HEXCEL CORP /DE/ - Quarter Report: 2018 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarter Ended September 30, 2018

or

For the transition period from                      to                    

Commission File Number 1-8472

Hexcel Corporation

(Exact name of registrant as specified in its charter)

Two Stamford Plaza

281 Tresser Boulevard

Stamford, Connecticut 06901-3238

(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (203) 969-0666

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).    Yes  ☐    No   ☒

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

HEXCEL CORPORATION AND SUBSIDIARIES

INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1. Condensed Consolidated Financial Statements

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Hexcel Corporation and Subsidiaries

Condensed Consolidated Statements of Operations

Hexcel Corporation and Subsidiaries

Condensed Consolidated Statements of Comprehensive Income

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Hexcel Corporation and Subsidiaries

Condensed Consolidated Statements of Cash Flows

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HEXCEL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1 — Significant Accounting Policies

In these notes, the terms “Hexcel,” “the Company,” “we,” “us,” or “our” mean Hexcel Corporation and subsidiary companies. The accompanying Condensed Consolidated Financial Statements are those of Hexcel Corporation.  Refer to Note 1 to the consolidated financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2017 for a discussion of our significant accounting policies. Significant changes to our accounting policies subsequent to the filing of our Form 10-K, relate solely to the adoption of Topic 606, Revenue from Contracts with Customers, are discussed below in Recent Accounting Pronouncements as well as in Note 9.

Basis of Presentation

The accompanying Condensed Consolidated Financial Statements have been prepared from the unaudited accounting records of Hexcel pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) and in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information.  Certain information and footnote disclosures normally included in financial statements have been omitted pursuant to rules and regulations of the SEC. In the opinion of management, the Condensed Consolidated Financial Statements include all normal recurring adjustments as well as any non-recurring adjustments necessary to present fairly the statement of financial position, results of operations and cash flows for the interim periods presented.  The Condensed Consolidated Balance Sheet as of December 31, 2017 was derived from the audited 2017 consolidated balance sheet.  Interim results are not necessarily indicative of results expected for any other interim period or for the full year.  These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our 2017 Annual Report on Form 10-K. Within the Unaudited Condensed Consolidated Statement of Cash Flows for the nine months ended September 30, 2017, borrowings and repayments related to our revolving credit facility previously presented net within financing activities have been presented gross to conform to the current year presentation. 

Investments in Affiliated Companies

We have a 50% equity investment in Aerospace Composites Malaysia Sdn. Bhd. (“ACM”), and a 25% equity investment in Hexcut Services.  These investments are accounted for using the equity method of accounting.      

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update No. 2014-09 (ASU 2014-09), Revenue from Contracts with Customers (“ASC 606”).  The update clarified the principles for recognizing revenue and developed a common revenue standard for all industries. We adopted this new standard January 1, 2018, using the modified retrospective method, as a result we adjusted the opening balance of our retained earnings by approximately $3.8 million, which represented the cumulative net earnings effect of revenue recognized over time prior to the date of adoption, related to those contracts whose performance obligations were not fully satisfied by the adoption date.

In February 2016, the FASB issued Accounting Standards Update No. 2016-02 (ASU 2016-02), Leases (Topic 842). This ASU requires lessees to recognize a right of use asset and lease liability on the balance sheet for all leases, with the exception of short-term leases (those of a duration of one year or less). We will adopt this standard on January 1, 2019.  We will adopt the provisions of this standard using the transition method which allows companies to recognize existing leases at the adoption date without requiring comparable presentation. We are in the process of finalizing our analysis and assessment of the impact this new standard will have on our financial statements.

In March 2017, the FASB issued Accounting Standards Update No. 2017-07 (ASU 2017-07), Compensation-Retirement Benefits, that amends the presentation of net periodic pension cost and net periodic postretirement benefit cost. This amendment requires entities to disaggregate the service cost component from the other components of net periodic benefit cost, to report the service cost component in the same line item as other compensation costs and to report the other components of net periodic benefit cost separately as a line item below operating income on our statement of operations. In addition, capitalization of net periodic benefit cost in assets is limited to the service cost component. We adopted this amendment on January 1, 2018. The adoption did not have a material impact to our financial statements or disclosures.

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In August 2017, the FASB issued Accounting Standards Update No. 2017-12 (ASU 2017-12), Targeted Improvement to Accounting for Hedging Activities, which better aligns hedge accounting with an organization’s risk management activities in the financial statements. In addition, the standard simplified the application of hedge accounting guidance in areas where practice issues exist. We adopted this standard on January 1, 2018, with no material impact to our results of operations, or financial position.

In February 2018, the FASB issued Accounting Standards Update No. 2018-02 (ASU 2018-02), Income Statement—Reporting Comprehensive Income (Topic 220), which amends the previous guidance to allow for certain tax effects “stranded” in accumulated other comprehensive income, which are impacted by the Tax Cuts and Jobs Act (the “Act”), to be reclassified from accumulated other comprehensive income into retained earnings. This amendment pertains only to those items impacted by the new tax law and will not apply to any future tax effects stranded in accumulated other comprehensive income. This standard is effective for fiscal years beginning after December 15, 2018, and allows for early adoption. The Company elected to early adopt this standard during the quarter ended March 31, 2018. As a result of the adoption of this standard, the Company reduced the opening balance of retained earnings by approximately $1.6 million.

In August 2018 the FASB issued Accounting Standards Update No. 2018-14 (ASU 2018-14), Compensation—Retirement Benefits—Defined Benefit Plans—General (Subtopic 715-20), which amends the current disclosure requirements regarding defined benefit pensions and other post retirement plans, and allows for the removal of certain disclosures, while adding certain new disclosure requirements. This standard is effective for fiscal years beginning after December 15, 2020, and allows for early adoption. We do not expect this new standard to have a significant impact to our disclosures.

Note 2 — Net Income per Common Share

Total shares underlying stock options of 0.2 million were excluded from the computation of diluted net income per share for the three and nine months ended September 30, 2018, as they were anti-dilutive. Total shares underlying stock options of 0.1 million and 0.2 million, respectively, were excluded from the computation of diluted net income per share for the three and nine months ended September 30, 2017, as they were anti-dilutive.  

Note 3 — Inventories

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Note 4 — Retirement and Other Postretirement Benefit Plans

We maintain qualified and nonqualified defined benefit retirement plans covering certain current and former U.S. and European employees, retirement savings plans covering eligible U.S. and U.K. employees and certain postretirement health care and life insurance benefit plans covering eligible U.S. retirees. We also participate in a union sponsored multi-employer pension plan covering certain U.S. employees with union affiliations.

Defined Benefit Retirement Plans

Net Periodic Benefit Costs

Net periodic benefit costs of our defined benefit retirement plans for the three and nine months ended September 30, 2018 and 2017 were as follows:

All costs related to our pensions are included as a component of operating income in our consolidated statements of operations. For the three months ended September 30, 2018 and 2017, amounts unrelated to service costs were a benefit of $1.0 million and $0.5 million, respectively, and for the nine months ended September 30, 2018 and 2017, amounts unrelated to service costs were a benefit of $3.0 million and $1.6 million, respectively.

Contributions

We generally fund our U.S. non-qualified defined benefit retirement plans when benefit payments are incurred.  We have contributed approximately $4.4 million in the first nine months of 2018 to cover unfunded benefits.  We expect to contribute a total of $4.6 million in 2018 to cover unfunded benefits.  We contributed $0.4 million to our U.S. non-qualified defined benefit retirement plans during the nine months ended September 30, 2017.

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We contributed $3.8 million and $2.8 million to our European defined benefit retirement plans in the nine months ended September 30, 2018 and 2017, respectively.  We plan to contribute approximately $5.0 million during 2018 to our European plans.

Postretirement Health Care and Life Insurance Benefit Plans

We recorded $0.3 million and $0.9 million of net amortization gain deferral for the three and nine months ended September 30, 2017, and  $0.9 million of net amortization gain deferral for the nine months ended September 30, 2018. There were no amounts related to the amortization gain deferral recorded during the three months ended September 30, 2018. Net periodic benefit costs of our postretirement health care and life insurance benefit plans for the three and nine months ended September 30, 2018 and 2017 were immaterial.

In connection with our postretirement plans, we contributed about $0.3 million during both the nine months ended September 30, 2018 and September 30, 2017. We periodically fund our postretirement plans to pay covered expenses as they are incurred. We expect to contribute approximately $0.4 million in 2018 to cover unfunded benefits.   

Note 5 –– Debt

In 2017, the Company issued $400 million in aggregate principal amount of 3.95% Senior Unsecured Notes due in 2027. The interest rate on these senior notes may be increased 0.25% each time a credit rating applicable to the notes is downgraded. Conversely, such increases would be reversed should the credit rating be subsequently upgraded. The maximum rate is 5.95%. The effective interest rate for the nine months ended September 30, 2018 was 3.88% inclusive of approximately a 0.25% benefit of treasury locks. The fair value of the senior notes due in 2027 based on quoted prices utilizing Level 2 inputs was $387.8 million at September 30, 2018.

In 2015, the Company issued $300 million in aggregate principal amount of 4.7% Senior Unsecured Notes due in 2025. The interest rate on these senior notes may be increased by 0.25% each time a credit rating applicable to the notes is downgraded. Conversely, such increases would be reversed should the credit rating be subsequently upgraded. The maximum rate is 6.7%.  The effective interest rate for the nine months ended September 30, 2018 was 4.84%. The fair value of the notes due in 2025 based on quoted prices utilizing Level 2 inputs was $305.5 million at September 30, 2018.

The Company has a revolving credit facility (the “Facility”) that allows up to $700 million of borrowings. The Facility matures in June 2021. The interest rate for the Facility at September 30, 2018 is LIBOR + 1.25%. The interest rate ranges from LIBOR + 0.875% to a maximum of LIBOR + 1.875%, depending upon the Company’s leverage ratio.     

The Facility contains financial and other covenants, including, but not limited to, restrictions on the incurrence of debt and the granting of liens, as well as the maintenance of an interest coverage ratio and a leverage ratio. In accordance with the terms of the Facility, we are required to maintain a minimum interest coverage ratio of 3.50 (based on the ratio of EBITDA, as defined in the

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Credit Agreement, to interest expense) and may not exceed a maximum leverage ratio of 3.50 (based on the ratio of total debt to EBITDA) throughout the term of the Facility. In addition, the Facility contains other terms and conditions such as customary representations and warranties, additional covenants and customary events of default.

As of September 30, 2018, total borrowings under the Facility were $235.0  million, which approximates fair value using Level 2 inputs. The Facility permits us to issue letters of credit up to an aggregate amount of $40 million. Outstanding letters of credit reduce the amount available for borrowing under our revolving loan. As of September 30, 2018, there were no outstanding letters of credit under the Facility, resulting in undrawn availability under the Facility as of September 30, 2018 of $465.0 million. The weighted average interest rate for the Facility was 3.34% for the nine months ended September 30, 2018.

In 2016, we entered into a €60 million term loan.  The loan has two tranches of which the first tranche for €25 million has a rate of Euribor +1.2% and a final maturity date of June 30, 2023, and a second tranche for €35 million has a rate of Euribor +1.25% with a final maturity date of June 30, 2024. The loans are payable in annual installments that began on June 30, 2017, for the first tranche, and beginning on June 30, 2019, for the second. There is a zero percent floor on the Euribor. Amounts outstanding under this loan at September 30, 2018 were $61.8 million which approximates fair value using Level 2 inputs under the market approach.      

Note 6 — Derivative Financial Instruments

Interest Rate Swap and Interest Lock Agreements

        As of September 30, 2018, the Company had interest rate swaps, having a combined notional value of $50.0 million, that swap floating rate obligations for fixed rate obligations at an average rate of 1.09% against LIBOR in U.S. dollars. Both swaps mature in September 2019. The swaps are accounted for as cash flow hedges of our floating rate bank loan. To ensure the swaps were highly effective, all of the critical terms of the swaps matched the terms of the bank loan. The fair value of the interest rate swaps was an asset of $0.8 million at both September 30, 2018 and December 31, 2017, respectively. 

At September 30 2018, we had interest swaps related to European debt obligations which had a combined notional value of approximately €52.9 million. These derivatives swapped floating rate obligations for fixed rate obligations at a weighted average rate of 0.51% against Euribor in Euros.  The swaps amortize through the final maturities of the obligations, on June 30, 2023 and June 30, 2024, in annual installments. The derivatives are accounted for as cash flow hedges of the floating rate term loans.  To ensure the swaps were highly effective, all of the principal terms of the swap matched the terms of the bank loans.  The fair value of the interest rate swaps was a liability of $0.3 million at September 30, 2018, and a liability of $0.4 million at December 31, 2017.

The Company had treasury lock agreements to protect against unfavorable movements in the benchmark treasury rate related to the issuance of our 3.95% Senior Unsecured Notes. These hedges were designated as cash flow hedges therefore any change in fair value was recorded as a component of other comprehensive income. As part of the issuance of our senior notes, we net settled these derivatives for $10 million in cash. As a result of settling these derivatives the previously deferred gains recorded in other comprehensive income will be released to interest expense over the life of the senior notes. The effect of these treasury locks reduced the effective interest rate on the senior notes by approximately 0.25%.  

Foreign Currency Forward Exchange Contracts

A number of our European subsidiaries are exposed to the impact of exchange rate volatility between the U.S. dollar and the subsidiaries’ functional currencies, being either the Euro or the British Pound sterling. We entered into contracts to exchange U.S. dollars for Euros and British Pound sterling through March 2021, which we account for as cash flow hedges. The aggregate notional amount of these contracts was $408.6 million and $285.4 million at September 30, 2018 and December 31, 2017, respectively.  The purpose of these contracts is to hedge a portion of the forecasted transactions of our European subsidiaries under long-term sales contracts with certain customers. These contracts are expected to provide us with a more balanced matching of future cash receipts and expenditures by currency, thereby reducing our exposure to fluctuations in currency exchange rates.  The effective portion of the hedges, losses of $0.6  million and $13.1 million, respectively, were recorded in other comprehensive income (“OCI”) for the three and nine months ended September 30, 2018, and gains of $9.7 million and $31.7 million for the three and nine months ended September 30, 2017, respectively.  We classified the carrying amount of these contracts of $4.8 million in other assets and $8.5 million in other liabilities on the Condensed Consolidated Balance Sheets at September 30, 2018 and $14.7 million in other assets and $2.8 million in other liabilities at December 31, 2017.  We recognized net losses of $0.9 million and net gains of $2.5 million in gross margin during the three and nine months ended September 30, 2018, and net losses of $0.6 million and $11.4 million for the three and nine months ended September 30, 2017, respectively.  

In addition, we enter into foreign exchange forward contracts which are not designated as hedges. These are used to provide an offset to transactional gains or losses arising from the re-measurement of non-functional monetary assets and liabilities such as accounts receivable. The change in the fair value of the derivatives is recorded in the statement of operations. There are no credit

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contingency features in these derivatives. During the quarters ended September 30, 2018 and 2017, we recognized net foreign exchange losses of $0.1 million and gains of $4.0 million, respectively, in the Condensed Consolidated Statements of Operations. During the nine months ended September 30, 2018 and 2017, we recognized net foreign exchange losses of $4.1 million and gains of $15.4 million, respectively, in the Condensed Consolidated Statements of Operations. The net foreign exchange impact recognized from these hedges offset the translation exposure of these transactions. The carrying amount of the contracts for derivatives not designated as hedging instruments was $0.5 million classified in other assets and $0.1 million in other liabilities, and $1.3 million classified in other assets, and $0.1 million in other liabilities on the September 30, 2018 and December 31, 2017 Condensed Consolidated Balance Sheets, respectively.

The change in fair value of our foreign currency forward exchange contracts under hedge designations recorded net of tax within accumulated other comprehensive income for the quarters and nine months ended September 30, 2018 and September 30, 2017 was as follows:

We expect to reclassify $0.7 million of unrealized losses into earnings over the next twelve months as revenue is recorded.

Note 7 — Income Taxes

The effective tax rate for the current quarter was 9.1% compared to 16.5% for the quarter ended September 30, 2017. The current quarter benefitted from discrete benefits of $9.6 million primarily related to a change in tax accounting method and the release of a valuation allowance in a foreign jurisdiction. The third quarter of 2017 included a non-recurring discrete benefit of $4.2 million resulting from the reversal of reserves for uncertain tax positions. The effective tax rate for the nine months ended September 30, 2018, was 16.9% compared to 18.6% for the nine months ended September 30, 2017. The provision for the nine months ended September 30, 2018 also included a discrete benefit of $1.3 million related to the release of reserves for uncertain tax positions. The provision for the nine months ended September 30, 2017, also included nonrecurring discrete benefits of $9.1 million related to the release of a valuation allowance in a foreign jurisdiction. Excluding these discrete benefits the effective tax rates were 21.3% and 24.2%, respectively. The 2018 periods also reflect the cumulative impact of the reduction of our underlying estimated annual effective rate to 24% from 25%. Both periods benefitted from deductions associated with share-based compensation payments.

The Tax Cuts and Jobs Act (the “Act”) enacted in 2017, resulted in the U.S. Federal income tax rate being reduced to 21% from 35% for the same period last year. During the measurement period, which is one year from the date of enactment, or the completion of all estimates made in connection with the Act, companies are permitted to make additional income tax adjustments and revisions of estimates related to the Act. During the quarter ended September 30, 2018, there were no material adjustments made to previously made estimates related to the Act. We are currently in the process of completing our estimates for the transition tax related to our 2018 earnings, which will be finalized during the fourth quarter of 2018.

Note 8 — Fair Value Measurements

The authoritative guidance for fair value measurements establishes a hierarchy for observable and unobservable inputs used to measure fair value, into three broad levels, which are described below:

In determining fair value, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible as well as consider counterparty credit risk in our assessment of fair value.

We have no assets or liabilities that utilize Level 1 inputs. However, we have derivative instruments classified as liabilities and assets which utilize Level 2 inputs, and one liability that utilizes Level 3 inputs.

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For derivative assets and liabilities that utilize Level 2 inputs, we prepare estimates of future cash flows of our derivatives, which are discounted to a net present value. The estimated cash flows and the discount factors used in the valuation model are based on observable inputs, and incorporate non-performance risk (the credit standing of the counterparty when the derivative is in a net asset position, and the credit standing of Hexcel when the derivative is in a net liability position). The fair value of these assets and liabilities was approximately $6.0 million and $8.9 million, respectively, at September 30, 2018.  In addition, the fair value of these derivative contracts, which are subject to a master netting arrangement under certain circumstances, is presented on a gross basis in the Consolidated Balance Sheet.

Below is a summary of valuation techniques for all Level 2 financial assets and liabilities:

Counterparties to the above contracts are highly rated financial institutions, none of which experienced any significant downgrades in the nine months ended September 30, 2018 that would reduce the receivable amount owed, if any, to the Company.

Liabilities classified as Level 3— we have a liability for $3.0 million, which represented contingent consideration, that was recognized in connection with an acquisition completed during the prior year. This amount was estimated based on certain contractual stipulations which requires payments to be made to the seller in the future based upon the achievement of certain results. We used forecasted results which were discounted using an internally derived discount rate. Future amounts payable may differ from this estimate by the difference between the actual and forecasted results. The amount of interest related to this liability accreted during the nine months ended September 30, 2018, was not material.  

Note 9 — Revenue

Our revenue is primarily derived from the sale of inventory under long-term agreements with our customers. We have determined that individual purchase orders (“PO”), whose terms and conditions taken with a master agreement, create the ASC 606 contracts which are generally short-term in nature.  For those sales, which are not tied to a long-term agreement, we generate a PO that is subject to our standard terms and conditions. The majority of our sales are covered under long-term agreements, with the remaining sales coming from POs. Our agreements (including POs) generally do not have multiple performance obligations and thus do not require an allocation of a single price amongst multiple goods or services.  All pricing is fixed and determinable. A majority of our revenue is earned when goods are shipped to a customer. In instances where our customers acquire our goods related to government contracts, the contracts are typically subject to terms similar, or equal to, the Federal Acquisition Regulation Part 52.249-2, which contains a termination for convenience clause (“T for C”). T for C allows for a customer to cancel a contract at any point for any reason, but also requires that the customer pay for the cost of both the finished and unfinished goods at the time of cancellation plus a reasonable profit relative to the work performed. Generally these arrangements relate to unique products manufactured to customer specifications and have no alternative use.

Upon adoption of ASC 606 we recognize revenue over time for those agreements that have T for C, and where the products being produced have no alternative use.  Prior to the adoption date, revenue related to these agreements was recognized when the goods were shipped, however, as a result of the adoption of ASC 606 a portion of our revenue may be earned in periods earlier than it would have been in prior years. The cumulative adjustment to retained earnings upon adoption represents those earnings, which would have been recognized in the previous year had ASC 606 been in effect during that time. As our production cycle is typically six months or less, it is expected that goods related to the revenue represented in that adjustment will be shipped and billed within the current year. Less than half of our agreements contain provisions which would require revenue to be recognized over time. For revenue recognized over time, we estimate the amount of revenue earned at a given point during the production cycle based on certain costs factors such as raw materials and labor, incurred to date, plus a reasonable profit. We believe this method, which is the cost-to-cost input method, best estimates the revenue recognizable for T for C agreements.

We disaggregate our revenue based on market for analytical purposes. The following table details our revenue by market for the three and nine months ended September 30, 2018 and 2017:

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Revenue recognized over time gives rise to contract assets, which represent revenue recognized but unbilled.  Contract assets are included in our Consolidated Balance Sheets as a component of current assets. The activity related to contract assets for the nine months ended September 30, 2018 is as follows:

Upon adoption of ASC 606, the Company recorded $38.1 million of contract assets for revenue that was unbilled at December 31, 2017, and a $33.0 million reduction in inventory representing the value of the inventory associated with the revenue recognized over time, with the offset recorded to the opening balance of retained earnings (less $1.3 million in taxes). The amount of contract assets billed, and subsequently reclassified to trade accounts receivable, during the quarter ended September 30, 2018, was approximately $37.7 million. Accounts receivable, net includes amounts billed to customers where the right to payment is unconditional. 

The financial results were not significantly impacted by the adoption of ASC 606. Under ASC 606 revenue and gross margin for the quarter ended September 30, 2018 were higher by $6.0 million and $0.4 million, respectively, than they would have been under ASC 605.  For the nine months ended September 30, 2018, the impact of ASC 606 to revenue was approximately $5.6 million and to gross margin was $0.2 million.  There was not a material impact earnings on per share for the quarter or nine months ended September 30, 2018. At September 30, 2018 our inventory was $38.4 million lower as a result of ASC 606.

We have elected the following practical expedients allowed under ASC 606:

Note 10 — Segment Information

The financial results for our operating segments are prepared using a management approach, which is consistent with the basis and manner in which we internally segregate financial information for the purpose of assisting in making internal operating decisions. We evaluate the performance of our operating segments based on operating income, and generally account for intersegment sales based on arm’s length prices.  Corporate and certain other expenses are not allocated to the operating segments, except to the extent that the expense can be directly attributable to the business segment.

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Financial information for our operating segments for the quarters and nine months ended September 30, 2018 and 2017 were as follows:

Goodwill and Intangible Assets

The carrying amount of gross goodwill and intangible assets by segment is as follows:

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No impairments have been recorded against these amounts.

Note 11 — Accumulated Other Comprehensive Loss

Comprehensive income represents net income and other gains and losses affecting stockholders’ equity that are not reflected in the Consolidated Statements of Operations. The components of accumulated other comprehensive loss as of September 30, 2018 and December 31, 2017 were as follows:

The amounts reclassified to earnings from the unrecognized net defined benefit and postretirement plan costs component of accumulated other comprehensive loss for the three and nine months ended September 30, 2018, were $0.6 million less taxes of $0.2 million and $0.7 million less $0.2 million of taxes. The amounts reclassified to earnings from the change in fair value of the derivatives component of accumulated other comprehensive loss for the three and nine months ended September 30, 2018 were net losses of $0.6 million with no material tax impact, and net gains of $3.4 million less taxes of $1.2 million. The currency translation adjustments are not currently adjusted for income taxes as they relate to indefinite investments in non-U.S. subsidiaries.

Note 12 — Other Operating Income (expense)

       During the second quarter of 2018 we recorded $7.3 million in other operating income (expense) related to an environmental insurance recovery which was offset by the write-down of our investment in Carbon Conversions, Inc., as well as an additional environmental reserve related to the Lower Passaic River matter described in Note 13 below.

Note 13 — Commitments and Contingencies

We are involved in litigation, investigations and claims arising out of the normal conduct of our business, including those relating to commercial transactions, environmental, employment, and health and safety matters.  We estimate and accrue our liabilities when a loss becomes probable and estimable.  These judgments take into consideration a variety of factors, including the stage of the proceeding; potential settlement value; assessments by internal and external counsel; and assessments by environmental engineers and consultants of potential environmental liabilities and remediation costs.  Such estimates are not discounted to reflect the time value of money due to the uncertainty in estimating the timing of the expenditures, which may extend over several years.

While it is impossible to ascertain the ultimate legal and financial liability with respect to certain contingent liabilities and claims, we believe, based upon our examination of currently available information, our experience to date, and advice from legal counsel, that the individual and aggregate liabilities resulting from the ultimate resolution of these contingent matters, after taking into consideration our existing insurance coverage and amounts already provided for, will not have a material adverse impact on our consolidated results of operations, financial position or cash flows.

Environmental Matters

We are subject to various international, U.S., state and local environmental, and health and safety laws and regulations. We are also subject to liabilities arising under the Federal Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA” or “Superfund”), the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, and similar state and international laws and regulations that impose responsibility for the control, remediation and abatement of air, water and soil pollutants and the manufacturing, storage, handling and disposal of hazardous substances and waste.

We have been named as a potentially responsible party (“PRP”) with respect to several hazardous waste disposal sites that we do not own or possess, which are included on, or proposed to be included on, the Superfund National Priority List of the U.S.

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Environmental Protection Agency (“EPA”) or on equivalent lists of various state governments. Because CERCLA allows for joint and several liability in certain circumstances, we could be responsible for all remediation costs at such sites, even if we are one of many PRPs.  We believe, based on the amount and nature of our waste, our existing insurance coverage, the amounts already provided for and the number of other financially viable PRPs, that our liability in connection with such matters will not be material.

Lower Passaic River Study Area

Hexcel and a group of approximately 48 other PRPs comprise the Lower Passaic Cooperating Parties Group (the “CPG”).  Hexcel and the CPG are subject to a May 2007 Administrative Order on Consent (“AOC”) to perform a Remedial Investigation/Feasibility Study (“RI/FS”) of environmental conditions in the Lower Passaic River watershed.  We were included in the CPG based on our operations at our former manufacturing site in Lodi, New Jersey.

In March 2016, the EPA issued a Record of Decision (“ROD”) setting forth the EPA’s selected remedy for the lower eight miles of the river. The ROD calls for capping and dredging of the lower eight miles of the Passaic River, with the placement of an engineered cap over the entire eight miles, at an expected cost ranging from $0.97 billion to $2.07 billion. Because the EPA has not yet selected a remedy for the upper nine miles of the Lower Passaic River, this estimate does not include any costs related to a future remedy for the upper portion of the river. The EPA has appointed an independent third party allocation expert (the “Allocator”) to conduct a complete review of and make recommendations to the EPA on the relative liability of approximately 120 identified non-governmental PRP’s. Hexcel is cooperating in the allocation process, which is not expected to be completed until 2020. However, based on a review of the Company’s position, and as no point within the range is a more probable outcome than any other point, the Company has determined that its accrual is sufficient at this time. The accrual balance was $2.2 million as of September 30, 2018 and $2.1 million at December 31, 2017. Despite the issuance of the final ROD, and given the ongoing work of the Allocator, there continues to be many uncertainties associated with the selected remedy, the Company’s allocable share of the remediation and the amount of insurance coverage. Given those uncertainties, the amounts accrued may not be indicative of the amounts for which the Company is ultimately responsible and will be refined as events in the remediation process develop.

   Omega Chemical Corporation Superfund Site, Whittier, California

We are a PRP at a former chemical waste site in Whittier, California. The PRPs at Omega have established The Omega Chemical Site PRP Organized Group, (the “OPOG”), and are currently investigating and remediating soil and groundwater at the site pursuant to a Consent Decree with the EPA. OPOG has attributed approximately 1.07% of the waste tonnage sent to the site to Hexcel.  In addition to the Omega site specifically, the EPA is investigating the scope of regional groundwater contamination in the vicinity of the Omega site and issued a Record of Decision; the Omega PRP Group members have been served notice by the EPA as PRPs who will be required to be involved in the remediation of the regional groundwater contamination in that vicinity as well.  As a member of OPOG, Hexcel will incur costs associated with the investigation and remediation of the Omega site and the regional groundwater remedy, although our ultimate liability, if any, in connection with this matter cannot be determined at this time. The total accrued liability relating to potential liability for both the Omega site and regional groundwater remedies was $0.4 million at September 30, 2018, and $0.6 million at December 31, 2017.

Summary of Environmental Reserves

Our estimate of liability as a PRP and our remaining costs associated with our responsibility to remediate the Lower Passaic River and other sites are accrued in the consolidated balance sheets. As of September 30, 2018 and December 31, 2017, our aggregate environmental related accruals were $2.8 million, of which $0.9 million was included in accrued liabilities with the remainder included in non-current liabilities.  As related to certain environmental matters the accrual was estimated at the low end of a range of possible outcomes since no amount within the range is a better estimate than any other amount.  If we had accrued at the high end of the range of possible outcomes for those sites where we are able to estimate our liability, our accrual would have been $16 million higher.  These accruals can change significantly from period to period due to such factors as additional information on the nature or extent of contamination, the methods of remediation required, changes in the apportionment of costs among responsible parties, amount of insurance coverage, and other actions by governmental agencies or private parties, or the impact, if any, of being named in a new matter.

Environmental remediation spending charged to our reserve balance for each of the quarters ended September 30, 2018 and 2017 was $0.3 million and $0.1 million, respectively, and $0.6 million and $0.4 million for the nine months ended September 30, 2018 and September 30, 2017, respectively. In addition, our operating costs relating to environmental compliance charged to expense were $4.2 million and $2.4 million for the quarters ended September 30, 2018 and September 30, 2017, respectively, and $11.4 million and $7.1 million for the nine months ended September 30, 2018 and 2017, respectively.

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Product Warranty

We provide standard assurance-type warranties for our products, which cannot be purchased separately and do not meet the criteria to be considered a performance obligation. Warranty expense for the quarter and nine months ended September 30, 2018, and accrued warranty cost, included in “accrued liabilities” in the Condensed Consolidated Balance Sheets at September 30, 2018 and December 31, 2017, were as follows:

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Business Overview

We develop, manufacture, and market lightweight, high-performance structural materials, including carbon fibers, specialty reinforcements, prepregs and other fiber-reinforced matrix materials, honeycomb, adhesives, engineered honeycomb and composite structures, for use in Commercial Aerospace, Space & Defense and Industrial markets. Our products are used in a wide variety of end applications, such as commercial and military aircraft, space launch vehicles and satellites, wind turbine blades, automotive, recreational products and other industrial applications.

We serve international markets through manufacturing facilities, sales offices and representatives located in the Americas, Asia Pacific, Europe, Russia, India and Africa. We are also a partner in a joint venture in Malaysia, which manufactures composite structures for Commercial Aerospace applications.

We have two segments, Composite Materials and Engineered Products. The Composite Materials segment is comprised of our carbon fiber, specialty reinforcements, resins, prepregs and other fiber-reinforced matrix materials, honeycomb core product lines and pultruded profiles.  The Engineered Products segment is comprised of lightweight high strength composite structures, engineered core and specialty machined honeycomb products with added functionality.

Net sales for the quarter were $540.5 million, 10.0% greater (10.4% in constant currency) than the $491.5 million reported for the third quarter of 2017.  Year to date net sales were 10.3% higher in constant currency driven by strong growth in all markets.

Commercial Aerospace sales of $373.1 million increased 5.8% (6.1% in constant currency) for the quarter as compared to the third quarter of 2017, and increased 8.7% (8.4% in constant currency) for the nine-month period as compared to 2017.  The quarter and the nine-month period benefited from increased production rates and higher composite content on the new narrow body planes.

Sales to other commercial aerospace, which includes regional and business aircraft customers, were up 15% and approximately 30% for the third quarter and first nine months of 2018, respectively, as compared to 2017, reflecting strengthening of business jet sales following an extended period of softness.

Space & Defense sales of $90.4 million increased 9.3% (9.7% in constant currency) for the quarter as compared to the third quarter of 2017. Growth was broad-based across a number of military, rotocraft and space programs. Space & Defense sales for the first nine months of 2018 were $272.2 million, which were 8.6% higher in constant currency than the sales for the first nine months of 2017, driven by the Joint Strike Fighter program.

Total Industrial sales of $77.0 million for the third quarter of 2018 increased 37.0% (38.2% in constant currency) as compared to the third quarter of 2017. Wind energy sales are experiencing a period of substantial growth following lower sales last year as a new generation of composite blades are adopted.  Industrial sales for the first nine months of 2018 were $216.3 million or 24.0% higher in constant currency than the sales for the first nine months of 2017, as wind energy sales have increased more than 50% in constant currency. 

Gross margin for the third quarter of 2018 was 26.5% as compared to 27.6% for the third quarter of 2017, and 26.4% and 28.0% for the first nine months of 2018 and 2017, respectively. We  continued to experience headwinds related to acrylonitrile (AN), as an indirect result of increased oil prices, wind energy resins, related to pollution control measures taken in China, and tariffs. Both periods in 2018 included additional depreciation and amortization, as well as costs related to the startup of the new greenfield site in France.

Selling, general and administrative expenses for the third quarter and first nine months of 2018 were lower in constant currency than the prior year periods as we maintained tight cost control.  Research and technology expenses for the third quarter and first nine months of 2018 were about 19% and 9% higher, respectively, in constant currency than the comparable 2017 period, as we continued to invest in advance composite technology and innovation.

Operating cash flow for the first nine months of 2018 was $278.4 million compared to $308.5 million in 2017 as working capital increased resulting in a cash use of $64.6 million in 2018 as compared to a source of $4.6 million in 2017. For the first nine months of 2018, capital expenditures were $150.2 million as compared to $221.3 million in the first nine months of 2017.  Free cash flow (defined as cash provided by operating activities less capital expenditures) for the first nine months of 2018 was $128.2 million versus $87.2 million in 2017.

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Accrual basis additions to capital expenditures were $133.5 million for the first nine months of 2018 and $218.0 million in 2017. We expect accrual basis capital expenditures to be in the $170 million to $190 million range for 2018.

Financial Overview

Results of Operations