KLDISCOVERY INC. Throughout this section, unless otherwise noted "we," "us," "our," "Company," "KLDiscovery ," "KLD", "KLDiscovery Inc. " or "LD Topco, Inc. " refer toKLDiscovery Inc. and its consolidated subsidiaries. As a result of the Business Combination, (i)KLDiscovery Inc.'s consolidated financial results for periods prior toDecember 19, 2019 reflect the financial results ofLD Topco, Inc. and its consolidated subsidiaries, as the accounting predecessor toKLDiscovery Inc. , and (ii) for periods from and after this date,KLDiscovery Inc.'s financial results reflect those ofKLDiscovery Inc. and its consolidated subsidiaries (includingLD Topco, Inc. and its subsidiaries) as the successor following the Business Combination. The following discussion and analysis of financial condition and results of operations of the Company should be read together with the financial statements and related notes included elsewhere in this Annual Report on Form 10-K. Such discussion and analysis reflects the historical results of operations and financial position of the Company. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under "Risk Factors," "Forward-Looking Statements" and elsewhere in this Annual Report on Form 10-K.
OVERVIEW
We are one of the leading eDiscovery providers and the leading data recovery services provider to corporations, law firms, government agencies and individual consumers. We provide technology-enabled services and software to help law firms, corporations, government agencies and consumers solve complex data challenges. We have broad geographical coverage in the eDiscovery and data recovery industries with more than 40 locations in 19 countries, 10 data centers and 22 data recovery labs around the globe. Our legal technology services cover both eDiscovery and information governance services to support the litigation, regulatory compliance, and internal investigation needs of our clients. We offer data collection and forensic investigation, early case assessment, electronic discovery and data processing, application software, data hosting, and managed review services. In addition, through our global Ontrack Data Recovery name, we deliver world-class data recovery, email extraction and restoration, data destruction and tape management services.
KEY COMPONENTS OF OUR RESULTS OF OPERATIONS
Data proliferation is contributing to growth in the eDiscovery and information governance market. Data is growing at an exponential rate due to several factors, including the adoption of mobile devices, accessibility of hosted systems and increased reliance on electronic data storage. We are well positioned to gain market share from the growth of electronically stored information given our prior and continued investment in our infrastructure and proprietary technologies that allows us to efficiently identify, preserve, collect, process, review and host complex data sets. We will continue to develop and enhance our technology which will position us to continue to evolve as the market changes. The eDiscovery and information governance market is highly fragmented and price competitive. While many of our competitors rely on third party software tools to provide their services, we offer our services utilizing third party platforms enhanced with our proprietary tools, as well as our own end-to-end tools. Because we can provide service offerings utilizing proprietary technology, we have more flexibility in pricing, and we are not hindered by third party licensing software expenses. As such, our proprietary tools allow us to be less impacted by significant price compression than our competitors. Historically, on-premise tools have been the dominant deployment solution in the past. However, recently the market has shifted to cloud-based solutions and this shift can result in increased revenue for us as we offer our own proprietary cloud-based solutions.
We classify our legal technology revenue as follows:
• Collections and Processing Services: We have remote and onsite collection
services. Our proprietary workflows and tools allow us to ingest, extract
native file metadata and index in a normalized format. We have near
duplication tools to quickly discard duplicative or irrelevant data,
significantly minimizing the data that needs to be reviewed. Ouranalytics include predictive coding which allows us to automatically
classify millions of documents in a matter of hours. We offer email
threading that looks at relationships between email messages to identify
the most content inclusive messages to avoid redundant review and we have
language identification that can automatically identify the primary
language in all documents in the data set. The collection of data is
billed either by the unit or hour and the data that is processed and
produced is billed by gigabyte, page or by file.
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• Forensics and Consulting Services: We provide the expertise and tools
needed to extract and analyze digital evidence to support a client's
legal matter. Our forensics experts help extract critical evidence,
recover any data that individuals may have sought to erase or hide,
retrieve key data buried in documents and organize data contained inmultiple information sources to give our client the insight and knowledge
they need. Our forensics and consulting services are billed by either
hour or unit.
• Professional Services: We manage complex eDiscovery matters and partnerwith our clients to assist thru the lifecycle of a case. Our professional
services are billed on an hourly basis.
• Managed Review Services: We use our extensive eDiscovery projectmanagement experience, technological excellence and global presence to
provide clients with a secure, seamless and cost effective managed review
solution. We assemble review teams of experienced legal professionals for
any type of case. Each team member is a qualified attorney who has passed
a selective screening process and has received training from
review manager to ensure the most efficient and defensible review of a
client's documents. Document review managers have extensive project
managed experience to oversee the entire review process and work with the
client's legal team as an integrated partner. Our industry experts have
developed advanced managed review processes and tools and deliver
services in state of the art facilities, handle subject matterversatility, are platform agnostic, possess expert working knowledge of
predictive coding and technology assisted review workflows, have
multilingual capabilities and focus on quality. Our managed review
services are billed on an hourly basis.
• Hosting: We have flexible technology options and platforms to host our
client's data for the life of the matter. We offer secure data centers
around the globe to support data across jurisdictions and privacy laws.
Hosting is billed by gigabyte
• Subscription: We offer subscription pricing options to provide cost
predictability over time. Subscriptions cover a range of our services and
are typically a fixed fee billed monthly for contract terms averaging 1
to 3 years.
We classify our data recovery revenue as follows:
• Data Recovery Services: We recover lost data from devices that store
digital information, including data centers, cloud, business servers,
workstations, laptops and mobile devices. Pricing is per device.
• PowerControls and
of data from database files and physically sound devices. Pricing is
typically an annual or multi-year agreement at a fixed price.
For the years ended December 31, 2019 and December 31, 2018 , our legal
technology revenue was $265.9 million and $250.5 million , respectively, and our
data recovery revenue was $46.2 million and $45.8 million , respectively.
Additionally, we have longstanding relationships with our clients and for the
years ended December 31, 2018 and 2019, no single client accounted for more than
5% of our revenues.
In 2018, we meaningfully increased the quality of our sales force. We incurred
approximately $15.2 million in recruiting fees, legal fees, sign on bonuses and
non-recoverable draws related to the investment in some new highly skilled
salespeople. The costs for these salespeople was included in our sales and
marketing costs for the year ended December 31, 2018 . We anticipate that revenue
generated from these salespeople will increase over the next 3 years.
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For the year ended
The results for the periods shown below should be reviewed in conjunction with
our audited consolidated financial statements included in "Item 8 - Financial
Statements and Supplementary Data."
For The Years Ended
December 31,
(in millions) 2019 2018
Revenues $ 312.1 $ 296.3
Cost of revenues 160.9 159.6
Gross profit 151.2 136.7
Operating expenses $ 148.6 161.5
Income (loss) from operations 2.6 (24.8 )
Interest expense 48.4 46.6
Loss on debt extinguishment 7.2 -
Other expense 0.3 0.0
Loss before income taxes (53.3 ) (71.4 )
Income tax provision (benefit) 0.7 (3.7 )
Net loss (54.0 ) (67.7 )
Total other comprehensive income, net of tax 0.3 (0.9 )
Comprehensive loss $ (53.7 ) $ (68.6 )
Revenues
Revenues increased by $15.8 million , or 5.3%, to $312.1 million for the year
ended December 31, 2019 as compared to $296.3 million for the year ended
December 31, 2018 . This increase is primarily due to an increase of $15.4
million in legal technology revenue and an increase of $0.4 million in data
recovery revenue. Legal technology revenue increased primarily due to increasing
revenue in 2019 related to the addition of salespeople in 2018, who brought in
new customers. Data recovery revenue increased due to a higher volume of data
recovery jobs than in the prior year.
Cost of Revenues
Cost of revenues increased by$1.3 million , or 0.8%, to$160.9 million for the year endedDecember 31, 2019 as compared to$159.6 million for the year endedDecember 31, 2018 . This increase is due to increased costs associated with increased revenues partially offset by lower amortization of acquired technologies of approximately$2.0 million due to fully amortized assets. As a percentage of revenue, our cost of revenues for the year endedDecember 31, 2019 decreased to 51.6% as compared to 53.9% for the year endedDecember 31, 2018 . This decrease as a percentage of revenue is due to lower amortization of acquired technologies due to fully amortized assets and no incremental costs associated with the additional revenue.
Gross Profit
Gross profit increased by$14.5 million , or 10.6%, to$151.2 million for the year endedDecember 31, 2019 as compared to$136.7 million for the year endedDecember 31, 2018 . Gross profit increased primarily due to the factors noted above. As a percentage of revenue, our gross profit for the year endedDecember 31, 2019 increased to 48.4% as compared to 46.1% for the year endedDecember 31, 2018 . Operating Expenses Operating expenses decreased by$12.9 million , or 8.0%, to$148.6 million for the year endedDecember 31, 2019 as compared to$161.5 million for the year endedDecember 31, 2018 . This decrease is primarily due to lower expenses of$2.4 million for depreciation and amortization due to the acquired assets being fully amortized, as well as$5.8 48 -------------------------------------------------------------------------------- million for the amortization of sign on bonuses,$2.3 million in legal fees,$2.0 million in non-recoverable draws and$1.0 million for recruiting fees, partially offset by professional fees incurred in anticipation of becoming a public company in late 2019 of$2.1 million . As a percentage of revenue, our operating expenses for the year endedDecember 31, 2019 decreased to 47.6% as compared to 54.5% for the year endedDecember 31, 2018 due to the factors noted above. Interest Expense Interest expense increased by$1.8 million , or 3.9%, to$48.4 million for the year endedDecember 31, 2019 as compared to$46.6 million for the year endedDecember 31, 2018 . This increase is primarily due to an increase in borrowings on the revolver and LIBOR rates during the year endedDecember 31, 2019 compared to the year endedDecember 31, 2018 .
Loss on Debt Extinguishment
During 2019, the Company repaid and retired its Second Lien Facility and
wrote-off deferred financing costs and debt discounts totaling
Income Tax Provision (Benefit)
A valuation allowance has been established against our net
During the years endedDecember 31, 2019 and 2018, we recorded an income tax provision (benefit) of$0.7 million and$(3.7) million , respectively, resulting in an effective tax rate of -1.3% and 5.2%, respectively. These effective tax rates differ from theU.S. federal statutory rate primarily due to the effects of foreign tax rate differences and the valuation allowance against our domestic deferred tax assets. The effective rate for the year endedDecember 31, 2019 decreased from the year endedDecember 31, 2018 primarily due to the$4.3 million tax benefit that was recorded during the year endedDecember 31, 2018 for changes in the realizability of our deferred tax assets due to indefinite lived domestic tax attributes and the impact of the TCJA as discussed below. We reported pre-tax loss of$53.3 million during the year endedDecember 31, 2019 with an effective tax rate of (1.3%), resulting in a$0.7 million income tax provision. The effective tax rate was primarily impacted by our valuation allowance, which caused a decrease in the tax benefit of$12.7 million . Without this item, our effective tax rate would have been 25.1%, which is higher than the statutory tax rate of 21.0%, primarily due to the effects of foreign tax rate differences,U.S. state taxes and certain permanent items. We reported pre-tax loss of$71.4 million during the year endedDecember 31, 2018 with an effective tax rate of 5.2%, resulting in a$3.7 million income tax benefit. The effective tax rate was primarily impacted by our valuation allowance, which caused a decrease in the tax benefit of$18.1 million . This was offset by a tax benefit of$7.7 million related to the tax impact of provisions of the Tax Cuts and Jobs Act of 2017 (the "TCJA"), due to certain indefinite lived deferred tax assets that allowed for a partial release of the valuation allowance. Without these two items, our effective tax rate would have been 19.8%, which is lower than the statutory tax rate of 21.0%, primarily due to the effects of foreign tax rate differences,U.S. state taxes and certain permanent items. Net Loss Net loss for the year endedDecember 31, 2019 was$54.0 million compared to$67.7 million for year endedDecember 31, 2018 . Net loss decreased for the year endedDecember 31, 2019 as compared to the year endedDecember 31, 2018 due to the factors noted above. 49
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Adjusted EBITDA
For The Years Ended
December 31,
(in millions) 2019 2018
Net loss $ (54.0 ) $ (67.7 )
Interest expense 48.4 46.6
Income tax (benefit) expense 0.7 (3.7 )
Depreciation and amortization expense 50.4 54.7
Loss on debt extinguishment 7.2 -
EBITDA $ 52.7 $ 29.9
Acquisition, financing and transaction costs 3.6 1.0
Strategic Initiatives:
Sign-on bonus amortization 0.4 6.2
Non-recoverable draw 3.7 5.7
Recruiting fees - 1.0
Legal fees - 2.3
Total strategic initiatives 4.1 15.2
Management fees, stock compensation and other 3.5 3.3
Restructuring costs 2.2 3.2
Systems establishment 2.6 2.0
Adjusted EBITDA $ 68.7 $ 54.6 Liquidity and Capital Resources
Our primary cash needs have been to meet debt service requirements and to fund working capital and capital expenditures. We fund these requirements from cash generated by our operations, as well as funds available under our Revolving Credit Facility (our "Revolving Credit Facility"). Although our eDiscovery solutions and information archiving services are billed on a monthly basis in arrears with amounts typically due within 30 to 45 days, the eDiscovery industry tends towards longer collectability trends. As a result, we have typically collected on the majority of our eDiscovery accounts receivables within 90 to 95 days, which is consistent within the industry. With respect to our data recovery services, they are billed as the services are provided, with payments due within 30 days of billing. We typically collect on our data recovery services accounts receivables within 30 to 45 days. Lastly, the majority of our data recovery software is billed monthly in advance with amounts typically due within 30 to 45 days; however, depending on the client contract, billing can occur annually, quarterly or monthly. We have experienced no material seasonality trends as it relates to collection on our accounts receivables. As ofDecember 31, 2019 , we had$43.4 million in cash compared to$23.4 million as ofDecember 31, 2018 . As ofDecember 31, 2019 , we had$506.0 million of outstanding borrowings compared to$448.0 million as ofDecember 31, 2018 . We expect to finance our operations over the next 12 months primarily through existing cash balances and cash flow, supplemented as necessary by funds available through our Revolving Credit Facility. OnMarch 25, 2020 , we borrowed$29.0 million under our Revolving Credit Facility. 2016 Credit Agreement The Facilities OnDecember 9, 2016 , we entered into a Credit Agreement (as amended or supplemented to date, the "2016 Credit Agreement") with a group of lenders to establish term loan facilities and a revolving line of credit for borrowings byLD Intermediate, Inc. andLD Lower Holdings, Inc. (the "Initial Term Loans"). The Initial Term Loan borrowings of$340.0 million (the "First Lien Facility") and$125.0 million (the "Second Lien Facility" and, together with the First Lien Facility, the "Facilities") were to mature onDecember 9, 2022 andDecember 9, 2023 , respectively. The Second Lien Facility was repaid onDecember 19, 2019 . 50 -------------------------------------------------------------------------------- The First Lien Facility established a term loan principal payment schedule with payments due on the last day of each calendar quarter, beginning onMarch 31, 2017 with a payment of$2.1 million . Quarterly principal payments increased to$4.3 million beginning onMarch 31, 2019 with a balloon payment of$259.3 million due at maturity. The interest rate for the First Lien Facility adjusts every interest rate period, which can be one, two, three or six months in duration and is decided by us, or to the extent consented to by all Appropriate Lenders (as defined in the 2016 Credit Agreement), 12 months thereafter. Interest payment dates include the last day of each interest period and any maturity dates of the facility; however, if any interest period exceeds three months, the respective dates that fall every three months after the beginning of an interest period is also an interest payment date. For each interest period, the interest rate per annum is 5.875% plus the Adjusted Eurocurrency Rate which is defined as an amount equal to the Statutory Reserve Rate (as defined in the 2016 Credit Agreement) multiplied by the greatest of (a) LIBOR, (b) 0.00% per annum and (c) solely with respect to the Initial Term Loans, 1.00% per annum. As ofDecember 31, 2019 , the balance due was$314.5 million , with an interest rate of 5.875% plus an Adjusted Eurocurrency Rate of 2.596%. AtDecember 31, 2018 ,$323.0 million was outstanding under the First Lien Facility, with an interest rate of 5.875% plus an Adjusted Eurocurrency Rate of 2.61463%. The Second Lien Facility required a balloon payment of$125.0 million due at maturity. The interest rate for the Second Lien Facility adjusted every interest rate period, which could be one, two, three or six months in duration and is decided by the Company, or to the extent consented to by all Appropriate Lenders (as defined in the 2016 Credit Agreement), 12 months thereafter. Interest payment dates included the last day of each interest period and any maturity dates of the facility; however, if any interest period exceeds three months, the respective dates that fall every three months after the beginning of an interest period was also an interest payment date. For each interest period, the interest rate per annum is 10.0% plus the Adjusted Eurocurrency Rate which was defined as an amount equal to the Statutory Reserve Rate multiplied by the greatest of (a) LIBOR, (b) 0.00% per annum and (c) solely with respect to the Initial Term Loans, 1.00% per annum. AtDecember 31, 2018 ,$125.0 million was outstanding under the Second Lien Facility with an interest rate of 10.00% plus an Adjusted Eurocurrency Rate of 2.61463%. The Second Lien Facility was repaid upon consummation of the Business Combination onDecember 19, 2019 .
The Facilities are secured by substantially all of our assets and contain
certain covenants. As of
The 2016 Credit Agreement includes a mandatory prepayment within ten days after delivery of the annual audited financial statements commencing with the year endedDecember 31, 2017 . The Excess Cash Flow amount is specifically defined in section 1.01 of the 2016 Credit Agreement. The Excess Cash Flow calculation starts with net income and then adds back a series of non-cash expenses, capital expenditures, M&A, and debt related amounts to arrive at a final amount due. The amount of the Excess Cash Flow payment is reduced if the FirstLien Net Leverage Ratio falls below certain thresholds. Such percentage in respect of any Excess Cash Flow Period shall be reduced to 50%, 25% or 0% if the FirstLien Net Leverage Ratio as of the last day of the year to which such Excess Cash Flow Period relates was equal to or less than 3.75 to 1.00, 3.25 to 1.00 or 2.75 to 1.00, respectively. We were not required to make any additional principal payments under the Excess Cash Flow covenant for the year endedDecember 31, 2018 orDecember 31, 2019 and do not anticipate making any additional principal payments under the Excess Cash Flow covenant for the year endedDecember 31, 2020 .
Revolving Credit Facility
The 2016 Credit Agreement also provides for a Revolving Credit Facility of up to$30.0 million that maturesDecember 9, 2021 . Borrowings under the Revolving Credit Facility may be subject to meeting certain financial covenants set forth in the 2016 Credit Agreement, including the First Lien Net Leverage Ratio. We may draw up to$30.0 million under the Revolving Credit Facility, on a term loan basis, with either an adjustable eurocurrency loan interest rate of 5.375%, 5.625%, or 5.875% with interest rates based on the First Lien Net Leverage Ratio plus an amount equal to the LIBOR, or a base rate loan interest rate of 4.375%, 4.635%, or 4.875% plus the Base Rate. As ofDecember 31, 2019 and 2018, we had no amounts outstanding under our Revolving Credit Facility and$0.9 million in letters of credit were issued with approximately$29.1 million of available borrowing capacity under the Revolving Credit Facility. 51 -------------------------------------------------------------------------------- The Initial Term Loan borrowings pursuant to the 2016 Credit Agreement were issued at an original issue discount of$11.9 million and$6.3 million for the First Lien Facility and Second Lien Facility, respectively. The original issue discount is amortized using the effective yield method over the respective term of each Facility. We incurred closing fees in connection with the entry into the Facilities and the Revolving Credit Facility pursuant to the 2016 Credit Agreement of$13.6 million . These closing fees were deferred onDecember 9, 2016 , along with fees of$0.6 million related to our prior term loan facility that we refinanced in connection with our entry into the 2016 Credit Agreement, and are amortized over their respective terms. We are always evaluating opportunities for a more advantageous indebtedness structure, which may include a refinancing or replacement of our Facilities and/or our Revolving Credit Facility.
Convertible Debenture Notes
In connection with the Business Combination onDecember 19, 2019 , we issued$200 million aggregate principal amount Debentures due 2024 in a private placement to certain "accredited investors" pursuant to an exemption from registration under Section 4(a)(2) of the Securities Act. The equity structure as of the date of the Business Combination included 2,097,974 shares of common stock and 1,764,719 warrants for the issuance of common stocks to the debenture holders related to the Debenture issuance. The proceeds of the Debentures were in part to repay our outstanding Second Lien Facility and amounts outstanding under the Revolving Credit Facility. The Debentures will mature onDecember 19, 2024 unless earlier converted, redeemed or repurchased. The Debentures will bear interest at an annual rate of 4.00% in cash and 4.00% in kind, payable quarterly on the last business day of March, June, September and December. In addition, on each anniversary of the Closing Date, we will add to the principal amount (subject to reduction for any principal amount repaid) of the Debentures an amount equal to 3.00% of the original aggregate principal amount of the Debentures outstanding, which will accrue from the last payment and will be payable at maturity, upon conversion or upon an optional redemption, if no prior payment was made. At any time, upon notice as set forth in the Debentures, the Debentures will be redeemable at our option, in whole or in part, at a price equal to 100% of the principal amount of the Debentures redeemed, plus accrued and unpaid interest thereon. Subject to approval to allow for the full conversion of the Debentures into common stock, the Debentures will be convertible into shares of our common stock at the option of the debenture holders at any time and from time to time at a price of$18 per share, subject to certain adjustments. However, in the event we elect to redeem any Debentures, the holders will have a right to purchase common stock from us in an amount equal to the amount redeemed at the conversion price. The Debentures contain covenants that limit our ability to, among other things: (i) incur additional debt; (ii) create liens on assets; (iii) engage in certain transactions with affiliates; or (iv) designate our subsidiaries as unrestricted subsidiaries. The Debentures provide for customary events of default, including non-payment, failure to comply with covenants or other agreements in the Debentures and certain events of bankruptcy or insolvency. If an event of default occurs and continues, the holders of at least 25% in aggregate principal amount of the outstanding Debentures may declare the entire principal amount of all the Debentures to be due and payable immediately.
Our net cash flows from operating, investing and financing activities for the
years ended
2019 2018
Net cash provided by (used in):
Operating activities $ (8,297 ) $ (11,942 )
Investing activities $ (15,218 ) $ (12,387 )
Financing activities $ 43,490 $ 29,030
Effect of foreign exchange rates $ (7 ) $ (158 )
Net increase in cash $ 19,968 $ 4,543
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Cash Flows Used in Operating Activities
Net cash used in operating activities was$8.3 million for the year endedDecember 31, 2019 as compared to net cash used in operating activities of$11.9 million for the year endedDecember 31, 2018 . The decrease in net cash used is due to a$13.7 million reduction in net loss, as well as a$11.6 million increase in non-cash expenses, offset by a$21.7 million decrease in working capital. The period over period decrease in non-cash items is primarily due to a$7.2 million increase in loss on extinguishment of debt, a$0.7 million increase in non-cash interest, a$6.9 million decrease in deferred tax benefit and an increase in the provision for losses on accounts receivable of$0.9 million , offset by a$4.3 million decrease in depreciation and amortization. The decrease in working capital for the period is primarily due to a$10.5 million decrease in accounts payable and accrued expenses, a$7.5 million increase in prepaid expense and other current assets and a$4.6 million increase in accounts receivable, offset by a$0.9 million increase in deferred revenue. Trade accounts receivable fluctuate from period to period depending on the period to period change in revenue and the timing of collections. Accounts payable fluctuate from period to period depending on the timing of purchases and payments.
Cash Flows Used in Investing Activities
Net cash used in investing activities was$15.2 million for the year endedDecember 31, 2019 as compared to net cash used in investing activities of$12.4 million for the year endedDecember 31, 2018 . The increase in cash used is due to increased purchases of property and equipment and cash payments related to acquisitions in 2019.
Cash Flows Provided by Financing Activities
For the year endedDecember 31, 2019 , net cash provided by financing activities of$43.5 million related to the net cash received in the Business Combination of$186.5 million and cash received on the issuance of common stock of$0.4 million , offset by payments of long-term debt of$142.0 million and capital lease obligations of$1.4 million . For the year endedDecember 31, 2018 , net cash provided by financing activities of$29.0 million related primarily to$40.5 million from the issuance of common stock offset by payments on long-term debt of$8.5 million , payments on capital lease obligations of$0.5 million and payments of$2.4 million for contingent consideration.
Contractual Obligations
Our operating lease obligations are disclosed below and in Note 5 to our audited consolidated financial statements included in "Item 8 - Financial Statements and Supplementary Data." Rent expense for the years endedDecember 31, 2019 and 2018 was$14.7 million and$13.0 million , respectively. The following table summarizes our contractual obligations as ofDecember 31, 2019 : Payments due by period Less than 1 to less 3 to less More than (in thousands) Total 1 year than 3 years than 5 years 5 years Contractual obligations Debt: Principal (1)$ 583,287 $ 17,000 $ 289,000 $ 277,287 $ - Interest on debt (2) 216,225 51,572 104,367 60,286 - Purchase obligations 10,777 3,514 6,198 1,065 - Capital leases 5,239 1,586 2,932 721 - Operating leases 44,014 12,057 15,530 10,985 5,442
Total contractual obligations
(1) Includes in kind interest in the Debentures.
(2) Assumed interest rates on our First Lien Facility and Debentures were
7.93% and 11.78%, respectively, as of December 31, 2019 .
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Off-Balance Sheet Financing Arrangements
We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities or purchased any nonfinancial assets.
Recent Accounting Pronouncements
See Note 1 to our consolidated financial statements included in "Item 8 - Financial Statements and Supplementary Data" for a summary of accounting standards not yet adopted.
Critical Accounting Policies and Estimates
We prepare our consolidated financial statements in accordance withU.S. GAAP. In applying accounting principles, it is often required to use estimates. These estimates consider the facts, circumstances and information available, and may be based on subjective inputs, assumptions and information known and unknown to us. Material changes in certain of the estimates that we use could potentially affect, by a material amount, our consolidated financial position and results of operations. Although results may vary, we believe our estimates are reasonable and appropriate. See Note 1 to our consolidated financial statements included in "Item 8 - Financial Statements and Supplementary Data" for a summary of our significant accounting policies. The following describes certain of our significant accounting policies that involve more subjective and complex judgments where the effect on our consolidated financial position and operating performance could be material.
Business combinations
We recognize all of the assets acquired, liabilities assumed, contractual contingencies and contingent consideration at their fair value on the acquisition date. Acquisition-related costs are recognized separately from the acquisition and expensed as incurred. Restructuring costs incurred in periods subsequent to the acquisition date are expensed when incurred. Subsequent changes to the purchase price, such as working capital adjustments, or other fair value adjustments determined during the measurement period are recorded as an adjustment to goodwill, with the exception of contingent consideration, which is recognized in the statement of operations in the period it is modified. All subsequent changes to a valuation allowance or uncertain tax position that relate to the acquired company and existed at the acquisition date that occur both within the measurement period and as a result of facts and circumstances that existed at the acquisition date are recognized as an adjustment to goodwill. All other changes in valuation allowances are recognized as a reduction or increase to income tax expense or as a direct adjustment to additional paid-in capital as required.
Intangible assets and other long-lived assets
We evaluate the recoverability of our long-lived assets, including finite-lived
intangible assets, for impairment whenever events or changes in circumstances
indicate that the carrying amount of such assets may not be recoverable.
Recoverability of assets to be held and used is measured by a comparison of the
carrying amount of any asset to future net undiscounted cash flows expected to
be generated by the asset. If such assets are considered to be impaired, the
impairment to be recognized is measured as the difference between the fair value
of the asset compared to its carrying amount.
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--------------------------------------------------------------------------------Goodwill represents the excess of the total consideration paid over our identified intangible and tangible assets and our acquisitions. We test our goodwill for impairment at the reporting unit level on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. As of the testing date (October 1 ), we have determined there is one entity-wide reporting unit.
We test goodwill resulting from acquisitions for impairment annually on
Goodwill impairment exists when the estimated fair value of the reporting unit is less than its carrying value. If impairment exists, the carrying value of the goodwill is reduced by the excess through an impairment charge recorded in our statements of operations. The process of evaluating the potential impairment of goodwill is subjective and requires significant judgment at many points during the analysis. The fair value of each reporting unit is estimated using a combination of a discounted cash flow ("DCF") analysis and market-based valuation methodologies such as comparable public company trading values and values observed in recent business combinations. Determining fair value requires the exercise of significant judgments, including the amount and timing of expected future cash flows, long-term growth rates, discount rates and relevant comparable public company earnings multiples and relevant transaction multiples. The cash flows employed in the DCF analyses are based on our best estimate of future sales, earnings and cash flows after considering factors such as general market conditions, changes in working capital, long term business plans and recent operating performance. The carrying value of each reporting unit includes the assets and liabilities employed in its operations and goodwill. Accordingly, we have not identified any indicators of impairment, nor have any impairment charges been recorded related to goodwill as a result of the annual impairment test. Income Taxes
Our annual tax rate is based on our income, statutory tax rates, and tax planning opportunities available in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax expense and in evaluating our tax positions.
Tax law requires certain items to be included in our tax returns at different times than when the items are reflected in the financial statements. The annual tax expense reflected in the Consolidated Statements of Income is different than that reported in our tax returns. Some of these differences are permanent (for example, expenses recorded for accounting purposes that are not deductible in the returns such as certain entertainment expenses) and some differences are temporary and reverse over time, such as depreciation expense. Temporary differences create deferred tax assets and liabilities. Deferred tax liabilities generally represent tax expense recognized in the financial statements for which payment has been deferred, or expense for which a deduction has been taken already in the tax return, but the expense has not yet been recognized in the financial statements. Deferred tax assets generally represent items that can be used as a tax deduction or credit in tax returns in future years for which a benefit has already been recorded in the financial statements, as well as tax losses that can be carried over and used in future years. Valuation allowances are established when necessary to reduce deferred income tax assets to the amounts we believe are more likely than not to be recovered. In evaluating the amount of any such valuation allowance, we consider the existence of cumulative income or losses in recent years, the reversal of existing temporary differences, the existence of taxable income in prior carry back years, available tax planning strategies and estimates of future taxable income for each of our taxable jurisdictions. The latter two factors involve the exercise of significant judgment. As ofDecember 31, 2019 , deferred tax asset valuation allowances totaled$51.9 million , primarily related to federal and state net operating losses available to carry forward to future years and, interest expense disallowance carryovers. Although realization is not assured, we believe it is more likely than not that all other deferred tax assets for which no valuation allowances have been established will be realized. This conclusion is based on our expectation that the reversal of existing taxable temporary differences will provide a source of taxable income to realize these deferred tax assets. 55
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We determine whether it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit is recorded in our financial statements. A tax position is measured as the portion of the tax benefit that is greater than 50% likely to be realized upon settlement with a taxing authority (that has full knowledge of all relevant information). We may be required to change our provision for income taxes when the ultimate treatment of certain items is challenged or agreed to by taxing authorities, when estimates used in determining valuation allowances on deferred tax assets significantly change, or when receipt of new information indicates the need for adjustment in valuation allowances. Future events, such as changes in tax laws, tax regulations, or interpretations of such laws or regulations, could have an impact on the provision for income tax and the effective tax rate. Any such changes could significantly affect the amounts reported in the consolidated financial statements in the year these changes occur.
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