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 “Executive Summary,” “Critical Accounting Estimates,” “Results of Operations,” “Currency and Other Risk Factors” and “Liquidity and Capital Resources” contain forward-looking statements. Words such as “expects,” “goals,” “plans,” “believes,” “continues,” “may,” “will,” 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. In addition to risk factors identified elsewhere in this report, attention should be given to the factors identified and discussed in the report on Form 10-K filed on February 28, 2012.
EXECUTIVE SUMMARY
Expeditors International of Washington, Inc. is engaged in the business of global logistics management, including international freight forwarding and consolidation, for both air and ocean freight. The Company acts as a customs broker in all domestic offices, and in many of its international offices. The Company also provides additional services for its customers including value-added distribution, purchase order management, vendor consolidation, domestic time definite services and other logistics solutions. The Company does not compete for overnight courier or small parcel business. The Company does not own or operate aircraft or steamships.
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. The Company cannot predict which, if any, of these proposals may be adopted, nor can the Company predict the effects the adoption of any such proposal will have on the Company’s business. Doing business in foreign locations also subjects the Company to a variety of risks and considerations not normally encountered by domestic enterprises. In addition to being influenced by governmental policies concerning international trade, the Company’s business may also be affected by political developments and changes in government personnel or policies, as well as economic turbulence, political unrest or security concerns in the nations in which it does 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 economic conditions, concerns over volatile fuel costs, rising costs in general, political unrest and fluctuating currency exchange rates, the Company’s pricing and terms continue to be pressured by customers, carriers and service providers. Absent of any meaningful improvement in economic conditions, the Company expects similar trends to continue in the near term.
The Company derives its 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 the financial statements.
As a non-asset based carrier, the Company does not own transportation assets. Rather, the Company generates the major portion of its air and ocean freight revenues by purchasing transportation services from direct (asset-based) carriers and reselling those services to its customers. The difference between the rate billed to customers (the sell rate) and the rate paid to the carrier or service provider (the buy rate) is termed “net revenue” or “yield.” By consolidating shipments from multiple customers and concentrating its buying power, the Company is able to negotiate favorable buy rates from the direct carriers and service providers, while at the same time offering lower sell rates than customers would otherwise be able to negotiate themselves.
Customs brokerage and other services involves providing services at destination, such as helping customers clear shipments through customs by preparing required documentation, calculating and providing for payment of duties and other taxes on behalf of the customers as well as arranging for any required inspections by governmental agencies, and arranging for delivery. This is a complicated function requiring technical knowledge of customs rules and regulations in the multitude of countries in which the Company has offices.
The Company’s ability to provide services to its customers is highly dependent on good working relationships with a variety of entities including airlines, ocean steamship lines, and governmental agencies. The significance of maintaining acceptable working relationships with governmental agencies and asset-based carriers involved in global trade has gained increased importance as a result of ongoing concern over terrorism. As each carrier labors to comply with additional governmental regulations implementing security policies and procedures, inherent conflicts emerge which can and do affect
global trade. A good reputation helps to develop practical working understandings that will assist in meeting security requirements while minimizing potential international trade obstacles. The Company considers its current working relationships with these entities to be satisfactory. However, the airline and ocean steamship line industries have incurred significant losses in recent years as a result of the global economic downturn and many carriers are highly leveraged with debt. This situation has required the Company to be increasingly selective in which carriers to utilize. Further changes in the financial stability, operating capabilities and capacity of asset-based carriers, space allotments available from carriers, governmental regulation or deregulation efforts, “modernization” of the regulations governing customs brokerage, and/or changes in governmental quota restrictions or trade accords could affect the Company’s business in unpredictable ways.
Historically, the Company’s operating results have been subject to a seasonal trend when measured on a quarterly basis. The first quarter has traditionally been the weakest and the third and fourth quarters have traditionally been the strongest. This pattern is the result of, or is influenced by, numerous factors including weather patterns, national holidays, consumer demand, 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 the Company’s international network and service offerings. The Company cannot accurately forecast many of these factors nor can the Company estimate accurately the relative influence of any particular factor and, as a result, there can be no assurance that historical patterns, if any, will continue in future periods.
A significant portion of the Company’s revenues are derived from customers in retail 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 the Company’s revenues are, to a large degree, impacted by factors out of the Company’s control, such as a sudden change in consumer demand for retail goods 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, the Company 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, any such shortfall from levels predicted by securities analysts could have an immediate and adverse effect on the trading price of the Company’s stock.
The Company operates in 63 countries throughout the world in the competitive global logistics industry and Company activities are tied directly to the global economy. From the inception of the 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. The Company’s 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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Aggressive marketing of all of the Company’s 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 is required, 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, 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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The Company reinforces 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 the Company became a publicly traded entity. There is no limit to how much a key manager can be compensated for success. The Company believes in a “real world” environment in every operating unit where individuals are not sheltered from the profit implications of their decisions. If these decisions result in operating losses, these losses must be made up from future operating profits, in the aggregate, before any cash incentive compensation can be earned. At the same time, the Company insists on continued focus on such things as accounts receivable collection, cash flow management and credit soundness in an attempt to insulate managers from the sort of catastrophic errors that might end a career.
Any failure to perpetuate this unique culture on a self-sustained basis throughout the Company provides a greater threat to the Company’s continued success than any external force, which would be largely beyond our control. Consequently, management spends the majority of its time focused on creating an environment where employees can learn and develop while also improving systems and taking preventative action to reduce exposure to negative events and risks. The Company strongly believes that it is nearly impossible to predict events that, in the aggregate, could have a positive or a negative impact on future operations. As a result our focus is on building and maintaining a global corporate culture of well-trained employees and managers that are prepared to identify and react to subtle changes as they develop and thereby help the Company adapt and thrive as major trends emerge.
Critical Accounting Estimates
Management believes that the nature of the Company’s business is such that there are few complex challenges in accounting for operations. While judgments and estimates are a necessary component of any system of accounting, the Company’s use of estimates is limited primarily to the following areas:
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accounts receivable valuation;
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accrual of costs related to ancillary services the Company provides;
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accrual of insurance liabilities for the portion of the freight related exposure which the Company has self-insured;
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accrual of various tax liabilities;
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accrual of loss contingencies; and
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calculation of share-based compensation expense.
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These estimates, other than the accrual of loss contingencies and calculation of share-based compensation expense, are not highly uncertain and have not historically been subject to significant change. Management believes that the methods utilized in all of these areas are non-aggressive in approach and consistent in application. Management believes that there are limited, if any, alternative accounting principles or methods which could be applied to the Company’s transactions. While the use of estimates means that actual future results may be different from those contemplated by the estimates, the Company believes that alternative principles and methods used for making such estimates would not produce materially different results than those reported.
The outcomes of government investigations, legal proceedings and claims brought against the Company are subject to significant uncertainty. An estimated loss from a contingency such as a government investigation, legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a loss contingency is required if there is at least a reasonable possibility that a significant loss has been incurred. In determining whether a loss should be accrued, management evaluates several factors, including advice from outside legal counsel, in order to estimate the degree of probability of an unfavorable outcome and make a reasonable estimate of the amount of loss or range of reasonably possible loss. Changes in these factors could have a material impact on the Company’s results of operations and operating cash flows for any particular quarter or year.
As described in Note 2 in the condensed consolidated financial statements in this quarterly report, the Company accounts for share-based compensation based on an estimate of the fair value of options granted to employees under the Company’s stock option and stock purchase rights plans. This expense, as adjusted for expected forfeitures, is recorded on a straight-line basis over the option vesting period.
Determining the appropriate option pricing model to use to estimate stock compensation expense requires judgment. Any option pricing model requires assumptions that are subjective and these assumptions also require judgment. Examples include assumptions about long-term stock price volatility, employee exercise patterns, pre-vesting option forfeitures, post-vesting option terminations, and future interest rates and dividend yields. The Company uses the Black-Scholes model for estimating the fair value of stock options.
Management believes that the assumptions used are appropriate based upon the Company’s historical and currently expected future experience. Looking to future events, management has been strongly influenced by historical patterns which may not be valid predictors of future developments and any future deviation may be material. The fair value of an option is more significantly impacted by changes in the expected volatility and expected life assumptions. The pre-vesting forfeitures assumption is ultimately adjusted to the actual forfeiture rate. Therefore, changes in the forfeitures assumption would not impact the total amount of expense ultimately recognized over the vesting period. Different forfeitures assumptions would only impact the timing of expense recognition over the vesting period. Estimated forfeitures will be reassessed in subsequent periods and may change based on new facts and circumstances.
Results of Operations
The following table shows the consolidated net revenues (revenues less transportation expenses) attributable to the Company’s principal services and the Company’s expenses for the three and
nine-month
periods ended
September 30, 2012
and
2011
, expressed as percentages of net revenues. Management believes that net revenues are a better measure than total revenues of the relative importance of the Company’s principal services since total revenues earned by the Company as a freight consolidator include the carriers’ charges to the Company for carrying the shipment whereas revenues earned by the Company in its other capacities include only the commissions and fees actually earned by the Company. The table and the accompanying discussion and analysis should be read in conjunction with the condensed consolidated financial statements and related notes thereto which appear elsewhere in this quarterly report.
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Three months ended September 30,
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Nine months ended September 30,
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2012
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2011
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2012
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2011
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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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(Amounts in thousands)
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Net Revenues:
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Airfreight services
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$
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150,731
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32
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%
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$
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178,899
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36
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%
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$
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462,830
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34
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%
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$
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528,767
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37
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%
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Ocean freight and ocean services
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116,732
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25
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118,272
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24
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324,665
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24
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327,890
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23
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Customs brokerage and other services
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197,675
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43
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196,675
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40
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577,865
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42
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563,665
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40
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Net revenues
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465,138
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100
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493,846
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100
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1,365,360
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100
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1,420,322
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100
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Overhead Expenses:
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Salaries and related costs
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252,899
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54
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258,512
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52
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748,956
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55
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745,441
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52
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Other
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67,140
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15
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71,576
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15
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213,631
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16
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211,618
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15
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Total overhead expenses
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320,039
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69
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330,088
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67
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962,587
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71
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957,059
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67
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Operating income
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145,099
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31
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163,758
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33
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402,773
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29
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463,263
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33
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Other income, net
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3,881
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1
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13,401
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3
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14,228
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1
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19,564
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1
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Earnings before income taxes
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148,980
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32
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177,159
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36
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417,001
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30
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482,827
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34
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Income tax expense
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60,253
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13
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70,283
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14
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167,531
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12
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189,724
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13
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Net earnings
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88,727
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19
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106,876
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22
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249,470
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18
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293,103
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21
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Less net earnings attributable to the noncontrolling interest
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237
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—
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272
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—
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318
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—
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267
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—
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Net earnings attributable to shareholders
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$
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88,490
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19
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%
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$
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106,604
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22
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%
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$
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249,152
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18
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%
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$
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292,836
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21
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%
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Airfreight services net revenues decreased 16% for the three-month period ended
September 30, 2012
, as compared with the same period for
2011
. The decrease in global airfreight services net revenues was primarily due to a 9% decrease in airfreight tonnage and a 7% decrease in net revenue per kilo. North America, Asia Pacific and Europe airfreight services net revenues decreased 11%, 17% and 22%, respectively, in the
third
quarter of
2012
as compared with the same period in
2011
, while airfreight export tonnage for North America, Asia Pacific and Europe decreased 13%, 7% and 12%, respectively.
Airfreight services net revenues decreased 12% for the
nine-month
period ended
September 30, 2012
, as compared with the same period for
2011
. The decrease in global airfreight services net revenues was primarily due to a 9% decrease in airfreight tonnage and a 3% decrease in net revenue per kilo. North America, Asia Pacific and Europe airfreight services net revenues decreased 8%, 16% and 16%, respectively, in the
nine months ended
September 30, 2012
as compared with the same period in
2011
, while airfreight export tonnage for North America, Asia Pacific and Europe decreased 14%, 6% and 9%, respectively.
The decline in airfreight tonnage for the three and
nine months ended
September 30, 2012
can be attributed to an overall decrease in the global airfreight market and a lower level of customer specific infrastructure and project related tonnage than experienced during the same period in 2011. Net revenue per kilo was lower in both the three and nine-month periods compared to the same periods in 2011, as carriers reduced overall available capacity to manage market pricing. Absent of any meaningful improvements in the uncertainties related to global economic conditions, the Company expects similar trends to continue in the near term.
Ocean freight and ocean services net revenues are comprised of three basic services: ocean freight consolidation, direct ocean forwarding and order management. The largest component of the Company’s ocean freight net revenue is derived from ocean freight consolidation which represented 47% of ocean freight net revenue for both the three and
nine-month
periods ended
September 30, 2012
, and 49% and 50% for the same periods ended
September 30, 2011
, respectively.
Ocean freight and ocean services net revenues decreased 1% for the three-month period ended
September 30, 2012
, as compared with the same period for
2011
. Europe ocean freight net revenues increased 2% while North America and Asia Pacific decreased 1% and 3%, respectively, in the
third
quarter of
2012
, as compared with the same period in
2011
. Ocean freight consolidation net revenue decreased 6% for the three-month period ended
September 30, 2012
, as compared with the same period for
2011
, due to a 2% decrease in net revenue per container and a 4% decrease in container volume as measured in terms of forty-foot container equivalent units (FEUs).
Ocean freight and ocean services net revenues decreased 1% for the
nine-month
period ended
September 30, 2012
, as compared with the same period for
2011
. North America ocean freight net revenues increased 1% while Asia Pacific and Europe decreased by 4% and 1%, respectively, in the
nine-month
period ended
September 30, 2012
, as compared with the same period in
2011
. Ocean freight consolidation net revenue decreased 7% for the
nine-month
period ended
September 30, 2012
, as compared with the same period for
2011
, due to a 6% decrease in net revenue per container and a 1% decrease in container volume as measured in terms of FEUs. The decreases in net revenues per container were primarily due to the timing of significant increases in buy rates implemented by carriers, requirements to provide notice of these increases to customers and the Company's ability to implement commensurate increases in its sell rates. Carrier reductions in available capacity and its associated impact on pricing also affected this timing. We expect carriers will continue to manage overall available capacity in an attempt to maintain rates and improve their operating results.
Direct ocean freight forwarding net revenues, which are primarily fee-based, increased 8% and 9%, respectively, for the three and nine-month periods ended
September 30, 2012
, as compared with the same periods in
2011
, primarily due to an increase in market share and volume. Order management net revenues decreased 3% for the three month period ended September 30, 2012 as compared with the same periods in
2011
due to lower volumes, which partially offset the net revenue increase in the first six months of 2012.
Customs brokerage and other services net revenues increased 1% and 3%, respectively, for the three and
nine-month
periods ended
September 30, 2012
, as compared with the same periods for
2011
. Higher volumes in domestic time definite services were partially offset by a decline in customs brokerage activity.
Salaries and related costs for the three-month period ended
September 30, 2012
, decreased 2% when compared with the same period in
2011
, primarily as a result of lower bonuses earned due to lower operating income, partially offset by a 2% increase in the number of employees and higher payroll related taxes and medical costs. Salaries and related costs for the
nine-month
period ended
September 30, 2012
, increased slightly as compared with the same period in
2011
as the increase in the number of employees and higher payroll related taxes and medical costs were mostly offset by lower earned bonuses as a result of the decrease in operating income. The effects of including stock-based compensation expense in salaries and related costs are as follows:
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Three months ended September 30,
|
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Nine months ended September 30,
|
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2012
|
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2011
|
|
2012
|
|
2011
|
Salaries and related costs
|
$
|
252,899
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|
|
$
|
258,512
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$
|
748,956
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$
|
745,441
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As a % of net revenue
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54.4
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%
|
|
52.3
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%
|
|
54.9
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%
|
|
52.5
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%
|
Stock compensation expense
|
$
|
11,320
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$
|
12,738
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$
|
32,846
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|
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$
|
33,446
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As a % of net revenue
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2.4
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%
|
|
2.6
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%
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2.4
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%
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2.4
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%
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Historically, the relatively consistent relationship between salaries and net revenues is the result of a compensation philosophy that has been maintained since the inception of the 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 will occur in proportion to changes in Company profits, creating a direct alignment between corporate performance and shareholder interests. However, the results in the
nine-month
period ended
September 30, 2012
were not consistent with this historical relationship primarily due to a decrease in net revenues while the number of employees increased to support customer driven initiatives, enhance information systems and expand certain product capabilities. Bonuses to field and executive management for the
nine-month
period ended
September 30, 2012
were down 9% and 13%, respectively, as compared with the same period for
2011
, primarily as a result of a 13% decrease in operating income for the nine-month period. The Company’s management incentive compensation programs have always been incentive-based and performance driven and there is no built-in bias that favors or enriches management in a manner inconsistent with overall corporate performance.
Because the Company’s management incentive compensation programs are also cumulative, no management bonuses can be paid unless the relevant business unit is, from inception, cumulatively profitable. Any operating losses must have been offset in their entirety by operating profits before management is eligible for a bonus. Since the most significant portion of management compensation comes from the incentive bonus programs, the Company believes that this cumulative feature is a disincentive to excessive risk taking by its managers. Due to the nature of the Company’s 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 the Company’s compensation program.
Other overhead expenses decreased 6% for the three months ended
September 30, 2012
, as compared with the same period in
2011
. This decrease is due primarily to transition in certain tax jurisdictions to a value added tax system and cost reduction measures, including decreased travel and entertainment expenses. These expenses increased 1% for the nine months ended September 30, 2012 as the reductions described above were offset by the European Commission's finding against the Company for anti-competitive behavior which resulted in a fine of
€4.14 million
(
$5.5 million
). Other overhead expenses as a percentage of net revenues remained constant for the three months ended September 30, 2012, as compared with the same period in 2011 and also remained constant for the nine months ended September 30, 2012, as compared with the same period in 2011 when excluding the fine discussed above.
The Company is subject to formal and informal investigations or litigation from governmental authorities and others. Further, the Company periodically conducts reviews of the operations and procedures of its offices worldwide relating to compliance with applicable laws and regulations. The Company will continue to incur legal costs until these legal proceedings are concluded.
Other income, net, decreased approximately $10 million and $5 million, respectively, for the three and
nine-month
periods ended
September 30, 2012
, primarily as a result of foreign exchange losses in 2012 as compared to foreign exchange gains in 2011. The net foreign exchange gains in 2011 resulted primarily from U.S. dollar accounts receivable in non U.S. dollar-based subsidiaries as the U.S. dollar appreciated against other currencies at the end of the third quarter of 2011.
The Company pays income taxes in the United States and other jurisdictions, as well as other taxes which are typically included in costs of operations. The Company’s consolidated effective income tax rate increased to approximately
40.4%
and
40.2%
, respectively, for the three and
nine-month
periods ended
September 30, 2012
, as compared to
39.7%
and
39.3%
, respectively, for the three and
nine-month
periods ended
September 30, 2011
, principally due to higher nondeductible expenses and a reduction in available tax deductions associated with disqualifying dispositions of incentive stock options relative to lower pre-tax earnings.
Currency and Other Risk Factors
The nature of the Company's worldwide operations necessitates the Company dealing with a multitude of currencies other than the U.S. dollar. This results in the Company being exposed to the inherent risks of volatile international currency markets and governmental interference. Some of the countries where the Company maintains offices and/or agency relationships have strict currency control regulations which influence the Company's ability to hedge foreign currency exposure. The Company tries to compensate for these exposures by accelerating international currency settlements among its offices or agents. The Company enters into foreign currency hedging transactions only in limited locations where there are regulatory or commercial limitations on the Company's 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
nine months ended
September 30, 2012
and
2011
was insignificant. The Company had no foreign currency derivatives outstanding at
September 30, 2012
and
December 31, 2011
. During the three and
nine months ended
September 30, 2012
, net foreign currency losses were approximately
$427
and
$2,934
, respectively. For the same periods of 2011, the Company's net foreign currency gains were approximately
$4,972
and
$4,642
, 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; however, the Company’s primary competition is confined to a relatively small number of companies within this group. 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. The Company emphasizes quality service and believes that its prices are competitive with those of others in the industry. 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. The Company believes 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 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
The Company’s 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
nine months ended
September 30, 2012
, was approximately
$69 million
and
$309 million
, respectively, as compared with
$93 million
and
$349 million
for the same periods in
2011
. The decreases of
$24 million
for the three-month period ended September 30, 2012 and
$40 million
for the
nine-month
period ended
September 30, 2012
are primarily due to lower earnings and changes in working capital accounts, partially offset by an increase in deferred taxes. At
September 30, 2012
, working capital was
$1,574 million
, including cash and cash equivalents of
$1,368 million
. The Company had no long-term debt at
September 30, 2012
. Management believes that the Company’s current cash position and operating cash flows will be sufficient to meet its capital and liquidity requirements for the foreseeable future, including meeting any contingent liabilities related to standby letters of credit and other obligations.
The Company’s business is subject to seasonal fluctuations. Cash flow fluctuates 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 peak season (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.
As a customs broker, the Company makes significant cash advances for a select group of its credit-worthy customers. These cash advances are for customer obligations such as the payment of duties 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. Management believes that the Company has effective credit control procedures, and historically has experienced relatively insignificant collection problems.
Cash from investing activities for the three and
nine months ended
September 30, 2012
was
$10 million
and
$37 million
, respectively. The largest use of cash in investing activities is cash paid for capital expenditures. The Company does have need, on occasion, to purchase or construct buildings to house staff and to facilitate the staging of customers’ freight. The Company routinely invests in technology, office furniture and equipment and leasehold improvements. In the
third
quarter of
2012
, the Company made capital expenditures of
$10 million
, as compared with
$21 million
for the same period in
2011
. Capital expenditures in the
third
quarter of
2012
related primarily to investments in technology, and office furniture and equipment. Total capital expenditures in
2012
are estimated to be approximately $50 million. This includes normal capital expenditures as noted above plus additional real estate development.
Cash used in financing activities during the three and
nine months ended
September 30, 2012
, was
$64 million
and
$205 million
, as compared with
$13 million
and
$103 million
for each of the same periods in
2011
. The Company uses the proceeds from stock option exercises and available cash to repurchase the Company’s common stock on the open market. In the
third
quarter of
2012
, the Company continued its policy of repurchasing stock to limit growth in issued and outstanding shares as a result of stock option exercises. The increase in cash used in financing activity during the three and
nine months ended
September 30, 2012
, as compared to the same periods in
2011
, is primarily the result of this policy and additional discretionary repurchases of 1.6 million and 3.1 million shares at an average price of $36.71 and $37.13, respectively. During the nine months ended
September 30, 2012
and
2011
, the Company paid dividends of
$.28
per share and
$.25
per share, respectively.
The Company follows established guidelines relating to credit quality, diversification and maturities of its investments to preserve principal and maintain liquidity. In the past, the Company’s investment portfolio has not been adversely impacted by disruptions in the credit markets. However, there can be no assurance that the Company’s investment portfolio will not be adversely affected in the future.
The Company cannot predict what impact ongoing uncertainties in the global economy may have on its operating results, freight volumes, pricing, changes in consumer demand, carrier stability and capacity, customers’ ability to pay or on changes in competitors' behavior.
The Company maintains international unsecured bank lines of credit. At
September 30, 2012
, amounts available for borrowing under international bank lines of credit totaled $15 million. At
September 30, 2012
, the Company was contingently liable for $102 million from standby letters of credit and guarantees. The standby letters of credit and guarantees relate to obligations of the Company’s 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.
The Company's 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, the Company’s ability to repatriate funds from foreign operations may be subject to foreign exchange controls. At
September 30, 2012
, cash and cash equivalent balances of
$650 million
were held by the Company’s non-United States subsidiaries, of which
$50 million
was held in banks in the United States. Earnings of the Company's 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
The Company is exposed to market risks in the ordinary course of its business. These risks are primarily related to foreign exchange risk and changes in short-term interest rates. The potential impact of the Company’s exposure to these risks is presented below:
Foreign Exchange Risk
The Company conducts business in many different countries and currencies. The Company’s business often results in revenue 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, the Company creates 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 the Company’s earnings. The principal foreign exchange risks to which the Company is exposed are in Chinese yuan, Euro, Mexican peso and Canadian dollar.
Foreign exchange rate sensitivity analysis can be quantified by estimating the impact on the Company’s earnings as a result of hypothetical changes in the value of the U.S. dollar, the Company’s functional currency, relative to the other currencies in which the Company transacts business. All other things being equal, an average 10% weakening of the U.S. dollar, throughout the
nine
months ended
September 30, 2012
, would have had the effect of raising operating income approximately $29 million. An average 10% strengthening of the U.S. dollar, for the same period, would have the effect of reducing operating income approximately $23 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.
As of
September 30, 2012
, the Company had approximately $1 million of net unsettled intercompany transactions. The Company currently does not use derivative financial instruments to manage foreign currency risk and only enters into foreign currency hedging transactions in limited locations where regulatory or commercial limitations restrict the Company’s ability to move money freely. Any such hedging activity during the
nine months ended
September 30, 2012
and
2011
was insignificant. During the three and
nine months ended
September 30, 2012
, net foreign currency losses were approximately
$427
and
$2,934
. For the same periods of
2011
, the Company's net foreign currency gains were approximately
$4,972
and
$4,642
, respectively. The Company had no foreign currency derivatives outstanding at
September 30, 2012
and
December 31, 2011
. The Company instead follows a policy of accelerating international currency settlements to manage foreign exchange risk relative to intercompany billings. The majority of intercompany billings are resolved within 30 days.
Interest Rate Risk
At
September 30, 2012
, the Company had cash and cash equivalents and short term investments of
$1,368 million
of which $822 million was invested at various short-term market interest rates. The Company had no long-term debt at
September 30, 2012
. A hypothetical change in the interest rate of 10 basis points at
September 30, 2012
would not have a significant impact on the Company’s earnings.
In management’s opinion, there has been no material change in the Company’s interest rate risk exposure in the
third
quarter of
2012
.
Item 4. Controls and Procedures
Evaluation of Controls and Procedures
The Company carried out an evaluation, under the supervision and with the participation of its management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s “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 the Company’s 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 the Company’s internal control over financial reporting that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
The Company's management has confidence in the Company’s internal controls and procedures. Nevertheless, the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s disclosure procedures and controls or the Company’s 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 the Company’s control issues and instances of fraud, if any, have been detected.