Derivative Instruments and Hedging Activities

12 Months Ended

Oct. 25, 2015

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Instruments and Hedging Activities

Derivative Instruments and Hedging Activities

Derivative Financial Instruments

Applied conducts business in a number of foreign countries, with certain transactions denominated in local currencies, such as the Japanese yen, euro, Israeli shekel and Taiwanese dollar. Applied uses derivative financial instruments, such as forward exchange contracts and currency option contracts, to hedge certain forecasted foreign currency denominated transactions expected to occur typically within the next 24 months. The purpose of Applied’s foreign currency management is to mitigate the effect of exchange rate fluctuations on certain foreign currency denominated revenues, costs and eventual cash flows. The terms of currency instruments used for hedging purposes are generally consistent with the timing of the transactions being hedged.

During fiscal 2015, Applied entered into and settled a series of forward-starting interest rate swap agreements, with a total notional amount of $600 million, to hedge against the variability of cash flows due to changes in the benchmark interest rate of fixed rate debt. These instruments were designated as cash flow hedges at inception and settled in conjunction with the issuance of debt in the fourth quarter of fiscal 2015. The loss from the settlement of the interest rate swap agreement was $20 million, which was included in accumulated other comprehensive income (AOCI) in stockholders' equity and will be amortized to interest expense over the term of the senior unsecured 10-year notes issued in September 2015.

Applied does not use derivative financial instruments for trading or speculative purposes. Derivative instruments and hedging activities, including foreign currency exchange contracts and interest rate swap agreements, are recognized on the balance sheet at fair value. Changes in the fair value of derivatives that do not qualify for hedge treatment, as well as the ineffective portion of any hedges, are recognized currently in earnings. All of Applied’s derivative financial instruments are recorded at their fair value in other current assets or in accounts payable and accrued expenses.

Hedges related to anticipated transactions are designated and documented at the inception of the hedge as cash flow hedges and foreign exchange derivatives are typically entered into once per month. Cash flow hedges are evaluated for effectiveness quarterly. The effective portion of the gain or loss on these hedges is reported as a component of AOCI in stockholders’ equity and is reclassified into earnings when the hedged transaction affects earnings. The majority of the after-tax net income or loss related to foreign exchange derivative instruments included in AOCI at October 25, 2015 is expected to be reclassified into earnings within 12 months. Changes in the fair value of currency forward exchange and option contracts due to changes in time value are excluded from the assessment of effectiveness. Both ineffective hedge amounts and hedge components excluded from the assessment of effectiveness are recognized in earnings. If the transaction being hedged is no longer probable to occur, or if a portion of any derivative is deemed to be ineffective, Applied promptly recognizes the gain or loss on the associated financial instrument in earnings. The amount recognized due to discontinuance of cash flow hedges that were probable not to occur by the end of the originally specified time period was not significant for fiscal 2015, 2014 or 2013.

Additionally, forward exchange contracts are generally used to hedge certain foreign currency denominated assets or liabilities. These derivatives are typically entered into once per month and are not designated for hedge accounting treatment. Accordingly, changes in the fair value of these hedges are recorded in earnings to offset the changes in the fair value of the assets or liabilities being hedged.

Following the announcement of the proposed business combination with Tokyo Electron Limited (TEL) in September 2013, Applied purchased foreign exchange option contracts to limit its foreign exchange risk associated with the proposed business combination. The derivatives used to hedge currency exposure did not qualify for hedge accounting treatment. These derivatives were marked to market at the end of each reporting period with gains and losses recorded as part of operating expenses. During fiscal 2014, the derivatives purchased in fiscal 2013 were sold, and the Company recorded gains of $42 million. Concurrently, during the fourth quarter of fiscal 2014, the Company purchased new foreign exchange option contracts for the same purpose with an extended maturity. At October 26, 2014, the fair value of these foreign exchange option contracts was approximately $52 million and Applied recognized an unrealized loss of $12 million during fiscal 2014 related to these contracts. Due to the termination of the proposed business combination with TEL on April 26, 2015, these foreign exchange option contracts were sold during the third quarter of fiscal 2015. Applied recorded a gain of $89 million in fiscal 2015 related to these contracts. The cash flow impacts of these derivatives have been classified as operating cash flows in the Consolidated Statements of Cash Flows. To further mitigate credit exposure in connection with these foreign exchange option contracts, the Company entered into security arrangements with certain counterparties, which require the counterparties to post collateral amounting to the approximate fair value of the derivative contracts. The cash collateral was included in cash and cash equivalents in the Consolidated Balance Sheets, with the corresponding liability included in accounts payable and accrued expenses as of October 26, 2014. The requirement to provide cash collateral was canceled following the settlement of the foreign exchange option contracts during fiscal 2015.

Other than the foreign exchange option contracts discussed in the preceding paragraph, the fair values of other foreign exchange derivative instruments at October 25, 2015 and October 26, 2014 were not material.

The effects of derivative instruments on the Consolidated Statements of Operations for each fiscal year were as follows:

		Effective Portion						Ineffective Portion and Amount Excluded from Effectiveness Testing
Derivatives in Cash Flow Hedging Relationships	Location of Gain or (Loss) Reclassified from AOCI into Income	Gain or (Loss) Recognized in AOCI			Gain or (Loss) Reclassified from AOCI into Income			Gain or (Loss) Recognized in Income
		(In millions)
2015
Foreign exchange contracts	Cost of products sold	$	6		$	15		$	(4	)
Foreign exchange contracts	General and administrative	—			(6		)	(2		)
Interest rate swaps	Interest expense	(20		)	—			—
Total		$	(14	)	$	9		$	(6	)
2014
Foreign exchange contracts	Cost of products sold	$	7		$	8		$	(2	)
Foreign exchange contracts	General and administrative	—			1			(2		)
Total		$	7		$	9		$	(4	)
2013
Foreign exchange contracts	Cost of products sold	$	29		$	21		$	(3	)
Foreign exchange contracts	General and administrative	—			7			(1		)
Total		$	29		$	28		$	(4	)

		Amount of Gain or (Loss)  Recognized in Income
Derivatives Not Designated as Hedging Instruments	Location of Gain or (Loss) Recognized in Income	2015		2014		2013
		(In millions)
Foreign exchange contracts	Gain (loss) on derivatives associated with terminated business combination	$	89	$	30	$	(7	)
Foreign exchange contracts	General and administrative	21		19		26
Total		$	110	$	49	$	19

Credit Risk Contingent Features

If Applied’s credit rating were to fall below investment grade, it would be in violation of credit risk contingent provisions of the derivative instruments discussed above, and certain counterparties to the derivative instruments could request immediate payment on derivative instruments in net liability positions. The aggregate fair value of all derivative instruments with credit-risk related contingent features that were in a net liability position was immaterial as of October 25, 2015 and October 26, 2014.

Entering into derivative contracts with banks exposes Applied to credit-related losses in the event of the banks’ nonperformance. However, Applied’s exposure is not considered significant.