NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars, except per share amounts, and shares in thousands)
(Unaudited)
Note 1. General
Basis of Presentation
In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments necessary to present fairly the financial position of Patterson Companies, Inc. (referred to herein as "Patterson" or in the first person notations "we," "our," and "us") as of
July 29, 2017
, and our results of operations and cash flows for the periods ended
July 29, 2017
and
July 30, 2016
. Such adjustments are of a normal recurring nature. The results of operations for the periods ended
July 29, 2017
and
July 30, 2016
are not necessarily indicative of the results to be expected for the full year. These financial statements should be read in conjunction with the financial statements included in our 2017 Annual Report on Form 10-K filed on June 28, 2017.
The unaudited condensed consolidated financial statements include the assets and liabilities of PDC Funding Company, LLC ("PDC Funding") and PDC Funding Company II, LLC ("PDC Funding II"), which are our wholly owned subsidiaries and separate legal entities formed under Minnesota law. PDC Funding and PDC Funding II are fully consolidated special purpose entities established to sell customer installment sale contracts to outside financial institutions in the normal course of their business. The assets of PDC Funding and PDC Funding II would be available first and foremost to satisfy the claims of its creditors. There are no known creditors of PDC Funding or PDC Funding II.
Fiscal Year End
We operate with a 52-53 week accounting convention with our fiscal year ending on the last Saturday in April. The
first
quarter of fiscal 2018 and 2017 represents the 13 weeks ended
July 29, 2017
and the 13 weeks ended
July 30, 2016
, respectively. Fiscal 2018 will include 52 weeks and fiscal 2017 included 52 weeks.
Comprehensive Income
Comprehensive income is computed as net income including certain other items that are recorded directly to stockholders’ equity. Significant items included in comprehensive income are foreign currency translation adjustments and the effective portion of cash flow hedges, net of tax. Foreign currency translation adjustments do not include a provision for income tax because earnings from foreign operations are considered to be indefinitely reinvested outside the U.S. The income tax expense related to cash flow hedges was
$265
and
$262
for the three months ended
July 29, 2017
and
July 30, 2016
, respectively.
Earnings Per Share
The following table sets forth the computation of the weighted average shares outstanding used to calculate basic and diluted earnings per share ("EPS"):
|
|
|
|
|
|
|
|
Three Months Ended
|
|
July 29,
2017
|
|
July 30,
2016
|
Denominator for basic earnings per share – weighted average shares
|
93,350
|
|
|
95,461
|
|
Effect of dilutive securities – stock options, restricted stock and stock purchase plans
|
669
|
|
|
629
|
|
Denominator for diluted earnings per share – weighted average shares
|
94,019
|
|
|
96,090
|
|
Potentially dilutive securities representing
1,165
shares for the
three
months ended
July 29, 2017
and
1,079
shares for the
three
months ended
July 30, 2016
, were excluded from the calculation of diluted earnings per share because their effects were anti-dilutive.
Recently Issued Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, "Revenue from Contracts with Customers (Topic 606)". ASU No. 2014-09 supersedes the revenue recognition requirements in "Revenue Recognition (Topic 605)," and requires entities to recognize revenue in a way that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In July 2015, the FASB deferred the effective date of this pronouncement by one year to December 15, 2017 for annual reporting periods beginning after that date. Early adoption is permitted, but not before the original effective date, which for annual periods was December 15, 2016. Companies may use either a full retrospective or a modified retrospective approach to adopt the standard. We plan to adopt the new guidance in the first quarter of fiscal 2019 and are currently evaluating the standard, including the method we will use for adoption and the effect it will have on our financial statements. We do not expect the standard to materially affect our consolidated net earnings, financial position, or cash flows. We are currently evaluating the new standard as it relates to certain sales transactions in which products are shipped directly from the vendor to our customers. We currently report these sales on a gross basis, and are evaluating if we will be required to report these sales on a net basis. Such sales represent approximately
2%
of our consolidated net sales. Any change to net presentation would not impact gross margin or earnings.
In July 2015, the FASB issued ASU No. 2015-11, "Inventory (Topic 330), Simplifying the Measurement of Inventory." ASU 2015-11 requires inventory measured using any method other than LIFO or the retail inventory method to be subsequently measured at the lower of cost or net realizable value, rather than at the lower of cost or market. Subsequent measurement of inventory using the LIFO and retail inventory method is unchanged. During the first quarter of fiscal 2018, we adopted ASU No. 2015-11 and it had no material impact to the condensed consolidated financial statements.
In January 2016, the FASB issued ASU No. 2016-01 "Financial Instruments- Recognition and Measurement of Financial Assets and Financial Liabilities (Subtopic 825-10)", which amends certain aspects of recognition, measurement, presentation and disclosure of financial instruments, including the requirement to measure certain equity investments at fair value with changes in fair value recognized in net income. We are required to adopt the ASU No. 2016-01 in the first quarter of fiscal 2019, with early adoption permitted. We are evaluating the impact of adopting this pronouncement.
In February 2016, the FASB issued ASU No. 2016-02, "Leases (Topic 842)," which requires lessees to recognize assets and liabilities on the balance sheet for the rights and obligations created by most leases, as well as requires additional qualitative and quantitative disclosures. We are required to adopt ASU 2016-02 in the first quarter of fiscal 2020, with early adoption permitted. We are evaluating the impact of adopting this pronouncement.
Reclassifications
None.
Note 2. Customer Financing
As a convenience to our customers, we offer several different financing alternatives, including a third party program and a Patterson-sponsored program. For the third party program, we act as a facilitator between the customer and the third party financing entity with no on-going involvement in the financing transaction. Under the Patterson-sponsored program, equipment purchased by creditworthy customers may be financed up to a maximum of
$1,000
. We generally sell our customers’ financing contracts to outside financial institutions in the normal course of our business. These financing arrangements are accounted for as a sale of assets under the provisions of ASC 860,
Transfers and Servicing
. We currently have
two
arrangements under which we sell these contracts.
First, we operate under an agreement to sell a portion of our equipment finance contracts to commercial paper conduits with The Bank of Tokyo-Mitsubishi UFJ, Ltd. ("BTMU") serving as the agent. We utilize PDC Funding to fulfill a requirement of participating in the commercial paper conduit. We receive the proceeds of the contracts upon sale to BTMU. At least
9%
of the proceeds are held by the conduit as security against eventual performance of the portfolio. This percentage can be greater and is based upon certain ratios defined in the agreement with BTMU. The capacity under the agreement with BTMU at
July 29, 2017
was
$575,000
.
Second, we maintain an agreement with Fifth Third Bank ("Fifth Third") whereby the bank purchases customers’ financing contracts. PDC Funding II sells financing contracts to Fifth Third. We receive the proceeds of the contracts
upon sale to Fifth Third. At least
10%
of the proceeds are held by the conduit as security against eventual performance of the portfolio. This percentage can be greater and is based upon certain ratios defined in the agreement with Fifth Third. The capacity under the agreement with Fifth Third at
July 29, 2017
was
$100,000
.
We retain servicing responsibilities for the financing contracts under both arrangements, for which we are paid a servicing fee. The servicing fees we receive are considered adequate compensation for services rendered. Accordingly, no servicing asset or liability has been recorded.
The portion of the purchase price for the receivables held by the conduits is deemed a deferred purchase price receivable, which is paid to the applicable special purpose entity as payments on the customers’ financing contracts are collected from customers. The difference between the carrying amount of the receivables sold under these programs and the sum of the cash and fair value of the deferred purchase price receivables received at time of transfer is recognized as a gain on sale of the related receivables and recorded in net sales in the condensed consolidated statements of income and other comprehensive income. Expenses incurred related to customer financing activities were recorded in operating expenses in our condensed consolidated statements of income and other comprehensive income.
During the three months ended
July 29, 2017
and
July 30, 2016
, we sold
$56,123
and
$109,594
of contracts under these arrangements, respectively. We recorded net sales in the condensed consolidated statements of income and other comprehensive income of
$4,260
and
$10,185
during the three months ended
July 29, 2017
and
July 30, 2016
, respectively, related to these contracts sold.
Included in cash and cash equivalents in the condensed consolidated balance sheets are
$23,525
and
$17,902
as of
July 29, 2017
and
April 29, 2017
, respectively, which represent cash collected from previously sold customer financing contracts that have not yet been settled. Included in current receivables in the condensed consolidated balance sheets are
$114,532
, net of unearned income of
$0
, and
$124,098
, net of unearned income of
$940
, as of
July 29, 2017
and
April 29, 2017
, respectively, of finance contracts we have not yet sold. A total of
$592,681
of finance contracts receivable sold under the arrangements was outstanding at
July 29, 2017
. The deferred purchase price receivable under the arrangements was
$105,618
and
$119,798
as of
July 29, 2017
and
April 29, 2017
, respectively. Since the internal financing program began in 1994, bad debt write-offs have amounted to less than
1%
of the loans originated.
The arrangements require us to maintain a minimum current ratio and maximum leverage ratio. We were in compliance with those covenants at
July 29, 2017
.
Note 3. Derivative Financial Instruments
We are a party to certain offsetting and identical interest rate cap agreements entered into to fulfill certain covenants of the equipment finance contract sale agreements. The interest rate cap agreements also provide a credit enhancement feature for the financing contracts sold by PDC Funding and PDC Funding II to the commercial paper conduit.
The interest rate cap agreements are canceled and new agreements are entered into periodically to maintain consistency with the dollar maximum of the sale agreements and the maturity of the underlying financing contracts. As of
July 29, 2017
, PDC Funding had purchased an interest rate cap from a bank with a notional amount of
$575,000
and a maturity date of November 2023. We sold an identical interest rate cap to the same bank. As of
July 29, 2017
, PDC Funding II had purchased an interest rate cap from a bank with a notional amount of
$100,000
and a maturity date of July 2024. We sold an identical interest rate cap to the same bank.
These interest rate cap agreements do not qualify for hedge accounting treatment and, accordingly, we record the fair value of the agreements as an asset or liability and the change as income or expense during the period in which the change occurs.
In March 2008, we entered into
two
forward starting interest rate swap agreements, each with notional amounts of
$100,000
and accounted for as cash flow hedges, to hedge interest rate fluctuations in anticipation of the issuance of the senior notes due fiscal
2015
and fiscal
2018
. Upon issuance of the hedged debt, we settled the forward starting interest rate swap agreements and recorded a
$1,000
increase, net of income taxes, to other comprehensive income (loss), which is being amortized as a reduction to interest expense over the life of the related debt.
In January 2014, we entered into a forward interest rate swap agreement with a notional amount of
$250,000
and accounted for as cash flow hedge, to hedge interest rate fluctuations in anticipation of refinancing the
5.17%
senior
notes due
March 25, 2015
. These notes were repaid on March 25, 2015 and replaced with new
$250,000
3.48%
senior notes due
March 24, 2025
. A cash payment of
$29,003
was made in March 2015 to settle the interest rate swap. This amount is recorded in other comprehensive income (loss), net of tax, and is recognized as interest expense over the life of the related debt.
The following presents the fair value of derivative instruments included in the condensed consolidated balance sheets:
|
|
|
|
|
|
|
|
|
|
Derivative type
|
Classification
|
July 29, 2017
|
|
April 29, 2017
|
Assets:
|
|
|
|
|
Interest rate cap agreements
|
Other noncurrent assets
|
$
|
723
|
|
|
$
|
1,188
|
|
Liabilities:
|
|
|
|
|
Interest rate cap agreements
|
Other noncurrent liabilities
|
723
|
|
|
1,188
|
|
The following table presents the pre-tax effect of derivative instruments in cash flow hedging relationships on the condensed consolidated statements of income and other comprehensive income ("OCI"):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Amount of Gain (Loss) Reclassified from Accumulated Other Comprehensive Loss into Income (Effective Portion)
|
|
|
|
|
Three Months Ended
|
Derivatives in cash flow hedging relationships
|
|
Income statement location
|
|
July 29, 2017
|
|
July 30, 2016
|
Interest rate swap
|
|
Interest expense
|
|
$
|
(702
|
)
|
|
$
|
(695
|
)
|
We recorded
no
effective portion of gains or losses on derivative instruments in cash flow hedging relationships in OCI during the current period.
We recorded
no
ineffectiveness during the
three
month periods ended
July 29, 2017
and
July 30, 2016
. As of
July 29, 2017
, the estimated pre-tax portion of accumulated other comprehensive loss that is expected to be reclassified into earnings over the next twelve months is
$2,840
, which will be recorded as an increase to interest expense.
Note 4. Fair Value Measurements
Fair value is the price at which an asset could be exchanged in a current transaction between knowledgeable, willing parties. The fair value hierarchy of measurements is categorized into one of three levels based on the lowest level of significant input used:
Level 1
- Quoted prices in active markets for identical assets and liabilities at the measurement date.
Level 2
- Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3
- Unobservable inputs for which there is little or no market data available. These inputs reflect management’s assumptions of what market participants would use in pricing the asset or liability.
Our hierarchy for assets and liabilities measured at fair value on a recurring basis is as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
July 29, 2017
|
|
Total
|
|
Level 1
|
|
Level 2
|
|
Level 3
|
Assets:
|
|
|
|
|
|
|
|
Cash equivalents
|
$
|
1,901
|
|
|
$
|
1,901
|
|
|
$
|
—
|
|
|
$
|
—
|
|
Deferred purchase price receivable
|
105,618
|
|
|
—
|
|
|
—
|
|
|
105,618
|
|
Derivative instruments
|
723
|
|
|
—
|
|
|
723
|
|
|
—
|
|
Total assets
|
$
|
108,242
|
|
|
$
|
1,901
|
|
|
$
|
723
|
|
|
$
|
105,618
|
|
Liabilities:
|
|
|
|
|
|
|
|
Derivative instruments
|
$
|
723
|
|
|
$
|
—
|
|
|
$
|
723
|
|
|
$
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
April 29, 2017
|
|
Total
|
|
Level 1
|
|
Level 2
|
|
Level 3
|
Assets:
|
|
|
|
|
|
|
|
Cash equivalents
|
$
|
6,798
|
|
|
$
|
6,798
|
|
|
$
|
—
|
|
|
$
|
—
|
|
Deferred purchase price receivable
|
119,798
|
|
|
—
|
|
|
—
|
|
|
119,798
|
|
Derivative instruments
|
1,188
|
|
|
—
|
|
|
1,188
|
|
|
—
|
|
Total assets
|
$
|
127,784
|
|
|
$
|
6,798
|
|
|
$
|
1,188
|
|
|
$
|
119,798
|
|
Liabilities:
|
|
|
|
|
|
|
|
Derivative instruments
|
$
|
1,188
|
|
|
$
|
—
|
|
|
$
|
1,188
|
|
|
$
|
—
|
|
Cash equivalents
– We value cash equivalents at their current market rates. The carrying value of cash equivalents approximates fair value and maturities are less than three months.
Deferred purchase price receivable
– We value the deferred purchase price receivable based on a discounted cash flow analysis using unobservable inputs, which include a forward yield curve, the estimated timing of payments and the credit quality of the underlying creditor. Significant changes in any of the significant unobservable inputs in isolation would not result in a materially different fair value estimate. The interrelationship between these inputs is insignificant.
Derivative instruments
– Our derivative instruments consist of interest rate cap agreements and interest rate swaps. These instruments are valued using inputs such as interest rates and credit spreads.
Certain assets are measured at fair value on a non-recurring basis. These assets are not measured at fair value on an ongoing basis, but are subject to fair value adjustments under certain circumstances, such as when there is evidence of impairment. There were no fair value adjustments to such assets during the
three
month periods ended
July 29, 2017
or
July 30, 2016
.
Our debt is not measured at fair value in the condensed consolidated balance sheets. The estimated fair value of our debt as of
July 29, 2017
and
April 29, 2017
was
$1,028,626
and
$1,025,761
, respectively, as compared to a carrying value of
$1,013,211
and
$1,013,026
at
July 29, 2017
and
April 29, 2017
, respectively. The fair value of debt was measured using a discounted cash flow analysis based on expected market based yields (i.e., level 2 inputs).
The carrying amounts of receivables, net of allowances, accounts payable, and certain accrued and other current liabilities approximated fair value at
July 29, 2017
and
April 29, 2017
.
Note 5. Income Taxes
The effective income tax rate for the three months ended
July 29, 2017
was
34.6%
compared to
32.5%
for the three months ended
July 30, 2016
. The increase in the rate was primarily due to a decrease in the excess tax benefits related to share-based payments.
Note 6. Segment Reporting
We present
three
reportable segments: Dental, Animal Health and Corporate. Dental and Animal Health are strategic business units that offer similar products and services to different customer bases. Dental provides a virtually complete range of consumable dental products, equipment and software, turnkey digital solutions and value-added services to dentists, dental laboratories, institutions, and other healthcare professionals throughout North America. Animal Health is a leading, full-line distributor in North America and the U.K. of animal health products, services and technologies to both the production-animal and companion-pet markets. Our Corporate segment is comprised of general and administrative expenses, including home office support costs in areas such as information technology, finance, legal, human resources and facilities. In addition, customer financing and other miscellaneous sales are reported within Corporate results. Corporate assets consist primarily of cash and cash equivalents, accounts receivable, property and equipment and long-term receivables. We evaluate segment performance based on operating income. The costs to operate the fulfillment centers are allocated to the operating units based on the through-put of the unit.
The following table presents information about our reportable segments:
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
July 29,
2017
|
|
July 30,
2016
|
Net sales
|
|
|
|
Dental
|
$
|
518,807
|
|
|
$
|
555,015
|
|
Animal Health
|
776,136
|
|
|
762,631
|
|
Corporate
|
9,172
|
|
|
14,790
|
|
Consolidated net sales
|
$
|
1,304,115
|
|
|
$
|
1,332,436
|
|
Operating income (loss)
|
|
|
|
Dental
|
$
|
59,519
|
|
|
$
|
60,295
|
|
Animal Health
|
16,676
|
|
|
14,829
|
|
Corporate
|
(19,362
|
)
|
|
(9,708
|
)
|
Consolidated operating income
|
$
|
56,833
|
|
|
$
|
65,416
|
|
|
|
|
|
|
|
|
|
|
|
July 29,
2017
|
|
April 29,
2017
|
Total assets
|
|
|
|
Dental
|
$
|
874,097
|
|
|
$
|
863,970
|
|
Animal Health
|
2,148,244
|
|
|
2,119,512
|
|
Corporate
|
472,901
|
|
|
524,431
|
|
Total assets
|
$
|
3,495,242
|
|
|
$
|
3,507,913
|
|
The following table presents sales information by product for all of our reportable segments:
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
July 29,
2017
|
|
July 30,
2016
|
Net sales
|
|
|
|
Consumable
|
$
|
1,080,105
|
|
|
$
|
1,076,221
|
|
Equipment and software
|
136,949
|
|
|
160,946
|
|
Other
|
87,061
|
|
|
95,269
|
|
Consolidated net sales
|
$
|
1,304,115
|
|
|
$
|
1,332,436
|
|
Note 7. Accumulated Other Comprehensive Loss ("AOCL")
The following table summarizes the changes in AOCL as of
July 29, 2017
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash Flow
Hedges
|
|
Currency
Translation
Adjustment
|
|
Total
|
AOCL at April 29, 2017
|
$
|
(14,989
|
)
|
|
$
|
(77,680
|
)
|
|
$
|
(92,669
|
)
|
Other comprehensive loss before reclassifications
|
—
|
|
|
12,084
|
|
|
12,084
|
|
Amounts reclassified from AOCL
|
437
|
|
|
—
|
|
|
437
|
|
AOCL at July 29, 2017
|
$
|
(14,552
|
)
|
|
$
|
(65,596
|
)
|
|
$
|
(80,148
|
)
|
The amounts reclassified from AOCL during fiscal
2018
represent gains and losses on cash flow hedges, net of taxes of
$265
. The impact to the condensed consolidated statements of income and other comprehensive income was an increase to interest expense of
$702
.
Note 8. Legal Proceedings
In September 2015, we were served with a summons and complaint in an action commenced in the U.S. District Court for the Eastern District of New York, entitled SourceOne Dental, Inc. v. Patterson Companies, Inc., Henry Schein, Inc. and Benco Dental Supply Company, Civil Action No. 15-cv-05440-JMA-GRB. SourceOne, as plaintiff, alleges that, through its website, it markets and sells dental supplies and equipment to dentists. SourceOne alleges in the complaint, among other things, that we, along with the defendants Henry Schein and Benco, conspired to eliminate plaintiff as a competitor and to exclude them from the market for the marketing, distribution and sale of dental supplies and equipment in the U.S. and that defendants unlawfully agreed with one another to boycott dentists, manufacturers, and state dental associations that deal with, or considered dealing with, plaintiff. Plaintiff asserts the following claims: (i) unreasonable restraint of trade in violation of state and federal antitrust laws; (ii) tortious interference with prospective business relations; (iii) civil conspiracy; and (iv) aiding and abetting the other defendants’ ongoing tortious and anticompetitive conduct. Plaintiff seeks equitable relief, compensatory and treble damages, jointly and severally, punitive damages, interest, and reasonable costs and expenses, including attorneys’ fees and expert fees.
In June 2017, Henry Schein settled with SourceOne and was dismissed from this litigation with prejudice.
We are vigorously defending ourselves in this litigation. We do not anticipate that this matter will have a material adverse effect on our financial condition.
Beginning in January 2016, purported class action complaints were filed against defendants Henry Schein, Inc., Benco Dental Supply Co. and Patterson Companies, Inc. Although there were factual and legal variations among these complaints, each alleged that defendants conspired to foreclose and exclude competitors by boycotting manufacturers, state dental associations, and others that deal with defendants’ competitors. On February 9, 2016, the U.S. District Court for the Eastern District of New York ordered all of these actions, and all other actions filed thereafter asserting substantially similar claims against defendants, consolidated for pre-trial purposes. On February 26, 2016, a consolidated class action complaint was filed by Arnell Prato, D.D.S., P.L.L.C., d/b/a Down to Earth Dental, Evolution Dental Sciences, LLC, Howard M. May, DDS, P.C., Casey Nelson, D.D.S., Jim Peck, D.D.S., Bernard W. Kurek, D.M.D., Larchmont Dental Associates, P.C., and Keith Schwartz, D.M.D., P.A. (collectively, the "putative class representatives") in the U.S. District Court for the Eastern District of New York, entitled In re Dental Supplies Antitrust Litigation, Civil Action No. 1:16-CV-00696-BMC-GRB. Burkhart Dental Supply Company, Inc. was added as a defendant on October 22, 2016. Subject to certain exclusions, the putative class representatives seek to represent all persons who purchased dental supplies or equipment in the U.S. directly from any of the defendants, since August 31, 2008. In the consolidated class action complaint, putative class representatives allege a nationwide agreement among Henry Schein, Benco, Patterson and Burkhart not to compete on price. The consolidated class action complaint asserts a single count under Section 1 of the Sherman Act, and seeks equitable relief, compensatory and treble damages, jointly and severally, interest, and reasonable costs and expenses, including attorneys’ fees and expert fees. Putative class representatives have not specified a damage amount in their complaint. While the outcome of litigation is inherently uncertain, we believe the consolidated class action complaint is without merit, and we are vigorously defending ourselves in this litigation.