and existing products (including challenges with our ability to accurately predict these pressures and the resulting impact on customer inventory levels and the impact of reduced hospital admission rates and elective surgery volumes), and the impact of those products on quality and patient safety concerns;•product development risks, including satisfactory clinical performance, the ability to manufacture at appropriate scale, and the general unpredictability associated with the product development cycle;•our ability to finance and develop new products or enhancements on commercially acceptable terms or at all;•our ability to identify business development and growth opportunities and to successfully execute on business development strategies;•product quality or patient safety issues, leading to product recalls, withdrawals, launch delays, warning letters, import bans, sanctions, seizures, litigation, or declining sales;•the impact of global economic conditions (including potential trade wars) and pandemics, epidemics or other public health crises, such as COVID-19, on us and our customers and suppliers, including foreign governments in countries in which we operate;•the continuity, availability and pricing of acceptable raw materials and component supply, and the related continuity of our manufacturing and distribution;•inability to create additional production capacity in a timely manner or the occurrence of other manufacturing, sterilization or supply difficulties (including as a result of natural disaster, public health crises and epidemics/pandemics, regulatory actions or otherwise);•breaches or failures of our information technology systems or products, including by cyber-attack, data leakage, unauthorized access or theft (as a result of increased remote working arrangements or otherwise);•future actions of (or failures to act or delays in acting by) FDA, the European Medicines Agency or any other regulatory body or government authority (including the SEC, DOJ or the Attorney General of any State) that could delay, limit or suspend product development, manufacturing or sale or result in seizures, recalls, injunctions, monetary sanctions or criminal or civil liabilities, including the continued delay in lifting the warning letter at our Ahmedabad facility or proceedings related to the misstatements in previously reported non-operating income related to foreign exchange gains and losses;•developments that would require the correction of additional misstatements in our previously issued financial statements;•failures with respect to our quality, compliance or ethics programs;46•future actions of third parties, including third-party payers, the impact of healthcare reform and its implementation, suspension, repeal, replacement, amendment, modification and other similar actions undertaken by the United States or foreign governments, including with respect to pricing, reimbursement, taxation and rebate policies; legislation, regulation and other governmental pressures in the United States or globally, including the cost of compliance and potential penalties for purported noncompliance thereof, all of which may affect pricing, reimbursement, taxation and rebate policies of government agencies and private payers or other elements of our business, including new or amended laws, rules and regulations (such as the California Consumer Privacy Act of 2018, the European Union’s General Data Protection Regulation and proposed regulatory changes of the U.S. Department of Health and Human Services in kidney health policy and reimbursement, which may substantially change the U.S. end stage renal disease market and demand for our peritoneal dialysis products, necessitating significant multi-year capital expenditures, which are difficult to estimate in advance, for example);•the outcome of pending or future litigation or government investigations, including the opioid litigation and litigation related to the internal investigation of foreign exchange gains and losses;•the impact of competitive products and pricing, including generic competition, drug reimportation and disruptive technologies;•global regulatory, trade and tax policies;•the ability to protect or enforce our owned or in-licensed patent or other proprietary rights (including trademarks, copyrights, trade secrets and know-how) or patents of third parties preventing or restricting our manufacture, sale or use of affected products or technology;•the impact of any goodwill or other intangible asset impairments on our operating results;•any failure by Baxalta or Shire to satisfy its obligations under the separation agreements, including the tax matters agreement, or that certain letter agreement entered into with Shire and Baxalta;•fluctuations in foreign exchange and interest rates;•any changes in law concerning the taxation of income (whether with respect to current or future tax reform), including income earned outside the United States and potential taxes associated with the Base Erosion and Anti-Abuse Tax;•actions by tax authorities in connection with ongoing tax audits;•loss of key employees or inability to identify and recruit new employees;•other factors identified elsewhere in this Annual Report on Form 10-K including those factors described in Item 1A and other filings with the SEC, all of which are available on our website.Actual results may differ materially from those projected in the forward-looking statements. We do not undertake to update our forward-looking statements.Item 7A. Quantitative and Qualitative Disclosures About Market Risk.Incorporated by reference to the section entitled “Financial Instrument Market Risk” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of this Annual Report on Form 10-K.47

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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Unless otherwise noted, transactions and other factors significantly impacting our financial condition, results of operations and liquidity are discussed in order of magnitude. Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Refer to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, in our Form 10-K for the fiscal year ended February 1, 2020, for discussion of the results of operations for the year ended February 1, 2020, compared to the year ended February 2, 2019, which is incorporated by reference herein. 23 Overview Our purpose is to enrich lives through technology. We have two reportable segments: Domestic and International. The Domestic segment is comprised of the operations, including our Best Buy Health business, in all states, districts and territories of the U.S. under various brand names including Best Buy, Best Buy Business, Best Buy Express, Best Buy Health, CST, Geek Squad, GreatCall, Lively, Magnolia and Pacific Kitchen and Home and the domain names bestbuy.com and greatcall.com. The International segment is comprised of all operations in Canada and Mexico under the brand names Best Buy, Best Buy Express, Best Buy Mobile and Geek Squad and the domain names bestbuy.ca and bestbuy.com.mx. During the third quarter of fiscal 2021 we made the decision to exit our operations in Mexico. Refer to Note 2, Restructuring, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for additional information. Our fiscal year ends on the Saturday nearest the end of January. Fiscal 2021, fiscal 2020 and fiscal 2019 included 52 weeks. Our business, like that of many retailers, is seasonal. A large proportion of our revenue and earnings is generated in the fiscal fourth quarter, which includes the majority of the holiday shopping season in the U.S., Canada and Mexico. Comparable Sales Throughout this MD&A, we refer to comparable sales. Comparable sales is a metric used by management to evaluate the performance of our existing stores, websites and call centers by measuring the change in net sales for a particular period over the comparable prior-period of equivalent length. Comparable sales includes revenue from stores, websites and call centers operating for at least 14 full months. Stores closed more than 14 days, including but not limited to relocated, remodeled, expanded and downsized stores, or stores impacted by natural disasters, are excluded from comparable sales until at least 14 full months after reopening. Acquisitions are included in comparable sales beginning with the first full quarter following the first anniversary of the date of the acquisition. Comparable sales also includes credit card revenue, gift card breakage, commercial sales and sales of merchandise to wholesalers and dealers, as applicable. Comparable sales excludes the impact of revenue from discontinued operations and the effect of fluctuations in foreign currency exchange rates (applicable to our International segment only). Online sales are included in comparable sales. Online sales represent those initiated on a website or app, regardless of whether customers choose to pick up product in store, curbside, at an alternative pick-up location or take delivery direct to their homes. All periods presented apply this methodology consistently. In March 2020, the World Health Organization declared the outbreak of novel coronavirus disease (“COVID-19”) as a pandemic. All stores that were temporarily closed as a result of COVID-19 or operating a curbside-only operating model are included in comparable sales. On November 24, 2020, we announced our decision to exit our operations in Mexico. As a result, all revenue from Mexico operations has been excluded from our comparable sales calculation beginning in December of fiscal 2021. On March 1, 2018, we announced our intent to close all of our 257 remaining Best Buy Mobile stand-alone stores in the U.S. As a result, all revenue related to these stores has been excluded from our comparable sales calculation beginning in March 2018. On October 1, 2018, we acquired all outstanding shares of GreatCall, Inc. (“GreatCall”) and on May 9, 2019, we acquired all outstanding shares of Critical Signal Technologies, Inc. (“CST”). Consistent with our comparable sales policy, the results of GreatCall are included in our comparable sales calculation beginning in the fourth quarter of fiscal 2020, and the results of CST are included in our comparable sales calculation beginning in the third quarter of fiscal 2021. We believe comparable sales is a meaningful supplemental metric for investors to evaluate revenue performance resulting from growth in existing stores, websites and call centers versus the portion resulting from opening new stores or closing existing stores. The method of calculating comparable sales varies across the retail industry. As a result, our method of calculating comparable sales may not be the same as other retailers' methods. Non-GAAP Financial Measures This MD&A includes financial information prepared in accordance with accounting principles generally accepted in the United States ("GAAP"), as well as certain adjusted or non-GAAP financial measures, such as constant currency, non-GAAP operating income, non-GAAP effective tax rate and non-GAAP diluted earnings per share ("EPS"). We believe that non-GAAP financial measures, when reviewed in conjunction with GAAP financial measures, can provide more information to assist investors in evaluating current period performance and in assessing future performance. For these reasons, our internal management reporting also includes non-GAAP financial measures. Generally, our non-GAAP financial measures include adjustments for items such as restructuring charges, goodwill impairments, price-fixing settlements, gains and losses on investments, intangible asset amortization, certain acquisition-related costs and the tax effect of all such items. In addition, certain other items may be excluded from non-GAAP financial measures when we believe doing so provides greater clarity to management and our investors. These non-GAAP financial measures should be considered in addition to, and not superior to or as a substitute for, GAAP financial measures. We strongly encourage investors and shareholders to review our financial statements and publicly-filed reports in their entirety and not to rely on any single financial measure. Non-GAAP financial measures as presented herein may not be comparable to similarly titled measures used by other companies. 24 In our discussions of the operating results of our consolidated business and our International segment, we sometimes refer to the impact of changes in foreign currency exchange rates or the impact of foreign currency exchange rate fluctuations, which are references to the differences between the foreign currency exchange rates we use to convert the International segment’s operating results from local currencies into U.S. dollars for reporting purposes. We also may use the term "constant currency," which represents results adjusted to exclude foreign currency impacts. We calculate those impacts as the difference between the current period results translated using the current period currency exchange rates and using the comparable prior period currency exchange rates. We believe the disclosure of revenue changes in constant currency provides useful supplementary information to investors in light of significant fluctuations in currency rates. Refer to the Non-GAAP Financial Measures section below for detailed reconciliations of items impacting non-GAAP operating income, non-GAAP effective tax rate and non-GAAP diluted EPS in the presented periods. Business Strategy and COVID-19 Update In fiscal 2021 our Enterprise comparable sales grew 9.7% as we leveraged our unique capabilities, including our supply chain expertise, flexible store operating model and ability to shift quickly to digital, to meet what was clearly elevated demand for products that help customers work, learn, cook, entertain and connect in their homes. We provided customers with multiple options for how, when and where they shopped with us to ensure it satisfied their need for safety and convenience. The pandemic environment underscored our purpose to enrich lives through technology, and the capabilities we strengthened in fiscal 2021 will benefit us going forward as we execute our strategy. Our strong financial performance allowed us to share our success with the community, our shareholders, and, importantly, our employees. In the third quarter of fiscal 2021, we made a $40 million donation to the Best Buy Foundation to accelerate the progress towards our goal to reach 100 Teen Tech Centers across the U.S. We believe our Teen Tech Centers help to further our commitments towards economic and social justice in our communities by making a measurable difference in the lives of underserved teens who may not otherwise have access to technology. In addition, we resumed our share repurchase program during the fourth quarter of fiscal 2021 and increased our quarterly dividend by 27% to $0.70 per share. For our employees, we provided hourly appreciation pay for those who were working on the frontlines, paid recognition bonuses to field employees and established multiple hardship funds for anyone impacted physically, emotionally or financially by COVID-19. Starting August 1, 2020, we also raised our starting wage to $15 per hour for all domestic employees and enhanced our employee benefits. Throughout the pandemic and across all the ways customers can shop, we adhered to safety protocols that limited store capacity, followed strict social distancing practices and used proper protective equipment, including requiring our employees and customers to wear masks. This COVID-19 pandemic and the shift in customer buying behavior underscores the importance of our strong multi-channel capabilities. In fiscal 2021 our Domestic online revenue grew 144% compared to last year. We believe it is essential to provide options that let customers choose what works best for them. To best serve our customers during the pandemic, we had to be innovative and flexible. Early in the year, we quickly rolled out enhanced curbside pick-up across our stores to provide our customers convenience when we made the difficult decision to close our stores in March 2020. In May 2020 we developed an in-store appointment model that provided our customers with an option to shop in our stores as we prepared to open stores back up to customer shopping. We developed solutions like virtual consultations with advisors and video chats with our store associates. In addition, we made significant improvements to the functionality and customer experience of our app to support shopping, support and fulfillment. We provided fulfillment options that customers have come to expect from all retailers like fast and free home delivery, in-store pick-up and curbside pick-up. As we look forward, the environment is still evolving, and our operating model and supporting cost structure are evolving as well. The pandemic has accelerated the evolution of retail and compelled us to change our operating model in the best interest of our employees and customers. We have also expedited some planned strategic changes that we believe will allow us to emerge from this time even stronger. During the third quarter of fiscal 2021 we made the difficult decision to exit our operations in Mexico and began taking other actions to more broadly align our organizational structure in support of our strategy. As a result, we recorded $144 million of charges in our International segment in fiscal 2021, including $23 million of inventory markdowns within cost of sales and $121 million within restructuring charges primarily comprised of asset impairments, currency translation adjustments and termination benefits. As of January 30, 2021, the exit was substantially complete and we do not expect to incur material future restructuring charges in fiscal 2022 related to the exit. We also recorded $133 million of restructuring charges in our Domestic segment in fiscal 2021, primarily related to termination benefits associated with field and corporate organizational changes in support of our strategy, as well as impairments of technology assets held in service of our Mexico operations. As we continue to evolve our Building the New Blue Strategy, it is possible that we will incur material future restructuring costs, but we are unable to forecast the timing and magnitude of such costs. Refer to Note 2, Restructuring, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for additional information. 25 We believe the following will be permanent and structural implications of the pandemic relevant to Best Buy: • Customer shopping behavior will be permanently changed in a way that is even more digital and puts customers entirely in control to shop how they want. Our strategy is to embrace that reality, and lead, not follow.• Our workforce will need to evolve in a way that meets the needs of customers while also providing more flexible opportunities for our people.• Technology is playing an even more crucial role in people’s lives, and, as a result, our purpose to enrich lives through technology has never been more important. Said differently, people are using technology to address their needs in ways they never contemplated before, and we play a vital role in bringing technology to life for both customers and our vendor partners. These implications are extensive and interdependent, and we are, as quickly as possible, both implementing change today and assessing future changes across our entire business, including how we evolve our stores and labor model, and how we spend our investment dollars.‌ In summary, during fiscal 2021 we managed through the challenging environment in a way that allowed us to accelerate many aspects of our strategy to deliver on our purpose. Our teams showed perseverance and commitment through the year and collectively changed the way we do business at a pace we never imagined. Results of Operations In order to align our fiscal reporting periods and comply with statutory filing requirements, we consolidate the financial results of our Mexico operations on a one-month lag. Consistent with such consolidation, the financial and non-financial information presented in our MD&A relative to these operations is also presented on a lag. Our policy is to accelerate the recording of events occurring in the lag period that significantly affect our consolidated financial statements. Other than the restructuring charges incurred related to our decision to exit our operations in Mexico, no such events were identified for the periods presented. Consolidated Results Selected consolidated financial data was as follows ($ in millions, except per share amounts): Consolidated Performance Summary2021 2020 2019Revenue$ 47,262 $ 43,638 $ 42,879 Revenue % increase 8.3 % 1.8 % 1.7 %Comparable sales growth 9.7 % 2.1 % 4.8 %Gross profit$ 10,573 $ 10,048 $ 9,961 Gross profit as a % of revenue(1) 22.4 % 23.0 % 23.2 %SG&A$ 7,928 $ 7,998 $ 8,015 SG&A as a % of revenue(1) 16.8 % 18.3 % 18.7 %Restructuring charges$ 254 $ 41 $ 46 Operating income$ 2,391 $ 2,009 $ 1,900 Operating income as a % of revenue 5.1 % 4.6 % 4.4 %Net earnings$ 1,798 $ 1,541 $ 1,464 Diluted earnings per share$ 6.84 $ 5.75 $ 5.20 (1)Because retailers vary in how they record costs of operating their supply chain between cost of sales and SG&A, our gross profit rate and SG&A rate may not be comparable to other retailers' corresponding rates. For additional information regarding costs classified in cost of sales and SG&A, refer to Note 1, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. In fiscal 2021 we generated $47.3 billion in revenue and our comparable sales increased 9.7%. The impact of the pandemic drove strong customer demand for products to help them work, learn, cook, entertain and connect in their homes. Our strong sales performance resulted in operating income rate expansion of 50 basis points compared to fiscal 2020. Revenue, gross profit rate, SG&A rate and operating income rate changes in fiscal 2021 were primarily driven by our Domestic segment. For further discussion of each segment's rate changes, see Segment Performance Summary, below. 26 Segment Performance Summary Domestic Segment Selected financial data for the Domestic segment was as follows ($ in millions): Domestic Segment Performance Summary2021 2020 2019Revenue$ 43,293 $ 40,114 $ 39,304 Revenue % increase 7.9 % 2.1 % 1.7 %Comparable sales growth(1) 9.2 % 2.3 % 4.8 %Gross profit$ 9,720 $ 9,234 $ 9,144 Gross profit as a % of revenue 22.5 % 23.0 % 23.3 %SG&A$ 7,239 $ 7,286 $ 7,300 SG&A as a % of revenue 16.7 % 18.2 % 18.6 %Restructuring charges$ 133 $ 41 $ 47 Operating income$ 2,348 $ 1,907 $ 1,797 Operating income as a % of revenue 5.4 % 4.8 % 4.6 %Selected Online Revenue Data Total online revenue$ 18,674 $ 7,640 $ 6,528 Online revenue as a % of total segment revenue 43.1 % 19.0 % 16.6 %Comparable online sales growth(1) 144.4 % 17.0 % 10.5 %(1)Comparable online sales are included in the comparable sales calculation. The increase in revenue in fiscal 2021 was primarily driven by the comparable sales growth across most of our product categories, partially offset by the loss of revenue from permanent store closures in the past year. Online revenue of $18.7 billion increased 144.4% on a comparable basis in fiscal 2021, primarily due to higher conversion rates and increased traffic as we saw a channel shift in our customer shopping behavior as a result of COVID-19. Domestic segment stores open at the end of each of the last three fiscal years, excluding stores that were temporarily closed as a result of COVID-19 in fiscal 2021, were as follows: 2019 2020 2021 Total Stores‎at End of‎Fiscal Year Stores‎Opened Stores‎Closed Total Stores‎at End of‎Fiscal Year Stores‎Opened Stores‎Closed Total Stores‎at End of‎Fiscal YearBest Buy 997 - (20) 977 - (21) 956 Outlet Centers 8 5 (2) 11 3 - 14 Pacific Sales 21 - - 21 - - 21 Total Domestic segment stores 1,026 5 (22) 1,009 3 (21) 991 We continuously monitor store performance. As we approach the expiration date of our leases, we evaluate various options for each location, including whether a store should remain open. Domestic segment revenue mix percentages and comparable sales percentage changes by revenue category were as follows: Revenue Mix Summary Comparable Sales Summary 2021 2020 2021 2020Computing and Mobile Phones 46 % 45 % 13.0 % 3.2 %Consumer Electronics 30 % 33 % (0.2)% 1.9 %Appliances 13 % 11 % 23.2 % 13.0 %Entertainment 6 % 6 % 17.9 % (18.5)%Services 5 % 5 % (1.4)% 6.8 %Total 100 % 100 % 9.2 % 2.3 % Continued strong demand in categories that help our customers work, learn, cook, entertain and connect from home contributed to our Domestic comparable sales changes across most of our categories. Notable comparable sales changes by revenue category were as follows: • Computing and Mobile Phones: The 13.0% comparable sales growth was driven primarily by computing, tablets and networking, partially offset by declines in mobile phones.• Consumer Electronics: The 0.2% comparable sales decline was driven primarily by headphones and digital imaging, partially offset by growth in home theater.• Appliances: The 23.2% comparable sales growth was driven by both large and small appliances.• Entertainment: The 17.9% comparable sales growth was driven primarily by gaming and virtual reality, partially offset by declines in movies.• Services: The 1.4% comparable sales decline was primarily driven by our repair, delivery and installation services. 27 Our gross profit rate decreased in fiscal 2021 primarily due to higher supply chain costs as a result of the increased mix of online revenue and lower profit-sharing revenue from our private label and co-branded credit card arrangement, partially offset by a more favorable promotional environment. Our SG&A decreased in fiscal 2021 primarily due to lower store payroll expense and other actions taken at the onset of the pandemic, such as the temporary suspension of the 401(k) employer match, reduced advertising and lower store overhead expenses. These decreases were partially offset by increases in variable costs associated with higher sales volume and a $40 million donation to the Best Buy Foundation. Lower store payroll expense was primarily due to fewer labor hours as a result of reduced store operating hours, lower store-generated revenue and efficiencies in our labor model, which was partially offset by increased wage rates. SG&A also includes $81 million of employee retention credits as a result of the Federal Coronavirus Aid, Relief and Economic Security (CARES) Act. Restructuring charges in fiscal 2021 related to termination benefits associated with actions taken to more broadly align our organizational structure in support of our strategy. Refer to Note 2, Restructuring, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for additional information. Our operating income rate increased in fiscal 2021 primarily driven by increased leverage from higher sales volume on our fixed expenses, which resulted in favorable SG&A rates, partially offset by the decrease in gross profit rate and restructuring charges described above. International Segment Selected financial data for the International segment was as follows ($ in millions): International Segment Performance Summary2021 2020 2019Revenue$ 3,969 $ 3,524 $ 3,575 Revenue % change 12.6 % (1.4)% 2.5 %Comparable sales % change 15.0 % (0.5)% 4.6 %Gross profit$ 853 $ 814 $ 817 Gross profit as a % of revenue 21.5 % 23.1 % 22.9 %SG&A$ 689 $ 712 $ 715 SG&A as a % of revenue 17.4 % 20.2 % 20.0 %Restructuring charges$ 121 $ - $ (1) Operating income$ 43 $ 102 $ 103 Operating income as a % of revenue 1.1 % 2.9 % 2.9 % The increase in revenue in fiscal 2021 was primarily driven by comparable sales growth across most of our product categories, partially offset by the negative impact of foreign currency exchange rate fluctuations related to our operations in Mexico and Canada, and lower revenue in Mexico as a result of our decision in the third quarter of fiscal 2021 to exit operations. International segment stores open at the end of each of the last three fiscal years, excluding stores that were temporarily closed as a result of COVID-19 in fiscal 2021, were as follows: 2019 2020 2021 Total Stores‎at End of‎Fiscal Year Stores‎Opened Stores Closed Total Stores‎at End of‎Fiscal Year Stores‎Opened Stores‎Closed Total Stores‎at End of‎Fiscal YearCanada Best Buy 132 - (1) 131 - - 131 Best Buy Mobile 45 - (3) 42 - (9) 33 Mexico Best Buy 29 6 - 35 - (31) 4 Best Buy Express 6 8 - 14 - (14) - Total International segment stores 212 14 (4) 222 - (54) 168 International segment revenue mix percentages and comparable sales percentage changes by revenue category were as follows: Revenue Mix Summary Comparable Sales Summary 2021 2020 2021 2020Computing and Mobile Phones 47 % 45 % 23.8 % 0.6 %Consumer Electronics 30 % 33 % 0.3 % 1.4 %Appliances 10 % 9 % 20.9 % 0.7 %Entertainment 8 % 6 % 52.1 % (20.0)%Services 4 % 6 % (11.0)% 9.3 %Other 1 % 1 % 9.4 % (14.1)%Total 100 % 100 % 15.0 % (0.5)% 28 Similar to the Domestic segment, strong demand in categories that help our customers work, learn, cook, entertain and connect from home contributed to our International comparable sales changes across most of our categories. Notable comparable sales changes by revenue category were as follows: • Computing and Mobile Phones: The 23.8% comparable sales growth was driven primarily by computing, tablets and networking, partially offset by declines in mobile phones.• Consumer Electronics: The 0.3% comparable sales growth was driven primarily by home theater and health and fitness, partially offset by declines in smart home and digital imaging.• Appliances: The 20.9% comparable sales growth was driven by both small and large appliances.• Entertainment: The 52.1% comparable sales growth was driven primarily by gaming and virtual reality.• Services: The 11.0% comparable sales decline was driven primarily by warranty and repair services.• Other: The 9.4% comparable sales growth was driven primarily by baby products. Our gross profit rate declined in fiscal 2021 primarily due to operations in Canada, which was largely driven by higher supply chain costs as a result of the increased mix of online revenue and a lower mix of higher margin services revenue. Gross profit also decreased $23 million as a result of inventory markdowns associated with our decision to exit our operations in Mexico. Our SG&A decreased in fiscal 2021 primarily due to operations in Canada as a result of lower store payroll expense, partially offset by higher incentive compensation. Restructuring charges in fiscal 2021 primarily related to asset impairments, currency translation adjustments and termination benefits associated with our decision to exit our operations in Mexico. Refer to Note 2, Restructuring, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for additional information. Our operating income rate decreased in fiscal 2021 primarily driven by restructuring charges and the lower gross profit rate described above, partially offset by a favorable SG&A rate driven by increased leverage from higher sales volume on our fixed expenses. Additional Consolidated Results Other Income (Expense) Our investment income and other decreased in fiscal 2021 primarily due to less favorable interest rates on our investments, partially offset by an increase in the fair value of a minority equity investment. Interest expense decreased in fiscal 2021 primarily due to more favorable interest rates related to our interest rate swap contracts, partially offset by an increase in interest expense as a result of our short-term draw on our $1.25 billion five-year senior unsecured revolving credit facility. Refer to Note 8, Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for additional information regarding our revolving credit facility. Income Tax Expense Income tax expense increased in fiscal 2021 primarily due to an increase in pre-tax earnings. Our effective tax rate increased in fiscal 2021 primarily due to an increase in losses for which tax benefits were not recognized, a decrease in the tax benefit from stock-based compensation and the impact of higher pre-tax earnings on discrete tax benefits, partially offset by an increase in the tax benefit from federal tax credits and the resolution of discrete tax matters. 29 Non-GAAP Financial Measures Reconciliations of operating income, effective tax rate and diluted EPS (GAAP financial measures) to non-GAAP operating income, non-GAAP effective tax rate and non-GAAP diluted EPS (non-GAAP financial measures) were as follows ($ in millions, except per share amounts): Fiscal Year2021 2020 2019Operating income$ 2,391 $ 2,009 $ 1,900 % of revenue 5.1 % 4.6 % 4.4 %Restructuring - inventory markdowns(1) 23 - - Price-fixing settlement(2) (21) - - Intangible asset amortization(3) 80 72 22 Restructuring charges(4) 254 41 46 Acquisition-related transaction costs(3) - 3 13 Tax reform-related item - employee bonus(5) - - 7 Non-GAAP operating income$ 2,727 $ 2,125 $ 1,988 % of revenue 5.8 % 4.9 % 4.6 % Effective tax rate 24.3 % 22.7 % 22.4 %Price-fixing settlement(2) 0.2 % -% -%Intangible asset amortization(3) (0.6)% 0.1 % -%Restructuring charges(4) (1.0)% -% (0.1)%Gain on investments, net(6) 0.1 % -% -%Tax reform - repatriation tax(5) -% -% 1.1 %Tax reform - deferred tax rate change(5) -% -% 0.3 %Non-GAAP effective tax rate 23.0 % 22.8 % 23.7 % Diluted EPS$ 6.84 $ 5.75 $ 5.20 Restructuring - inventory markdowns(1) 0.09 - - Price-fixing settlement(2) (0.08) - - Intangible asset amortization(3) 0.30 0.27 0.08 Restructuring charges(4) 0.97 0.15 0.16 Gain on investments, net(6) (0.05) - (0.04) Acquisition-related transaction costs(3) - 0.01 0.05 Tax reform-related item - employee bonus(5) - - 0.02 Tax reform - repatriation tax(5) - - (0.07) Tax reform - deferred tax rate change(5) - - (0.02) Income tax impact of non-GAAP adjustments(7) (0.16) (0.11) (0.06) Non-GAAP diluted EPS$ 7.91 $ 6.07 $ 5.32 For additional information regarding the nature of charges discussed below, refer to Note 2, Restructuring; Note 3, Acquisitions; Note 4, Goodwill and Intangible Assets; Note 6, Derivative Instruments; and Note 11, Income Taxes, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.(1)Represents inventory markdowns recorded within cost of sales associated with the decision to exit operations in Mexico.(2)Represents a price-fixing litigation settlement received in relation to products purchased and sold in prior fiscal years.(3)Represents charges associated with acquisitions, including: (1) the non-cash amortization of definite-lived intangible assets, including customer relationships, tradenames and developed technology; and (2) acquisition-related transaction costs primarily comprised of professional fees.(4)Represents charges associated with actions taken to better align the company’s organizational structure with its strategic focus and the decision to exit operations in Mexico in fiscal 2021, charges and subsequent adjustments associated with U.S. retail operating model changes in fiscal 2020, and charges and subsequent adjustments primarily associated with the closure of Best Buy Mobile stand-alone stores in the U.S. in fiscal 2019.(5)Represents adjustments resulting from the Tax Cuts and Jobs Act of 2017 (“tax reform”) enacted into law in the fourth quarter of fiscal 2018, including amounts associated with a deemed repatriation tax and the revaluation of deferred tax assets and liabilities, as well as a one-time bonus for certain employees in response to future tax savings created by tax reform.(6)Represents an increase in the fair value of a minority equity investment in fiscal 2021 and a gain on sale of investments in fiscal 2019.(7)Represents the summation of the calculated income tax charge related to each non-GAAP non-income tax adjustment. The non-GAAP adjustments primarily relate to the U.S. and Mexico. As such, the income tax charge is calculated using the statutory tax rate of 24.5% for all U.S. non-GAAP items for all periods presented. There is no income tax charge for Mexico non-GAAP items, as there was no tax benefit recognized on these expenses in the calculation of GAAP income tax expense. Our non-GAAP operating income rate increased in fiscal 2021 primarily driven by increased leverage from higher sales volume on our fixed expenses, which resulted in a favorable SG&A rate, partially offset by a decrease in gross profit rate. Our non-GAAP effective tax rate increased in fiscal 2021 primarily due to a decrease in the tax benefit from stock-based compensation and the impact of higher pre-tax earnings on discrete tax benefits, partially offset by an increase in the tax benefit from federal tax credits and the resolution of discrete tax matters. Our non-GAAP diluted EPS increased in fiscal 2021 primarily driven by increases in non-GAAP operating income and lower diluted weighted-average common shares outstanding from share repurchases. 30 Liquidity and Capital Resources We closely manage our liquidity and capital resources. Our liquidity requirements depend on key variables, including the level of investment required to support our business strategies, the performance of our business, capital expenditures, credit facilities, short-term borrowing arrangements and working capital management. Capital expenditures and share repurchases are a component of our cash flow and capital management strategy which, to a large extent, we can adjust in response to economic and other changes in our business environment. We have a disciplined approach to capital allocation, which focuses on investing in key priorities that support our strategy. Cash and cash equivalents were as follows ($ in millions): January 30, 2021 February 1, 2020Cash and cash equivalents$ 5,494 $ 2,229 The increase in cash and cash equivalents in fiscal 2021 was primarily driven by the increase in operating cash flows and a reduction in share repurchases, which were temporarily suspended from March to November of fiscal 2021. Cash Flows Cash flows from total operations were as follows ($ in millions): 2021 2020 2019Total cash provided by (used in): Operating activities$ 4,927 $ 2,565 $ 2,408 Investing activities (788) (895) 508 Financing activities (876) (1,498) (2,018) Effect of exchange rate changes on cash 7 (1) (14) Increase in cash, cash equivalents and restricted cash$ 3,270 $ 171 $ 884 Operating Activities The increase in cash provided by operating activities in fiscal 2021 was primarily due to higher inventory turnover and the timing of inventory purchases and payments to meet continued higher demand. The increase was also driven by the timing of payments related to accrued compensation and benefits and higher earnings. Investing Activities The decrease in cash used in investing activities in fiscal 2021 was primarily due to the absence of acquisitions. Financing Activities The decrease in cash used in financing activities in fiscal 2021 was primarily due to lower share repurchases, which were temporarily suspended from March to November of fiscal 2021. Sources of Liquidity Funds generated by operating activities, available cash and cash equivalents, our credit facilities and other debt arrangements are our most significant sources of liquidity. We believe our sources of liquidity will be sufficient to fund operations and anticipated capital expenditures, share repurchases, dividends and strategic initiatives, including business combinations. However, in the event our liquidity is insufficient, we may be required to limit our spending. There can be no assurance that we will continue to generate cash flows at or above current levels or that we will be able to maintain our ability to borrow under our existing credit facilities or obtain additional financing, if necessary, on favorable terms. We have a $1.25 billion five-year senior unsecured revolving credit facility (the "Facility”) with a syndicate of banks. Refer to Note 8, Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for additional information on the terms of the Facility. In light of the uncertainty surrounding the impact of COVID-19 and to maximize liquidity, we executed a short-term draw on the full amount of the Facility on March 19, 2020, which remained outstanding until July 27, 2020, when the amounts we had borrowed under the Facility were repaid in full. There were no borrowings outstanding under the Facility as of January 30, 2021, or February 1, 2020. Our ability to continue to access the Facility is subject to our compliance with its terms and conditions, including financial covenants. The financial covenants require us to maintain certain financial ratios. As of January 30, 2021, we were in compliance with all financial covenants. If an event of default were to occur with respect to any of our other debt, it would likely constitute an event of default under the Facility as well. 31 Our credit ratings and outlook as of March 18, 2021, are summarized below. On February 26, 2021, Moody’s upgraded its rating to A3 and confirmed its outlook of Stable. Standard & Poor’s rating and outlook remained unchanged from the prior year. Rating AgencyRating OutlookStandard & Poor'sBBB StableMoody'sA3 Stable Credit rating agencies review their ratings periodically, and, therefore, the credit rating assigned to us by each agency may be subject to revision at any time. Factors that can affect our credit ratings include changes in our operating performance, the economic environment, conditions in the retail and consumer electronics industries, our financial position and changes in our business strategy. If changes in our credit ratings were to occur, they could impact, among other things, interest costs for certain of our credit facilities, our future borrowing costs, access to capital markets, vendor financing terms and future new-store leasing costs. Restricted Cash Our liquidity is also affected by restricted cash balances that are primarily restricted to use for workers' compensation and general liability insurance claims. Restricted cash, which is included in Other current assets on our Consolidated Balance Sheets, was $131 million and $126 million as of January 30, 2021, and February 1, 2020, respectively. Capital Expenditures Our capital expenditures typically include investments in our information technology (including e-commerce), stores and distribution capabilities. Capital expenditures were as follows ($ in millions): 2021 2020 2019E-commerce and information technology$ 539 $ 431 $ 448 Store-related projects(1) 117 238 264 Supply chain 57 74 107 Total capital expenditures(2)$ 713 $ 743 $ 819 (1)Store-related projects are primarily comprised of store remodels and various merchandising projects.(2)Total capital expenditures exclude non-cash capital expenditures of $32 million, $10 million and $53 million in fiscal 2021, fiscal 2020 and fiscal 2019, respectively. Non-cash capital expenditures are comprised of finance leases, as well as additions to property and equipment included in accounts payable. Debt and Capital As of January 30, 2021, we had $500 million of principal amount of notes due October 1, 2028 (“2028 Notes”) and $650 million of principal amount of notes due October 1, 2030 (“2030 Notes”). Upon issuance of our 2030 Notes, we cash settled the associated Treasury Rate Lock ("T-Lock") contracts entered into in fiscal 2021 to hedge the base interest rate variability on a portion of our then-expected refinancing of our maturing $650 million of principal amount of notes due March 15, 2021 (“2021 Notes”). The net proceeds from the 2030 Notes were used to replace our 2021 Notes that we retired in December 2020 by exercising our option to redeem the notes at par. Refer to Note 6, Derivative Instruments, and Note 8, Debt, in the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for further information about our T-Lock contracts and outstanding debt. Share Repurchases and Dividends We repurchase our common stock and pay dividends pursuant to programs approved by our Board. The payment of cash dividends is also subject to customary legal and contractual restrictions. Our long-term capital allocation strategy is to first fund operations and investments in growth and then return excess cash over time to shareholders through dividends and share repurchases while maintaining investment-grade credit metrics. On February 23, 2019, the Board authorized a $3.0 billion share repurchase program. On February 16, 2021, the Board approved a new $5.0 billion share repurchase program, replacing the existing program which had $1.7 billion remaining available for repurchases as of January 30, 2021. There is no expiration date governing the period over which we can repurchase shares under this authorization. We temporarily suspended all share repurchases from March to November of fiscal 2021 to conserve liquidity in light of COVID-19-related uncertainties. Between the end of fiscal 2021 on January 30, 2021, and March 18, 2021, we repurchased an incremental 8.1 million shares of our common stock at a cost of $873 million. On February 25, 2021, we announced our plans to spend at least $2 billion on share repurchases in fiscal 2022. Share repurchase and dividend activity were as follows ($ and shares in millions, except per share amounts): 2021 2020 2019Total cost of shares repurchased$ 318 $ 1,009 $ 1,493 Average price per share$ 102.63 $ 72.34 $ 70.28 Total number of shares repurchased 3.1 14.0 21.2 Regular quarterly cash dividends per share$ 2.20 $ 2.00 $ 1.80 Cash dividends declared and paid$ 568 $ 527 $ 497 32 Dividends declared and paid increased in fiscal 2021 primarily due to an increase in the regular quarterly cash dividend per share. On February 25, 2021, we announced the Board’s approval of a 27% increase in the regular quarterly dividend to $0.70 per share. Other Financial Measures Our current ratio, calculated as current assets divided by current liabilities, remained relatively unchanged at 1.2 as of January 30, 2021, compared to 1.1 as of February 1, 2020. Our debt to earnings ratio, calculated as total debt (including current portion) divided by net earnings, remained unchanged at 0.8 as of January 30, 2021, and February 1, 2020. Off-Balance-Sheet Arrangements and Contractual Obligations We do not have outstanding off-balance-sheet arrangements. Contractual obligations as of January 30, 2021, were as follows ($ in millions): Payments Due by PeriodContractual ObligationsTotal Less Than ‎1 Year 1-3 Years 3-5 Years More Than ‎5 YearsPurchase obligations(1)$ 3,107 $ 2,922 $ 151 $ 29 $ 5 Operating lease obligations(2)(3) 2,917 741 1,147 637 392 Long-term debt obligations(4) 1,150 - - - 1,150 Interest payments(5) 217 22 44 50 101 Short-term debt obligations(4) 110 110 - - - Finance lease obligations(2) 41 14 17 6 4 Total$ 7,542 $ 3,809 $ 1,359 $ 722 $ 1,652 For additional information regarding the nature of contractual obligations discussed below, refer to Note 6, Derivative Instruments; Note 7, Leases; Note 8, Debt; and Note 13, Contingencies and Commitments, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.(1)Purchase obligations include agreements to purchase goods or services that are enforceable, are legally binding and specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations do not include agreements that are cancelable without penalty. Additionally, although they do not contain legally binding purchase commitments, we included open purchase orders in the table above. Substantially all open purchase orders are fulfilled within 30 days.(2)Lease obligations exclude $56 million of legally binding fixed costs for leases signed but not yet commenced.(3)Operating lease obligations exclude payments to landlords covering real estate taxes and common area maintenance. These charges, if included, would increase total operating lease obligations by $0.7 billion as of January 30, 2021.(4)Represents principal amounts only and excludes interest rate swap valuation adjustments related to our long-term debt obligations.(5)Interest payments related to our 2028 Notes and 2030 Notes include the variable interest rate payments included in our interest rate swaps. Additionally, we have $1.25 billion in undrawn capacity on our Facility as of January 30, 2021, which if drawn upon, would be included as short-term debt on our Consolidated Balance Sheets. Critical Accounting Estimates The preparation of our financial statements requires us to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses and the related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors believed to be relevant at the time our consolidated financial statements are prepared. Because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Other than our adoption of Accounting Standards Update (“ASU”) 2016-02, Leases, in the first quarter of fiscal 2020, and our adoption of ASU 2014-09, Revenue from Contracts with Customers, in the first quarter of fiscal 2019, we have not made any material changes to our accounting policies or methodologies during the past three fiscal years. We believe that the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results. These estimates require our most difficult, subjective or complex judgments and generally incorporate significant uncertainty. Vendor Allowances DescriptionWe receive funds from our merchandise vendors through a variety of programs and arrangements for product advertising and product placement, primarily in the form of allowances based on purchases or sales volumes. We recognize allowances based on purchases and sales as a reduction of cost of sales when the associated inventory is sold. Allowances for advertising and placement are recognized as a reduction of cost of sales ratably over the corresponding performance period. Funds that are determined to be a reimbursement of specific, incremental and identifiable costs incurred to sell a vendor's products are recorded as an offset to the related expense when incurred. 33 Judgments and uncertainties involved in the estimateDue to the quantity and diverse nature of our vendor agreements, estimates are made to determine the amount of funding to be recognized in earnings or deferred as an offset to inventory. These estimates require a detailed analysis of complex factors, including (1) proper classification of the type of funding received; and (2) the methodology to estimate the portion of purchases-based funding that should be recognized in cost of sales in each period, which considers factors such as inventory turn by product category and actual sell-through of inventory. Effect if actual results differ from assumptionsA 10% change in our vendor funding deferral as of January 30, 2021, would have affected net earnings by approximately $33 million in fiscal 2021. The overall level of deferral has remained relatively stable over the last three years. Goodwill DescriptionGoodwill is not amortized but is evaluated for impairment annually in the fiscal fourth quarter or whenever events or circumstances indicate the carrying value may not be recoverable. The impairment test involves a comparison of the fair value of each reporting unit with its carrying value. Fair value reflects the price a potential market participant would be willing to pay for the reporting unit in an arms-length transaction. Judgments and uncertainties involved in the estimateDetermining fair value of a reporting unit is complex and typically requires analysis of discounted cash flows and other market information, such as trading multiples and other observable metrics. Cash flow analysis requires judgment regarding many factors, such as revenue growth rates, expenses and capital expenditures. Market information requires judgmental selection of relevant market comparables. We have goodwill in two reporting units – Best Buy Domestic and Best Buy Health – with carrying values of $444 million and $542 million, respectively, as of January 30, 2021. There is greater uncertainty surrounding the key assumptions used to estimate the fair value of the Best Buy Health reporting unit and therefore a greater degree of complexity and judgment involved in our impairment analysis. Our valuation of Best Buy Health incorporates relatively higher levels of revenue growth than our valuation of Best Buy Domestic and, consequently, estimation of factors such as new customer growth, customer retention rates, capital expenditure requirements, advertising and cost to serve expenses and weighted-average cost of capital rates that incorporate significant judgment. Effect if actual results differ from assumptionsA 10% change in the fair value of the Best Buy Health reporting unit as of January 30, 2021, would not have had a material effect on our net earnings in fiscal 2021. Since acquisition, our estimate of the fair value of Best Buy Health has remained relatively stable. Inventory Markdown DescriptionOur merchandise inventories were $5.6 billion as of January 30, 2021. We value our inventory at the lower of cost or net realizable value through the establishment of inventory markdown adjustments. Markdown adjustments reflect the excess of cost over the net recovery we expect to realize from the ultimate sale or other disposal of inventory and establish a new cost basis. No adjustment is recorded for inventory that we are able to return to our vendors for full credit. Judgments and uncertainties involved in the estimateMarkdown adjustments involve uncertainty because the calculations require management to make assumptions and to apply judgment about the expected revenue and incremental costs we will generate for current inventory. Such estimates include the evaluation of historical recovery rates, as well as factors such as product type and condition, forecasted consumer demand, product lifecycles, promotional environment, vendor return rights and the expected sales channel of ultimate disposition. We also apply judgment in the assumptions about other components of net realizable value, such as vendor allowances and selling costs. Effect if actual results differ from assumptionsA 10% change in our markdown adjustment as of January 30, 2021, would have affected net earnings by approximately $13 million in fiscal 2021. The level of markdown adjustments has remained relatively stable over the last three fiscal years. Tax Contingencies DescriptionOur income tax returns are periodically audited by U.S. federal, state and local and foreign taxing authorities. Taxing authorities audit our tax filing positions, including the timing and amount of income and deductions and the allocation of income among various tax jurisdictions. At any one time, multiple tax years are subject to audit by the various taxing authorities. In evaluating the exposures associated with our various tax filing positions, we may record a liability for such exposures. A number of years may elapse before a particular matter, for which we have established a liability, is audited and fully resolved or clarified. We adjust our liability for unrecognized tax benefits and income tax provisions in the period in which an uncertain tax position is effectively settled, the statute of limitations expires for the relevant taxing authority to examine the tax position or when more information becomes available. Our effective income tax rate is also affected by changes in tax law, the tax jurisdiction of new stores or business ventures, the level of earnings and the results of tax audits. 34 Judgments and uncertainties involved in the estimateOur liability for unrecognized tax benefits contains uncertainties because management is required to make assumptions and apply judgment to estimate the exposures associated with our various tax filing positions. Such assumptions can include complex and uncertain external factors, such as changes in tax law, interpretations of tax law and the timing of such changes, and uncertain internal factors such as taxable earnings by jurisdiction, the magnitude and timing of certain transactions and capital spending. Effect if actual results differ from assumptionsAlthough we believe that the judgments and estimates discussed herein are reasonable, actual results could differ, and we may be exposed to losses or gains that could be material. To the extent we prevail in matters for which a liability has been established or are required to pay amounts in excess of our established liability, our effective income tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement generally would require use of our cash and may result in an increase in our effective income tax rate in the period of resolution. A favorable tax settlement may reduce our effective income tax rate in the period of resolution. Service Revenue DescriptionWe sell support plans as part of a bundled service offer which may include items such as technical support, price discounts on future purchases, anti-virus software and one-time service repairs. We allocate the transaction price to all performance obligations identified in the contract based on their relative fair value. For technical support services, we typically recognize revenue over time on a usage basis, an input method of measuring progress over the related contract term. This method involves the estimation of expected usage patterns, primarily derived from historical information. Judgments and uncertainties involved in the estimateThere is judgment in (1) measuring the relative standalone selling price for bundled performance obligations, and (2) assessing the appropriate recognition and methodology for each performance obligation, and for those based on usage, estimating the expected pattern of consumption across a large portfolio of customers. When insufficient reliable and relevant history is available to estimate usage, we generally recognize revenue ratably over the life of the contract until such history has accumulated. Effect if actual results differ from assumptionsA 10% change in the amount of services membership deferred revenue as of January 30, 2021, would have affected net earnings by approximately $13 million in fiscal 2021. The amount of services membership deferred revenue has remained relatively stable over the last three fiscal years. New Accounting Pronouncements For a description of new applicable accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. In addition to the risks inherent in our operations, we are exposed to certain market risks. Interest Rate Risk We are exposed to changes in short-term market interest rates and these changes in rates will impact our net interest expense. Our cash and cash equivalents generate interest income that will vary based on changes in short-term interest rates. In addition, we have swapped a portion of our fixed-rate debt to floating-rate such that the interest expense on this debt will vary with short-term interest rates. Refer to Note 6, Derivative Instruments, and Note 8, Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for further information regarding our interest rate swaps. In fiscal 2021 we entered into T-Lock contracts to hedge the base interest rate variability on a portion of our then-expected refinancing of our maturing 2021 Notes. The T-Lock contracts were immaterial and cash settled upon issuance of our 2030 Notes in fiscal 2021. The fair value of the T-Lock contracts upon settlement was released from Accumulated other comprehensive income on our Consolidated Balance Sheets and recorded in Interest expense on our Consolidated Statements of Earnings as interest is accrued over the life of the 2030 Notes. As of January 30, 2021, we had $5.5 billion of cash and cash equivalents and $500 million of debt that has been swapped to floating rate, and therefore the net balance exposed to interest rate changes was $5.0 billion. As of January 30, 2021, a 50-basis point increase in short-term interest rates would have led to an estimated $25 million reduction in net interest expense, and conversely a 50-basis point decrease in short-term interest rates would have led to an estimated $25 million increase in net interest expense. 35 Foreign Currency Exchange Rate Risk We have market risk arising from changes in foreign currency exchange rates related to our International segment operations. On a limited basis, we utilize foreign exchange forward contracts to manage foreign currency exposure to certain forecasted inventory purchases, recognized receivable and payable balances and our investment in our Canadian operations. Our primary objective in holding derivatives is to reduce the volatility of net earnings and cash flows, as well as net asset value associated with changes in foreign currency exchange rates. Our foreign currency risk management strategy includes both hedging instruments and derivatives that are not designated as hedging instruments, which generally have terms of up to 12 months. Refer to Note 6, Derivative Instruments, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for further information regarding these instruments. In fiscal 2021 foreign currency exchange rate fluctuations were driven by the strength of the U.S. dollar compared to the Mexican peso and the Canadian dollar compared to the prior-year period, which had a negative overall impact on our revenue as foreign currencies translated into fewer U.S. dollars. The strength of the U.S. dollar compared to the Mexican peso also had a favorable impact on earnings as the operating loss in Mexican pesos translated into fewer U.S. dollars. We estimate that foreign currency exchange rate fluctuations had a net unfavorable impact on our revenue of approximately $45 million and a net favorable impact on earnings of approximately $15 million in fiscal 2021, excluding the reclassification of cumulative translation adjustments into earnings as a result of our exit from Mexico. ‎ 36

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+ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. General Impact of COVID-19 The coronavirus pandemic (“COVID-19”) and the resulting economic disruption are impacting and will likely continue to impact business activity across many industries worldwide. COVID-19 remains dynamic, with uncertainty around its duration and broader impact. We are monitoring and assessing the situation and will continue to adapt our business practices over the coming quarters to serve our customers and protect our employees. The pandemic has reduced, and is expected to continue to negatively impact, the volume of business from new customers and insurable exposure units for existing customers. Company Overview The following discussion should be read in conjunction with our Consolidated Financial Statements and the related Notes to those Financial Statements included elsewhere in this Annual Report on Form 10-K. In addition, please see “Information Regarding Non-GAAP Measures” below, regarding important information on non-GAAP financial measures contained in our discussion and analysis. We are a diversified insurance agency, wholesale brokerage, insurance programs and services organization headquartered in Daytona Beach, Florida. As an insurance intermediary, our principal sources of revenue are commissions paid by insurance companies and, to a lesser extent, fees paid directly by customers. Commission revenues generally represent a percentage of the premium paid by an insured and are affected by fluctuations in both premium rate levels charged by insurance companies and the insureds’ underlying “insurable exposure units,” which are units that insurance companies use to measure or express insurance exposed to risk (such as property values, or sales and payroll levels) to determine what premium to charge the insured. Insurance companies establish these premium rates based upon many factors, including loss experience, risk profile and reinsurance rates paid by such insurance companies, none of which we control. We have increased revenues every year from 1993 to 2020, with the exception of 2009, when our revenues declined 1.0%. Our revenues grew from $95.6 million in 1993 to $2.6 billion in 2020, reflecting a compound annual growth rate of 13.0%. In the same 27-year period, we increased net income from $8.1 million to $480.5 million in 2020, a compound annual growth rate of 16.3%. The volume of business from new and existing customers, fluctuations in insurable exposure units, changes in premium rate levels, changes in general economic and competitive conditions, a health pandemic, and the occurrence of catastrophic weather events all affect our revenues. For example, level rates of inflation or a general decline in economic activity could limit increases in the values of insurable exposure units. Conversely, increasing costs of litigation settlements and awards could cause some customers to seek higher levels of insurance coverage. Historically, our revenues have typically grown as a result of our focus on net new business growth and acquisitions. We foster a strong, decentralized sales and service culture with the goal of consistent, sustained growth over the long-term. The term “Organic Revenue,” a non-GAAP measure, is our core commissions and fees less: (i) the core commissions and fees earned for the first 12 months by newly-acquired operations; and (ii) divested business (core commissions and fees generated from offices, books of business or niches sold or terminated during the comparable period). The term “core commissions and fees” excludes profit-sharing contingent commissions and guaranteed supplemental commissions, and therefore represents the revenues earned directly from specific insurance policies sold, and specific fee-based services rendered. “Organic Revenue” is reported in this manner in order to express the current year’s core commissions and fees on a comparable basis with the prior year’s core commissions and fees. The resulting net change reflects the aggregate changes attributable to: (i) net new and lost accounts; (ii) net changes in our customers’ exposure units; (iii) net changes in insurance premium rates or the commission rate paid to us by our carrier partners; and (iv) the net change in fees paid to us by our customers. Organic Revenue is reported in “Results of Operations” and in “Results of Operations – Segment Information” of this Annual Report on Form 10-K. We also earn “profit-sharing contingent commissions,” which are commissions based primarily on underwriting results, but which may also reflect considerations for volume, growth and/or retention. These commissions, which are included in our commissions and fees in the Consolidated Statement of Income, are accrued throughout the year based on actual premiums written and are primarily received in the first and second quarters of each subsequent year, based upon the aforementioned considerations for the prior year(s). Over the last three years, profit-sharing contingent commissions have averaged approximately 3.0% of commissions and fees revenue. Certain insurance companies offer guaranteed fixed-base agreements, referred to as “Guaranteed Supplemental Commissions” (“GSCs”) in lieu of profit-sharing contingent commissions. GSCs are accrued throughout the year based upon actual premiums written. For the year ended December 31, 2020, we had earned $16.2 million of GSCs, of which $11.9 million remained accrued at December 31, 2020 and most of this will be collected over the first and second quarters of 2021. For the years ended December 31, 2020 and 2019, we earned $16.2 million and $23.1 million, respectively, from GSCs. Combined, our profit-sharing contingent commissions and GSCs for the year ended December 31, 2020 increased by $4.9 million over 2019. The net increase of $4.9 million was mainly driven by: (i) cash received for profit-sharing contingent commissions in the first and second quarters of 2020 being somewhat higher than the amount accrued as of December 31, 2019 for the estimate of contingents earned in 2019; (ii) growth associated with acquisitions completed over the last twelve months; and (iii) partially offset by a GSC of approximately $9 million recorded in the second quarter of 2019 for the National Programs Segment that will not recur in the future as the associated multi-year contract has ended. 25 Table of Contents Fee revenues primarily relate to services other than securing coverage for our customers, as well as fees negotiated in lieu of commissions, and are recognized as performance obligations are satisfied. Fee revenues have historically been generated primarily by: (1) our Services Segment, which provides insurance-related services, including third-party claims administration and comprehensive medical utilization management services in both the workers’ compensation and all-lines liability arenas, as well as Medicare Set-aside services, Social Security disability and Medicare benefits advocacy services, and claims adjusting services; (2) our National Programs and Wholesale Brokerage Segments, which earn fees primarily for the issuance of insurance policies on behalf of insurance companies; and to a lesser extent (3) our Retail Segment in our large-account customer base, where we primarily earn fees for securing insurance for our customers, and in our automobile dealer services (“F&I”) businesses where we primarily earn fees for assisting our customers with creating and selling warranty and service risk management programs. Fee revenues as a percentage of our total commissions and fees, represented 26.1% in 2020 and 27.1% in 2019. For the years ended December 31, 2020 and 2019, our commissions and fees growth rate was 9.3% and 18.7%, respectively, and our consolidated Organic Revenue growth rate was 3.8% and 3.6%, respectively. Historically, investment income has consisted primarily of interest earnings on operating cash, and where permitted, on premiums and advance premiums collected and held in a fiduciary capacity before being remitted to insurance companies. Our policy is to invest available funds in high-quality, short-term fixed income investment securities. Investment income also includes gains and losses realized from the sale of investments. Other income primarily reflects legal settlements and other miscellaneous income. Income before income taxes for the year ended December 31, 2020 increased over 2019 by $98.2 million, primarily as a result of net new business, acquisitions we completed since 2019, and management of our expense base. Information Regarding Non-GAAP Measures In the discussion and analysis of our results of operations, in addition to reporting financial results in accordance with generally accepted accounting principles (“GAAP”), we provide references to the following non-GAAP financial measures as defined in Regulation G of SEC rules: Organic Revenue, Organic Revenue growth, EBITDAC and EBITDAC Margin. We view these non-GAAP financial measures as important indicators when assessing and evaluating our performance on a consolidated basis and for each of our segments because they allow us to determine a more comparable, but non-GAAP, measurement of revenue growth and operating performance that is associated with the revenue sources that were a part of our business in both the current and prior year. We believe that Organic Revenue provides a meaningful representation of our operating performance and view Organic Revenue growth as an important indicator when assessing and evaluating the performance of our four segments. Organic Revenue can be expressed as a dollar amount or a percentage rate when describing Organic Revenue growth. We also use Organic Revenue growth and EBITDAC Margin for incentive compensation determinations for executive officers and other key employees. We view EBITDAC and EBITDAC Margin as important indicators of operating performance, because they allow us to determine more comparable, but non-GAAP, measurements of our operating margins in a meaningful and consistent manner by removing the significant non-cash items of depreciation, amortization and the change in estimated acquisition earn-out payables, and also interest expense and taxes, which are reflective of investment and financing activities, not operating performance. These measures are not in accordance with, or an alternative to the GAAP information provided in this Annual Report on Form 10-K. We present such non-GAAP supplemental financial information because we believe such information is of interest to the investment community and because we believe they provide additional meaningful methods of evaluating certain aspects of our operating performance from period to period on a basis that may not be otherwise apparent on a GAAP basis. We believe these non-GAAP financial measures improve the comparability of results between periods by eliminating the impact of certain items that have a high degree of variability. Our industry peers may provide similar supplemental non-GAAP information with respect to one or more of these measures, although they may not use the same or comparable terminology and may not make identical adjustments. This supplemental financial information should be considered in addition to, not in lieu of, our Consolidated Financial Statements. Tabular reconciliations of this supplemental non-GAAP financial information to our most comparable GAAP information are contained in this Annual Report on Form 10-K under “Results of Operation - Segment Information.” Acquisitions Part of our business strategy is to attract high-quality insurance intermediaries and service organizations to join our operations. From 1993 through the fourth quarter of 2020, we acquired 561 insurance intermediary operations. Critical Accounting Policies Our Consolidated Financial Statements are prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We continually evaluate our estimates, which are based upon historical experience and on assumptions that we believe to be reasonable under the circumstances. These estimates form the basis for our judgments about the recognition of revenues, expenses, carrying values of our assets and liabilities, of which values are not readily apparent from other sources. Actual results may differ from these estimates. 26 Table of Contents We believe that of our significant accounting and reporting policies, the more critical policies include our accounting for revenue recognition, business combinations and purchase price allocations, intangible asset impairments, non-cash stock-based compensation and reserves for litigation. In particular, the accounting for these areas requires significant use of judgment to be made by management. Different assumptions in the application of these policies could result in material changes in our consolidated financial position or consolidated results of operations. Revenue Recognition The majority of our revenue is commissions derived from our performance as agents and brokers, acting on behalf of insurance carriers to sell products to customers that are seeking to transfer risk, and conversely, acting on behalf of those customers in negotiating with insurance carriers seeking to acquire risk in exchange for premiums. In the majority of these arrangements, our performance obligation is complete upon the effective date of the bound policy, as such, that is when the associated revenue is recognized. In some arrangements, where we are compensated through commissions, we also perform other services for our customer beyond the binding of coverage. In those arrangements we apportion the commission between the binding of coverage and other services based on their relative fair value and recognize the associated revenue as those performance obligations are satisfied. Where the Company’s performance obligations have been completed, but the final amount of compensation is unknown due to variable factors, we estimate the amount of such compensation. We refine those estimates upon our receipt of additional information or final settlement, whichever occurs first. To a lesser extent, the Company earns revenues in the form of fees. Like commissions, fees paid to us in lieu of commission, are recognized upon the effective date of the bound policy. When we are paid a fee for service, however, the associated revenue is recognized over a period of time that coincides with when the customer simultaneously receives and consumes the benefit of our work, which characterizes most of our claims processing arrangements and various services performed in our property and casualty, and employee benefits practices. Other fees are typically recognized upon the completion of the delivery of the agreed-upon services to the customer. Management determines a policy cancellation reserve based upon historical cancellation experience adjusted in accordance with known circumstances. Please see Note 2 “Revenues” in the “Notes to Consolidated Financial Statements” for additional information regarding the nature and timing of our revenues. Business Combinations and Purchase Price Allocations We have acquired significant intangible assets through acquisitions of businesses. These assets generally consist of purchased customer accounts, non-compete agreements, and the excess of purchase prices over the fair value of identifiable net assets acquired (goodwill). The determination of estimated useful lives and the allocation of purchase price to intangible assets requires significant judgment and affects the amount of future amortization and possible impairment charges. Our business combinations are accounted for using the acquisition method. In connection with these acquisitions, we record the estimated value of the net tangible assets purchased and the value of the identifiable intangible assets purchased, which typically consist of purchased customer accounts and non-compete agreements. Purchased customer accounts include the physical records and files obtained from acquired businesses that contain information about insurance policies, customers and other matters essential to policy renewals of delivery of services. However, they primarily represent the present value of the underlying cash flows expected to be received over the estimated future renewal periods of the insurance policies comprising those purchased customer accounts. The valuation of purchased customer accounts involves significant estimates and assumptions concerning matters such as cancellation frequency, expenses and discount rates. Any change in these assumptions could affect the carrying value of purchased customer accounts. Non-compete agreements are valued based upon their duration and any unique features of the particular agreements. Purchased customer accounts and non-compete agreements are amortized on a straight-line basis over the related estimated lives and contract periods, which range from 3 to 15 years. The excess of the purchase price of an acquisition over the fair value of the identifiable tangible and intangible assets is assigned to goodwill and is not amortized. Acquisition purchase prices are typically based upon a multiple of average EBITDA, annual operating profit and/or core revenue earned over a one to three-year period within a minimum and maximum price range. The recorded purchase prices for all acquisitions include an estimation of the fair value of liabilities associated with any potential earn-out provisions, where an earn-out is part of the negotiated transaction. Subsequent changes in the fair value of earn-out obligations are recorded in the Consolidated Statement of Income when changes to the expected performance of the associated business are realized. 27 Table of Contents The fair value of earn-out obligations is based upon the present value of the expected future payments to be made to the sellers of the acquired businesses in accordance with the provisions contained in the respective purchase agreements. In determining fair value, the acquired business’s future performance is estimated using financial projections developed by management for the acquired business, and this estimate reflects market participant assumptions regarding revenue growth and/or profitability. The expected future payments are estimated based on the earn-out formula and performance targets specified in each purchase agreement compared to the associated financial projections. These estimates are then discounted to a present value using a risk-adjusted rate that takes into consideration the likelihood that the forecasted earn-out payments will be made. Intangible Assets Impairment Goodwill is subject to at least an annual assessment for impairment measured by a fair-value-based test. Amortizable intangible assets are amortized over their useful lives and are subject to an impairment review based upon an estimate of the undiscounted future cash flows resulting from the use of the assets. To determine if there is potential impairment of goodwill, we compare the fair value of each reporting unit with its carrying value. If the fair value of the reporting unit is less than its carrying value, an impairment loss would be recorded to the extent that the fair value of the goodwill within the reporting unit is less than its carrying value. Fair value is estimated based upon multiples of earnings before interest, income taxes, depreciation, amortization and change in estimated acquisition earn-out payables (“EBITDAC”), or on a discounted cash flow basis. Management assesses the recoverability of our goodwill and our amortizable intangibles and other long-lived assets annually and whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Any of the following factors, if present, may trigger an impairment review: (i) a significant underperformance relative to historical or projected future operating results, (ii) a significant negative industry or economic trend, and (iii) a significant decline in our market capitalization. If the recoverability of these assets is unlikely because of the existence of one or more of the above-referenced factors, an impairment analysis is performed. Management must make assumptions regarding estimated future cash flows and other factors to determine the fair value of these assets. If these estimates or related assumptions change in the future, we may be required to revise the assessment and, if appropriate, record an impairment charge. We completed our most recent evaluation of impairment for goodwill as of November 30, 2020 and determined that the fair value of goodwill exceeded the carrying value of such assets. Additionally, there have been no impairments recorded for amortizable intangible assets for the years ended December 31, 2020 and 2019. Non-Cash Stock-Based Compensation We grant non-vested stock awards to our employees, with the related compensation expense recognized in the financial statements over the associated service period based upon the grant-date fair value of those awards. During the performance measurement period, we review the probable outcome of the performance conditions associated with our performance awards and align the expense accruals with the expected performance outcome. During the first quarter of 2020, the performance conditions for 1,880,512 shares of the Company’s common stock granted under the Company’s 2010 SIP were determined by the Compensation Committee to have been satisfied relative to performance-based grants issued in 2015 and 2017. These grants had a performance measurement period that concluded on December 31, 2019. The vesting condition for these grants requires continuous employment for a period of up to seven years from the 2015 grant date and five years from the 2017 grant date in order for the awarded shares to become fully vested and nonforfeitable. As a result of the awarding of these shares, the grantees will be eligible to receive payments of dividends and exercise voting privileges after the awarding date, and the awarded shares will be included as issued and outstanding common stock shares and included in the calculation of basic and diluted net income per share. During the first quarter of 2021, the performance conditions for approximately 1.2 million shares of the Company’s common stock granted under the Company’s 2010 SIP and approximately 22,000 shares of the Company’s common stock granted under the Company’s 2019 SIP were determined by the Compensation Committee to have been satisfied relative to performance-based grants issued in 2018 and 2020. These grants had a performance measurement period that concluded on December 31, 2020. The vesting condition for these grants requires continuous employment for a period of up to five years from the 2018 grant date and four years from the 2020 grant date in order for the awarded shares to become fully vested and nonforfeitable. As a result of the awarding of these shares, the grantees will be eligible to receive payments of dividends and exercise voting privileges after the awarding date, and the awarded shares will be included as issued and outstanding common stock shares and included in the calculation of basic and diluted net income per share. Litigation and Claims We are subject to numerous litigation claims that arise in the ordinary course of business. If it is probable that a liability has been incurred at the date of the financial statements and the amount of the loss is estimable, an accrual for the costs to resolve these claims is recorded in accrued expenses in the accompanying Consolidated Financial Statements. Professional fees related to these claims are included in other operating expenses in the accompanying Consolidated Statement of Income as incurred. Management, with the assistance of in-house and outside counsel, determines whether it is probable that a liability has been incurred and estimates the amount of loss based upon analysis of individual issues. New developments or changes in settlement strategy in dealing with these matters may significantly affect the required reserves and affect our net income. 28 Table of Contents RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 The following discussion and analysis regarding results of operations and liquidity and capital resources should be considered in conjunction with the accompanying Consolidated Financial Statements and related Notes. For a comparison of our results of operations and liquidity and capital resources for the years ended December 31, 2019 and 2018, please see Part II, Item 7 of our Annual Report on Form 10-K filed with the SEC on February 24, 2020. Financial information relating to our Consolidated Financial Results is as follows: (in thousands, except percentages) 2020 % Change 2019 REVENUES Core commissions and fees $ 2,518,980 9.4 % $ 2,302,506 Profit-sharing contingent commissions 70,934 19.9 % 59,166 Guaranteed supplemental commissions 16,194 (29.8 )% 23,065 Total commissions and fees 2,606,108 9.3 % 2,384,737 Investment income 2,811 (51.4 )% 5,780 Other income, net 4,456 169.4 % 1,654 Total revenues 2,613,375 9.2 % 2,392,171 EXPENSES Employee compensation and benefits 1,436,377 9.8 % 1,308,165 Other operating expenses 365,973 (2.9 )% 377,089 (Gain)/loss on disposal (2,388 ) (76.2 )% (10,021 ) Amortization 108,523 3.1 % 105,298 Depreciation 26,276 12.2 % 23,417 Interest 58,973 (7.4 )% 63,660 Change in estimated acquisition earn-out payables (4,458 ) NMF (1,366 ) Total expenses 1,989,276 6.6 % 1,866,242 Income before income taxes 624,099 18.7 % 525,929 Income taxes 143,616 12.7 % 127,415 NET INCOME $ 480,483 20.6 % $ 398,514 Income Before Income Taxes Margin (1) 23.9 % 22.0 % EBITDAC (2) $ 813,413 13.5 % $ 716,938 EBITDAC Margin (2) 31.1 % 30.0 % Organic Revenue growth rate (2) 3.8 % 3.6 % Employee compensation and benefits relative to total revenues 55.0 % 54.7 % Other operating expenses relative to total revenues 14.0 % 15.8 % Capital expenditures $ 70,700 (3.3 )% $ 73,108 Total assets at December 31 $ 8,966,492 17.6 % $ 7,622,821 (1) “Income Before Income Taxes Margin” is defined as income before income taxes divided by total revenues (2) A non-GAAP measure NMF = Not a meaningful figure Commissions and Fees Commissions and fees, including profit-sharing contingent commissions and GSCs for 2020, increased $221.4 million to $2,606.1 million, or 9.3% over 2019. Core commissions and fees in 2020 increased $216.5 million, composed of (i) $141.1 million from acquisitions that had no comparable revenues in the same period of 2019; (ii) an offsetting decrease of $12.1 million related to commissions and fees revenue from business divested in the preceding twelve months; and (iii) approximately $87.5 million of net new and renewal business, which reflects an Organic Revenue growth rate of 3.8%. Profit-sharing contingent commissions and GSCs for 2020 increased by $4.9 million, or 6.0%, compared to the same period in 2019. The net increase of $4.9 million was mainly driven by: (i) cash received for profit-sharing contingent commissions in the first and second quarters of 2020 being somewhat higher than the amount accrued as of December 31, 2019 for the estimate of contingents earned in 2019; (ii) growth associated with acquisitions completed over the last twelve months; and (iii) partially offset by a GSC of approximately $9 million recorded in the second quarter of 2019 for the National Programs Segment that will not recur in the future as the associated multi-year contract ended in 2019. 29 Table of Contents Investment Income Investment income decreased to $2.8 million in 2020, compared with $5.8 million in 2019. The decrease was primarily due to lower interest rates as compared to the prior year. Other Income, Net Other income for 2020 was $4.5 million, compared with $1.7 million in 2019. Other income consists primarily of legal settlements and other miscellaneous income. Employee Compensation and Benefits Employee compensation and benefits expense increased 9.8%, or $128.2 million, in 2020 compared to 2019. This increase included $48.0 million of compensation costs related to stand-alone acquisitions that had no comparable costs in the same period of 2019. Therefore, employee compensation and benefits expense attributable to those offices that existed in the same time periods of 2020 and 2019 increased by $80.2 million or 6.2%. This underlying employee compensation and benefits expense increase was primarily related to (i) an increase in staff salaries attributable to salary inflation; (ii) an increase in non-cash stock-based compensation expense; (iii) increased producer compensation due to higher revenue; and (iv) higher accrued performance bonuses. Employee compensation and benefits expense as a percentage of total revenues was 55.0% for 2020 as compared to 54.7% for the year ended December 31, 2019. Other Operating Expenses Other operating expenses represented 14.0% of total revenues for 2020 as compared to 15.8% for the year ended December 31, 2019. Other operating expenses for 2020 decreased $11.1 million, or 2.9%, from the same period of 2019. The net decrease included: (i) lower variable operating expenses, including such items as travel & entertainment, meetings and professional fees, resulting from responses to COVID-19; partially offset by (ii) $22.6 million of other operating expenses related to stand-alone acquisitions that had no comparable costs in the same period of 2019; and (iii) the write-off recorded in 2020 of certain receivables in one of our programs where it was determined the collectability was in doubt. Gain or Loss on Disposal The Company recognized gains on disposal of $2.4 million in 2020 and $10.0 million in 2019. The change in the gain on disposal was due to activity associated with book of business sales. Although we are not in the business of selling customer accounts, we periodically sell an office or a book of business (one or more customer accounts) that we believe does not produce reasonable margins or demonstrate a potential for growth, or because doing so is in the Company’s best interest. Amortization Amortization expense for 2020 increased $3.2 million to $108.5 million, or 3.1% over 2019. The increase reflects the amortization of new intangible assets from recently acquired businesses, partially offset by certain intangible assets becoming fully amortized. Depreciation Depreciation expense for 2020 increased $2.9 million to $26.3 million, or 12.2% over 2019. Changes in depreciation expense reflect the addition of fixed assets resulting from capital projects related to our multi-year technology investment program and other business initiatives, net additions of fixed assets resulting from businesses acquired in the past 12 months, partially offset by fixed assets which became fully depreciated. Interest Expense Interest expense for 2020 decreased $4.7 million to $59.0 million, or 7.4%, from 2019. The decrease is due to the decrease in interest rates associated with our floating rate debt balances, partially offset by higher average debt balances from increased borrowings in 2020. Change in Estimated Acquisition Earn-Out Payables Accounting Standards Codification (“ASC”) Topic 805-Business Combinations is the authoritative guidance requiring an acquirer to recognize 100% of the fair value of acquired assets, including goodwill, and assumed liabilities (with only limited exceptions) upon initially obtaining control of an acquired entity. Additionally, the fair value of contingent consideration arrangements (such as earn-out purchase price arrangements) at the acquisition date must be included in the purchase price consideration. The recorded purchase price for acquisitions includes an estimation of the fair value of liabilities associated with any potential earn-out provisions. Subsequent changes in these earn-out obligations are required to be recorded in the Consolidated Statement of Income when incurred or reasonably estimated. Estimations of potential earn-out obligations are typically based upon future earnings of the acquired operations or entities, usually for periods ranging from one to three years. 30 Table of Contents The net charge or credit to the Consolidated Statement of Income for the period is the combination of the net change in the estimated acquisition earn-out payables balance, and the interest expense imputed on the outstanding balance of the estimated acquisition earn-out payables. As of December 31, 2020, the fair values of the estimated acquisition earn-out payables were re-evaluated and measured at fair value on a recurring basis using unobservable inputs (Level 3) as defined in ASC 820-Fair Value Measurement. The resulting net changes, as well as the interest expense accretion on the estimated acquisition earn-out payables, for the years ended December 31, 2020 and 2019 were as follows: (in thousands) 2020 2019 Change in fair value of estimated acquisition earn-out payables $ (11,814 ) $ (7,298 ) Interest expense accretion 7,356 5,932 Net change in earnings from estimated acquisition earn-out payables $ (4,458 ) $ (1,366 ) For the years ended December 31, 2020 and 2019, the fair value of estimated earn-out payables was re-evaluated and decreased by $11.8 million for 2020 and decreased by $7.3 million for 2019, which resulted in a credit, net of interest expense accretion, to the Consolidated Statement of Income for 2020 and 2019. As of December 31, 2020, the estimated acquisition earn-out payables equaled $258.9 million, of which $79.2 million was recorded as accounts payable and $179.7 million was recorded as other non-current liabilities. As of December 31, 2019, the estimated acquisition earn-out payables equaled $161.5 million, of which $17.9 million was recorded as accounts payable and $143.6 million was recorded as other non-current liabilities. Income Taxes The effective tax rate on income from operations was 23.0% in 2020 and 24.2% in 2019. The reduction in the effective tax rate in 2020 as compared to 2019 was primarily driven the tax benefit associated with additional vesting of stock awards in 2020 as compared to 2019. RESULTS OF OPERATIONS — SEGMENT INFORMATION As discussed in Note 17 “Segment Information” of the Notes to Consolidated Financial Statements, we operate four reportable segments: Retail, National Programs, Wholesale Brokerage and Services. On a segmented basis, changes in amortization, depreciation and interest expenses generally result from activity associated with acquisitions. Likewise, other income in each segment reflects net gains primarily from legal settlements and miscellaneous income. As such, in evaluating the operational efficiency of a segment, management focuses on the Organic Revenue growth rate of core commissions and fees, the ratio of total employee compensation and benefits to total revenues, and the ratio of other operating expenses to total revenues. The reconciliation of total commissions and fees included in the Consolidated Statements of Income to Organic Revenue, a non-GAAP financial measure, including by Segment, and the growth rates for Organic Revenue for the year ended December 31, 2020 are as follows: 2020 Retail(1) National Programs Wholesale Brokerage Services Total (in thousands, except percentages) 2020 2019 2020 2019 2020 2019 2020 2019 2020 2019 Commissions and fees $ 1,470,093 $ 1,364,755 $ 609,842 $ 516,915 $ 352,161 $ 309,426 $ 174,012 $ 193,641 $ 2,606,108 $ 2,384,737 Total change $ 105,338 $ 92,927 $ 42,735 $ (19,629 ) $ 221,371 Total growth % 7.7 % 18.0 % 13.8 % (10.1 )% 9.3 % Profit-sharing contingent commissions (35,785 ) (34,150 ) (27,278 ) (17,517 ) (7,871 ) (7,499 ) — — (70,934 ) (59,166 ) GSCs (15,128 ) (11,056 ) 238 (10,566 ) (1,304 ) (1,443 ) — — (16,194 ) (23,065 ) Core commissions and fees $ 1,419,180 $ 1,319,549 $ 582,802 $ 488,832 $ 342,986 $ 300,484 $ 174,012 $ 193,641 $ 2,518,980 $ 2,302,506 Acquisitions (79,580 ) — (34,173 ) — (25,861 ) — (1,484 ) — (141,098 ) — Dispositions — (11,772 ) — (377 ) — — — — — (12,149 ) Organic Revenue(2) $ 1,339,600 $ 1,307,777 $ 548,629 $ 488,455 $ 317,125 $ 300,484 $ 172,528 $ 193,641 $ 2,377,882 $ 2,290,357 Organic Revenue growth(2) $ 31,823 $ 60,174 $ 16,641 $ (21,113 ) $ 87,525 Organic Revenue growth %(2) 2.4 % 12.3 % 5.5 % (10.9 )% 3.8 % (1) The Retail Segment includes commissions and fees reported in the “Other” column of the Segment Information in Note 17 of the Notes to the Consolidated Financial Statements, which includes corporate and consolidation items. (2) A non-GAAP financial measure. 31 Table of Contents The reconciliation of total commissions and fees included in the Consolidated Statements of Income to Organic Revenue, a non-GAAP financial measure, including by Segment, and the growth rates for Organic Revenue for the year ended December 31, 2019, by Segment, are as follows: 2019 Retail(1) National Programs Wholesale Brokerage Services Total (in thousands, except percentages) 2019 2018 2019 2018 2019 2018 2019 2018 2019 2018 Commissions and fees $ 1,364,755 $ 1,040,574 $ 516,915 $ 493,878 $ 309,426 $ 286,364 $ 193,641 $ 189,041 $ 2,384,737 $ 2,009,857 Total change $ 324,181 $ 23,037 $ 23,062 $ 4,600 $ 374,880 Total growth % 31.2 % 4.7 % 8.1 % 2.4 % 18.7 % Profit-sharing contingent commissions (34,150 ) (24,517 ) (17,517 ) (23,896 ) (7,499 ) (7,462 ) — — (59,166 ) (55,875 ) GSCs (11,056 ) (8,535 ) (10,566 ) (76 ) (1,443 ) (1,350 ) — — (23,065 ) (9,961 ) Core commissions and fees $ 1,319,549 $ 1,007,522 $ 488,832 $ 469,906 $ 300,484 $ 277,552 $ 193,641 $ 189,041 $ 2,302,506 $ 1,944,021 Acquisitions (272,383 ) — (5,721 ) — (3,628 ) — (16,541 ) — (298,273 ) — Dispositions — (7,743 ) — (790 ) — (1,268 ) — — — (9,801 ) Organic Revenue(2) $ 1,047,166 $ 999,779 $ 483,111 $ 469,116 $ 296,856 $ 276,284 $ 177,100 $ 189,041 $ 2,004,233 $ 1,934,220 Organic Revenue growth(2) $ 47,387 $ 13,995 $ 20,572 $ (11,941 ) $ 70,013 Organic Revenue growth %(2) 4.7 % 3.0 % 7.4 % (6.3 )% 3.6 % (1) The Retail Segment includes commissions and fees reported in the “Other” column of the Segment Information in Note 17 of the Notes to the Consolidated Financial Statements, which includes corporate and consolidation items. (2) A non-GAAP financial measure. The reconciliation of income before incomes taxes, included in the Consolidated Statement of Income, to EBITDAC, a non-GAAP measure, and Income Before Income Taxes Margin to EBITDAC Margin, a non-GAAP measure, for the year ended December 31, 2020, is as follows: (in thousands) Retail National Programs Wholesale Brokerage Services Other Total Income before income taxes $ 262,245 $ 182,892 $ 93,593 $ 27,994 $ 57,375 $ 624,099 Income Before Income Taxes Margin 17.8 % 30.0 % 26.5 % 16.1 % NMF 23.9 % Amortization 67,315 27,166 8,481 5,561 — 108,523 Depreciation 9,071 8,658 1,948 1,424 5,175 26,276 Interest 85,968 20,597 10,281 4,142 (62,015 ) 58,973 Change in estimated acquisition earn-out payables 8,689 (10,484 ) 422 (3,085 ) — (4,458 ) EBITDAC $ 433,288 $ 228,829 $ 114,725 $ 36,036 $ 535 $ 813,413 EBITDAC Margin 29.4 % 37.5 % 32.5 % 20.7 % NMF 31.1 % NMF = Not a meaningful figure The reconciliation of income before incomes taxes, included in the Consolidated Statement of Income, to EBITDAC, a non-GAAP measure, and Income Before Income Taxes Margin to EBITDAC Margin, a non-GAAP measure, for the year ended December 31, 2019, is as follows: (in thousands) Retail National Programs Wholesale Brokerage Services Other Total Income before income taxes $ 222,875 $ 143,737 $ 82,739 $ 40,337 $ 36,241 $ 525,929 Income Before Income Taxes Margin 16.3 % 27.7 % 26.7 % 20.8 % NMF 22.0 % Amortization 63,146 25,482 11,191 5,479 — 105,298 Depreciation 7,390 6,791 1,674 1,229 6,333 23,417 Interest 87,295 16,690 4,756 4,404 (49,485 ) 63,660 Change in estimated acquisition earn-out payables 8,004 (751 ) (4 ) (8,615 ) — (1,366 ) EBITDAC $ 388,710 $ 191,949 $ 100,356 $ 42,834 $ (6,911 ) $ 716,938 EBITDAC Margin 28.4 % 37.0 % 32.4 % 22.1 % NMF 30.0 % NMF = Not a meaningful figure 32 Table of Contents Retail Segment The Retail Segment provides a broad range of insurance products and services to commercial, public and quasi-public, professional and individual insured customers, and non-insurance risk-mitigating products through our automobile dealer services (“F&I”) businesses. Approximately 80.8% of the Retail Segment’s commissions and fees revenue is commission based. Financial information relating to our Retail Segment for the twelve months ended December 31, 2020 and 2019 is as follows: (in thousands, except percentages) 2020 % Change 2019 REVENUES Core commissions and fees $ 1,420,439 7.5 % $ 1,320,810 Profit-sharing contingent commissions 35,785 4.8 % 34,150 Guaranteed supplemental commissions 15,128 36.8 % 11,056 Total commissions and fees 1,471,352 7.7 % 1,366,016 Investment income 163 9.4 % 149 Other income, net 1,251 14.1 % 1,096 Total revenues 1,472,766 7.7 % 1,367,261 EXPENSES Employee compensation and benefits 820,368 7.9 % 760,208 Other operating expenses 221,496 (3.0 )% 228,256 (Gain)/loss on disposal (2,386 ) (75.9 )% (9,913 ) Amortization 67,315 6.6 % 63,146 Depreciation 9,071 22.7 % 7,390 Interest 85,968 (1.5 )% 87,295 Change in estimated acquisition earn-out payables 8,689 8.6 % 8,004 Total expenses 1,210,521 5.8 % 1,144,386 Income before income taxes $ 262,245 17.7 % $ 222,875 Income Before Income Taxes Margin (1) 17.8 % 16.3 % EBITDAC (2) 433,288 11.5 % 388,710 EBITDAC Margin (2) 29.4 % 28.4 % Organic Revenue growth rate (2) 2.4 % 4.7 % Employee compensation and benefits relative to total revenues 55.7 % 55.6 % Other operating expenses relative to total revenues 15.0 % 16.7 % Capital expenditures $ 13,175 5.4 % $ 12,497 Total assets at December 31 $ 7,093,627 10.6 % $ 6,413,459 (1) “Income Before Income Taxes Margin” is defined as income before income taxes divided by total revenues (2) A non-GAAP measure NMF = Not a meaningful figure The Retail Segment’s total revenues in 2020 increased 7.7%, or $105.5 million, over the same period in 2019, to $1,472.8 million. The $99.6 million increase in core commissions and fees was driven by the following: (i) approximately $79.6 million related to the core commissions and fees from acquisitions that had no comparable revenues in the same period of 2019; (ii) $31.8 million related to net new and renewal business; offset by (iii) a decrease of $11.8 million related to commissions and fees from businesses or books of business divested in 2019 and 2020. Profit-sharing contingent commissions and GSCs in 2020 increased 12.6%, or $5.7 million, over 2019, to $50.9 million primarily from acquisitions completed in 2019 and 2020. The Retail Segment’s growth rate for total commissions and fees was 7.7% and the Organic Revenue growth rate was 2.4% for 2020. The Organic Revenue growth rate was driven by new business, higher customer retention and increasing premium rates across most lines of business over the preceding 12 months. Income before income taxes for 2020 increased 17.7%, or $39.4 million, over the same period in 2019, to $262.2 million. The primary factors driving this increase were: (i) the net increase in revenue as described above, (ii) other operating expenses which decreased by $6.8 million, or 3.0%, due primarily to COVID-19 related expense savings, partially offset by the impact of our multi-year technology investment program and increased professional services to support our customers and acquisitions over the past 12 months; (iii) offset by a 7.9%, or $60.2 million, increase in employee compensation and benefits, due primarily to the year-on-year impact of acquisitions, salary inflation and additional teammates to support revenue growth and incremental non-cash stock compensation costs, (iv) a decrease in the gain on disposal associated with the sale of certain books of business compared to prior year; and (v) a combined increase in amortization, depreciation and intercompany interest expense of $4.5 million resulting from our acquisition activity in 2020 and 2019. 33 Table of Contents EBITDAC for 2020 increased 11.5%, or $44.6 million, from the same period in 2019, to $433.3 million. EBITDAC Margin for 2020 increased to 29.4% from 28.4% in the same period in 2019. EBITDAC Margin was impacted by (i) the net increase in revenue and COVID-19 related expense savings, as described above, (ii) higher profit-sharing contingent commissions and guaranteed supplemental commissions; partially offset by, (iii) increased non-stock cash compensation costs and intercompany IT charges. National Programs Segment The National Programs Segment manages over 40 programs supported by approximately 100 well-capitalized carrier partners. In most cases, the insurance carriers that support the programs have delegated underwriting and, in many instances, claims-handling authority to our programs operations. These programs are generally distributed through a nationwide network of independent agents and Brown & Brown retail agents, and offer targeted products and services designed for specific industries, trade groups, professions, public entities and market niches. The National Programs Segment operations can be grouped into five broad categories: Professional Programs, Personal Lines Programs, Commercial Programs, Public Entity-Related Programs and the National Flood Program. The National Programs Segment’s revenue is primarily commission based. Financial information relating to our National Programs Segment for the twelve months ended December 31, 2020 and 2019 is as follows: (in thousands, except percentages) 2020 % Change 2019 REVENUES Core commissions and fees $ 582,802 19.2 % $ 488,832 Profit-sharing contingent commissions 27,278 55.7 % 17,517 Guaranteed supplemental commissions (238 ) (102.3 )% 10,566 Total commissions and fees 609,842 18.0 % 516,915 Investment income 756 -45.9 % 1,397 Other income, net 42 (41.7 )% 72 Total revenues 610,640 17.8 % 518,384 EXPENSES Employee compensation and benefits 260,141 17.5 % 221,425 Other operating expenses 121,670 15.7 % 105,118 (Gain)/loss on disposal — (100.0 )% (108 ) Amortization 27,166 6.6 % 25,482 Depreciation 8,658 27.5 % 6,791 Interest 20,597 23.4 % 16,690 Change in estimated acquisition earn-out payables (10,484 ) NMF (751 ) Total expenses 427,748 14.2 % 374,647 Income before income taxes $ 182,892 27.2 % $ 143,737 Income Before Income Taxes Margin (1) 30.0 % 27.7 % EBITDAC (2) 228,829 19.2 % 191,949 EBITDAC Margin (2) 37.5 % 37.0 % Organic Revenue growth rate (2) 12.3 % 3.0 % Employee compensation and benefits relative to total revenues 42.6 % 42.7 % Other operating expenses relative to total revenues 19.9 % 20.3 % Capital expenditures $ 7,208 (30.5 )% $ 10,365 Total assets at December 31 $ 3,510,983 12.9 % $ 3,110,368 (1) “Income Before Income Taxes Margin” is defined as income before income taxes divided by total revenues (2) A non-GAAP measure NMF = Not a meaningful figure The National Programs Segment’s total revenues in 2020 increased 17.8%, or $92.3 million, over 2019, to a total $610.6 million. The $94.0 million increase in core commissions and fees was driven by the following: (i) $60.2 million related to net new and renewal business; (ii) an increase of approximately $34.2 million related to core commissions and fees from acquisitions that had no comparable revenues in 2019; offset by (iii) a decrease of $0.4 million related to commissions and fees recorded in 2019 from businesses since divested. Profit-sharing contingent commissions and GSCs were $27.0 million in 2020, which was a decrease of $1.0 million from 2019, as a result of a non-recurring GSC received from one of our partners in the second quarter of 2019. 34 Table of Contents The National Programs Segment’s growth rate for total commissions and fees was 18.0% and the Organic Revenue growth rate was 12.3% for 2020. The total commissions and fees growth was mainly due to new acquisitions, strong growth in our earthquake programs, lender placement program, personal property program and wind programs. The Organic Revenue growth rate increase was driven by net new business, growth in renewals and higher premium rates in a number of our programs compared to the prior year. Income before income taxes for 2020 increased 27.2%, or $39.2 million, from the same period in 2019, to $182.9 million. The increase was the result of strong total revenue growth and a decrease in estimated acquisition earn-out payables of $9.7 million. EBITDAC for 2020 increased 19.2%, or $36.9 million, from the same period in 2019, to $228.8 million. EBITDAC Margin for 2020 increased to 37.5% due to (i) leveraging revenue growth and scaling of a number of our programs; (ii) new acquisitions in 2020, and (iii) lower variable costs in response to COVID-19. Wholesale Brokerage Segment The Wholesale Brokerage Segment markets and sells excess and surplus commercial and personal lines insurance, primarily through independent agents and brokers, including Brown & Brown retail agents. Like the Retail and National Programs Segments, the Wholesale Brokerage Segment’s revenues are primarily commission based. Financial information relating to our Wholesale Brokerage Segment for the twelve months ended December 31, 2020 and 2019 is as follows: (in thousands, except percentages) 2020 % Change 2019 REVENUES Core commissions and fees $ 342,986 14.1 % $ 300,484 Profit-sharing contingent commissions 7,871 5.0 % 7,499 Guaranteed supplemental commissions 1,304 -9.6 % 1,443 Total commissions and fees 352,161 13.8 % 309,426 Investment income 184 3.4 % 178 Other income, net 452 (6.4 )% 483 Total revenues 352,797 13.8 % 310,087 EXPENSES Employee compensation and benefits 184,429 16.8 % 157,924 Other operating expenses 53,643 3.5 % 51,807 (Gain)/loss on disposal — — — Amortization 8,481 (24.2 )% 11,191 Depreciation 1,948 16.4 % 1,674 Interest 10,281 116.2 % 4,756 Change in estimated acquisition earn-out payables 422 NMF (4 ) Total expenses 259,204 14.0 % 227,348 Income before income taxes $ 93,593 13.1 % $ 82,739 Income Before Income Taxes Margin (1) 26.5 % 26.7 % EBITDAC (2) 114,725 14.3 % 100,356 EBITDAC Margin (2) 32.5 % 32.4 % Organic Revenue growth rate (2) 5.5 % 7.4 % Employee compensation and benefits relative to total revenues 52.3 % 50.9 % Other operating expenses relative to total revenues 15.2 % 16.7 % Capital expenditures $ 3,324 -46.1 % $ 6,171 Total assets at December 31 $ 1,791,717 28.9 % $ 1,390,250 (1) “Income Before Income Taxes Margin” is defined as income before income taxes divided by total revenues (2) A non-GAAP measure NMF = Not a meaningful figure The Wholesale Brokerage Segment’s total revenues for 2020 increased 13.8%, or $42.7 million, over 2019, to $352.8 million. The $42.5 million increase in core commissions and fees was driven by the following: (i) $25.9 million related to the core commissions and fees from acquisitions that had no comparable revenues in 2019 and (ii) $16.6 million related to net new and renewal business. Profit-sharing contingent commissions and GSCs for 2020 increased $0.2 million over 2019, to $9.2 million. The Wholesale Brokerage Segment’s growth rate for total commissions and fees was 13.8%, and the Organic Revenue growth rate was 5.5% for 2020. The Organic Revenue growth rate was driven by net new business, as well as increased rates seen across most lines of business, which was partially offset by shrinking capacity in the catastrophe exposed personal lines market. 35 Table of Contents Income before income taxes for 2020 increased 13.1%, or $10.9 million, over 2019, to $93.6 million, primarily due to the following: (i) the net increase in total revenues as described above, and (ii) a decrease in amortization expense; offset by (iii) an increase in intercompany interest expense, (iv) an increase in employee compensation and benefits of $26.5 million, related to additional teammates from acquisitions completed in the past 12 months and growth to support increased transaction volumes, compensation increases for existing teammates, and additional non-cash stock-based compensation expense, and (v) a net $1.3 million increase in other operating expenses, primarily acquisition related. EBITDAC for 2020 increased 14.3%, or $14.4 million, from the same period in 2019, to $114.7 million. EBITDAC Margin for 2020 increased to 32.5% from 32.4% in the same period in 2019. The increase in EBITDAC Margin was primarily driven by leveraging revenue growth as described above and lower variable costs in response to COVID-19, which were partially offset by increased employee compensation and non-cash stock-based compensation costs. Services Segment The Services Segment provides insurance-related services, including third-party claims administration and comprehensive medical utilization management services in both the workers’ compensation and all-lines liability arenas. The Services Segment also provides Medicare Set-aside account services, Social Security disability and Medicare benefits advocacy services, and claims adjusting services. Unlike the other segments, nearly all of the Services Segment’s revenue is generated from fees, which are not significantly affected by fluctuations in general insurance premiums. Financial information relating to our Services Segment for the twelve months ended December 31, 2020 and 2019 is as follows: (in thousands, except percentages) 2020 % Change 2019 REVENUES Core commissions and fees $ 174,012 (10.1 )% $ 193,641 Profit-sharing contingent commissions — — — Guaranteed supplemental commissions — — — Total commissions and fees 174,012 (10.1 )% 193,641 Investment income — (100.0 )% 139 Other income, net — (100.0 )% 1 Total revenues 174,012 (10.2 )% 193,781 EXPENSES Employee compensation and benefits 88,787 (3.0 )% 91,514 Other operating expenses 49,191 (17.2 )% 59,433 (Gain)/loss on disposal (2 ) — — Amortization 5,561 1.5 % 5,479 Depreciation 1,424 15.9 % 1,229 Interest 4,142 (5.9 )% 4,404 Change in estimated acquisition earn-out payables (3,085 ) (64.2 )% (8,615 ) Total expenses 146,018 (4.8 )% 153,444 Income before income taxes $ 27,994 (30.6 )% $ 40,337 Income Before Income Taxes Margin (1) 16.1 % 20.8 % EBITDAC (2) 36,036 (15.9 )% 42,834 EBITDAC Margin (2) 20.7 % 22.1 % Organic Revenue growth rate (2) (10.9 )% (6.3 )% Employee compensation and benefits relative to total revenues 51.0 % 47.2 % Other operating expenses relative to total revenues 28.3 % 30.7 % Capital expenditures $ 1,424 77.1 % $ 804 Total assets at December 31 $ 480,440 (0.2 )% $ 481,336 (1) “Income Before Income Taxes Margin” is defined as income before income taxes divided by total revenues (2) A non-GAAP measure NMF = Not a meaningful figure 36 Table of Contents The Services Segment’s total revenues for 2020 decreased 10.2%, or $19.8 million, from 2019, to $174.0 million. The $19.6 million decrease in core commissions and fees was driven primarily by a decrease of $21.1 million related to net new and renewal business that was driven by lower claims volume in our Social Security advocacy businesses; (i) the effect a prior year terminated customer contract in one of our claims processing businesses; and (ii) lower weather-driven claims; partially offset by (iii) $1.5 million related to the core commissions and fees from acquisitions that had no comparable revenues in the same period of 2019. Total commissions and fees decreased 10.1%, and Organic Revenue decreased 10.9% in 2020, both as compared to 2019. Income before income taxes for 2020 decreased 30.6%, or $12.3 million, from 2019, to $28.0 million due to a combination of: (i) lower revenue as described above; (ii) a $5.5 million decrease in the change in estimated acquisition earn-out payables; partially offset by (iii) a decline in other operating expenses driven by management of our costs in response to COVID-19. EBITDAC for 2020 decreased 15.9%, or $6.8 million, from the same period in 2019, to $36.0 million. EBITDAC Margin for 2020 decreased to 20.7% from 22.1% in the same period in 2019. The decrease in EBITDAC Margin was due to: (i) lower revenue as described above; offset by (ii) a decline in other operating expenses driven by management of our costs in response to COVID-19. Other As discussed in Note 17 of the Notes to Consolidated Financial Statements, the “Other” column in the Segment Information table includes any income and expenses not allocated to reportable segments, and corporate-related items, including the intercompany interest expense charges to reporting segments. LIQUIDITY AND CAPITAL RESOURCES The Company seeks to maintain a conservative balance sheet and liquidity profile. Our capital requirements to operate as an insurance intermediary are low and we have been able to grow and invest in our business principally through cash that has been generated from operations. We have the ability to utilize our revolving credit facility, which as of December 31, 2020 provided access to up to $800.0 million in available cash. We believe that we have access to additional funds, if needed, through the capital markets or private placements to obtain further debt financing under the current market conditions. The Company believes that its existing cash, cash equivalents, short-term investment portfolio and funds generated from operations, together with the funds available under the revolving credit facility, will be sufficient to satisfy our normal liquidity needs, including principal payments on our long-term debt, for at least the next 12 months. The revolving credit facility contains an expansion for up to an additional $500.0 million of borrowing capacity, subject to the approval of participating lenders. In addition, under the term loan credit agreement, the unsecured term loan in the initial amount of $300.0 million may be increased by up to $150.0 million, subject to the approval of participating lenders. Including the expansion options under all existing credit agreements, the Company has access to up to $1.5 billion of incremental borrowing capacity as of December 31, 2020. Our cash and cash equivalents of $817.4 million at December 31, 2020 reflected an increase of $275.2 million from the $542.2 million balance at December 31, 2019. During 2020, $721.6 million of cash was generated from operating activities, representing an increase of 6.4%. During this period, $694.8 million of cash was used for new acquisitions, $29.5 million was used for acquisition earn-out payments, $70.7 million was used to purchase additional fixed assets, $100.6 million was used for payment of dividends, $55.1 million was used for share repurchases and $55.0 million was used to pay outstanding principal balances owed on long-term debt. We hold approximately $34.3 million in cash outside of the U.S., which we currently have no plans to repatriate in the near future. Our cash and cash equivalents of $542.2 million at December 31, 2019 reflected an increase of $103.2 million from the $439.0 million balance at December 31, 2018. During 2019, $678.2 million of cash was generated from operating activities, representing an increase of 19.5%. During this period, $353.0 million of cash was used for new acquisitions, $9.9 million was used for acquisition earn-out payments, $73.1 million was used to purchase additional fixed assets, $91.3 million was used for payment of dividends, $38.7 million was used for share repurchases and $50.0 million was used to pay outstanding principal balances owed on long-term debt. Our ratio of current assets to current liabilities (the “current ratio”) was 1.26 and 1.22 for December 31, 2020 and December 31, 2019, respectively. 37 Table of Contents Contractual Cash Obligations As of December 31, 2020, our contractual cash obligations were as follows: Payments Due by Period (in thousands) Total Less Than 1 Year(4) 1-3 Years(4) 4-5 Years After 5 Years Long-term debt $ 2,110,000 $ 70,000 $ 490,000 $ 500,000 $ 1,050,000 Other liabilities(1) 110,109 4,456 14,575 7,204 83,874 Operating leases(2) 244,289 50,443 87,255 55,589 51,002 Interest obligations 394,710 62,571 115,394 79,625 137,120 Unrecognized tax benefits 1,267 — 1,267 — — Maximum future acquisition contingency payments(3) 544,723 139,465 405,258 — — Total contractual cash obligations $ 3,405,098 $ 326,935 $ 1,113,749 $ 642,418 $ 1,321,996 (1) Includes the current portion of other long-term liabilities. (2) Includes $5.0 million of future lease commitments expected to commence in 2021. (3) Includes $258.9 million of current and non-current estimated earn-out payables. $25.0 million of this balance is not subject to any further contingency as a result of the Amendment dated as of July 27, 2020 by and among the Company, The Hays Group, Inc., and certain of their affiliates, to the Asset Purchase Agreement, dated as of October 22, 2018. (4) Does not include approximately $31.1 million of deferred employer-only payroll tax payments related to the CARES Act which are expected to be paid in equal installments in each of December 2021 and December 2022. Debt Total debt at December 31, 2020 was $2,095.9 million net of unamortized discount and debt issuance costs, which was an increase of $540.6 million compared to December 31, 2019. The increase includes: (i) incremental borrowings of $700.0 million related to the Company's 2.375% Senior Notes due 2031 issued on September 24, 2020; (ii) net of the amortization of discounted debt related to our various unsecured Senior Notes, and debt issuance cost amortization of $2.3 million; offset by (iii) the repayment of the principal balance of $55.0 million for scheduled principal amortization balances related to our various existing floating rate debt term notes; (iv) the net repayment of $100.0 million under the revolving credit facility; and (v) an additional $6.7 million including debt issuance costs and the portion of discount applied to the proceeds issued under the incremental borrowings related to the Company's 2.375% Senior Notes due 2031 issued on September 24, 2020. On September 24, 2020, the Company completed the issuance of $700.0 million aggregate principal amount of the Company's 2.375% Senior Notes due 2031. The Senior Notes were given investment grade ratings of BBB- stable outlook and Baa3 positive outlook. The notes are subject to certain covenant restrictions, which are customary for credit rated obligations. At the time of funding, the proceeds were offered at a discount of the original note amount, which also excluded an underwriting fee discount. The net proceeds received from the issuance were used to repay a portion of the outstanding balance of $200.0 million on the revolving credit facility, to pay a portion of the purchase price in connection with the acquisitions of LP Insurance Services, LLP and CKP Insurance, LLC and for other general corporate purposes. As of December 31, 2020, there was an outstanding debt balance of $700.0 million exclusive of the associated discount balance. During the twelve months ended December 31, 2020, the Company has repaid $40.0 million of principal related to the amended and restated credit agreement term loan through quarterly scheduled amortized principal payments each equaling $10.0 million on March 31, 2020, June 30, 2020, September 30, 2020 and December 31, 2020. The amended and restated credit agreement term loan had an outstanding balance of $290.0 million as of December 31, 2020. The Company’s next scheduled amortized principal payment is due March 31, 2021 and is equal to $10.0 million. During the twelve months ended December 31, 2020, the Company has repaid $15.0 million of principal related to the term loan credit agreement through quarterly scheduled amortized principal payments each equaling $3.8 million on March 31, 2020, June 30, 2020, September 30, 2020 and December 31, 2020. The term loan credit agreement had an outstanding balance of $270.0 million as of December 31, 2020. The Company’s next scheduled amortized principal payment is due March 31, 2021 and is equal to $7.5 million. On April 30, 2020, the Company borrowed $250.0 million under the revolving credit facility. The proceeds were used in conjunction with the payment of the purchase price for the previously announced acquisition of LP Insurance Services LLC and for additional liquidity to further strengthen the Company’s financial position and balance sheet in the event cash receipts from customers or carrier partners are delayed due to the COVID-19 pandemic. On June 30, 2020, the Company repaid $150.0 million on the revolving credit facility. On September 24, 2020, the Company repaid the total outstanding borrowings under the revolving credit facility of $200.0 million using the proceeds received from the borrowings under the Company's 2.375% Senior Notes due 2031. 38 Table of Contents Total debt at December 31, 2019 was $1,555.3 million net of unamortized discount and debt issuance costs, which was an increase of $48.4 million compared to December 31, 2018. The increase includes (i) a drawdown on the revolving credit facility of $100.0 million on August 9, 2019 in connection with the acquisition of CKP Insurance, LLC and various other acquisitions closed in the third quarter of 2019, (ii) the repayment of principal of $50.0 million for scheduled principal amortization balances related to our various existing floating rate debt term notes, (iii) amortization of discounted debt related to our various unsecured Senior Notes, and debt issuance cost amortization of $2.1 million, offset by (iv) additional discount to par and aggregate debt issuance costs of $3.7 million related to the issuance of the Company's 4.500% Senior Notes due 2029 as of December 31, 2019. On March 11, 2019, the Company completed the issuance of $350.0 million aggregate principal amount of the Company's 4.500% Senior Notes due 2029. The Senior Notes were given investment grade ratings of BBB-/Baa3 with a stable outlook. The notes are subject to certain covenant restrictions which are customary for credit-rated obligations. At the time of funding, the proceeds were offered at a discount to the notional amount which also excluded an underwriting fee discount. The net proceeds received from the issuance were used to repay a portion of the outstanding balance of $350.0 million on the revolving credit facility, utilized in connection with financing related to our acquisition of Hays, and for other general corporate purposes. As of December 31, 2019, there was an outstanding debt balance of $350.0 million exclusive of the associated discount balance. Off-Balance Sheet Arrangements Neither we nor our subsidiaries have ever incurred off-balance sheet obligations through the use of, or investment in, off-balance sheet derivative financial instruments or structured finance or special purpose entities organized as corporations, partnerships or limited liability companies or trusts. For further discussion of our cash management and risk management policies, see “Quantitative and Qualitative Disclosures About Market Risk.” ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk. Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates, foreign exchange rates and equity prices. We are exposed to market risk through our investments, revolving credit line, term loan agreements and international operations. Our invested assets are held primarily as cash and cash equivalents, restricted cash, available-for-sale marketable debt securities, non-marketable debt securities, certificates of deposit, U.S. treasury securities, and professionally managed short duration fixed income funds. These investments are subject to interest rate risk. The fair values of our invested assets at December 31, 2020 and December 31, 2019, approximated their respective carrying values due to their short-term duration and therefore, such market risk is not considered to be material. We do not actively invest or trade in equity securities. In addition, we generally dispose of any significant equity securities received in conjunction with an acquisition shortly after the acquisition date. As of December 31, 2020, we had $560.0 million of borrowings outstanding under our various credit agreements, all of which bear interest on a floating basis tied to London Interbank Overnight Rate (“LIBOR”) and is therefore subject to changes in the associated interest expense. The effect of an immediate hypothetical 10% change in interest rates would not have a material effect on our Consolidated Financial Statements. As of July 2017, the UK Financial Conduct Authority (“FCA”) has urged banks and institutions to discontinue their use of the LIBOR benchmark rate for floating rate debt, and other financial instruments tied to the rate after 2021. However, on November 30, 2020, the ICE Benchmark Administration Limited (“IBA”), announced that it would consult in early December 2020 on its intention to cease the publication of the one-week and two-month U.S. dollar LIBOR settings immediately following the LIBOR publication on December 31, 2021, and the remaining U.S. dollar LIBOR settings (overnight and one, three, six and 12 months) immediately following the LIBOR publication on June 30, 2023. The consultation was open for feedback until January 25, 2021 and IBA “intends to share the results of the consultation with the FCA and to publish a feedback statement summarizing responses from the consultation shortly thereafter.” In connection to the released statement from the IBA, on December 4, 2020, the FCA released a similar statement in support of the continuation of the LIBOR rate beyond 2021. The Alternative Reference Rates Committee (“ARRC”) have recommended the Secured Overnight Financing Rate (“SOFR”) as the best alternative rate to LIBOR post discontinuance and has proposed a transition plan and timeline designed to encourage the adoption of SOFR from LIBOR. The Company is currently evaluating the transition from LIBOR as an interest rate benchmark to other potential alternative reference rates, including but not limited to the SOFR interest rate. Management will continue to actively assess the related opportunities and risks associated with the transition and monitor related proposals and guidance published by ARRC and other alternative-rate initiatives, with an expectation that we will be prepared to for a termination of LIBOR benchmarks after 2021. We are subject to exchange rate risk primarily in our U.K.-based wholesale brokerage business that has a cost base principally denominated in British pounds and a revenue base in several other currencies, but principally in U.S. dollars, and in our Canadian MGA business that has substantially all of its revenues and cost base denominated in Canadian Dollars. As of January 14, 2021, the Company announced the completion of the acquisition of O’Leary Insurances, an Ireland based retail brokerage business which has substantially all of its revenue and cost base in Euro Dollars. Based upon our foreign currency rate exposure as of December 31, 2020, an immediate 10% hypothetical changes of foreign currency exchange rates would not have a material effect on our Consolidated Financial Statements. 39 Table of Contents

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+ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSManagement's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) should be read in conjunction with the consolidated financial statements included in

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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe information required by this Item is set forth in the MD&A and Notes 3, 6, 12, 14, 19, 22 and 23 of the Notes to Consolidated Financial Statements in the Annual Report, which portions are incorporated herein by reference.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKThe information required by this Item is set forth in the “Critical accounting estimates,” “Trading activities and risk management,” “Asset/liability management” and “Risk Management” sections in the MD&A in the Annual Report and “Derivative financial instruments” under Note 1 and Notes 20 and 23 of the Notes to Consolidated Financial Statements in the Annual Report, which portions are incorporated herein by reference.

C. H. ROBINSON WORLDWIDE, INC._10-K_2021-02-19 00:00:00_1043277-0001043277-21-000009.html

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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEWC.H. Robinson Worldwide, Inc. (“C.H. Robinson,” “the company,” “we,” “us,” or “our”) is one of the world's largest logistics platforms. Our mission is to improve the world's supply chains through our people, processes, and technology by delivering exceptional value to our customers and suppliers. We provide freight transportation services and logistics solutions to companies of all sizes in a wide variety of industries. We operate through a network of offices in North America, Europe, Asia, Oceania, and South America. We offer a global suite of services using tailored, market-leading technology built by and for supply chain experts. Our global network of supply chain experts work with our customers to drive better supply chain outcomes by leveraging our experience, data, technology, and scale.Our adjusted gross profit and adjusted gross profit margin are non-GAAP financial measures. Adjusted gross profit is calculated as gross profit excluding amortization of internally developed software utilized to directly serve our customers and contracted carriers. Adjusted gross profit margin is calculated as adjusted gross profit divided by total revenues. We believe adjusted gross profit and adjusted gross profit margin are useful measures of our ability to source, add value, and sell services and products that are provided by third parties, and we consider adjusted gross profit to be a primary performance measurement. Accordingly, the discussion of our results of operations often focuses on the changes in our adjusted gross profit and adjusted gross profit margin. The reconciliation of gross profit to adjusted gross profit and gross profit margin to adjusted gross profit margin is presented below (dollars in thousands):Twelve Months Ended December 31,202020192018Revenues:Transportation$15,147,562 $14,322,295 $15,515,921 Sourcing1,059,544 987,213 1,115,251 Total revenues16,207,106 15,309,508 16,631,172 Costs and expenses:Purchased transportation and related services12,834,608 11,839,433 12,922,177 Purchased products sourced for resale960,241 883,765 1,003,760 Direct internally developed software amortization16,634 11,492 9,664 Total direct costs13,811,483 12,734,690 13,935,601 Gross profit / Gross profit margin2,395,623 14.8 %2,574,818 16.8 %2,695,571 16.2 %Plus: Direct internally developed software amortization16,634 11,492 9,664 Adjusted gross profit / Adjusted gross profit margin$2,412,257 14.9 %$2,586,310 16.9 %$2,705,235 16.3 %Our adjusted operating margin is a non-GAAP financial measure calculated as operating income divided by adjusted gross profit. We believe adjusted operating margin is a useful measure of our profitability in comparison to our adjusted gross profit, which we consider a primary performance metric as discussed above. The reconciliation of operating margin to adjusted operating margin is presented below (dollars in thousands):Twelve Months Ended December 31,202020192018Total revenues$16,207,106 $15,309,508 $16,631,172 Operating income673,268 789,976 912,083 Operating margin4.2 %5.2 %5.5 %Adjusted gross profit$2,412,257 $2,586,310 $2,705,235 Operating income673,268 789,976 912,083 Adjusted operating margin27.9 %30.5 %33.7 %22Table of ContentMARKET TRENDSThe North American surface transportation market experienced significant volatility in freight volumes and costs over the duration of 2020 as a result of the COVID-19 pandemic. The impact on the market varied significantly depending on the severity of the restrictions in place to control the outbreak, industry, and customer size. Certain industries, such as retail, saw periods of elevated demand while other industries, especially smaller customers in those industries, experienced extended periods of demand and production well below historical levels. Industry freight volumes, as measured by the Cass Freight Index, declined approximately eight percent in 2020 compared to 2019, which reflects the volatility resulting from the COVID-19 pandemic. Industry freight volumes compared to 2019 bottomed out in the second quarter of 2020, declining approximately 21 percent before showing growth of approximately four percent in the fourth quarter of 2020 compared to the prior year. The impact of reduced consumer demand and production, in addition to driver shortages, resulted in reduced carrier capacity, most notably in truckload, as many carriers either reduced lanes or exited the market entirely. This reduced carrier capacity caused routing guides to rapidly degrade and more loads moved to the spot market, driving sharp increases in transportation costs, most significantly in the second half of 2020. One of the metrics we use to measure market conditions is the truckload routing guide depth from our Managed Services business. Routing guide depth is calculated as a simple average of all accepted shipments over all tender instances for any shipment facilitated by our Managed Services business. The average routing guide depth was 1.4 in 2020 and increased steadily during the second half of 2020, to 1.8 in the fourth quarter of 2020. This compared to an average depth of tender of 1.2 during 2019, which is among the lowest levels we have experienced this decade. The global forwarding market also experienced significant volatility resulting from the COVID-19 pandemic. The air freight market experienced a significant decline in capacity due to a reduction in commercial flights from COVID-19 restrictions, which resulted in sharp pricing increases. The impact of the COVID-19 pandemic on the ocean freight market varied significantly over the course of 2020 depending on the severity of the outbreak in regions in which we operate. Many industries experienced temporary volume reductions and factory closures due to efforts to contain the spread of the virus, which initially resulted in excess capacity and decreased pricing early in 2020. In the second half of 2020, most industries had resumed production and companies began to replenish low inventory levels amidst continued market uncertainty from the ongoing COVID-19 pandemic. As demand accelerated, it outpaced carrier capacity returning to the market, which resulted in significant pricing increases for the cost of ocean freight. BUSINESS TRENDSOur 2020 surface transportation results were largely consistent with the overall market trends summarized above, although we did experience volume increases in excess of the industry trends as measured by the Cass Freight Index. Despite industry freight volumes declining approximately eight percent in 2020, our combined North American Surface Transportation (“NAST”) truckload and LTL volumes increased approximately 5.5 percent. The COVID-19 pandemic had a significant impact on our small business customers as our customer count decreased nearly 12 percent, driven almost entirely by small and emerging market customers. Similarly, the number of active contracted transportation companies we utilized declined approximately six percent, solely with those carriers having a fleet under 100 trucks. We continued to work with our customers to meet our contractual commitments while adapting our pricing to reflect the volatile cost of transportation pricing seen since the beginning of the COVID-19 pandemic while also serving customers' needs in the spot market. This resulted in an increase in average truckload linehaul rates per mile, excluding fuel costs, charged to customers, although our truckload transportation costs, excluding fuel prices, increased at a faster rate resulting in adjusted gross profit margin compression.Our global forwarding results were largely consistent with the overall market trends summarized above. Throughout 2020, we augmented our air freight capacity with charter flights due to the significant capacity shortages in the market, which resulted in larger than normal shipment sizes. The increase in air freight pricing more than offset an 18.0 percent decline in air freight volumes. Ocean volumes increased a modest 0.5 percent in 2020 as volume reductions in the first half of 2020 due to the COVID-19 pandemic were more than offset by increases in the second half of 2020 as industries resumed production and demand increased. Our ocean business experienced significant increases in the cost of ocean freight beginning in the second quarter as many ocean carriers idled capacity due to the impacts of the COVID-19 pandemic and this capacity was slow to return to the market in comparison to the demand and production increases experienced in the second half of 2020. These factors resulted in a rapidly increasing price and cost environment. On March 2, 2020, we acquired Prime Distribution Services (“Prime Distribution” or "Prime"), a leading provider of retail consolidation services in North America, for $222.7 million in cash. The acquisition was effective as of February 29, 2020, and therefore the results of operations of Prime Distribution have been included as part of the NAST segment in our consolidated financial statements since March 1, 2020. On February 28, 2019, we acquired The Space Cargo Group (“Space Cargo”) for the purpose of expanding our presence and capabilities in Spain and Colombia. Our consolidated results include the results of 23Table of ContentSpace Cargo since March 1, 2019. On May 22, 2019, we acquired Dema Service S.p.A (“Dema Service”) to strengthen our existing footprint in Italy. Our consolidated results include the results of Dema Service since May 23, 2019.SIGNIFICANT DEVELOPMENTSOur 2020 financial results and operations were impacted by the COVID-19 pandemic described above and discussed throughout Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations.” In addition, see Part I—“Item 1A, Risk Factors,” included within this Annual Report on Form 10-K for discussion of the impacts and potential impacts of the COVID-19 pandemic. The extent to which the COVID-19 pandemic impacts our financial results and operations in 2021 and going forward will depend on future developments, which are highly uncertain and cannot be predicted, including fluctuations in the severity of the outbreak and the actions being taken to contain and treat it.During 2020, we have taken a variety of measures to ensure the availability, continuity, and security of our critical infrastructure, ensure the health and safety of our employees around the globe, and provide service and supply chain continuity to our customers and contracted carriers in order to deliver critical and essential goods and services. We continue to follow public and private sector policies and initiatives to reduce the transmission of COVID-19, such as requiring social distancing, wearing a mask, and limiting the number of employees to less than 50 percent capacity when in the office, in addition to the elimination of all non-essential travel. We have also adopted work-from-home arrangements, and near the end of 2020 approximately 84 percent of our employees were working remotely, executing their duties and responsibilities. In addition, we took steps in 2020 to reduce costs, including the elimination of all non-essential travel, temporary salary reductions for company executive officers, temporary reductions in cash retainers for board members, temporary suspension of the company match to retirement plans for U.S. and Canadian employees, accelerating the use of paid time off, and furloughing approximately seven percent of our U.S. and Canadian employees in the second quarter of 2020. As we continued to harness the benefits of our technology investment and network transformation, we eliminated certain positions during 2020, and therefore, a portion of employees did not return from furlough. We recognized $4.4 million in severance in 2020 as a result of these reductions.Due to the ongoing uncertainty around the severity and duration of the outbreak, we are not able at this time to estimate the impact the COVID-19 pandemic may have on our financial results and operations in 2021 and going forward. However, the impact could be material in all business segments and could be material during any future period affected either directly or indirectly by this pandemic. Many businesses, in particular small businesses, continue to experience reduced production and output, which could result in a decrease in freight volumes across a number of industries, which may reduce our contractual and spot market opportunities. In addition, a significant number of our contracted carriers may reduce their capacity or charge higher prices in light of the volatile market conditions, which may reduce our adjusted gross profit margins as we honor our contractual freight rates.SELECTED OPERATING PERFORMANCE AND OTHER SIGNIFICANT ITEMSThe following summarizes select 2020 year-over-year operating comparisons to 2019:•Total revenues increased 5.9 percent to $16.2 billion, driven primarily by higher pricing in ocean and air freight services and contributions from the Prime acquisition. •Gross profits decreased 7.0 percent to $2.4 billion. Adjusted gross profits decreased 6.7 percent to $2.4 billion, primarily driven by lower adjusted gross profit margins in truckload services, partially offset by contributions from the Prime acquisition and higher adjusted gross profits in air freight and ocean services. •Personnel expenses decreased 4.3 percent to $1.2 billion, driven primarily by cost savings initiatives, including a 2.8 percent decrease in average headcount and a decline in benefits expenses and incentive compensation.•Selling, general, and administrative (“SG&A”) expenses decreased 0.3 percent to $496.1 million, primarily due to significantly lower travel expenses, partially offset by the ongoing expenses from the Prime acquisition.•Income from operations totaled $673.3 million, down 14.8 percent from last year due to a decline in adjusted gross profits. Adjusted operating margin of 27.9 percent decreased 260 basis points.•Interest and other expenses totaled $44.9 million, which primarily consisted of $49.1 million of interest expense and was partially offset by a $3.3 million favorable impact from foreign currency revaluation and realized foreign currency gains and losses. 24Table of Content•The effective tax rate for 2020 was 19.4 percent compared to 22.3 percent in 2019. The lower effective tax rate was due primarily to the tax benefit related to stock-based compensation, including delivery of a one-time deferred stock award that was granted to the company's prior Chief Executive Officer in 2000, and excess foreign tax credits.•Net income totaled $506.4 million, down 12.2 percent from a year ago. Diluted earnings per share (EPS) decreased 11.2 percent to $3.72. •Cash flow from operations decreased 40.2 percent to $499.2 million. CONSOLIDATED RESULTS OF OPERATIONSThe following table summarizes our results of operations (dollars in thousands, except per share data):Twelve Months Ended December 31,20202019% change2018% changeRevenues:Transportation$15,147,562 $14,322,295 5.8 %$15,515,921 (7.7)%Sourcing1,059,544 987,213 7.3 %1,115,251 (11.5)%Total revenues 16,207,106 15,309,508 5.9 %16,631,172 (7.9)%Costs and expenses:Purchased transportation and related services$12,834,608 11,839,433 8.4 %12,922,177 (8.4)%Purchased products sourced for resale960,241 883,765 8.7 %1,003,760 (12.0)%Personnel expenses1,242,867 1,298,528 (4.3)%1,343,542 (3.4)%Other selling, general, and administrative expenses496,122 497,806 (0.3)%449,610 10.7 %Total costs and expenses 15,533,838 14,519,532 7.0 %15,719,089 (7.6)%Income from operations 673,268 789,976 (14.8)%912,083 (13.4)%Interest and other expense(44,937)(47,719)(5.8)%(31,810)50.0 %Income before provision for income taxes 628,331 742,257 (15.3)%880,273 (15.7)%Provision for income taxes121,910 165,289 (26.2)%215,768 (23.4)%Net income $506,421 $576,968 (12.2)%$664,505 (13.2)%Diluted net income per share $3.72 $4.19 (11.2)%$4.73 (11.4)%Average headcount 15,119 15,551 (2.8)%15,204 2.3 %Adjusted gross profit margin percentage(1)Transportation15.3%17.3%(2.0) pts16.7%0.6 ptsSourcing9.4%10.5%(1.1) pts10.0%0.5 ptsTotal adjusted gross profit margin14.9%16.9%(2.0) pts16.3%0.6 pts________________________________ (1) Adjusted gross profit margin is a non-GAAP financial measure explained above. The following discussion and analysis of our Results of Operations and Liquidity and Capital Resources includes a comparison of the twelve months ended December 31, 2020, to the twelve months ended December 31, 2019. A similar discussion and analysis that compares the twelve months ended December 31, 2019, to the twelve months ended December 31, 2018, can be found in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," of our 2019 Annual Report on Form 10-K filed with the SEC on February 19, 2020. A reconciliation of our reportable segments to our consolidated results can be found in Note 9, Segment Reporting, in Part II, Financial Information of this Annual Report on Form 10-K.25Table of ContentConsolidated Results of Operations—Twelve Months Ended December 31, 2020 Compared to Twelve Months Ended December 31, 2019Total revenues and related costs. Total transportation revenues increased driven by significant pricing increases in our ocean and air freight service lines and increased LTL volumes. Ocean pricing increased significantly in the second half of 2020 as improving demand outpaced carrier capacity returning to the market. In addition, a significant decline in capacity due to a reduction in commercial flights from COVID-19 restrictions resulted in sharp increases in air freight pricing. These increases were partially offset by lower pricing in LTL and truckload services. Total purchased transportation and related services increased due to increased cost of transportation in most of our transportation services resulting from the factors discussed above. Our sourcing total revenues and purchased products sourced for resale increased due to higher pricing and costs per case, which was partially offset by lower case volume most notably in the foodservice industry, which has been significantly impacted by the COVID-19 pandemic.Gross profits and adjusted gross profits. Our transportation adjusted gross profit decreased driven by adjusted gross profit margin declines in truckload services due to tight carrier capacity in the marketplace and the significant transportation cost volatility resulting from the impact of the COVID-19 pandemic relative to our contractual customer pricing. We continued to meet our customer commitments despite increases for the cost of capacity, which has resulted in adjusted gross profit margin compression. Partially offsetting these declines was an increase in air freight pricing resulting in adjusted gross profit margin expansion as we were able to leverage our contractual air freight capacity despite significant shortages in the air freight market. Sourcing adjusted gross profits declined driven by the costs of purchased products sourced for resale increasing at a faster rate than our sourcing total revenues in addition to lower case volumes.Operating expenses. Personnel expenses decreased primarily due to cost savings initiatives, including the temporary suspension of the company match to retirement plans for U.S. and Canadian employees, declines in healthcare costs, lower variable compensation and a decrease in average headcount. Other SG&A expenses decreased driven by the elimination of all non-essential travel. Partially offsetting this decrease was an increase in occupancy expenses, including those attributable to acquisitions, and an $11.5 million loss on the sale-leaseback of a company-owned data center. Interest and other expense. Interest and other expense primarily consisted of $49.1 million of interest expense, partially offset by a $3.3 million favorable impact of foreign currency revaluation and realized foreign currency gains and losses in 2020. This compared to a $4.2 million unfavorable impact of foreign currency revaluation and realized foreign currency gains and losses in 2019. Interest expense decreased from 2019 due to lower average borrowings and interest rates.Provision for income taxes. Our effective income tax rate was 19.4 percent in 2020 and 22.3 percent in 2019. The effective income tax rate for the twelve months ended December 31, 2020, was lower than the statutory federal income tax rate primarily due to the tax impact of share-based payment awards, including the tax benefit from the delivery of a one-time deferred stock award that was granted to the company's prior Chief Executive Officer in 2000 and excess foreign tax credits. These impacts were partially offset by state income taxes, net of federal benefits and foreign income taxes. The effective income tax rate for the twelve months ended December 31, 2019, was higher than the statutory federal income tax rate due to state income taxes, net of federal benefit, and foreign income taxes, but was partially offset by the tax impact of excess foreign tax credits and share-based payment awards. 26Table of ContentNAST Segment Results of OperationsTwelve Months Ended December 31,(dollars in thousands)20202019% change2018% changeTotal revenues$11,312,553 $11,283,692 0.3 %$12,346,757 (8.6)%Costs and expenses:Purchased transportation and related services9,795,462 9,486,323 3.3 %10,440,496 (9.1)%Personnel expenses624,358 698,187 (10.6)%749,120 (6.8)%Other selling, general, and administrative expenses384,258 376,419 2.1 %335,297 12.3 %Total costs and expenses10,804,078 10,560,929 2.3 %11,524,913 (8.4)%Income from operations$508,475 $722,763 (29.6)%$821,844 (12.1)%Twelve Months Ended December 31,20202019% change2018% changeAverage headcount 6,811 7,354 (7.4)%7,387 (0.4)%Service line volume statisticsTruckload— %(2.0)%LTL9.5 %3.5 %Adjusted gross profits(1)Truckload$981,420 $1,275,199 (23.0)%$1,375,361 (7.3)%LTL452,033 471,616 (4.2)%466,725 1.0 %Other 83,638 50,554 65.4 %64,175 (21.2)%Total adjusted gross profits$1,517,091 $1,797,369 (15.6)%$1,906,261 (5.7)%________________________________ (1) Adjusted gross profits is a non-GAAP financial measure explained above. Twelve Months Ended December 31, 2020 Compared to Twelve Months Ended December 31, 2019Total revenues and related costs. NAST total revenues increased due to the acquisition of Prime, which added one percentage point to NAST total revenues. This increase was partially offset by declines in truckload total revenues driven by lower pricing in the first half of 2020 and significantly lower fuel prices in 2020. NAST cost of transportation and related services increased driven by increased cost per mile in truckload services and was partially offset by significantly lower fuel prices.Gross profits and adjusted gross profits. NAST adjusted gross profits decreased driven, primarily, by lower adjusted gross profit per shipment in truckload and LTL services. The lower adjusted gross profit per shipment in truckload was driven by the tight carrier capacity in the marketplace and the significant transportation cost volatility resulting from the impact of the COVID-19 pandemic relative to our contractual customer pricing. We continued to meet our customer commitments despite increases for the cost of capacity, which has resulted in adjusted gross profit margin compression. Our average truckload linehaul rate per mile charged to our customers, which excludes fuel surcharges, increased approximately 5.5 percent resulting from the market and business trends discussed above. Our truckload transportation costs, excluding fuel surcharges, increased approximately 11.0 percent. NAST LTL adjusted gross profits decreased primarily due to reduced adjusted gross profit margins driven by the tight carrier capacity in the marketplace, partially offset by increased volume. The acquisition of Prime Distribution contributed five percentage points of LTL adjusted gross profit growth.NAST other adjusted gross profits increased primarily due to incremental warehousing services related to the acquisition of Prime.Operating expenses. NAST personnel expense decreased primarily due to cost savings initiatives, including the temporary suspension of the company match to retirement plans for U.S. and Canadian employees, lower variable compensation, declines in healthcare costs, and a decrease in average headcount. NAST SG&A expenses increased due to the ongoing expenses from the Prime acquisition, which were partially offset by the elimination of all non-essential travel.27Table of ContentGlobal Forwarding Segment Results of OperationsTwelve Months Ended December 31,(dollars in thousands)20202019% change2018% changeTotal revenues$3,100,525 $2,327,913 33.2 %$2,487,744 (6.4)%Costs and expenses:Purchased transportation and related services2,471,537 1,793,937 37.8 %1,943,838 (7.7)%Personnel expenses281,048 276,255 1.7 %284,586 (2.9)%Other selling, general, and administrative expenses172,427 177,194 (2.7)%167,694 5.7 %Total costs and expenses2,925,012 2,247,386 30.2 %2,396,118 (6.2)%Income from operations$175,513 $80,527 118.0 %$91,626 (12.1)%Twelve Months Ended December 31,20202019% change2018% changeAverage headcount 4,7084,766(1.2)%4,7111.2 %Service line volume statisticsOcean0.5 %— %Air(18.0)%(7.0)%Customs(3.5)%0.5 %Adjusted gross profits(1)Ocean$349,868 $308,068 13.6 %$312,327 (1.4)%Air146,056 101,991 43.2 %111,038 (8.1)%Customs87,092 91,833 (5.2)%88,515 3.7 %Other 45,972 32,084 43.3 %32,026 0.2 %Total adjusted gross profits$628,988 $533,976 17.8 %$543,906 (1.8)%________________________________ (1) Adjusted gross profits is a non-GAAP financial measure explained above. Twelve Months Ended December 31, 2020 compared to Twelve Months Ended December 31, 2019Total revenues and related costs. Total revenues and related costs increased driven by higher pricing and costs in the ocean and air freight markets which were significantly impacted by the COVID-19 pandemic as discussed above. Ocean pricing and purchased transportation costs increased significantly in the second half of 2020 as improving demand outpaced carrier capacity returning to the market. The air freight market has been significantly impacted by reduced cargo capacity due to fewer commercial flights, an increase in charter flights, and larger than normal shipment sizes which has created an environment with unusually high pricing and purchased transportation costs.Gross profits and adjusted gross profits. Global Forwarding adjusted gross profits increased driven by the significant increase in air freight and ocean pricing due to the impact of the COVID-19 pandemic. The air freight market has been significantly impacted by reduced cargo capacity due to fewer commercial flights, an increase in charter flights, and larger than normal shipment sizes which has created an environment with unusually high pricing. The price for ocean services has also increased significantly due to tight ocean carrier capacity. These increases were partially offset by volume declines in air freight. Customs adjusted gross profits decreased driven by decreased volumes.Operating expenses. Personnel expenses increased driven by an increase in incentive compensation but was partially offset by a decrease in average headcount. SG&A expenses decreased driven by the elimination of non-essential travel, partially offset by an increase in credit loss expense.28Table of ContentAll Other and Corporate Segment Results of OperationsAll Other and Corporate includes our Robinson Fresh and Managed Services segment, as well as Other Surface Transportation outside of North America and other miscellaneous revenues and unallocated corporate expenses. Twelve Months Ended December 31,(dollars in thousands)20202019% change2018% changeTotal revenues$1,794,028 $1,697,903 5.7 %$1,796,671 (5.5)%Income from operations(10,720)(13,314)N/M(1,387)N/MAdjusted gross profits(1)Robinson Fresh105,700 109,183 (3.2)%116,283 (6.1)%Managed Services94,828 83,365 13.8 %78,789 5.8 %Other Surface Transportation65,650 62,417 5.2 %59,996 4.0 %Total adjusted gross profits$266,178 $254,965 4.4 %$255,068 — %________________________________ (1) Adjusted gross profits is a non-GAAP financial measure explained above. Twelve Months Ended December 31, 2020 compared to Twelve Months Ended December 31, 2019Total revenues and related costs. Total revenues and related costs increased driven by increased pricing in our Robinson Fresh business, which was partially offset by decreased demand from customers in the foodservice industry resulting from the COVID-19 pandemic, and to a lesser extent, an increase in Other Surface Transportation and Managed Services.Gross profits and adjusted gross profits. Robinson Fresh adjusted gross profits decreased driven by reduced case volumes, most notably from customers in the foodservice industry. Managed Services adjusted gross profits increased driven by a combination of new customer wins and selling additional services to existing customers. Other Surface Transportation adjusted gross profits increased primarily driven by the acquisition of Dema Service, which contributed three percentage points of growth in Other Surface Transportation.LIQUIDITY AND CAPITAL RESOURCESWe have historically generated substantial cash from operations, which has enabled us to fund our organic growth while paying cash dividends and repurchasing stock. In addition, we maintain the following debt facilities as described in Note 4, Financing Arrangements (dollars in thousands):DescriptionCarrying Value as of December 31, 2020Borrowing CapacityMaturityRevolving credit facility$— $1,000,000 October 2023Senior Notes, Series A175,000 175,000 August 2023Senior Notes, Series B150,000 150,000 August 2028Senior Notes, Series C175,000 175,000 August 2033Senior Notes (1)593,301 600,000 April 2028Total debt$1,093,301 $2,100,000 ________________________________ (1) Net of unamortized discounts and issuance costs.We expect to use our current debt facilities and potentially other indebtedness incurred in the future to assist us in continuing to fund working capital, capital expenditures, possible acquisitions, dividends, and share repurchases.Cash and cash equivalents totaled $243.8 million as of December 31, 2020, and $447.9 million as of December 31, 2019. Cash and cash equivalents held outside the United States totaled $230.9 million as of December 31, 2020, and $405.1 million as of December 31, 2019. Working capital increased from $1.08 billion at December 31, 2019, to $1.10 billion at December 31, 2020.29Table of ContentWe prioritize our investments to grow the business, as we require some working capital and a relatively small amount of capital expenditures to grow. We are continually looking for acquisitions, but those acquisitions must fit our culture and enhance our growth opportunities.The following table summarizes our major sources and uses of cash and cash equivalents (dollars in thousands):Twelve months ended December 31, 20202019% change2018% changeSources (uses) of cash:Cash provided by operating activities$499,191 $835,419 (40.2)%$792,896 5.4 %Capital expenditures(54,009)(70,465)(63,871)Acquisitions(223,230)(59,200)(5,315)Other investing activities5,525 16,636 (3,622)Cash used for investing activities(271,714)(113,029)140.4 %(72,808)55.2 %Repurchase of common stock(177,514)(309,444)(300,991)Cash dividends(209,956)(277,786)(265,219)Net payments on debt(143,000)(112,000)(118,988)Other financing activities89,803 47,977 30,021 Cash used for financing activities(440,667)(651,253)(32.3)%(655,177)(0.6)%Effect of exchange rates on cash and cash equivalents9,128 (1,894)(20,186)Net change in cash and cash equivalents$(204,062)$69,243 $44,725 Cash flow from operating activities. The decrease in cash flow from operating activities in 2020 from 2019 was primarily due to unfavorable changes in working capital. The unfavorable changes in working capital were primarily related to a sequential increase in accounts receivable associated with increasing pricing in a number of service lines during 2020. Given the COVID-19 pandemic, we are closely monitoring credit and collections activities to minimize risk as well as working with our customers to facilitate the movement of goods across their supply chains while also ensuring timely payment.Cash used for investing activities. Our investing activities consist primarily of capital expenditures and cash paid for acquisitions. Capital expenditures consisted primarily of investments in information technology, which are intended to increase employee productivity, automate interactions with our customers and contracted carriers, and improve our internal workflows to help expand our adjusted operating margins and grow the business. During 2019, we sold a facility we owned in Chicago, Illinois for approximately $17.0 million. In 2020, we used $222.7 million for the acquisition of Prime. In 2019, we used $45.0 million for the acquisition of Space Cargo and $14.2 million for the acquisition of Dema Service. We anticipate capital expenditures in 2021 to be approximately $55 million to $65 million. Cash used for financing activities. We had net repayments on debt of $143.0 million in 2020 and $112.0 million in 2019. The 2020 and 2019 net repayments were primarily to reduce the outstanding balance of the receivables securitization facility (the "Facility"). This Facility expired in December 2020 and was not renewed. There was no outstanding balance on our senior unsecured revolving credit facility (the "Credit Agreement") as of December 31, 2020 and 2019. As of December 31, 2020, we were in compliance with all of the covenants under the Credit Agreement, note purchase agreement, and senior unsecured notes. The decrease in cash dividends paid was the result of our fourth quarter dividend being paid on January 4, 2021. The decrease in share repurchases in 2020 was due to the temporary suspension of our share repurchase activity near the end of the first quarter of 2020 as we assessed the impacts of the COVID-19 pandemic. We resumed our repurchase activity in the fourth quarter of 2020. In May 2018, the Board of Directors increased the number of shares authorized to be repurchased by 15,000,000 shares. As of December 31, 2020, there were 7,789,752 shares remaining for future repurchases. The number of shares we repurchase, if any, during future periods will vary based on our cash position, potential alternative uses of our cash, and market conditions. We may seek to retire or purchase our outstanding Senior Notes through open market cash purchases, privately negotiated transactions, or otherwise.30Table of ContentAlthough there is uncertainty related to the anticipated impact of the COVID-19 pandemic on our future results, we believe that, assuming no change in our current business plan, our available cash, together with expected future cash generated from operations, the amount available under our credit facilities, and credit available in the market, will be sufficient to satisfy our anticipated needs for working capital, capital expenditures, and cash dividends for at least the next 12 months. We also believe we could obtain funds under lines of credit or other forms of indebtedness on short notice, if needed.Recently Issued Accounting Pronouncements. Refer to Note 14, Recently Issued Accounting Pronouncements, of the accompanying consolidated financial statements for a discussion of recently issued accounting pronouncements.CRITICAL ACCOUNTING POLICIES AND ESTIMATESOur consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States. The preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and the related disclosures. Because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, of the Notes to the Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. We consider the following items in our consolidated financial statements to require significant estimation or judgment. REVENUE RECOGNITION. At contract inception, we assess the goods and services promised in our contracts with customers and identify our performance obligations to provide distinct goods and services to our customers. Our transportation and logistics service arrangements often require management to use judgment and make estimates that impact the amounts and timing of revenue recognition. Transportation and Logistics Services - As a global logistics provider, our primary performance obligation under our customer contracts is to utilize our relationships with a wide variety of transportation companies to efficiently and cost-effectively transport our customers’ freight. Revenue is recognized for these performance obligations as they are satisfied over the contract term, which generally represents the transit period. The transit period can vary based upon the method of transport, generally a number of days for over the road, rail, and air transportation, or several weeks in the case of an ocean shipment. Recognizing revenue for contracts where the transit period is partially complete or completed and not yet invoiced at period end requires management to make judgments that affect the amounts and timing of revenue recognized at period end. At December 31, 2020 we recorded revenue of $197.2 million for services we have provided while a shipment was still in-transit but for which we had not yet completed our performance obligation or had not yet invoiced our customer compared to $132.9 million at December 31, 2019. We utilize our historical knowledge of shipping lanes and estimated transit times to determine the transit period in cases where our customers’ freight has not reached its intended destination. In addition, we analyze contract data for the first few days following the reporting date combined with our historical experience of trends related to partially completed contracts as of the reporting date to determine our right to consideration for the services we have provided where the transit period is partially complete or completed and not yet invoiced at period end. Differences in contract data for the first few days following the reporting date compared with our historical experience or disruptions such as weather events or other delays could cause the actual amount of revenue earned at period end to differ from these estimates. Total revenues represent the total dollar value of revenue recognized from contracts with customers for the goods and services we provide. Substantially all of our revenue is attributable to contracts with our customers. Most transactions in our transportation and sourcing businesses are recorded at the gross amount we charge our customers for the service we provide and goods we sell. In these transactions, we are primarily responsible for fulfilling the promise to provide the specified good or service to our customer and we have discretion in establishing the price for the specified good or service. Additionally, in our sourcing business, in some cases we take inventory risk before the specified good has been transferred to our customer. Customs brokerage, managed services, freight forwarding, and sourcing managed procurement transactions are recorded at the net amount we charge our customers for the service we provide because many of the factors stated above are not present. See also Note 1, Summary of Significant Accounting Policies, for further information regarding our revenue recognition policies. GOODWILL. Goodwill represents the excess of the cost of acquired businesses over the net of the fair value of identifiable tangible assets and identifiable intangible assets purchased and liabilities assumed.Goodwill is tested for impairment annually on November 30, or more frequently if events or changes in circumstances indicate that the asset might be impaired. We first perform a qualitative assessment to determine whether it is more likely than not that the fair value of our reporting units is less than their respective carrying value (“Step Zero Analysis”). If the Step Zero Analysis 31Table of Contentindicates it is more likely than not that the fair value of our reporting units is less than their respective carrying value, an additional impairment assessment is performed (“Step One Analysis”). As part of our Step Zero Analysis, we considered the impacts of the COVID-19 pandemic on financial markets and our business operations and determined that the more likely than not criteria had not been met, and therefore a Step One Analysis was not required. When we perform a Step One Analysis, the fair value of each reporting unit is compared with the carrying amount of the reporting unit, including goodwill. If the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. In the Step One Analysis, the fair value of each reporting unit is determined using a discounted cash flow analysis and market approach. Projecting discounted future cash flows requires us to make significant estimates regarding future revenues and expenses, projected capital expenditures, changes in working capital, and the appropriate discount rate. Use of the market approach consists of comparisons to comparable publicly-traded companies that are similar in size and industry. Actual results may differ from those used in our valuations when a Step One Analysis is performed. DISCLOSURES ABOUT CONTRACTUAL OBLIGATIONS AND COMMERCIAL CONTINGENCIESThe following table aggregates all contractual commitments and commercial obligations, due by period, that affect our financial condition and liquidity position as of December 31, 2020 (dollars in thousands):20212022202320242025ThereafterTotalSenior notes (1)$25,200 $25,200 $25,200 $25,200 $25,200 $657,750 $783,750 Long-term notes payable(1)21,388 21,388 196,388 14,440 14,440 408,570 676,614 Maturity of lease liabilities(2)75,624 69,980 57,597 39,547 29,935 104,455 377,138 Purchase obligations(3)102,799 39,225 35,349 23,649 1,658 210 202,890 Total$225,011 $155,793 $314,534 $102,836 $71,233 $1,170,985 $2,040,392 ________________________________ (1)Amounts payable relate to the semi-annual interest due on the senior and long-term notes and the principal amount at maturity. (2) We maintain operating leases for office space, warehouses, office equipment, and a small number of intermodal containers. See Note 11, Leases, for further information.(3) Purchase obligations include agreements for services that are enforceable and legally binding and that specify all significant terms. As of December 31, 2020, such obligations primarily include ocean and air freight capacity, telecommunications services, maintenance contracts, and information technology related capacity. In some instances our contractual commitments may be usage based or require estimates as to the timing of cash settlement.We have no financing lease obligations. Long-term liabilities consist primarily of noncurrent taxes payable and long-term notes payable. Due to the uncertainty with respect to the amounts or timing of future cash flows associated with our unrecognized tax benefits at December 31, 2020, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authority. Therefore, $42.3 million of unrecognized tax benefits have been excluded from the contractual obligations table above. See Note 5, Income Taxes, to the consolidated financial statements for a discussion on income taxes. As of December 31, 2020, we do not have significant off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.32Table of ContentITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We had $243.8 million of cash and cash equivalents on December 31, 2020. Substantially all of the cash equivalents are in demand accounts with financial institutions. The primary market risks associated with these investments are liquidity risks. We are a party to a credit agreement with various lenders consisting of a $1 billion revolving loan facility. Interest accrues on the revolving loan at a variable rate determined by a pricing schedule or the base rate (which is the highest of (a) the administrative agent's prime rate, (b) the federal funds rate plus 0.50 percent, or (c) the sum of one-month LIBOR plus a specified margin). At December 31, 2020, there was no outstanding balance on the revolving loan.We are a party to the Note Purchase Agreement, as amended, with various institutional investors with fixed rates consisting of: (i) $175 million of the company’s 3.97 percent Senior Notes, Series A, due August 27, 2023, (ii) $150 million of the company’s 4.26 percent Senior Notes, Series B, due August 27, 2028, and (iii) $175 million of the company’s 4.6 percent Senior Notes, Series C, due August 27, 2033. At December 31, 2020, there was $500 million outstanding on the notes. We issued Senior Notes through a public offering on April 9, 2018. The Senior Notes bear an annual interest rate of 4.2 percent payable semi-annually on April 15 and October 15, until maturity on April 15, 2028. Taking into effect the amortization of the original issue discount and all underwriting and issuance expenses, the Senior Notes have an effective yield to maturity of approximately 4.39 percent per annum. The fair value of the Senior Notes, excluding debt discounts and issuance costs, approximated $710.2 million as of December 31, 2020, based primarily on the market prices quoted from external sources. The carrying value of the Senior Notes was $593.3 million at December 31, 2020.A hypothetical 100-basis-point change in the interest rate would not have a material effect on our earnings. We do not use derivative financial instruments to manage interest rate risk or to speculate on future changes in interest rates. A rise in interest rates could negatively affect the fair value of our debt facilities. Foreign Exchange RiskWe operate through a network of offices in North America, Europe, Asia, Oceania, and South America. As a result, we frequently transact using currencies other than the U.S. Dollar, primarily the Chinese Yuan, Euro, Canadian Dollar, and Mexican Peso. This often results in assets and liabilities, including intercompany balances, denominated in a currency other than the functional currency. In these instances, most commonly, we have balances denominated in U.S. Dollars in regions where the U.S. Dollar is not the functional currency. This results in foreign exchange risk.Foreign exchange risk can be quantified by performing a sensitivity analysis assuming a hypothetical change in the value of the U.S. Dollar compared to other currencies in which we transact. Our primary foreign exchange risk is associated with balances denominated in U.S. Dollars held in China where the functional currency is the Chinese Yuan. All other things being equal, a hypothetical 10 percent weakening of the U.S. Dollar against the Chinese Yuan on December 31, 2020 would have decreased our net income by approximately $11.9 million and a hypothetical 10 percent strengthening of the U.S. Dollar against the Chinese Yuan on December 31, 2020 would have increased our net income by approximately $9.7 million. Our use of derivative financial instruments to manage foreign exchange risk is insignificant.33Table of Content

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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following discussion should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K and with Part I, Item 1A, “Risk Factors.” Please refer to the cautionary language at the beginning of Part I of this Annual Report on Form 10-K regarding forward-looking statements.Business OverviewWe enable our customers to develop electronic products. Our products and services are designed to give our customers a competitive edge in their development of ICs, SoCs, and increasingly sophisticated electronic devices and systems. Our products and services do this by optimizing performance, minimizing power consumption, shortening the time to bring our customers’ products to market, improving engineering productivity and reducing their design, development and manufacturing costs. We offer software, hardware, services and reusable IC design blocks, which are commonly referred to as IP.Our strategy, which we call Intelligent System Design™, is to provide the technology necessary for our customers to develop electronic products across a variety of vertical markets including consumer, hyperscale computing, 5G communications, automotive, aerospace and defense, industrial and healthcare. Our products and services enable our customers to develop complex and innovative electronic products, so demand for our technology is driven by our customers’ investment in new designs and products. Historically, the industry that provided the tools used by IC engineers was referred to as EDA. Today, our offerings include and extend beyond EDA.We group our products into categories related to major design activities:•Custom IC Design and Simulation;•Digital IC Design and Signoff;•Functional Verification;•IP; and•System Design and Analysis.For additional information about our products, see the discussion in Item 1, “Business,” under the heading “Products and Product Strategy.”During the first quarter of fiscal 2020, we completed our acquisitions of AWR and Integrand. The aggregate cash consideration for these acquisitions of approximately $196 million was allocated to the assets acquired and liabilities assumed based on their respective estimated fair values on the respective acquisition dates. These acquisitions enhance our technology portfolio to address growing radio frequency design activity, driven by expanding use of 5G communications. These acquisitions increased expenses, including amortization of acquired intangible assets, more than revenue during fiscal 2020.During the first quarter of fiscal 2021, we entered into a definitive agreement to acquire all of the outstanding equity of Belgium-based NUMECA, a leader in CFD, mesh generation, multi-physics simulation and optimization. The addition of NUMECA’s technologies and talent supports our Intelligent System Design™ strategy. The acquisition is expected to close in the first quarter of fiscal 2021, subject to customary closing conditions.Management uses certain performance indicators to manage our business, including revenue, certain elements of operating expenses and cash flow from operations, and we describe these items further below under the headings “Results of Operations” and “Liquidity and Capital Resources.”COVID-19 ImpactIn March 2020, the World Health Organization declared the outbreak of COVID-19 a pandemic, which continues to spread throughout the U.S. and the world and has resulted in authorities implementing numerous measures to contain the virus, including travel bans and restrictions, quarantines, shelter-in-place orders, and business limitations and shutdowns. We are unable to accurately predict the full impact that COVID-19 will have on our results of operations, financial condition, liquidity and cash flows due to numerous uncertainties, including the duration and severity of the pandemic and containment measures. Our compliance with these containment measures has impacted our day-to-day operations and could disrupt our business and operations, as well as that of our key customers, suppliers (including contract manufacturers) and other counterparties, for an indefinite period of time. To support the health and well-being of our employees, customers, partners and communities, a vast majority of our employees are still working remotely as of February 22, 2021.The COVID-19 pandemic has caused some volatility in our usual delivery timing for our hardware and IP products to certain customers. Many of our customers' employees are working remotely, and, in some cases, we have experienced delivery lead times that are longer than normal because of delays in getting access to customer sites to complete our deliveries. In other cases, the amount of our hardware and IP products that we have been able to deliver has been greater than we originally anticipated at the beginning of the respective period. We have also received numerous COVID-19 pandemic-related requests from our customers to allow them to delay their payments to us, while we continue to provide services to these customers. Despite the challenges the COVID-19 pandemic has posed to our operations, it did not have material adverse impact on our results of operations, financial condition, liquidity or cash flows during fiscal 2020. We will continue to evaluate the nature and extent of the impact of COVID-19 on our business. See Part I, Item 1A, “Risk Factors” for additional information on the impact of COVID-19.29Table of ContentsResults of OperationsThe discussion of our fiscal 2020 consolidated results of operations include year-over-year comparisons to fiscal 2019 for revenue, cost of revenue, operating expenses, operating margin, other non-operating expenses, income taxes and cash flows. For a discussion of the fiscal 2019 changes compared to fiscal 2018, see the discussion in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 28, 2019, filed on February 24, 2020.Our fiscal years are 52- or 53-week periods ending on the Saturday closest to December 31. Fiscal 2020 was a 53-week year, compared to 2019 and 2018, which were each 52-week fiscal years. The additional week in fiscal 2020 resulted in additional revenue of approximately $45 million and additional expense, including stock-based compensation and amortization of acquired intangibles, of approximately $35 million.Results of operations for fiscal 2020, as compared to fiscal 2019, reflect the following:•increased product and maintenance revenue, resulting from growth in software, IP and hardware, particularly in China and the United States;•higher selling costs, including additional investment in technical sales support in response to our customers’ increasing technological requirements; •continued investment in research and development activities focused on expanding and enhancing our product portfolio; •decreased operating expenses for travel, meetings and events due to various measures implemented to contain COVID-19; •a 3 percentage point increase in operating margin driven primarily by revenue growth and temporary decreases in certain operating expenses due to the COVID-19 pandemic; and•changes in our provision (benefit) for income taxes due to a non-cash tax benefit resulting from intercompany transfers of certain intangible property rights to our Irish subsidiary during fiscal 2019.RevenueWe primarily generate revenue from licensing our software and IP, selling or leasing our emulation and prototyping hardware technology, providing maintenance for our software, hardware and IP, providing engineering services and earning royalties generated from the use of our IP. The timing of our revenue is significantly affected by the mix of software, hardware and IP products generating revenue in any given period and whether the revenue is recognized over time or at a point in time, upon completion of delivery.In any fiscal year, we expect that between 85% and 90% of our annual revenue will be characterized as recurring revenue. Revenue characterized as recurring includes revenue recognized over time from our software arrangements, services, royalties, maintenance on IP licenses and hardware, and operating leases of hardware and revenue recognized at varying points in time over the term of our IP Access Agreements. The remainder of our revenue is characterized as up-front revenue. Up-front revenue is primarily generated by our sales of emulation and prototyping hardware and individual IP licenses. The percentage of our recurring and up-front revenue may be impacted by delivery of hardware and IP products to our customers in any single fiscal period.Revenue by YearThe following table shows our revenue for fiscal 2020 and 2019 and the change in revenue between years: Change 202020192020 vs. 2019 (In millions, except percentages)Product and maintenance$2,536.6 $2,204.6 $332.0 15 %Services146.3 131.7 14.6 11 %Total revenue$2,682.9 $2,336.3 $346.6 15 %Product and maintenance revenue increased during fiscal 2020, as compared to fiscal 2019, primarily because of increased investments by our customers in new, complex designs for their products that include the design of electronic systems for consumer, hyperscale computing, 5G communications, automotive, aerospace and defense, industrial and healthcare. Services revenue may fluctuate from period to period based on the timing of fulfillment of our services and IP performance obligations.No one customer accounted for 10% or more of total revenue during fiscal 2020 or 2019.30Table of ContentsRevenue by Product CategoryThe following table shows the percentage of product and related maintenance revenue contributed by each of our five product categories and services during fiscal 2020 and 2019: 20202019Custom IC Design and Simulation25 %25 %Digital IC Design and Signoff29 %30 %Functional Verification, including Emulation and Prototyping Hardware22 %23 %IP14 %13 %System Design and Analysis10 %9 %Total100 %100 %Revenue by product category fluctuates from period to period based on demand for our products and services, our available resources and our ability to deliver and support them. Certain of our licensing arrangements allow customers the ability to remix among software products. Additionally, we have arrangements with customers that include a combination of our products, with the actual product selection and number of licensed users to be determined at a later date. For these arrangements, we estimate the allocation of the revenue to product categories based upon the expected usage of our products. The actual usage of our products by these customers may differ and, if that proves to be the case, the revenue allocation in the table above would differ. Revenue by Geography Change 202020192020 vs. 2019 (In millions, except percentages)United States$1,096.3 $982.4 $113.9 12 %Other Americas43.6 43.5 0.1 — %China406.6 241.5 165.1 68 %Other Asia487.4 459.0 28.4 6 %Europe, Middle East and Africa469.8 433.3 36.5 8 %Japan179.2 176.6 2.6 1 %Total revenue$2,682.9 $2,336.3 $346.6 15 %Revenue in the United States increased during fiscal 2020, as compared to fiscal 2019, primarily due to an increase in revenue for software and IP offerings.Revenue in China increased during fiscal 2020, as compared to fiscal 2019,due to increased demand from many of our customers in China. We experienced an increase in demand in the first half of fiscal 2020 that resulted in approximately 13% of our total revenue being generated from customers in China, as compared to approximately 11% during the first half of fiscal 2019. This was followed by an additional increase in demand in the second half of fiscal 2020 that resulted in approximately 17% of our revenue being generated from customers in China, as compared to approximately 10% during the second half of fiscal 2019. During fiscal 2021, we expect revenue from our customers in China to be consistent, as a percentage of total revenue, with the first half of fiscal 2020. Beginning in the second quarter of fiscal 2019, we have not been able to deliver maintenance or support for certain customers in China due to the U.S. Department of Commerce’s designation of these customers to the “Entity List.” We expect these restrictions and new or expanded trade restrictions to continue to impact revenue from certain customers in China.For the primary factors contributing to the change in revenue for other geographies during fiscal 2020, as compared to fiscal 2019, see the general description under “Revenue by Year” and “Revenue by Product Category” above.31Table of ContentsRevenue by Geography as a Percent of Total Revenue 20202019United States41 %42 %Other Americas1 %2 %China15 %10 %Other Asia18 %20 %Europe, Middle East and Africa18 %18 %Japan7 %8 %Total100 %100 %Most of our revenue is transacted in the United States dollar. However, certain revenue transactions are denominated in foreign currencies. For an additional description of how changes in foreign exchange rates affect our consolidated financial statements, see the discussion under Item 7A, “Quantitative and Qualitative Disclosures About Market Risk – Foreign Currency Risk.”Cost of Revenue Change 202020192020 vs. 2019 (In millions, except percentages)Cost of product and maintenance$231.0 $189.1 $41.9 22 %Cost of services74.5 77.2 (2.7)(3)%Total cost of revenue$305.5 $266.3 $39.2 15 %The following table shows cost of revenue as a percentage of related revenue for fiscal 2020 and 2019: 20202019Cost of product and maintenance9 %9 %Cost of services51 %59 %Cost of Product and MaintenanceCost of product and maintenance includes costs associated with the sale and lease of our emulation and prototyping hardware and licensing of our software and IP products, certain employee salary and benefits and other employee-related costs, cost of our customer support services, amortization of technology-related and maintenance-related acquired intangibles, costs of technical documentation and royalties payable to third-party vendors. Cost of product and maintenance depends primarily on our hardware product sales in any given period, but is also affected by employee salary and benefits and other employee-related costs, reserves for inventory, and the timing and extent to which we acquire intangible assets, license third-party technology or IP, and sell our products that include such acquired or licensed technology or IP. A summary of cost of product and maintenance for fiscal 2020 and 2019 is as follows: Change 202020192020 vs. 2019 (In millions, except percentages)Product and maintenance-related costs$184.8 $148.1 $36.7 25 %Amortization of acquired intangibles46.2 41.0 5.2 13 %Total cost of product and maintenance$231.0 $189.1 $41.9 22 %32Table of ContentsProduct and maintenance-related costs increased during fiscal 2020, when compared to fiscal 2019, due to the following: Change 2020 vs. 2019 (In millions)Emulation and prototyping hardware costs34.1 Professional services2.5 Salary, benefits and other employee-related costs1.8 Other items(1.7)Total change in product and maintenance-related costs$36.7 Costs associated with our emulation and prototyping hardware products include components, assembly, testing, applicable reserves and overhead. These costs make our cost of emulation and prototyping hardware products higher, as a percentage of revenue, than our cost of software and IP products. The increase in emulation and prototyping hardware costs during fiscal 2020, as compared to fiscal 2019, was primarily due to increased demand for our emulation and prototyping hardware, increased reserves for inventory, and the mix of products generating revenue. Amortization of acquired intangibles included in cost of product and maintenance increased by $9.4 million during fiscal 2020, as compared to fiscal 2019, due to technology-related intangible assets acquired from AWR and Integrand during fiscal 2020 and in-process technology being placed into service during fiscal 2020 and 2019. This increase was partially offset by certain technology-related intangible assets becoming fully amortized during fiscal 2020 and 2019.Cost of ServicesCost of services primarily includes employee salary, benefits and other employee-related costs to perform work on revenue-generating projects and costs to maintain the infrastructure necessary to manage a services organization. Cost of services may fluctuate from period to period based on our utilization of design services engineers on revenue-generating projects rather than internal development projects. Despite an increase in services revenue, cost of services decreased during fiscal 2020, as compared to fiscal 2019, due to a higher margin on the mix of services arrangements in fiscal 2020, compared to fiscal 2019, and temporary savings due to the COVID pandemic.Operating ExpensesOur operating expenses include marketing and sales, research and development, and general and administrative expenses. Factors that tend to cause our operating expenses to fluctuate include changes in the number of employees due to hiring and acquisitions, stock-based compensation, restructuring activities, foreign exchange rate movements, and the impact of our variable compensation programs that are driven by operating results. During fiscal 2020 we experienced decreased operating expenses for travel, meetings and events due to various measures implemented to contain COVID-19.Many of our operating expenses are transacted in various foreign currencies. We recognize lower expenses in periods when the United States dollar strengthens in value against other currencies and we recognize higher expenses when the United States dollar weakens against other currencies. For an additional description of how changes in foreign exchange rates affect our consolidated financial statements, see the discussion in Item 7A, “Quantitative and Qualitative Disclosures About Market Risk – Foreign Currency Risk.”Our operating expenses for fiscal 2020 and 2019 were as follows: Change 202020192020 vs. 2019 (In millions, except percentages)Marketing and sales$516.5 $481.7 $34.8 7 %Research and development1,033.7 935.9 97.8 10 %General and administrative154.4 139.8 14.6 10 %Total operating expenses$1,704.6 $1,557.4 $147.2 9 %Our operating expenses, as a percentage of total revenue, for fiscal 2020 and 2019 were as follows: 20202019Marketing and sales19 %21 %Research and development39 %40 %General and administrative6 %6 %Total operating expenses64 %67 %33Table of Contents Marketing and SalesThe changes in marketing and sales expense were due to the following: Change 2020 vs. 2019 (In millions)Salary, benefits and other employee-related costs$41.7 Stock-based compensation3.0 Home office-related expenses2.0 Travel and sales meetings(13.0)Other items1.1 Total change in marketing and sales expense$34.8 Salary, benefits and other employee-related costs included in marketing and sales increased during fiscal 2020, as compared to fiscal 2019, salary, benefits and other employee-related costs included in marketing and sales expense increased due primarily to additional headcount from hiring and acquisitions and variable compensation as we continue to invest in technical sales support in response to our customers’ increasing technological requirements. This increase was partially offset by reduced costs for marketing events and travel due to COVID-19.Research and Development The changes in research and development expense were due to the following: Change 2020 vs. 2019 (In millions)Salary, benefits and other employee-related costs95.7 Stock-based compensation10.3 Product development costs3.7 Home office-related expenses5.3 Facilities and other infrastructure costs(2.2)Professional services(2.8)Travel(11.8)Other items(0.4)Total change in research and development expense$97.8 Salary, benefits and other employee-related costs included in research and development expense increased during fiscal 2020, as compared to fiscal 2019, due primarily to additional headcount from hiring and acquisitions and variable compensation as we continue to expand and enhance our product portfolio. This increase was partially offset by reduced costs for travel due to COVID-19. General and AdministrativeThe changes in general and administrative expense were due to the following: Change 2020 vs. 2019 (In millions)Salary, benefits and other employee-related costs$6.5 Facilities and other infrastructure costs2.6 University endowment2.0 Stock-based compensation2.0 Other items1.5 Total change in general and administrative expense$14.6 Salary, benefits and other employee-related costs included in general and administrative expense increased during fiscal 2020, as compared to fiscal 2019, due primarily to an increase in variable compensation and additional headcount from hiring.34Table of ContentsAmortization of Acquired IntangiblesAmortization of acquired intangibles consists primarily of amortization of customer relationships, acquired backlog, trade names, trademarks and patents. Amortization in any given period depends primarily the timing and extent to which we acquire intangible assets. Change 202020192020 vs. 2019 (In millions, except percentages)Amortization of acquired intangibles$18.0 $12.1 $5.9 49 %Amortization of acquired intangibles increased by $7.3 million during fiscal 2020, as compared to fiscal 2019, due to intangibles assets acquired from AWR and Integrand during fiscal 2020. This increase was partially offset by certain intangible assets becoming fully amortized during fiscal 2020 and 2019.Restructuring and Other ChargesWe have initiated restructuring plans in recent years to better align our resources with our business strategy. Because the restructuring charges and related benefits are derived from management’s estimates made during the formulation of the restructuring plans, based on then-currently available information, our restructuring plans may not achieve the benefits anticipated on the timetable or at the level contemplated. Additional actions, including further restructuring of our operations, may be required in the future.The following table presents restructuring and other charges, net for our restructuring plans:20202019(In millions)Severance and benefits$7.5 $8.6 Excess facilities1.7 — Total$9.2 $8.6 For an additional description of our restructuring plans, see Note 13 in the notes to consolidated financial statements.Operating marginOperating margin represents income from operations as a percentage of total revenue. Our operating margin for fiscal 2020 and 2019 was as follows:20202019Operating margin24 %21 %Operating margin increased during fiscal, 2020, as compared to fiscal 2019, because revenue growth exceeded the growth of our costs and expenses. During fiscal 2021, we expect growth in operating margin will be more moderate due to an increase in costs and expenses associated with acquisitions, including increased amortization of intangibles. We also expect an increase in expenses related to travel, meetings and events if measures implemented to contain COVID-19 are lifted.Interest ExpenseInterest expense for fiscal 2020 and 2019 was comprised of the following: 20202019 (In millions)Contractual cash interest expense:2024 Notes$15.5 $15.3 Revolving credit facility4.4 2.4 Amortization of debt discount:2024 Notes0.8 0.7 Other— 0.4 Total interest expense$20.7 $18.8 Interest expense increased during fiscal 2020, as compared to fiscal 2019, due to borrowings of $350 million under our revolving credit facility during the first quarter of fiscal 2020 as a precautionary measure to provide additional liquidity in light of global economic uncertainty. All outstanding borrowings under our revolving credit facility were repaid in the fourth quarter of fiscal 2020. For an additional description of our debt arrangements, including our revolving credit facility, see Note 3 in the notes to consolidated financial statements.35Table of ContentsIncome TaxesThe following table presents the provision (benefit) for income taxes and the effective tax rate for fiscal 2020 and 2019: 20202019 (In millions, except percentages)Provision (benefit) for income taxes$42.1 $(510.0)Effective tax rate6.7 %(106.5)%In June 2020, the State of California enacted legislation that, for a three-year period beginning in fiscal 2020, will limit our utilization of California research and development tax credits to $5 million annually and will suspend the use of California net operating loss deductions. We accounted for the effects of the California tax law change and we recognized a tax benefit of approximately $22.2 million due to a partial release of the valuation allowance on our California research and development tax credit deferred tax assets as a result of certain tax elections made in our 2019 California tax return.Our provision for fiscal 2020 was primarily attributable to federal, state and foreign income taxes on our fiscal 2020 income, partially offset by the tax benefit of $22.2 million related to the partial release of the valuation allowance on our California research and development tax credit deferred tax assets and the tax benefit of $60.1 million related to stock-based compensation that vested or was exercised during fiscal 2020.During fiscal 2019, we completed intercompany transfers of certain intangible property rights to our Irish subsidiary, which resulted in the establishment of a net deferred tax asset and the recognition of an income tax benefit of $575.6 million. We expected to realize the deferred tax asset in future periods and did not provide for a valuation allowance. This income tax benefit was partially offset by the federal, state and foreign income taxes on our fiscal 2019 income. We also recognized $36.8 million of tax benefit related to stock-based compensation that vested or was exercised during the year.Our future effective tax rates may be materially impacted by tax amounts associated with our foreign earnings at rates different from the United States federal statutory rate, research credits, the tax impact of stock-based compensation, accounting for uncertain tax positions, business combinations, closure of statutes of limitations or settlement of tax audits, changes in valuation allowance and changes in tax law. A significant amount of our foreign earnings is generated by our subsidiaries organized in Ireland and Hungary. Our future effective tax rates may be adversely affected if our earnings were to be lower in countries where we have lower statutory tax rates. We currently expect that our fiscal 2021 effective tax rate will be approximately 14%. We expect that our quarterly effective tax rates will vary from our fiscal 2021 effective tax rate as a result of recognizing the income tax effects of stock-based awards in the quarterly periods that the awards vest or are settled and other items that we cannot anticipate. For additional discussion about how our effective tax rate could be affected by various risks, see Part I, Item 1A, “Risk Factors.” For further discussion regarding our income taxes, see Note 6 in the notes to consolidated financial statements.Liquidity and Capital Resources As ofChange January 2,2021December 28,20192020 vs. 2019 (In millions)Cash and cash equivalents$928.4 $705.2 $223.2 Net working capital681.8 497.0 184.8 Cash and Cash EquivalentsAs of January 2, 2021, our principal sources of liquidity consisted of $928.4 million of cash and cash equivalents as compared to $705.2 million as of December 28, 2019.Our primary sources of cash and cash equivalents during fiscal 2020 were cash generated from operations, proceeds from borrowings under our revolving credit facility, proceeds from the exercise of stock options and proceeds from stock purchases under our employee stock purchase plan.Our primary uses of cash and cash equivalents during fiscal 2020 were payments related to salaries and benefits, operating expenses, repurchases of our common stock, payments on our revolving credit facility, payments for business combinations, net of cash acquired, and purchases of property, plant and equipment.36Table of Contents Approximately 61% of our cash and cash equivalents were held by our foreign subsidiaries as of January 2, 2021. Our cash and cash equivalents held by our foreign subsidiaries may vary from period to period due to the timing of collections and repatriation of foreign earnings. We expect that current cash and cash equivalent balances, cash flows that are generated from operations and cash borrowings available under our revolving credit facility will be sufficient to meet our domestic and international working capital needs, and other capital and liquidity requirements, including acquisitions and share repurchases for at least the next 12 months.Net Working CapitalNet working capital is comprised of current assets less current liabilities, as shown on our consolidated balance sheets. The increase in our net working capital as of January 2, 2021, as compared to December 28, 2019, is primarily due to improved results from operations, the timing of cash receipts from customers and disbursements made to vendors.Cash Flows from Operating ActivitiesCash flows from operating activities during fiscal 2020 and 2019 were as follows: Change 202020192020 vs. 2019 (In millions)Cash provided by operating activities$904.9 $729.6 $175.3 Cash flows from operating activities include net income, adjusted for certain non-cash items, as well as changes in the balances of certain assets and liabilities. Our cash flows from operating activities are significantly influenced by business levels and the payment terms set forth in our customer agreements. The increase in cash flows from operating activities during fiscal 2020, as compared to fiscal 2019, was primarily due to the improved results from operations and timing of cash receipts from customers and disbursements made to vendors.Cash Flows from Investing ActivitiesCash flows used for investing activities during fiscal 2020 and 2019 were as follows: Change 202020192020 vs. 2019 (In millions)Cash used for investing activities$(292.2)$(105.7)$(186.5)The increase in cash used for investing activities during fiscal 2020, as compared to fiscal 2019, was primarily due to an increase in cash paid in business combinations, net of cash acquired, and an increase in purchases of property, plant and equipment. These increases were partially offset by a decrease in payments to acquire equity instruments of other entities. We expect to continue our investing activities, including purchasing property, plant and equipment, purchasing intangible assets, business combinations, purchasing software licenses, and making strategic investments.Cash Flows from Financing ActivitiesCash flows used for financing activities during fiscal 2020 and 2019 were as follows: Change 202020192020 vs. 2019 (In millions)Cash used for financing activities$(415.3)$(443.9)$28.6 The decrease in cash used for financing activities during fiscal 2020, as compared to fiscal 2019, was primarily due to a decrease in net cash paid for debt arrangements, partially offset by an increase in payments for repurchases of our common stock.37Table of ContentsOther Factors Affecting Liquidity and Capital ResourcesStock Repurchase ProgramAt the end of fiscal 2019, approximately $369 million remained available under our previously announced authorization to repurchase shares of our common stock. In July 2020, Cadence’s Board of Directors increased the previously announced authorization to repurchase shares of Cadence common stock by an additional $750 million. The actual timing and amount of repurchases are subject to business and market conditions, corporate and regulatory requirements, stock price, acquisition opportunities and other factors. As of January 2, 2021, approximately $739 million remained available to repurchase shares of Cadence common stock. See Part II, Item 5, “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” for additional information.Revolving Credit FacilityOur senior unsecured revolving credit facility provides for borrowings up to $350.0 million, with the right to request increased capacity up to an additional $250.0 million upon the receipt of lender commitments, for total maximum borrowings of $600.0 million. The credit facility expires on January 28, 2022 and currently has no subsidiary guarantors. Any outstanding loans drawn under the credit facility are due at maturity on January 28, 2022. Outstanding borrowings may be paid at any time prior to maturity. As of January 2, 2021, there were no borrowings outstanding under our revolving credit facility, and we were in compliance with all financial covenants associated with the revolving credit facility.2024 NotesIn October 2014, we issued $350.0 million aggregate principal amount of 4.375% Senior Notes due October 15, 2024. We received net proceeds of $342.4 million from the issuance of the 2024 Notes, net of a discount of $1.4 million and issuance costs of $6.2 million. Interest is payable in cash semi-annually. The 2024 Notes are unsecured and rank equal in right of payment to all of our existing and future senior indebtedness. As of January 2, 2021, we were in compliance with all covenants associated with the 2024 Notes.For additional information relating to our debt arrangements, see Note 3 in the notes to consolidated financial statements.Contractual ObligationsA summary of our contractual obligations as of January 2, 2021 is as follows:Payments Due by PeriodTotalLessThan 1 Year1-3 Years3-5 YearsMoreThan 5 Years(In millions)Operating lease obligations(1)$173.5 $38.4 $51.9 $35.6 $47.6 Purchase obligations46.8 36.3 8.7 1.3 0.5 Long-term debt350.0 — — 350.0 — Contractual interest payments61.8 15.8 30.7 15.3 — Current income tax payable7.8 7.8 Other long-term contractual obligations (2)40.4 — 19.8 4.0 16.6 Total$680.3 $98.3 $111.1 $406.2 $64.7 _________________(1) This table includes future payments under leases that had commenced as of January 2, 2021 as well as leases that had been signed but not yet commenced as of January 2, 2021.(2) Included in other long-term contractual obligations are long-term income tax liabilities of $17.6 million related to unrecognized tax benefits. Of the $17.6 million, we estimate $16.3 million will be paid or settled within 1 to 3 years, $1.2 million within 3 to 5 years and $0.1 million in more than 5 years. The remaining portion of other long-term contractual obligations is primarily liabilities associated with defined benefit retirement plans and acquisitions.Off-Balance Sheet ArrangementsAs of January 2, 2021, we did not have any significant off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.38Critical Accounting EstimatesIn preparing our consolidated financial statements, we make assumptions, judgments and estimates that can have a significant impact on our revenue, operating income and net income, as well as on the value of certain assets and liabilities on our consolidated balance sheets. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. At least quarterly, we evaluate our assumptions, judgments and estimates, and make changes as deemed necessary.We believe that the assumptions, judgments and estimates involved in the accounting for income taxes, revenue recognition and business combinations have the greatest potential impact on our consolidated financial statements; therefore, we consider these to be our critical accounting estimates. For information on our significant accounting policies, see Note 2 in the notes to consolidated financial statements.Revenue Recognition Our contracts with customers often include promises to transfer multiple software and/or IP licenses, hardware and services, including professional services, technical support services, and rights to unspecified updates to a customer. These contracts require us to apply judgement in identifying and evaluating any terms and conditions in contracts which may impact revenue recognition. Determining whether licenses and services are distinct performance obligations that should be accounted for separately, or not distinct and thus accounted for together, requires significant judgment. In some arrangements, such as most of our IP license arrangements, we have concluded that the licenses and associated services are distinct from each other. In other arrangements, like our time-based software arrangements, the licenses and certain services are not distinct from each other. Our time-based software arrangements include multiple software licenses and updates to the licensed software products, as well as technical support, and we have concluded that these promised goods and services are a single, combined performance obligation.Judgment is required to determine the stand-alone selling prices (“SSPs”) for each distinct performance obligation. We rarely license or sell products on a standalone basis, so we are required to estimate the SSP for each performance obligation. In instances where the SSP is not directly observable because we do not sell the license, product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual performance obligations due to the stratification of those items by classes of customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region of the customer in determining the SSP.Revenue is recognized over time for our combined performance obligations that include software licenses, updates, and technical support as well as for maintenance and professional services that are separate performance obligations. For our professional services, revenue is recognized over time, generally using costs incurred or hours expended to measure progress. Judgment is required in estimating project status and the costs necessary to complete projects. A number of internal and external factors can affect these estimates, including labor rates, utilization and efficiency variances and specification and testing requirement changes. For our other performance obligations recognized over time, revenue is generally recognized using a time-based measure of progress reflecting generally consistent efforts to satisfy those performance obligations throughout the arrangement term.If a group of agreements are so closely related that they are, in effect, part of a single arrangement, such agreements are deemed to be one arrangement for revenue recognition purposes. We exercise significant judgment to evaluate the relevant facts and circumstances in determining whether the separate agreements should be accounted for separately or as, in substance, a single arrangement. Our judgments about whether a group of contracts comprise a single arrangement can affect the allocation of consideration to the distinct performance obligations, which could have an effect on results of operations for the periods involved.We are required to estimate the total consideration expected to be received from contracts with customers. In some circumstances, the consideration expected to be received is variable based on the specific terms of the contract or based on our expectations of the term of the contract. Generally, we have not experienced significant returns or refunds to customers. These estimates require significant judgment and the change in these estimates could have an effect on our results of operations during the periods involved.Accounting for Income TaxesWe are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating and estimating our provision for these taxes. There are many transactions that occur during the ordinary course of business for which the ultimate tax determination is uncertain. Our provision for income taxes could be adversely affected by our earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, losses incurred in jurisdictions for which we are not able to realize the related tax benefit, changes in foreign currency exchange rates, entry into new businesses and geographies and changes to our existing businesses, acquisitions and investments, changes in our deferred tax assets and liabilities including changes in our assessment of valuation allowances, changes in the relevant tax laws or interpretations of these tax laws, and developments in current and future tax examinations.39We only recognize the tax benefit of an income tax position if we judge that it is more likely than not that the tax position will be sustained, solely on its technical merits, in a tax audit including resolution of any related appeals or litigation processes. To make this judgment, we must interpret complex and sometimes ambiguous tax laws, regulations and administrative practices. If we judge that an income tax position meets this recognition threshold, then we must measure the amount of the tax benefit to be recognized by estimating the largest amount of tax benefit that has a greater than 50% cumulative probability of being realized upon settlement with a taxing authority that has full knowledge of all of the relevant facts. It is inherently difficult and subjective to estimate such amounts, as this requires us to determine the probability of various possible settlement outcomes. We must reevaluate our income tax positions on a quarterly basis to consider factors such as changes in facts or circumstances, changes in tax law, effectively settled issues under audit, the lapse of applicable statute of limitations, and new audit activity. Such a change in recognition or measurement would result in recognition of a tax benefit or an additional charge to the tax provision. For a more detailed description of our unrecognized tax benefits, see Note 6 in the notes to consolidated financial statements.During fiscal 2019, we completed intercompany transfers of certain intangible property rights to our Irish subsidiary, which resulted in the establishment of a deferred tax asset and the recognition of an income tax benefit of $575.6 million. To determine the value of the deferred tax asset, we were required to make significant estimates in determining the fair value of the transferred IP rights. These estimates included, but are not limited to, the income and cash flows that the IP rights are expected to generate in the future, the appropriate discount rate to apply to the income and cash flow projections, and the useful lives of the IP rights. These estimates are inherently uncertain and unpredictable, and if different estimates were used, it would impact the fair value of the IP rights and the related value of the deferred tax asset and the income tax benefit recognized in fiscal 2019 and in future periods when the deferred tax asset is realized. In addition, we reviewed the need to establish a valuation allowance on the deferred tax asset of $575.6 million by evaluating whether there is a greater than 50% likelihood that some portion or all of the deferred tax asset will not be realized. To make this judgment, we must make significant estimates and predictions of the amount and category of future taxable income from various sources and weigh all available positive and negative evidence about these possible sources of taxable income. We give greater weight to evidence that can be objectively verified. Based on our evaluation and weighting of the positive and negative evidence, we concluded that it is greater than 50% likely that the deferred tax asset of $575.6 million will be realized in future periods and that a valuation allowance was not currently required. If, in the future, we evaluate that this deferred tax asset is not likely to be realized, an increase in the related valuation allowance could result in a material income tax expense in the period such a determination is made.Business CombinationsWhen we acquire businesses, we allocate the purchase price to the acquired tangible assets and assumed liabilities, including deferred revenue, liabilities associated with the fair value of contingent consideration and acquired identifiable intangible assets. Any residual purchase price is recorded as goodwill. The allocation of the purchase price requires us to make significant estimates in determining the fair values of these acquired assets and assumed liabilities, especially with respect to intangible assets and goodwill. These estimates are based on information obtained from management of the acquired companies, our assessment of this information, and historical experience. These estimates can include, but are not limited to, the cash flows that an acquired business is expected to generate in the future, the cash flows that specific assets acquired with that business are expected to generate in the future, the appropriate weighted-average cost of capital, and the cost savings expected to be derived from acquiring an asset. These estimates are inherently uncertain and unpredictable, and if different estimates were used, the purchase price for the acquisition could be allocated to the acquired assets and assumed liabilities differently from the allocation that we have made to the acquired assets and assumed liabilities. In addition, unanticipated events and circumstances may occur that may affect the accuracy or validity of such estimates, and if such events occur, we may be required to adjust the value allocated to acquired assets or assumed liabilities.We also make significant judgments and estimates when we assign useful lives to the definite-lived intangible assets identified as part of our acquisitions. These estimates are inherently uncertain and if we used different estimates, the useful life over which we amortize intangible assets would be different. In addition, unanticipated events and circumstances may occur that may impact the useful life assigned to our intangible assets, which would impact our amortization of intangible assets expense and our results of operations.During the first quarter of fiscal 2020, we acquired intangible assets of $101.3 million with our acquisition of AWR and Integrand. The fair value of the definite-lived intangible assets acquired with these acquisitions was determined using variations of the income approach. For existing technology, the fair value was determined by applying the relief-from-royalty method. This method is based on the application of a royalty rate to forecasted revenue to quantify the benefit of owning the intangible asset rather than paying a royalty for use of the asset. To estimate royalty savings over time, we projected revenue from existing technology over the estimated remaining life of the technology, including the effect of technological obsolescence which was estimated at rate between 5% and 7.5% annually, before applying an assumed royalty rate of 20%. The present value of after-tax royalty savings were determined using discount rates ranging from 10% to 11.5%.The fair value for customer contracts and related relationships was determined by using the multi-period excess earnings method. This method reflects the present value of the projected cash flows that are expected to be generated from existing customers, less charges representing the contribution of other assets to those cash flows. Projected income from existing customer relationships considered customer retention rates ranging between 85% and 95%. The present value of operating cash flows from existing customer was determined using discount rates 10% and 11.5%.40We also assumed obligations related to deferred revenue of $6.9 million during the first quarter of fiscal 2020 with our acquisition of AWR. The fair value of these obligations was estimated using the cost build-up approach. The cost build-up approach determines fair value using estimates of the costs required to fulfill the contracted obligations plus an assumed profit margin, which approximates the amount that AWR would be required to pay a third party to assume the obligation.Cadence believes that its estimates and assumptions related to the fair value of its acquired intangible assets and deferred revenue obligations are reasonable, but significant judgment is involved.New Accounting StandardsFor additional information about the adoption of new accounting standards, see Note 2 in the notes to consolidated financial statements.41Item 7A. Quantitative and Qualitative Disclosures About Market RiskForeign Currency RiskA material portion of our revenue, expenses and business activities are transacted in the U.S. dollar. In certain foreign countries where we price our products and services in U.S. dollars, a decrease in value of the local currency relative to the U.S. dollar results in an increase in the prices for our products and services compared to those products of our competitors that are priced in local currency. This could result in our prices being uncompetitive in certain markets.In certain countries where we may invoice customers in the local currency, our revenues benefit from a weaker dollar and are adversely affected by a stronger dollar. The opposite impact occurs in countries where we record expenses in local currencies. In those cases, our costs and expenses benefit from a stronger dollar and are adversely affected by a weaker dollar. The fluctuations in our operating expenses outside the United States resulting from volatility in foreign exchange rates are not generally moderated by corresponding fluctuations in revenues from existing contracts.We enter into foreign currency forward exchange contracts to protect against currency exchange risks associated with existing assets and liabilities. A foreign currency forward exchange contract acts as a hedge by increasing in value when underlying assets decrease in value or underlying liabilities increase in value due to changes in foreign exchange rates. Conversely, a foreign currency forward exchange contract decreases in value when underlying assets increase in value or underlying liabilities decrease in value due to changes in foreign exchange rates. These forward contracts are not designated as accounting hedges, so the unrealized gains and losses are recognized in other income, net, in advance of the actual foreign currency cash flows with the fair value of these forward contracts being recorded as accrued liabilities or other current assets.We do not use forward contracts for trading purposes. Our forward contracts generally have maturities of 90 days or less. We enter into foreign currency forward exchange contracts based on estimated future asset and liability exposures, and the effectiveness of our hedging program depends on our ability to estimate these future asset and liability exposures. Recognized gains and losses with respect to our current hedging activities will ultimately depend on how accurately we are able to match the amount of foreign currency forward exchange contracts with actual underlying asset and liability exposures.The following table provides information about our foreign currency forward exchange contracts as of January 2, 2021. The information is provided in United States dollar equivalent amounts. The table presents the notional amounts, at contract exchange rates, and the weighted average contractual foreign currency exchange rates expressed as units of the foreign currency per United States dollar, which in some cases may not be the market convention for quoting a particular currency. All of these forward contracts matured during February 2021.NotionalPrincipalWeightedAverageContractRate (In millions) Forward Contracts:European Union euro$133.0 0.84 British pound103.2 0.75 Israeli shekel68.4 3.34 Japanese yen31.0 103.96 Swedish krona29.9 8.49 Chinese renminbi24.4 6.59 Indian rupee27.4 74.57 Taiwan dollar14.8 28.02 Canadian dollar7.9 1.3Other 6.6 N/ATotal$446.6 Estimated fair value$8.9 We actively monitor our foreign currency risks, but our foreign currency hedging activities may not substantially offset the impact of fluctuations in currency exchange rates on our results of operations, cash flows and financial position.42Interest Rate RiskOur exposure to market risk for changes in interest rates relates primarily to our portfolio of cash and cash equivalents and balances outstanding on our revolving credit facility, if any. We are exposed to interest rate fluctuations in many of the world’s leading industrialized countries, but our interest income and expense is most sensitive to fluctuations in the general level of United States interest rates. In this regard, changes in United States interest rates affect the interest earned on our cash and cash equivalents and the costs associated with foreign currency hedges.All highly liquid securities with a maturity of three months or less at the date of purchase are considered to be cash equivalents. The carrying value of our interest-bearing instruments approximated fair value as of January 2, 2021.Interest rates under our revolving credit facility are variable, so interest expense could be adversely affected by changes in interest rates, particularly for periods when we maintain a balance outstanding under the revolving credit facility. Interest rates for our revolving credit facility can fluctuate based on changes in market interest rates and in an interest rate margin that varies based on our consolidated leverage ratio. As of January 2, 2021, there were no borrowings outstanding under our revolving credit facility. For an additional description of the revolving credit facility, see Note 3 in the notes to consolidated financial statements. Equity Price RiskEquity InvestmentsWe have a portfolio of equity investments that includes marketable equity securities and non-marketable investments. Our equity investments are made primarily in connection with our strategic investment program. Under our strategic investment program, from time to time, we make cash investments in companies with technologies that are potentially strategically important to us. See Note 8 in the notes to consolidated financial statements for an additional description of these investments.

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