Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS UNDER PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995; CERTAIN CAUTIONARY STATEMENTS
Certain portions of this report on Form 10-Q including the sections entitled “Overview,” "Expeditors' Culture and Strategy," "International Trade and Competition," "Seasonality," “Critical Accounting Estimates,” "Recent Accounting Pronouncements," “Results of Operations,” “Currency and Other Risk Factors” and “Liquidity and Capital Resources” contain forward-looking statements. Words such as "will likely result," "are expected to," "would expect," "would not expect," "will continue," "is anticipated," "estimate," "project," "plan," "believe," "probable," "reasonably possible," "may," "could," "should," "intends," "foreseeable future" and variations of such words and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of future financial performance, our anticipated growth and trends in the Company's businesses, and other characterizations of future events or circumstances are forward-looking statements. These statements must be considered in connection with the discussion of the important factors that could cause actual results to differ materially from the forward-looking statements. Attention should be given to the factors identified and discussed in the Company's annual report on Form 10-K filed on February 23, 2017.
Overview
Expeditors International of Washington, Inc. (herein referred to as "Expeditors," the "Company," "we," "us," "our") is a global logistics company. Our services include air and ocean freight consolidation and forwarding, customs clearance, warehousing and distribution, purchase order management, vendor consolidation, time-definite transportation services, cargo insurance and other logistics solutions. We do not compete for overnight courier or small parcel business. As a non-asset based carrier, we do not own or operate transportation assets.
We derive our revenues from three principal sources: 1) airfreight services, 2) ocean freight and ocean services, and 3) customs brokerage and other services. These are the revenue categories presented in our financial statements.
We generate the major portion of our air and ocean freight revenues by purchasing transportation services on a wholesale basis from direct (asset-based) carriers and reselling those services to our customers on a retail basis. The difference between the rate billed to our customers (the sell rate) and the rate we pay to the carrier (the buy rate) is termed “net revenue” (a non-GAAP measure), “yield” or “margin.” By consolidating shipments from multiple customers and concentrating our buying power, we are able to negotiate favorable buy rates from the direct carriers, while at the same time offering lower sell rates than customers would otherwise be able to negotiate themselves. The most significant drivers of changes in gross revenues and related transportation expenses are volume, sell rates and buy rates. Volume has a similar effect on the change in both gross revenues and related transportation expenses in each of our three primary sources of revenue.
In most cases we act as an indirect carrier. When acting as an indirect carrier, we issue a House Airway Bill (HAWB), a House Ocean Bill of Lading (HOBL) or a House Seaway Bill to customers as the contract of carriage. In turn, when the freight is physically tendered to a direct carrier, we receive a contract of carriage known as a Master Airway Bill for airfreight shipments and a Master Ocean Bill of Lading for ocean shipments. In these transactions, we evaluate whether it is appropriate to record the gross or net amount as revenue. Generally, revenue is recorded on a gross basis when we are the primary obligor, are obligated to compensate direct carriers for services performed regardless of whether customers accept the service, have latitude in establishing price, have discretion in selecting the direct carrier, have credit risk or have several but not all of these indicators. Revenue is generally recorded on a net basis where we are not primarily obligated and do not have latitude in establishing prices. Such amounts earned are determined using a fixed fee, a per unit of activity fee or a combination thereof.
For revenues earned in other capacities, for instance, when we do not issue a HAWB, a HOBL or a House Seaway Bill or otherwise act solely as an agent for the shipper, only the commissions and fees earned for such services are included in revenues. In these transactions, we are not a principal and report only commissions and fees earned in revenue.
Customs brokerage and other services involve providing services at destination, such as helping customers clear shipments through customs by preparing and filing required documentation, calculating and providing for payment of duties and other taxes on behalf of customers as well as arranging for any required inspections by governmental agencies, and arranging for delivery. These are complicated functions requiring technical knowledge of customs rules and regulations in the multitude of countries in which we have offices.
We manage our company along five geographic areas of responsibility: Americas; North Asia; South Asia; Europe; and Middle East, Africa and India (MAIR). Each area is divided into sub-regions which are composed of operating units with individual profit and loss responsibility. Our business involves shipments between operating units and typically touches more than one geographic area. The nature of the international logistics business necessitates a high degree of communication and
cooperation among operating units. Because of this inter-relationship between operating units, it is very difficult to examine any one geographic area and draw meaningful conclusions as to its contribution to our overall success on a stand-alone basis.
Our operating units share revenue using the same arms-length pricing methodologies that we use when our offices transact business with independent agents. Certain costs are allocated among the segments based on the relative value of the underlying services, which can include allocation based on actual costs incurred or estimated cost plus a profit margin. Our strategy closely links compensation with operating unit profitability. Individual success is closely linked to cooperation with other operating units within our network.
The mix of services varies by segment based primarily on the import or export orientation of local operations in each of our regions. In accordance with our revenue recognition policy (see Note 1. E.
to the consolidated financial statements in our annual report on Form 10-K filed on February 23, 2017
), almost all freight revenues and related expenses are recorded at origin and shipment profits are split between origin and destination offices by recording a commission fee or profit share revenue at destination and a corresponding commission or profit share expense as a component of origin consolidation costs.
Expeditors' Culture and Strategy
From the inception of our company, management has believed that the elements required for a successful global service organization can only be assured through recruiting, training, and ultimately retaining superior personnel. We believe that our greatest challenge is now and always has been perpetuating a consistent global corporate culture which demands:
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Total dedication, first and foremost, to providing superior customer service;
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Compliance with our policies and procedures and government regulations;
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Aggressive marketing of all of our service offerings;
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Ongoing development of key employees and management personnel via formal and informal means;
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Creation of unlimited advancement opportunities for employees dedicated to hard work, personal growth and continuous improvement;
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Individual commitment to the identification and mentoring of successors for every key position so that when inevitable change occurs, a qualified and well-trained internal candidate is ready to step forward; and
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Continuous identification, design and implementation of system solutions and differentiated service offerings, both technological and otherwise, to meet and exceed the needs of our customers while simultaneously delivering tools to make our employees more efficient and more effective.
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We reinforce these values with a compensation system that rewards employees for profitably managing the things they can control. This compensation system has been in place since we became a publicly traded company. There is no limit to how much a key manager can be compensated for success. We believe in a “real world” environment where the employees of our operating units are held accountable for the profit implications of their decisions. If these decisions result in operating losses, management generally must make up these losses with future operating profits, in the aggregate, before any cash incentive compensation can be earned. Executive management, in limited circumstances, makes exceptions at the branch operating unit level. At the same time, our policies, processes and relevant training focus on such things as cargo management, risk mitigation, compliance, accounts receivable collection, cash flow and credit soundness in an attempt to help managers avoid the kinds of errors that might end a career.
We believe that failure to perpetuate our unique culture on a self-sustained basis throughout our organization quite possibly provides a greater threat to our continued success than any external force, which likely would be largely beyond our control. We strongly believe that it is nearly impossible to predict events that, individually or in the aggregate, could have a positive or a negative impact on our future operations. As a result, management's focus is on building and maintaining a global corporate culture and an environment where well-trained employees and managers are prepared to identify and react to changes as they develop and thereby help us adapt and thrive as major trends emerge.
Our business growth strategy emphasizes a focus on the right markets and, within each market, on the right customers to drive profitable business growth. Expeditors' teams are aligned on the specific markets of its focused priorities; on the targeted accounts within those markets; and on ways that we can continue to differentiate ourselves from our competitors.
Our ability to provide services to customers is highly dependent on good working relationships with a variety of entities including airlines, ocean carriers, ground transportation providers and governmental agencies. The significance of maintaining acceptable working relationships with these entities has gained increased importance as a result of ongoing concern over terrorism, security, changes in governmental regulation and oversight of international trade. A good reputation helps to develop practical working understandings that will assist in meeting security requirements while minimizing potential international trade obstacles, especially as governments promulgate new regulations and increase oversight and enforcement of new and existing laws. We consider our current working relationships with these entities to be satisfactory.
Our business is also highly dependent on the financial stability and operational capabilities of the carriers we utilize. Many air and ocean carriers are highly leveraged with debt. Moreover, certain ocean carriers are facing significant liquidity challenges. This situation requires that we be selective in determining which carriers to utilize. Further changes in the financial stability, operating capabilities and capacity of asset-based carriers, space allotments available from carriers, governmental regulations, and/or trade accords could adversely affect our business in unpredictable ways.
International Trade and Competition
We operate in over 60 countries in the competitive global logistics industry and our activities are closely tied to the global economy. International trade is influenced by many factors, including economic and political conditions in the United States and abroad, currency exchange rates, and laws and policies relating to tariffs, trade restrictions, foreign investments and taxation. Periodically, governments consider a variety of changes to current tariffs and trade restrictions and accords. We cannot predict which, if any, of these proposals may be adopted or the effects the adoption of any such proposal will have on our business. Doing business in foreign locations also subjects us to a variety of risks and considerations not normally encountered by domestic enterprises. In addition to being influenced by governmental policies concerning international trade, our business may also be negatively affected by political developments and changes in government personnel or policies in the United States and other countries, as well as economic turbulence, political unrest and security concerns in the nations in which we conduct business and the future impact that these events may have on international trade and oil prices.
The global logistics services industry is intensely competitive and is expected to remain so for the foreseeable future. Consistent with continuing uncertainty in global trade and economic conditions, concerns over volatile fuel costs, disruptions in port services, political unrest and fluctuating currency exchange rates, our pricing and terms continue to be pressured by customers, carriers and service providers. We expect these operating and competitive conditions to continue.
Ocean carriers have incurred substantial operating losses in recent years, and many are highly leveraged with debt. These financial challenges resulted in the 2016 bankruptcy of one of the larger carriers in the market, as well as multiple carrier acquisitions and carrier alliance formations. Carriers continue to pursue scale and market share in an effort to reduce operating costs and improve their financial results. Additionally, while the overall global volumes have recently increased, carriers continue to take delivery of new and larger ships, which creates additional capacity. Consequently, when the market experiences seasonal peaks or any sort of disruption, the carriers react by increasing their pricing as quickly as possible. This carrier behavior creates pricing volatility that could impact Expeditors' ability to maintain historical unitary profitability.
There is uncertainty as to how changes in oil prices will impact future buy rates. Because fuel is an integral part of carriers' costs and impacts both our cargo space buy rates and sell rates to customers, we would expect our gross revenues and costs to be impacted as carriers adjust rates for the effect of changing fuel prices. To the extent that we are unable to pass through any increases to our customers, this could adversely affect our net revenues.
The global economic environment and trade growth remain uncertain. We cannot predict what impact this may have on our operating results, freight volumes, pricing, changes in consumer demand, carrier stability and capacity, customers’ abilities to pay or on changes in competitors' behavior. Additionally, we cannot predict the direct or indirect impact that changes in consumer purchasing behavior, such as on-line shopping, could have on our business.
Seasonality
Historically, our operating results have been subject to seasonal trends with the first quarter being the weakest and the third and fourth quarters being the strongest; however, there is no assurance this seasonal trend will occur in the future. This pattern has been the result of, or influenced by, numerous factors, including weather patterns, national holidays, consumer demand, new product launches, economic conditions and a myriad of other similar and subtle forces. In addition, this historical quarterly trend has been influenced by the growth and diversification of our international network and service offerings.
A significant portion of our revenues is derived from customers in the retail and consumer technology industries whose shipping patterns are tied closely to consumer demand, and from customers in industries whose shipping patterns are dependent upon just-in-time production schedules. Therefore, the timing of our revenues are, to a large degree, impacted by factors out of our control, such as a sudden change in consumer demand for retail goods, product launches and/or manufacturing production delays. Additionally, many customers ship a significant portion of their goods at or near the end of a quarter and, therefore, we may not learn of a shortfall in revenues until late in a quarter.
To the extent that a shortfall in revenues or earnings was not expected by securities analysts or investors, any such shortfall from levels predicted by securities analysts or investors could have an immediate and adverse effect on the trading price of our stock. We cannot accurately forecast many of these factors, nor can we estimate accurately the relative influence of any particular factor and, as a result, there can be no assurance that historical patterns will continue in future periods.
Critical Accounting Estimates
The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States requires us to make estimates and judgments. We base our estimates on historical experience and on assumptions that we believe are reasonable. Our critical accounting estimates are discussed in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of our annual report on Form 10-K for the year ended
December 31, 2016
, filed on February 23, 2017. There have been no material changes to the critical accounting estimates previously disclosed in that report.
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (FASB) issued an Accounting Standard Update (ASU) amending existing revenue recognition guidance and requiring related detailed disclosures to enable users of financial statements to understand the nature, amount, timing and uncertainty of our revenues and cash flows arising from contracts with customers. This ASU is effective for us beginning on January 1, 2018. We formed a cross-functional project team that is in the process of evaluating the adoption impacts of the ASU for each of our products and services.
At this stage of our assessment, we expect changes to the timing of recognition of our transportation and related services revenue as the standard requires revenue to be recognized as control is transferred to the customer over time. Under the current standard, our transportation revenue is recognized at the point in time freight is tendered to the direct carrier at origin. We are also evaluating whether we act as principal or an agent with regards to our promise to transfer services to the customer.
We are in the early stages of process and systems solution design changes and development to facilitate revenue recognition under the ASU. We will adopt the ASU standard using the modified retrospective transition method applied to those contracts which are not completed as of January 1, 2018. Upon adoption, we will recognize the cumulative effect of adopting the ASU as an adjustment to our opening balance of retained earnings. Prior periods will not be retrospectively adjusted.
At this time, based on the nature of our operations, we do not believe that the adoption of the ASU will have a material impact on our results of operations, financial position and cash flows once implemented. However, we are continuing our assessment and a significant amount of effort will be required to complete the system development, design and process changes that will be required to comply with the ASU. We expect to complete our assessment of the impact towards the end of 2017.
In February 2016, the FASB issued an ASU changing the accounting for leases and including a requirement to record all leases on the consolidated balance sheet as assets and liabilities. The ASU will be effective for us beginning on January 1, 2019 and will be adopted using a modified retrospective transition. Adoption of the ASU will impact our consolidated balance sheets as future minimum lease payments under noncancelable leases totaled approximately
$214 million
as of
June 30, 2017
. We are currently evaluating the full impact that the adoption of this ASU will have on our consolidated financial statements and related disclosures.
Results of Operations
The following table shows the revenues and directly related expenses for our principal services and total net revenues (a non-GAAP measure calculated as revenues less directly related operating expenses attributable to our principal services) and our expenses for the three and
six-month
periods ended
June 30, 2017
and
2016
, expressed as percentages of net revenues. Management believes that net revenues are a better measure than total revenues when analyzing and discussing management's effectiveness in managing our principal services since total revenues earned by Expeditors as a freight consolidator include the carriers’ charges to us for carrying the shipment, whereas revenues earned by Expeditors in our other capacities include primarily the commissions and fees actually earned by us. Net revenue is one of our primary operational and financial measures and demonstrates our ability to manage sell rates to customers with our ability to concentrate and leverage our purchasing power through effective consolidation of shipments from multiple customers utilizing a variety of transportation carriers and optimal routings. Using net revenue also provides a commonality for comparison among various services.
The table and the accompanying discussion and analysis should be read in conjunction with the condensed consolidated financial statements and related notes thereto in this quarterly report.
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Three months ended June 30,
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Six months ended June 30,
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2017
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2016
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2017
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2016
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Amount
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Percent
of net
revenues
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Amount
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Percent
of net
revenues
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Amount
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Percent
of net
revenues
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Amount
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Percent
of net
revenues
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(in thousands)
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Airfreight services:
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Revenues
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$
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671,868
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$
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582,093
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$
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1,287,413
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$
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1,142,946
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Expenses
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499,418
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403,419
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942,822
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792,196
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Net revenues
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172,450
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31
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%
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178,674
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32
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%
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344,591
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31
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%
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350,750
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33
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%
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Ocean freight services and ocean services:
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Revenues
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528,585
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464,692
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1,022,344
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918,884
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Expenses
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385,927
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323,699
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751,990
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646,719
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Net revenues
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142,658
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25
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140,993
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26
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270,354
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25
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272,165
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25
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Customs brokerage and other services:
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Revenues
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471,826
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428,379
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907,654
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831,806
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Expenses
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223,301
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194,929
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431,361
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384,535
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Net revenues
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248,525
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44
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233,450
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42
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476,293
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44
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447,271
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42
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Total net revenues
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563,633
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100
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553,117
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100
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1,091,238
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100
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1,070,186
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100
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Overhead expenses:
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Salaries and related costs
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318,529
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56
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293,532
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53
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611,109
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56
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576,887
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54
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Other
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76,864
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14
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80,721
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15
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165,775
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15
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162,609
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15
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Total overhead expenses
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395,393
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70
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374,253
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68
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776,884
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71
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739,496
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69
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Operating income
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168,240
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30
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178,864
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|
32
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314,354
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29
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330,690
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31
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Other income (expense), net
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5,570
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1
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4,493
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1
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8,609
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1
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8,151
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1
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Earnings before income taxes
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173,810
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31
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183,357
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33
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322,963
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30
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338,841
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32
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Income tax expense
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65,055
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12
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66,918
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12
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120,641
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11
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125,355
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12
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Net earnings
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108,755
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|
19
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116,439
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|
21
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202,322
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19
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213,486
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20
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Less net (loss) earnings attributable to the noncontrolling interest
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(96
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)
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—
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387
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—
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207
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—
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850
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—
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Net earnings attributable to shareholders
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$
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108,851
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19
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%
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$
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116,052
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21
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%
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$
|
202,115
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19
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%
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$
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212,636
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20
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%
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Airfreight services:
Airfreight services revenues increased 15% and 13%, respectively,
in the three and
six-month
periods ended
June 30, 2017
, as compared with the same periods for
2016
, primarily due to 9% and 12% increases in tonnage and higher sell rates in response to market conditions. Airfreight services expenses increased 24% and 19%, respectively, in the three and
six-month
periods ended
June 30, 2017
, principally as a result of the increase in tonnage and higher buy rates due to tighter capacity caused by increased market demand.
Airfreight services net revenues decreased 3% for the three-month period ended
June 30, 2017
, as compared with the same period for
2016
. This was principally due to a 17% decrease in net revenue per kilo, partially offset by the 9% tonnage growth. Average net revenue per kilo declined in most regions primarily due to competitive market conditions. Carriers in North Asia increased pricing significantly as a result of higher demand relative to available capacity. North America and Europe net revenues increased by 3% and 12%, respectively, while tonnage increased 8% and 14%. North Asia net revenues decreased 9% despite an increase in tonnage of 8%, principally due to higher average buy rates, which outpaced our increases in average sell rates. South Asia net revenues decreased 27% despite tonnage growth of 5%, primarily due to higher average buy rates and competitive market conditions, which resulted in lower average sell rates.
Airfreight services net revenues decreased 2% for the six-month period ended
June 30, 2017
, as compared with the same period for
2016
. This was principally due to a 17% decrease in net revenue per kilo, offset by the 12% increase in tonnage. Average net revenue per kilo declined in most regions primarily due to competitive market conditions. Carriers in North Asia increased pricing significantly as a result of higher demand relative to available capacity. North America and Europe net revenues increased by 3% and 5%, respectively, while tonnage increased 10% in both segments. North Asia net revenues decreased 4% despite a tonnage increase of 14%, as a result of the factors discussed above. South Asia net revenues decreased 18% despite tonnage growth of 13% primarily due to lower average sell rates.
The global airfreight market is experiencing imbalances between carrier capacity and demand in certain lanes, which is resulting in higher average buy rates. Customers remain focused on improving supply-chain efficiency, reducing overall logistics costs by negotiating lower rates and utilizing ocean freight whenever possible. We expect these trends to continue in conjunction with carriers' efforts to manage available capacity. These conditions could be affected by new product launches during periods that have historically experienced higher demand. Historically, we have experienced lower airfreight margins in the fourth quarter as seasonal volumes increase and carriers correspondingly increase buy rates. These conditions, should they continue to occur, could create a higher degree of volatility in volumes and, ultimately, buy and sell rates.
Ocean freight and ocean services:
Ocean freight consolidation, direct ocean forwarding and order management are the three basic services that constitute and are collectively referred to as ocean freight and ocean services. Ocean freight and ocean services revenues increased 14% and 11%, respectively, for the three and
six-month
periods ended
June 30, 2017
, as compared with the same periods in
2016
, primarily due to 4% and 5% increases in container volume and higher average sell rates to customers. Ocean freight and ocean services expenses increased 19% and 16%, respectively, for the three and
six-month
periods ended
June 30, 2017
, due to increased volumes and higher average buy rates as overall market demand increased and carriers managed available capacity.
Ocean freight and ocean services net revenues increased 1% and decreased 1%, respectively, for the three and
six-month
periods ended
June 30, 2017
, as compared with the same periods for
2016
. The largest component of our ocean freight net revenue was derived from ocean freight consolidation, which represented 46% and 51% of ocean freight net revenue for the
six-month
periods ended
June 30, 2017
and
2016
, respectively.
Ocean freight consolidation net revenues decreased 10% in the second quarter of
2017
, as compared with the same period in
2016
, due primarily to a 13% decrease in net revenue per container, partially offset by a 4% increase in volume. Ocean freight consolidation net revenues decreased 10% for the
six-month
period ended
June 30, 2017
, as compared with the same period in
2016
, due primarily to a 15% decrease in net revenue per container, partially offset by a 5% increase in volume. Direct ocean freight forwarding net revenues increased 11% and 7%, respectively, for the three and
six-month
periods ended
June 30, 2017
, as compared with the same periods in
2016
, due to higher volumes. Order management net revenues increased 16% and 13%, respectively, for the three and
six-month
periods ended
June 30, 2017
, mostly resulting from higher volumes with new and existing customers primarily in North Asia.
North America ocean freight and ocean services net revenues decreased 4% and 5%, respectively, for the three and
six-month
periods ended
June 30, 2017
, primarily due to a decrease in ocean freight consolidation resulting from declining margins on imports. Europe net revenues decreased 10% in the second quarter and 9% in the first half of 2017 due primarily to lower net revenue per container. South Asia net revenues decreased 7% and 6%, respectively, in the second quarter and the first half of 2017 due primarily to lower net revenue per container. North Asia net revenues increased 12% and 6%, in the three and six-month periods of 2017, respectively, as increases in order management and direct ocean forwarding, resulting from higher volumes, more than offset lower ocean consolidation net revenues.
We expect that pricing volatility will continue as customers solicit bids and carriers adapt to changing market conditions, new alliances and liquidity challenges. These conditions could result in lower margins.
Customs brokerage and other services:
Customs brokerage and other services revenues increased 10% and 9%, respectively, for the three and
six-month
periods ended
June 30, 2017
, as compared with the same periods in
2016
, primarily as a result of higher volumes in both customs brokerage and road freight services. Customs brokerage and other services expenses increased 15% and 12%, respectively, for the three and
six-month
periods ended
June 30, 2017
, as compared with the same periods in
2016
, principally as a result of higher volumes.
Customs brokerage and other services net revenues increased 6% for both the three and
six-month
periods ended
June 30, 2017
, as compared with the same periods in
2016
, primarily as a result of an increase in customs brokerage and road freight volumes, particularly in North America. Customers continue to seek out customs brokers, such as Expeditors, with sophisticated computerized capabilities critical to an overall logistics management program, including rapid responses to changes in the regulatory and security environment.
North America net revenues increased 10% and 9%, respectively, for the three and
six-month
periods ended
June 30, 2017
, as compared with the same periods for
2016
, primarily as a result of higher volumes in customs brokerage and road freight services. Europe net revenues increased 5% and 7%, respectively, in the second quarter and first half of 2017 primarily due to higher customs brokerage and road freight services.
Overhead expenses:
Salaries and related costs increased 9% and 6%, respectively, for the three and
six-month
periods ended
June 30, 2017
, as compared with the same periods in
2016
due principally to an increase in the number of employees, primarily in North America, Europe, and South Asia, higher base salaries and benefits, and higher share-based compensation expense partially offset by reduced bonuses from lower operating income. The number of employees increased primarily to support the volume growth in our business operations and our continuing investments in information systems.
Historically, the relatively consistent relationship between salaries and net revenues has been the result of a compensation philosophy that has been maintained since the inception of our company: offer a modest base salary and the opportunity to share in a fixed and determinable percentage of the operating profit of the business unit controlled by each key employee. Using this compensation model, changes in individual incentive compensation occur in proportion to changes in our operating income, creating a direct alignment between corporate performance and shareholder interests. Bonuses to field and executive management for the
six-month
period ended
June 30, 2017
were down 4% and 6%, respectively, as compared with the same period in
2016
, primarily as a result of a 5% decrease in operating income. In 2017, we reduced senior executive management bonus pool allocations by 6% to help fund expansion of our strategic growth initiatives. Our management compensation programs have always been incentive-based and performance driven. Salaries and related costs increased 3% and 2%, respectively, to 56% of net revenues for both the three and six-month periods ended
June 30, 2017
as compared to the same periods of
2016
.
Because our management incentive compensation programs are also cumulative, generally no management bonuses can be paid unless the relevant business unit is, from inception, cumulatively profitable. Any operating losses must be offset in their entirety by operating profits before management is eligible for a bonus. Executive management, in limited circumstances, makes exceptions at the branch operating unit level. Since the most significant portion of management compensation comes from the incentive bonus programs, we believe that this cumulative feature is a disincentive to excessive risk taking by our managers. Due to the nature of our services, it has a short operating cycle. The outcome of any higher risk transactions, such as overriding established credit limits, would be known in a relatively short time frame. Management believes that when the potential and certain impact on the bonus is fully considered in light of this short operating cycle, the potential for short-term gains that could be generated by engaging in risky business practices is sufficiently mitigated to discourage excessive and inappropriate risk taking. Management believes that both the stability and the long-term growth in revenues, net revenues and net earnings are a result of the incentives inherent in our compensation programs.
Other overhead expenses decreased 5% for the three-month period, and increased 2% for the
six-month
period ended
June 30, 2017
, as compared with the same periods in
2016
. We continue to invest in additional technology and facilities, which resulted in higher rent expense, technology-related fees and consulting costs. These increases were offset by the recovery of certain legal and related costs totaling $8 million for both the quarter and year-to date periods ended
June 30, 2017
compared to $5 million in the same periods in
2016
and the favorable resolution of an indirect tax contingency of $6 million in the second quarter of 2017. We do not expect further recoveries in either matter. We will continue to make important investments in people, processes and technology, as well as to invest in our strategic efforts to explore new areas for profitable growth. Other overhead expenses as a percentage of net revenues for the three and
six-month
periods ended
June 30, 2017
remained comparable with the same periods in
2016
.
Income tax expense:
We pay income taxes in the United States and other jurisdictions. Our consolidated effective income tax rate was
37.4%
for both the three and
six-month
periods ended
June 30, 2017
, and
36.5%
and
37.0%
for the same periods in
2016
. Our effective tax rate is subject to variation and the 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 the effective tax rate is greater when pre-tax income is lower.
Currency and Other Risk Factors
The nature of our worldwide operations necessitates dealing with a multitude of currencies other than the U.S. dollar. This results in our being exposed to the inherent risks of volatile international currency markets and governmental interference. Some of the countries where we maintain offices and/or agency relationships have strict currency control regulations which influence our ability to hedge foreign currency exposure. We try to compensate for these exposures by accelerating international currency settlements among our offices and agents. We may enter into foreign currency hedging transactions where there are regulatory or commercial limitations on our ability to move money freely around the world or the short-term financial outlook in any country is such that hedging is the most time-sensitive way to mitigate short-term exchange losses. Any such hedging activity during the
three and six
months ended
June 30, 2017
and
2016
was insignificant. We had no foreign currency derivatives outstanding at
June 30, 2017
and
December 31, 2016
. During the three and
six-month
periods ended
June 30, 2017
, total net foreign currency losses were approximately
$4 million
and
$9 million
, respectively. During the three and
six-month
periods ended
June 30, 2016
, net foreign currency gains were approximately
$2 million
and net foreign currency losses were
$2 million
, respectively.
International air and ocean freight forwarding and customs brokerage are intensively competitive and are expected to remain so for the foreseeable future. There are a large number of entities competing in the international logistics industry, including new technology-based competitors entering the industry, many of which have significantly more resources than us; however, our primary competition is confined to a relatively small number of companies within this group. Expeditors must compete against both the niche players and larger entities. The industry continues to experience consolidations into larger firms striving for stronger and more complete multinational and multi-service networks. However, regional and local brokers and forwarders remain a competitive force.
The primary competitive factors in the international logistics industry continue to be price and quality of service, including reliability, responsiveness, expertise, convenience, and scope of operations. We emphasize quality customer service and believe that our prices are competitive with those of others in the industry. Customers regularly solicit bids from competitors in order to improve service, pricing and contractual terms such as seeking longer payment terms, higher or unlimited liability limits and performance penalties. Increased competition and competitors' acceptance of expanded contractual terms could result in reduced revenues, reduced margins, higher operating costs or loss of market share, any of which would damage our results of operations and financial condition.
Larger customers utilize more sophisticated and efficient procedures for the management of their logistics supply chains by embracing strategies such as just-in-time inventory management. We believe that this trend has resulted in customers using fewer service providers with greater technological capacity and more consistent global coverage. Accordingly, sophisticated computerized customer service capabilities and a stable worldwide network have become significant factors in attracting and retaining customers. Developing and maintaining these systems and a worldwide network has added a considerable indirect cost to the services provided to customers. Smaller and middle-tier competitors, in general, do not have the resources available to develop customized systems and a worldwide network.
Liquidity and Capital Resources
Our principal source of liquidity is cash and cash equivalents and cash generated from operating activities. Net cash provided by operating activities for the
three and six
months ended
June 30, 2017
was
$81 million
and
$277 million
, respectively, as compared with
$105 million
and
$341 million
for the same periods in
2016
. The decreases of
$24 million
and
$64 million
in the second quarter and first half of
2017
, respectively, are primarily due to changes in working capital accounts and lower earnings. At
June 30, 2017
, working capital was
$1,487 million
, including cash and cash equivalents of
$1,115 million
. We had no long-term debt at
June 30, 2017
. Management believes that our current cash position and operating cash flows will be sufficient to meet our capital and liquidity requirements for at least the next 12 months and thereafter for the foreseeable future, including meeting any contingent liabilities related to standby letters of credit and other obligations.
As a customs broker, we make significant cash advances for a select group of our credit-worthy customers. These cash advances are for customer obligations such as the payment of duties and taxes to customs authorities in various countries throughout the world. Cash advances are a “pass through” and are not recorded as a component of revenue and expense. The billings of such advances to customers are accounted for as a direct increase in accounts receivable from the customer and a corresponding increase in accounts payable to governmental customs authorities. As a result of these “pass through” billings, the conventional Days Sales Outstanding or DSO calculation does not directly measure collection efficiency. For customers that meet certain criteria, we have agreed to extend payment terms beyond our customary terms. Management believes that it has established effective credit control procedures, and historically has experienced relatively insignificant collection problems.
Our business historically has been subject to seasonal fluctuations and this is expected to continue in the future. Cash flows fluctuate as a result of this seasonality. Historically, the first quarter shows an excess of customer collections over customer billings. This results in positive cash flow. The increased activity associated with periods of higher demand (typically commencing late second or early third quarter and continuing well into the fourth quarter) causes an excess of customer billings over customer collections. This cyclical growth in customer receivables consumes available cash.
Cash used in investing activities for the
three and six
months ended
June 30, 2017
was
$20 million
and
$34 million
, as compared with
$9 million
and
$23 million
in the same periods of
2016
. We had capital expenditures of
$20 million
and
$33 million
for the
three and six
-month periods ended
June 30, 2017
, as compared with
$13 million
and
$27 million
for the same periods in
2016
, respectively. Capital expenditures in the
three and six
months ended
June 30, 2017
related primarily to building construction and continuing investments in technology, office and warehouse furniture and equipment and building and leasehold improvements. Occasionally, we elect to purchase buildings to house staff and to facilitate the staging of customers’ freight. In 2016, we completed a land acquisition in Europe. Additional expenditures are expected to be made in
2017
and 2018 in connection with the construction of a building on this land. Total anticipated capital expenditures in 2017 are currently estimated to be $100 million. This includes routine capital expenditures, including the construction of the building in Europe, plus additional real estate development.
Cash used in financing activities during the
three and six
months ended
June 30, 2017
was
$108 million
and
$117 million
, as compared with
$121 million
and
$149 million
for the same periods in
2016
. We use the proceeds from stock option exercises, employee stock purchases and available cash to repurchase our common stock on the open market to limit the growth in issued and outstanding shares. During the
three and six
months ended
June 30, 2017
, we used cash to repurchase
1.5 million
and
2.5 million
shares, respectively, to reduce the number of total outstanding shares, compared to
1.9 million
and
3.4 million
shares in the same periods in
2016
.
We follow established guidelines relating to credit quality, diversification and maturities of our investments to preserve principal and maintain liquidity. Historically, our investment portfolio has not been adversely impacted by disruptions occurring in the credit markets. However, there can be no assurance that our investment portfolio will not be adversely affected in the future.
We maintain international unsecured bank lines of credit. At
June 30, 2017
, we were contingently liable for $71 million from standby letters of credit and guarantees. The standby letters of credit and guarantees relate to obligations of our foreign subsidiaries for credit extended in the ordinary course of business by direct carriers, primarily airlines, and for duty and tax deferrals available from governmental entities responsible for customs and value-added-tax (VAT) taxation. The total underlying amounts due and payable for transportation and governmental excises are properly recorded as obligations in the books of the respective foreign subsidiaries, and there would be no need to record additional expense in the unlikely event the parent company is required to perform.
We typically enter into short-term unconditional purchase obligations with asset-based providers reserving space on a guaranteed basis. The pricing of these obligations varies to some degree with market conditions. We only enter into agreements that management believes we can fulfill.
Our foreign subsidiaries regularly remit dividends to the U.S. parent company after evaluating their working capital requirements and needs to finance local capital expenditures. In some cases, our ability to repatriate funds from foreign operations may be subject to foreign exchange controls. At
June 30, 2017
, cash and cash equivalent balances of
$632 million
were held by our non-United States subsidiaries, of which
$120 million
was held in banks in the United States. Earnings of our foreign subsidiaries are not considered to be indefinitely reinvested outside of the United States and, accordingly, a deferred tax liability has been accrued for all undistributed earnings, net of foreign related tax credits that are available to be repatriated.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to market risks in the ordinary course of our business. These risks are primarily related to foreign exchange risk and changes in short-term interest rates. The potential impact of our exposure to these risks is presented below:
Foreign Exchange Risk
We conduct business in many different countries and currencies. Our business often results in billings issued in a country and currency which differs from that where the expenses related to the service are incurred. In the ordinary course of business, we create numerous intercompany transactions and may have receivables, payables and currencies that are not denominated in the local functional currency. This brings foreign exchange risk to our earnings. The principal foreign exchange risks to which Expeditors is exposed are in Chinese Yuan, Euro, Mexican Peso, Canadian Dollar and British Pound.
Foreign exchange rate sensitivity analysis can be quantified by estimating the impact on our earnings as a result of hypothetical changes in the value of the U.S. dollar, our functional currency, relative to the other currencies in which we transact business. All other things being equal, an average 10% weakening of the U.S. dollar, throughout the
six
months ended
June 30, 2017
, would have had the effect of raising operating income approximately
$22 million
. An average 10% strengthening of the U.S. dollar, for the same period, would have the effect of reducing operating income approximately
$18 million
. This analysis does not take into account changes in shipping patterns based upon this hypothetical currency fluctuation. For example, a weakening in the U.S. dollar would be expected to increase exports from the United States and decrease imports into the United States over some relevant period of time, but the exact effect of this change cannot be quantified without making speculative assumptions.
We currently do not use derivative financial instruments to manage foreign currency risk and only enter into foreign currency hedging transactions in limited locations where regulatory or commercial limitations restrict our ability to move money freely. Any such hedging activity throughout the
three and six
months ended
June 30, 2017
and
2016
was insignificant. During the three and
six-month
periods ended
June 30, 2017
, total net foreign currency losses were approximately
$4 million
and
$9 million
, respectively. During the three and
six-month
periods ended
June 30, 2016
, net foreign currency gains were approximately
$2 million
and net foreign currency losses were
$2 million
, respectively. We had no foreign currency derivatives outstanding at
June 30, 2017
and
December 31, 2016
. We instead follow a policy of accelerating international currency settlements to manage foreign exchange risk relative to intercompany billings. As of
June 30, 2017
, we had approximately
$41 million
of net unsettled intercompany transactions. The majority of intercompany billings are resolved within 30 days.
Interest Rate Risk
At
June 30, 2017
, we had cash and cash equivalents of
$1,115 million
, of which
$619 million
was invested at various short-term market interest rates. We had no long-term debt at
June 30, 2017
. A hypothetical change in the interest rate of 10 basis points at
June 30, 2017
would not have a significant impact on our earnings. In management’s opinion, there has been no material change in our interest rate risk exposure in the
second
quarter of
2017
.
Item 4. Controls and Procedures
Evaluation of Controls and Procedures
We carried out an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in the Exchange Act Rule 13a-15(e)) as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report at the reasonable assurance level.
Changes in Internal Controls
There were no changes in our internal control over financial reporting that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
We are developing a new accounting system which is being implemented on a worldwide basis over the next several years. This system is expected to improve the efficiency of certain financial and transactional processes and reporting. This transition affects the processes that constitute our internal control over financial reporting and requires testing for operating effectiveness.
In the next two fiscal years we will adopt two significant new accounting standards related to revenue recognition and accounting for leases. The adoption of these accounting standards will require changes to existing processes and systems that are an integral part of our internal controls and will require testing for operating effectiveness.
Our management has confidence in our internal controls and procedures. Nevertheless, our management, including Expeditors’ Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all errors or intentional fraud. An internal control system, no matter how well-conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of such internal controls are met. Further, the design of an internal control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all internal control systems, no evaluation of controls can provide absolute assurance that all of our control issues and instances of fraud, if any, have been detected.