NOTE 10. DERIVATIVE INSTRUMENTS AND FAIR VALUE MEASUREMENTS

Derivative Instruments and Hedging Activities

As a global supplier of office products and services the Company is exposed to risks associated with changes in foreign currency exchange rates, fuel and other commodity prices and interest rates. Depending on the exposure, settlement timeframe and other factors, the Company may enter into derivative transactions to mitigate those risks. The Company may designate and account for such qualifying arrangements as hedges. Historically, the Company has not entered into transactions to hedge its net investment in foreign operations but may do so in future periods.

Financial instruments authorized under the Company’s established risk management policy include spot trades, swaps, options, caps, collars, forwards and futures. Use of derivative financial instruments for speculative purposes is expressly prohibited. The fair value and activity of derivative financial instruments were not material as of June 28, 2014 and December 28, 2013 and for the periods ended June 28, 2014 and June 29, 2013.

Financial Instruments

The Company measures fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In developing its fair value estimates, the Company uses the following hierarchy:


Level 1:		Quoted prices in active markets for identical assets or liabilities.

Level 2:		Observable market based inputs or unobservable inputs that are corroborated by market data.

Level 3:		Significant unobservable inputs that are not corroborated by market data. Generally, these fair value measures are model-based valuation techniques such as discounted cash flows or option pricing models using the Company’s own estimates and assumptions or those expected to be used by market participants.

The fair values of cash and cash equivalents, receivables, accounts payable and accrued expenses and other current liabilities approximate their carrying values because of their short-term nature.

The fair values of foreign currency contracts and fuel contracts are the amounts receivable or payable to terminate the agreements at the reporting date, taking into account current exchange rates and commodity prices. The values are based on market-based inputs or unobservable inputs that are corroborated by market data (Level 2 measure). As of June 28, 2014, the amounts receivable or payable under foreign currency and fuel contracts were not significant.

The following table presents information about financial instruments at the balance sheet dates indicated.


	June 28, 2014				December 28, 2013
(In millions)	Carrying Value		Fair Value		Carrying Value		Fair Value
Financial assets
Timber notes receivables	$	935	$	948	$	945	$	933
Financial liabilities
Recourse debt
9.75% senior secured notes		250		288		250		290
7.35% debentures, due 2016		18		19		18		19
Revenue bonds, due in varying amounts periodically through 2029		186		185		186		186
American & Foreign Power Company, Inc. 5% debentures, due 2030		13		13		13		13
Non-recourse debt	$	849	$	861	$	859	$	851

The following methods and assumptions were used to estimate the fair value of each class of financial instruments:

•

Timber notes receivable: Fair value is determined as the present value of expected future cash flows discounted at the current interest rate for loans of similar terms with comparable credit risk (Level 2 measure).

•

Recourse debt: Recourse debt for which there were no transactions on the measurement date was valued based on quoted market prices near the measurement date when available or by discounting the future cash flows of each instrument using rates based on the most recently observable trade or using rates currently offered to the Company for similar debt instruments of comparable maturities (Level 2 measure).

•

Non-recourse debt: Fair value is estimated by discounting the future cash flows of the instrument at rates currently available to the Company for similar instruments of comparable maturities (Level 2 measure).

Fair Value Estimates Used in Impairment Analyses

Because of declining sales in recent periods, the Company has conducted a detailed quarterly store impairment analysis. The analysis uses input from retail store operations and the Company’s accounting and finance personnel that organizationally report to the Chief Financial Officer. These projections are based on management’s estimates of store-level sales, gross margins, direct expenses, exercise of future lease renewal options, where applicable, and resulting cash flows and, by their nature, include judgments about how current initiatives will impact future performance. If the anticipated cash flows of a store cannot support the carrying value of its assets, the assets are impaired and written down to estimated fair value using Level 3 inputs.

The Company recognized store asset impairment charges of $10 million and $19 million, in the second quarter and first half of 2014, respectively, and $4 million and $10 million, in the second quarter and first half of 2013, respectively.

As part of the integration of the Office Depot and OfficeMax stores, the Company is implementing a new real estate strategy. This strategy anticipates closing at least 400 stores through 2016. Because the specific identity of retail locations to be closed over this timeframe is subject to change as the real estate strategy evolves, the Company applied a probability-weighted method to estimate store closures. The financial analysis used in developing this real estate strategy considered projected sales transfer to stores remaining open, the impact of fixed costs on the remaining stores, projected store closing costs, expected impacts on other sales channels and an overall market strategy. Based on the identification of locations likely to close through the probability-weighted real estate strategy, the second quarter 2014 store impairment analysis considered the projected operating cash flows consistent with these anticipated closing dates. The actual stores to close may be more, fewer or different from the current projections as market and competitive conditions change. However, at the end of the second quarter of 2014, the impairment analysis reflects the Company’s best estimate of future performance, based on the current business model.

The second quarter and first half of 2014 impairment charges were based on a discounted cash flow analyses of the retail locations that assumed a sales decline next year similar to recent experience, with negative but improving trends for later years. Gross margin and operating costs have been assumed to be consistent with recent actual results and planned activities. For the second quarter 2014 impairment analysis, 36 locations were reduced to estimated fair value of $4 million based on their projected cash flows, discounted at 13% and 95 locations were reduced to estimated salvage value of $2 million. A 100 basis point decrease in next year sales used in these estimates would have increased impairment by approximately $1 million. Independent of the sensitivity on sales assumptions, a 50 basis point decrease in next year gross margin would have increased the impairment by approximately $2 million. The interrelationship of having both of those inputs change as indicated would have resulted in impairment of approximately equal to the sum of the two individual inputs.

Other asset impairment charges for the second quarter of 2014 include $12 million following a decision to convert certain websites to a common platform. The impairment amount was determined based on a cash flow analysis over the remaining use period. The first half of 2014 also includes a $28 million charge related to the abandonment of a software implementation project in Europe and $13 million for the write off of capitalized software following certain information technology platform decisions related to the Merger.