NOTE 16. 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. 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 Company may designate and account for such qualifying arrangements as hedges. As of December 27, 2014, the foreign exchange contracts extend through March 2015 and fuel contracts extended through January 2016.

The fair values of the Company’s foreign currency contracts and fuel contracts are the amounts receivable or payable to terminate the agreements at the reporting date, taking into account current interest rates, exchange rates and commodity prices. The values are based on market-based inputs or unobservable inputs that are corroborated by market data. At December 27, 2014, Accrued expenses and other liabilities in the Consolidated Balance Sheet includes $6 million related to derivative fuel contracts payable.

Financial Instruments

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


	2014				2013
(In millions)	Carrying Value		Fair Value		Carrying Value		Fair Value
Financial assets:
Timber notes receivables	$	926	$	930	$	945	$	933
Boise investment		—		—		46		47
Financial liabilities:
Recourse debt:
9.75% Senior Secured Notes		250		280		250		290
7.35% debentures, due 2016		18		18		18		19
Revenue bonds, due in varying amounts periodically through 2029		186		185		186		186
American & Foreign Power Company, Inc. 5% debentures, due 2030		14		13		13		13
Non-recourse debt		839		845		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).

•

Boise Investment: Fair value at December 28, 2013 was calculated as the sum of the market value of the Company’s indirect investment in Boise Cascade, the primary investment of Boise Cascade Holdings, plus the Company’s portion of any cash held by Boise Cascade Holdings as of the balance sheet date (together, Level 2 measure). The Company’s indirect investment in Boise Cascade was calculated using the number of shares the Company indirectly held in Boise Cascade multiplied by its closing stock price as of the last trading day prior to the balance sheet date. The investment in Boise Cascade Holdings was fully disposed of in 2014. Refer to Note 6 for further details.

•

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

All impairment charges discussed in the sections below are presented in Asset impairments in the Consolidated Statements of Operations.

Retail Stores

Because of declining sales in recent periods and adoption of the Real Estate Strategy in 2014, 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 Level 3 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 measure. The Company recognized store asset impairment charges of $25 million, $26 million, and $124 million in 2014, 2013, and 2012, respectively.

Following the Merger, the asset group tested for impairment included the retail store operating assets, as well as any favorable lease intangible asset. The impairment results of this analysis are addressed in the following paragraph for the operating assets and in the Intangible Assets, Software and Definite-lived intangible assets sections, respectively.

The 2014 analysis incorporated the probability assessment of which stores will be closed through 2016, as well as projected cash flows through the base lease period for stores identified for ongoing operations. The projections assumed flat sales for one year, decreasing thereafter. Gross margin assumptions have been held constant at current actual levels and operating costs have been assumed to be consistent with recent actual results and planned activities. For the fourth quarter 2014 impairment analysis, identified locations were reduced to estimated fair value of $1 million based on their projected cash flows, discounted at 13% or estimated salvage value of $2 million, as appropriate. The Company continues to capitalize additions to previously-impaired operating stores and tests for subsequent impairment. A 100 basis point decrease in next year sales combined with a 50 basis point decrease in next year gross margin would have increased the impairment by approximately $1 million. Further, a 100 basis point decrease in sales for all future periods would increase the impairment by approximately $1 million. The 2014 store impairment charge also includes $1 million related to the closure of stores in Canada.

The store impairment analysis for 2013 projected sales declines for several years, then stabilizing. Gross margin and operating cost assumptions were consistent with actual results and planned activities. For the 2013 impairment analysis, identified locations were reduced to estimated fair value of $10 million based on their projected cash flows, discounted at 13% or estimated salvage value of $7 million, as appropriate.

A review of the North American Retail portfolio during 2012 concluded with a plan for each location to maintain its current configuration, downsize to either small or mid-size format, relocate, remodel, renew or close at the end of the base lease term. The asset impairment analysis previously had assumed at least one optional lease renewal. Additionally, projected sales trends included in the impairment calculation model in prior periods were reduced. These changes, and continued store performance, served as a basis for the Company’s asset impairment review for 2012.

The Company will continue to evaluate initiatives to improve performance and lower operating costs. To the extent that forward-looking sales and operating assumptions are not achieved and are subsequently reduced, or in certain circumstances, even if store performance is as anticipated, additional impairment charges may result. However, at the end of 2014, the impairment analysis reflects the Company’s best estimate of future performance.

Intangible Assets

Indefinite-lived intangible assets — During 2014, the Company reassessed its use of a private brand trade name used internationally, that previously had been assigned an indefinite life. The expected change in profile and life of this brand, along with assigning an estimated life of three years, resulted in an impairment charge of $5 million. This charge is not included in determination of Division operating income. The estimated fair value was calculated based on a discounted relief from royalty method using Level 3 inputs.

Goodwill associated with the Merger has been allocated to the reporting units for the purposes of the annual goodwill impairment test. The estimated fair value of each reporting unit exceeds its carrying value at the test date. The reporting unit of Australia and New Zealand, which was not combined with any existing Office Depot businesses, has an estimated fair value approximately 10% above its carrying value. Goodwill in that reporting unit is $15 million. The estimated fair value of this reporting unit includes projected cash outflows related to certain restructuring activities. Should these restructuring activities not result in the anticipated future period benefits, or if there is a downturn in performance, a potential future goodwill impairment could result. However, the Company believes, based on these projections, that there are no current indicators of impairment in this reporting unit. The estimated fair values of the other reporting units, which were combined with existing Office Depot businesses, were substantially in excess of their carrying values.

As of December 29, 2012, goodwill of $45 million (at then-current exchange rates) was included in the International Division in a reporting unit comprised of wholly-owned operating subsidiaries in Europe and ownership of the joint venture operating in Mexico. The total estimated fair value of the reporting unit exceeded its carrying value by approximately 30%, however, a substantial majority of that excess value was associated with the joint venture. In 2013, when the reporting unit sold its investment in the joint venture and distributed essentially all of the after tax proceeds to its U.S. parent, the fair value fell below its carrying value. Because the investment was accounted for under the equity method, no goodwill was allocated to the gain on disposition of joint venture calculation. However, concurrent with the sale and gain recognition, a goodwill impairment charge of $44 million was recognized.

Software and Definite-lived intangible assets — Asset impairment charges for 2014 include $12 million resulting from a decision to convert certain websites to a common platform, $28 million related to the abandonment of a software implementation project in Europe, and $13 million write off of capitalized software following certain information technology platform decisions related to the Merger.

Following identification of retail stores for closure as part of the Real Estate Strategy, the related favorable lease assets were assessed for accelerated amortization or impairment. Considerations included the Level 3 projected cash flows discussed above, the net book value of operating assets and favorable lease assets, and likely sublease over the option period after closure or return of property to landlords. Impairment of $5 million was recognized during 2014.

During 2011, the Company acquired an office supply company in Sweden to supplement the existing business in that market. As a result of slowing economic conditions in Sweden after the acquisition, difficulties in the consolidation of multiple distribution centers and the adoption of new warehousing systems which impacted customer service and delayed or undermined planned marketing activities, the Company re-evaluated remaining balances of acquisition-related intangible assets of customer relationships and short-lived trade name values. Cash flows related to these acquired customer relationships with the updated Level 3 inputs were projected to be negative, then recovering, but were insufficient to recover the intangible assets’ remaining carrying values. Accordingly, an impairment charge of approximately $14 million was recognized during the third quarter of 2012.

Fair Value Estimates Used for Paid-in-Kind Dividends

Prior to redemption of the Company’s Redeemable Preferred Stock in 2013, any dividends paid-in-kind were measured at fair value, using a Level 3 measure. The Company used a binomial simulation to capture the call, conversion, and interest rate reset features as well the optionality of paying the dividend in-kind or in cash. Dividends were paid in kind for the first three quarters of 2012.

For dividends paid-in-kind for the three quarters of 2012, the average stock price volatility was 63%, the risk free rate was 3.0% and the risk adjusted rate was 14.5%. The aggregate fair value calculated for these three quarters was $22.8 million, $6.3 million below the amount added to the liquidation preference. For the dividend paid-in-kind for the third quarter of 2012, a stock price volatility of 55% or 75% would have increased the estimate by $0.7 million or decreased the estimate by $0.6 million, respectively. Using a beginning of period stock price of $1.50 or $3.50 would have decreased the estimate by $1.7 million or increased the estimate by $1.1 million, respectively. Assuming that all future dividends would be paid in cash would have increased the estimate by $1.3 million. Assuming all future dividends would be paid-in-kind had no significant impact. Refer to Note 11 for additional information.

There were no significant differences between the carrying values and fair values of the Company’s financial instruments as of December 27, 2014 and December 28, 2013, except as disclosed above.