Red Lobster 2014 Annual Report Download - page 39

Notes to Consolidated Financial Statements
Darden
2014 Annual Report 37
NOTE 10
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
We use financial and commodities derivatives to manage interest rate,
equity-based compensation and commodities pricing and foreign currency
exchange rate risks inherent in our business operations. By using these
instruments, we expose ourselves, from time to time, to credit risk and market
risk. Credit risk is the failure of the counterparty to perform under the terms
of the derivative contract. When the fair value of a derivative contract is posi-
tive, the counterparty owes us, which creates credit risk for us. We minimize
this credit risk by entering into transactions with high-quality counterparties.
We currently do not have any provisions in our agreements with counterparties
that would require either party to hold or post collateral in the event that the
market value of the related derivative instrument exceeds a certain limit. As
such, the maximum amount of loss due to counterparty credit risk we would
incur at May 25, 2014, if counterparties to the derivative instruments failed
completely to perform, would approximate the values of derivative instruments
currently recognized as assets on our consolidated balance sheet. Market
risk is the adverse effect on the value of a financial instrument that results
from a change in interest rates, commodity prices, or the market price
of our common stock. We minimize this market risk by establishing and
monitoring parameters that limit the types and degree of market risk that
may be undertaken.
The notional values of our derivative contracts are as follows:
May 25, May 26,
(in millions) 2014 2013
Derivative contracts designated as
hedging instruments:
Commodities $ 0.9 $ 18.2
Foreign currency 0.3 20.3
Interest rate swaps 200.0 100.0
Equity forwards 20.6 24.9
Derivative contracts not designated as
hedging instruments:
Equity forwards $ 47.4 $ 49.1
Commodities – 0.6
We periodically enter into commodity futures, swaps and option contracts
(collectively, commodity contracts) to reduce the risk of variability in cash
flows associated with fluctuations in the price we pay for natural gas, diesel
fuel and butter. For certain of our commodity purchases, changes in the price
we pay for these commodities are highly correlated with changes in the
market price of these commodities. For these commodity purchases, we
designate commodity contracts as cash flow hedging instruments. For the
remaining commodity purchases, changes in the price we pay for these
commodities are not highly correlated with changes in the market price,
generally due to the timing of when changes in the market prices are
reflected in the price we pay. For these commodity purchases, we utilize
commodity contracts as economic hedges. Our commodity contracts
extended through May 2014.
We periodically enter into foreign currency forward contracts to reduce
the risk of fluctuations in exchange rates specifically related to forecasted
transactions or payments made in a foreign currency either for commodities
and items used directly in our restaurants or for forecasted payments of ser-
vices. Our foreign currency forward contracts extended through May 2014.
We are currently party to interest-rate swap agreements with
$200.0 million of notional value to limit the risk of changes in fair value of a
portion of the $400.0 million 4.500 percent senior notes due October 2021
and a portion of the $500.0 million 6.200 percent senior notes due October
2017. The swap agreements effectively swap the fixed-rate obligations for
floating-rate obligations, thereby mitigating changes in fair value of the
related debt prior to maturity. The swap agreements were designated as fair
value hedges of the related debt and met the requirements to be accounted
for under the short-cut method, resulting in no ineffectiveness in the hedging
relationship. During fiscal 2014, 2013 and 2012, $2.9 million, $3.0 million
and $3.3 million, respectively, was recorded as a reduction to interest
expense related to net swap settlements.
We enter into equity forward contracts to hedge the risk of changes in
future cash flows associated with the unvested, unrecognized Darden stock
units. The equity forward contracts will be settled at the end of the vesting
periods of their underlying Darden stock units, which range between four
and five years. The contracts were initially designated as cash flow hedges to
the extent the Darden stock units are unvested and, therefore, unrecognized
as a liability in our financial statements. As of May 25, 2014, we were party
to equity forward contracts that were indexed to 1.2 million shares of our
common stock, at varying forward rates between $31.19 per share and
$52.66 per share, extending through August 2018. The forward contracts can
only be net settled in cash. As the Darden stock units vest, we will de-designate
that portion of the equity forward contract that no longer qualifies for hedge
accounting and changes in fair value associated with that portion of the
equity forward contract will be recognized in current earnings. We periodically
incur interest on the notional value of the contracts and receive dividends on
the underlying shares. These amounts are recognized currently in earnings
as they are incurred or received.
We entered into equity forward contracts to hedge the risk of changes
in future cash flows associated with recognized, cash-settled performance
stock units and employee-directed investments in Darden stock within the
non-qualified deferred compensation plan. The equity forward contracts are
indexed to 0.3 million shares of our common stock at forward rates between
$46.17 and $51.95 per share, can only be net settled in cash and expire
between fiscal 2015 and 2019. We did not elect hedge accounting with the
expectation that changes in the fair value of the equity forward contracts
would offset changes in the fair value of the performance stock units and
Darden stock investments in the non-qualified deferred compensation plan
within selling, general and administrative expenses in our consolidated
statements of earnings.