ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help you understand Cantel Medical Corp. (“Cantel”). The MD&A is provided as a supplement to and should be read in conjunction with our financial statements and the accompanying notes. Our MD&A includes the following sections:
Overview
provides a brief description of our business and a summary of significant activity that has affected or may affect our results of operations and financial condition.
Results of Operations
provides a discussion of the consolidated results of operations for the three and six months ended January 31, 2014 compared with the three and six months ended January 31, 2013.
Liquidity and Capital Resources
provides an overview of our working capital, cash flows, contractual obligations, financing and foreign currency activities.
Critical Accounting Policies
provides a discussion of our accounting policies that require critical judgments, assumptions and estimates.
Forward-Looking Statements
provides a discussion of cautionary factors that may affect future results.
Overview
Cantel is a leading provider of infection prevention and control products and services in the healthcare market, specializing in the following operating segments:
·
Endoscopy
: Medical device reprocessing systems, disinfectants, detergents and other supplies used to high-level disinfect flexible endoscopes. This segment also offers disposable infection control products intended to eliminate the challenges associated with proper cleaning and high-level disinfection of numerous reusable components used in gastrointestinal endoscopy procedures. Additionally, this segment includes technical maintenance service on its products.
·
Water Purification and Filtration
: Water purification equipment and services, filtration and separation products, and disinfectants for the medical, pharmaceutical, biotech, beverage and commercial industrial markets. In addition, our therapeutic filtration business and chemistries business, formerly included in our Other reporting segment, have been integrated with our Water Purification and Filtration segment for both operating and reporting purposes. Therapeutic filtration includes hollow fiber membrane filtration and separation technologies for medical applications. Chemistries include certain sterilants, disinfectants and decontamination services used in various applications for infection prevention and control.
·
Healthcare Disposables
: Single-use, infection prevention and control products used principally in the dental market including face masks, sterilization pouches, towels and bibs, tray covers, saliva ejectors, germicidal wipes, plastic cups and disinfectants. This segment also manufactures and provides biological and chemical indicators for sterility assurance monitoring services in the acute-care, alternate-care and dental markets.
·
Dialysis
: Medical device reprocessing systems, sterilants/disinfectants, dialysate concentrates and other supplies for renal dialysis.
·
Specialty Packaging
: Specialty packaging and thermal control products, as well as related
35
compliance training, for the transport of infectious and biological specimens and thermally sensitive pharmaceutical, medical and other products. (The Specialty Packaging operating segment is reported in the Other reporting segment.)
Most of our equipment, consumables and supplies are used to help prevent or control the occurrence or spread of infections.
See our Annual Report on Form 10-K for the fiscal year ended July 31, 2013 (the “2013 Form 10-K”) and our Condensed Consolidated Financial Statements for additional financial information regarding our reporting segments.
Significant Activity
(i)
For the three and six months ended January 31, 2014 compared with the three and six months ended January 31, 2013, net sales increased by 11.9% and 15.2%, respectively, and net income increased 6.4% and 11.4%, respectively. We continue to benefit from having a broad portfolio of infection prevention and control products sold into diverse business segments, where approximately 73% of our net sales are attributable to consumable products and service. The primary factors that contributed to this financial performance, as further described elsewhere in this MD&A, were as follows:
·
improved sales and profitability in our Water Purification and Filtration segment primarily relating to (i) higher sales of our capital equipment, consumables and service in the dialysis industry mainly attributable to the increased overall demand driven by both the growing number of dialysis patients and clinics in the United States, as well as our new product introductions such as our heat sanitized water purification systems, which carry higher average selling prices than the systems with the traditional non-heated sanitization technology, and the acquisition of the dialysis water business from Siemens Industry, Inc. and Siemens Canada Limited (collectively, “Siemens”), and (ii) increased demand for our water purification equipment used for commercial and industrial (large capital) applications,
·
with respect to the six months ended January 31, 2014, higher sales and improved gross profit percentage in our Healthcare Disposables segment, primarily due to (i) the November 1, 2012 acquisition of SPS Medical Supply Corp. and (ii) increased demand for our sterility assurance and disinfectant products,
·
higher sales and improved gross profit percentage in our Endoscopy segment principally due to a shift of product mix to higher margin products including increases in sales volume of (i) endoscope reprocessing disinfectant, service and filter products as a result of the increased field population of equipment and (ii) disposable infection control products used in gastrointestinal endoscopy procedures primarily as a result of new product introductions, and
·
the prior year inclusion of $778,000 in costs for personnel changes relating to severance and recruiting a Chief Operating Officer during the three months ended January 31, 2013.
36
The above factors were partially offset by:
·
favorable fair value adjustments of contingent consideration and a price floor financial instrument recorded in general and administrative expenses in our Endoscopy segment that were more favorable in the prior periods compared with the current periods resulting in an unfavorable net change of $1,909,000 and $2,178,000 for the three and six months ended January 31, 2014, respectively, as further described in Note 6 to the Condensed Consolidated Financial Statements,
·
our strategic decision to invest in sales and marketing initiatives in our three largest segments and corporate internal and external resources designed to expand into new markets and gain or maintain market share while also addressing new compliance requirements,
·
the recording within cost of sales of $936,000 and $1,892,000 for the three and six months ended January 31, 2014, respectively, in medical device excise tax as part of the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010, which became effective January 2013 and therefore resulted in only $322,000 for the month of January being recorded in the three and six months ended January 31, 2013,
·
decreases in sales volume of certain therapeutic filters in our Water Purification and Filtration segment as sales of these filters were elevated in prior periods due to a market shortage as a result of damage done from an earthquake to the manufacturing facilities of a large competitor,
·
decreases in net sales and profitability in our Dialysis operating segment, as further described below,
·
an increase in bad debt expense primarily associated with a single customer, and
·
the inclusion of the initial operating expenses, as well as acquisition costs, in our Endoscopy segment relating to the November 5, 2013 acquisition of Jet Prep Ltd., as more fully described in Note 3 to the Condensed Consolidated Financial Statements.
(ii)
We sell our dialysis products to a concentrated number of customers. Sales in our Dialysis segment were adversely impacted by the decrease in demand for our sterilants, RENATRON
®
reprocessing equipment and dialysate concentrate products, as more fully described elsewhere in this MD&A. This reduction in dialysis sales has reduced overall profitability in this segment as compared with profitability in prior periods. Our market for dialysis reprocessing products is limited to dialysis centers that reuse dialyzers, which market has been decreasing in the United States despite the environmental advantages and our belief that the per-procedure cost of reuse dialyzers is more economical than single-use dialyzers. A material decrease in the market for reprocessing products is likely to result in a significant loss of net sales and a lower level of profitability in this segment in the
37
future. See “Risk Factors” in the 2013 Form 10-K.
(iii)
In March 2010, the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 was signed into law. The legislation imposed a significant new tax on medical device makers in the form of an excise tax on certain U.S. medical device sales beginning in January 2013. Since a significant portion of our sales are considered medical device sales under this new legislation, our gross profit percentage is being adversely affected beginning in January 2013, as more fully described elsewhere in this MD&A.
(iv)
On March 4, 2014, we entered into a $250,000,000 Third Amended and Restated Credit Agreement with our senior lenders to refinance our working capital credit facilities, as more fully described in Note 9 to the Condensed Consolidated Financial Statements.
(v)
On January 7, 2014, Crosstex’ subsidiary acquired all the issued and outstanding stock of Sterilator Company, Inc. (the “Sterilator Business” or “Sterilator Acquisition”), as more fully described in Note 3 to the Condensed Consolidated Financial Statements.
(vi)
On November 5, 2013, our Medivators B.V. subsidiary acquired all the issued and outstanding stock of Jet Prep Ltd. (the “Jet Prep Business” or “Jet Prep Acquisition”), as more fully described in Note 3 to the Condensed Consolidated Financial Statements. Certain components of the acquisition’s purchase price were recorded at fair value and will be continually remeasured at each balance sheet date, which has the potential for creating earnings volatility in the future as further described elsewhere in this MD&A and in Notes 3 and 6 to the Condensed Consolidated Financial Statements.
(vii)
On March 22, 2013, our Mar Cor subsidiary entered into an agreement to acquire from Siemens certain net assets of Siemens’ hemodialysis water business (the “Siemens Water Business” or the “Siemens Water Acquisition”), as more fully described in Note 3 to the Condensed Consolidated Financial Statements.
(viii)
On December 31, 2012, our Mar Cor subsidiary acquired certain net assets of Eagle Pure Water Systems, Inc. (the “Eagle Pure Water Business” or the “Eagle Pure Water Acquisition”), as more fully described in Note 3 to the Condensed Consolidated Financial Statements.
(ix)
On November 1, 2012, our Crosstex subsidiary acquired all the issued and outstanding stock of SPS Medical Supply Corp. (the “SPS Business” or “SPS Medical”), as more fully described in Note 3 to the Condensed Consolidated Financial Statements.
(x)
On October 16, 2013, our Board of Directors approved a 22% increase in the semiannual cash dividend to $0.045 per share of outstanding common stock, which was paid on January 31, 2014 to shareholders of record on January 17, 2014, as more fully described elsewhere in this MD&A.
(xi)
The Company issued 15,044,000 additional shares of common stock in connection
38
with a three-for-two stock split effected in the form of a 50% stock dividend paid on July 12, 2013 to stockholders of record July 1, 2013.
Results of Operations
The results of operations described below reflect the operating results of Cantel and its wholly-owned subsidiaries.
Since the acquisitions of the Sterilator Business and the Jet Prep Business were consummated on January 7, 2014 and November 5, 2013, respectively, their results of operations are included in our consolidated results of operations for the portion of the three and six months ended January 31, 2014 subsequent to their acquisition dates and are not included in our results of operations for the three and six months ended January 31, 2013. However, their results of operations had an insignificant effect on our consolidated results of operations due to the small size of these businesses.
On March 22, 2013, Mar Cor entered into an agreement to acquire the Siemens Water Business by gradually assigning and transitioning customer service agreements to Mar Cor. The majority of such contracts were transitioned as of July 30, 2013, the deemed acquisition date. Consequently, the results of operations of the Siemens Water Business are included in our results of operations for the three and six months ended January 31, 2014 and are not included in our results of operations for the three and six months ended January 31, 2013.
Since the acquisitions of the SPS Business and the Eagle Pure Water Business were consummated on November 1, 2012 and December 31, 2012, respectively, their results of operations are included in the three and six months ended January 31, 2014 and are included in our results of operations for the three and six months ended January 31, 2013 subsequent to their acquisition dates. The results of operations of the Eagle Pure Water Business had an insignificant effect on our consolidated results of operations due to its small size.
During the fourth quarter of fiscal 2013, we changed our internal reporting processes by combining our Therapeutic Filtration and Chemistries operating segments, previously reported in the Other reporting segment, with our Water Purification and Filtration reporting segment to reflect the way the Company, through its executive management, manages, allocates resources and measures the performance of its businesses. All periods presented have been recast to reflect these changes.
The following discussion should also be read in conjunction with our 2013 Form 10-K.
39
The following table gives information as to the net sales and the percentage to the total net sales for each of our reporting segments:
|
|
|
Three Months Ended
|
|
Six Months Ended
|
|
|
|
|
January 31,
|
|
January 31,
|
|
|
|
|
2014
|
|
2013
|
|
2014
|
|
2013
|
|
|
|
|
(Dollar amounts in thousands)
|
|
(Dollar amounts in thousands)
|
|
|
|
|
$
|
|
%
|
|
$
|
|
%
|
|
$
|
|
%
|
|
$
|
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Endoscopy
|
|
$
|
44,587
|
|
37.4
|
|
$
|
39,422
|
|
37.1
|
|
$
|
88,200
|
|
37.2
|
|
$
|
76,101
|
|
36.9
|
|
|
Water Purification and Filtration
|
|
40,719
|
|
34.2
|
|
32,369
|
|
30.4
|
|
80,469
|
|
33.9
|
|
65,530
|
|
31.8
|
|
|
Healthcare Disposables
|
|
24,716
|
|
20.8
|
|
24,339
|
|
22.9
|
|
50,965
|
|
21.4
|
|
44,294
|
|
21.5
|
|
|
Dialysis
|
|
7,611
|
|
6.4
|
|
8,760
|
|
8.2
|
|
14,920
|
|
6.3
|
|
16,947
|
|
8.2
|
|
|
Other
|
|
1,409
|
|
1.2
|
|
1,473
|
|
1.4
|
|
2,760
|
|
1.2
|
|
3,172
|
|
1.6
|
|
|
|
|
$
|
119,042
|
|
100.0
|
|
$
|
106,363
|
|
100.0
|
|
$
|
237,314
|
|
100.0
|
|
$
|
206,044
|
|
100.0
|
|
Net Sales
Net sales increased by $12,679,000, or 11.9%, to $119,042,000 for the three months ended January 31, 2014 from $106,363,000 for the three months ended January 31, 2013.
Net sales increased by $31,270,000, or 15.2%, to $237,314,000 for the six months ended January 31, 2014 from $206,044,000 for the six months ended January 31, 2013.
The increase in net sales for the three and six months ended January 31, 2014 was primarily attributable to increases in sales in our Water Purification and Filtration and Endoscopy segments, as well as our Healthcare Disposables segment with respect to the six months ended January 31, 2014.
Net sales of water purification and filtration products and services increased by $8,350,000, or 25.8%, and $14,939,000, or 22.8%, for the three and six months ended January 31, 2014, respectively, compared with the three and six months ended January 31, 2013, primarily due to (i) increased demand for our water purification capital equipment, consumables and service in the dialysis industry mainly attributable to the increased overall demand driven by both the growing number of dialysis patients and clinics in the United States, as well as our new product introductions such as our heat sanitized water purification systems, which have higher average selling prices than the systems with the traditional non-heated sanitization technology, and the Siemens Water Acquisition, (ii) price increases on certain water purification and filtration products, which were implemented to partially offset increasing costs and (iii) increased demand for our water purification equipment used for commercial and industrial (large capital) applications. These increases were partially offset by a decrease in sales volume of our hemoconcentrator products (filter devices used to concentrate red blood cells and remove excess fluid from the bloodstream during open-heart surgery) for the six months ended January 31, 2014 due to elevated demand in the prior year as a result of a market shortage of these filters due to damage done from an earthquake to the manufacturing facilities of a large competitor, which were subsequently repaired.
Net sales of endoscopy products and services increased by $5,165,000, or 13.1%, and $12,099,000, or 15.9%, for the three and six months ended January 31, 2014, respectively, compared with the three and six months ended January 31, 2013, primarily due to increases in demand in the United States and internationally for (i) our disinfectants, service, filters and
40
equipment accessories due to the increase in the installed base of endoscope reprocessing equipment and (ii) our new product introductions of valves, kits and hybrid tubing procedural products (disposable infection control products used in gastrointestinal endoscopy procedures). We expect sales of disinfectants, service, filters and equipment accessories, which carry higher margins, to continue to benefit as we increase the installed base of endoscope reprocessing equipment. These increases were partially offset by overall lower selling prices principally related to procedural products as a result of our strategic growth plan as well as increased competition.
Net sales of healthcare disposables products increased by $377,000, or 1.5%, and $6,671,000, or 15.1%, for the three and six months ended January 31, 2014, respectively, compared with the three and six months ended January 31, 2013, principally due to (i) the inclusion of only three months of net sales of the SPS Business in the six months ended January 31, 2013 as a result of acquiring the SPS Business on November 1, 2012, (ii) increases in customer demand in the United States and internationally for our sterility assurance and disinfectant products and (iii) price increases on certain healthcare disposables products, which were implemented to partially offset increased costs.
Net sales of dialysis products and services decreased by $1,149,000, or 13.1%, and $2,027,000, or 12.0%, for the three and six months ended January 31, 2014, respectively, compared with the three and six months ended January 31, 2013, primarily due to decreases in demand in the United States (including a decrease from our largest dialysis customer, DaVita, Inc. (“DaVita”)) for our sterilants, RENATRON
®
dialyzer reprocessing equipment and dialysate concentrate product (a concentrated acid or bicarbonate used to prepare dialysate, a chemical solution that draws waste products from a patient’s blood through a dialyzer membrane during hemodialysis treatment). Our market for dialysis reprocessing products is limited to dialysis centers that reuse dialyzers, which market has been decreasing in the United States despite the environmental advantages and our belief that the per-procedure cost of reuse dialyzers is more economical than single-use dialyzers. The shift from reusable to single-use dialyzers is principally due to the lowering cost of single-use dialyzers, the ease of using a dialyzer one time, and the commitment of Fresenius Medical Care, the largest dialysis provider chain in the United States and a manufacturer of single-use dialyzers, to convert dialysis clinics performing reuse to single-use facilities. In addition, DaVita has been evaluating the economics and other factors associated with single-use versus reuse on a regional basis. This evaluation has resulted in the conversion by DaVita of certain clinics from reuse to single-use and in many cases the opening of new clinics as single-use clinics. A material decrease in the market for reprocessing products is likely to result in a significant loss of net sales and a lower level of profitability and operating cash flow in this segment in the future as well as potential future impairments of long-lived assets. Additionally, our Dialysis segment is highly dependent upon DaVita as a customer and any further shift by this customer away from reuse would have a material adverse effect on our Dialysis segment net sales.
Gross profit
Gross profit increased by $7,184,000, or 15.9%, to $52,335,000 for the three months ended January 31, 2014 from $45,151,000 for the three months ended January 31, 2013. Gross profit as a percentage of net sales for the three months ended January 31, 2014 and 2013 was 44.0% and 42.4%, respectively.
Gross profit increased by $14,956,000, or 16.8%, to $103,834,000 for the six months ended January 31, 2014 from $88,878,000 for the six months ended January 31, 2013. Gross profit as a percentage of net sales for the six months ended January 31, 2014 and 2013 was 43.8% and
41
43.1%, respectively.
The higher gross profit as a percentage of net sales for the three and six months ended January 31, 2014 compared with the three and six months ended January 31, 2013 was primarily due to (i) more favorable sales mix in our three largest segments primarily due to increases in sales volume of certain products that carry higher gross margin percentages than each segment’s prior year overall gross profit percentages such as our sterilants and certain equipment products in our Water Purification and Filtration segment, disinfectants and procedural products in our Endoscopy segment, and sterility assurance and disinfectant products (including sales of products relating to the November 1, 2012 SPS Acquisition) in our Healthcare Disposables segment as well as the decrease in sales volume in certain low margin products in our Dialysis segment and (ii) the inclusion in the three and six months ended January 31, 2013 of $417,000 in severance related charges as part of the prior year cost reduction initiatives and a $177,000 one-time acquisition accounting charge relating to the acquired inventory in the November 1, 2012 acquisition of the SPS Business. These items were partially offset by (i) lower selling prices of certain products primarily in our Endoscopy segment as a result of our strategic growth plan and increased competition and (ii) the incremental impact of $614,000 and $1,570,000 for the three and six months ended January 31, 2014, compared with the three and six months ended January 31, 2013, for a new excise tax on qualified U.S. medical device sales beginning January 2013.
In March 2010, the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 was signed into law. The legislation imposes a significant new tax on medical device makers in the form of an excise tax on all U.S. medical device sales beginning in January 2013. Since a significant portion of our sales are considered medical device sales under this new legislation, we began recording the excise tax in cost of sales in January 2013 thereby adversely affecting our gross profit percentage. Although we have implemented cost reductions and revenue enhancement initiatives to partially offset this new excise tax, we cannot provide any assurances that we will be successful in further reducing the impact of this tax on our business. Additionally, other elements of this legislation could meaningfully change the way health care is developed and delivered and may materially impact numerous aspects of our business in the future. See “Risk Factors” in the 2013 Form 10-K.
Furthermore, we cannot provide assurances that our gross profit percentage will not be adversely affected in the future (i) by uncertainties associated with our product mix, (ii) by further price competition in certain of our segments such as Healthcare Disposables (due to a more competitive environment as well as competition from products manufactured in lower cost locations, as explained below), Endoscopy (primarily due to our growth strategy and increased competition) and Dialysis (relating to the market shift from reusable to single-use dialyzers as explained above) or (iii) if raw materials and distribution costs increase and we are unable to implement further price increases. Some of our competitors manufacture certain healthcare disposable products in lower cost locations such as China, Southeast Asia and certain locations within North America due to lower overall costs despite expensive shipping costs, quality concerns, sustainability issues and other matters. Although we believe the quality of our healthcare disposable products, which are generally produced in the United States, are superior, we may experience significant pricing pressure that would adversely affect our gross profit or level of sales in the future in our Healthcare Disposables segment as a result of lower cost competition from products produced in other geographic locations.
42
Operating Expenses
Selling expenses increased by $2,354,000, or 17.2%, to $16,077,000 for the three months ended January 31, 2014 from $13,723,000 for the three months ended January 31, 2013. For the six months ended January 31, 2014, selling expenses increased by $4,705,000, or 17.3%, to $31,841,000 from $27,136,000 for the six months ended January 31, 2013. For the three and six months ended January 31, 2014, these increases were primarily due to (i) increased sales and marketing initiatives to expand into new markets, including international markets, and gain or maintain market share by hiring additional sales and marketing personnel and increasing travel budgets primarily in our Endoscopy segment and to a lesser extent our Water Purification and Filtration segment and increased marketing and advertising in our Healthcare Disposable segment, (ii) the inclusion of only three months of sales and marketing expenses of the SPS Business in the six months ended January 31, 2013 as a result of acquiring the SPS Business on November 1, 2012, (iii) increases in annual salaries and stock-based compensation and (iv) higher commission expense for the six months ended January 31, 2014 principally in our Endoscopy segment as a result of higher sales.
Selling expenses as a percentage of net sales were 13.5% and 12.9% for the three months ended January 31, 2014 and 2013, respectively, and 13.4% and 13.2% for the six months ended January 31, 2014 and 2013, respectively.
General and administrative expenses increased by $3,175,000, or 25.6%, to $15,557,000 for the three months ended January 31, 2014, from $12,382,000 for the three months ended January 31, 2013. For the six months ended January 31, 2014, general and administrative expenses increased by $6,291,000, or 25.8%, to $30,721,000 from $24,430,000 for the six months ended January 31, 2013. For the three and six months ended January 31, 2014, these increases were primarily due to (i) an unfavorable net change of $1,909,000 and $2,178,000, respectively, in our Endoscopy segment due to favorable fair value adjustments of contingent consideration and a price floor financial instrument that were more favorable in the prior periods compared with the current periods, as more fully described in Note 6 to the Condensed Consolidated Financial Statements, (ii) hiring additional personnel as part of our strategic growth initiative as well as to address new compliance requirements, (iii) the inclusion of only three months of general administrative expenses of the SPS Business in the six months ended January 31, 2013 as a result of acquiring the SPS Business on November 1, 2012, (iv) an increase of $329,000 and $657,000, respectively, in bad debt expense, the majority of which relates to a single customer, (v) increases in annual salaries and stock-based compensation, and (vi) an increase of $234,000 and $331,000, respectively, of acquisition related expenses associated with our acquisition program.
General and administrative expenses as a percentage of net sales were 13.1% and 11.6% for the three months ended January 31, 2014 and 2013, respectively, and 12.9% and 11.9% for the six months ended January 31, 2014 and 2013, respectively.
Research and development expenses (which include continuing engineering costs) increased by $309,000 to $2,492,000 for the three months ended January 31, 2014 from $2,183,000 for the three months ended January 31, 2013. For the six months ended January 31, 2014, research and development expenses increased by $274,000 to $4,751,000, from $4,477,000 for the six months ended January 31, 2013. The increase for the three and six months ended January 31, 2014 was primarily due to the inclusion of research and development costs relating to the Jet Prep Acquisition.
43
Operating Income by Segment
The following table gives information as to the amount of operating income, as well as operating income as a percentage of net sales, for each of our reporting segments.
|
|
|
Three Months Ended
|
|
Six Months Ended
|
|
|
|
|
January 31,
|
|
January 31,
|
|
|
|
|
2014
|
|
2013
|
|
2014
|
|
2013
|
|
|
|
|
(Dollar amounts in thousands)
|
|
(Dollar amounts in thousands)
|
|
|
|
|
Operating
|
|
% of
|
|
Operating
|
|
% of
|
|
Operating
|
|
% of
|
|
Operating
|
|
% of
|
|
|
|
|
Income
|
|
Net sales
|
|
Income
|
|
Net sales
|
|
Income
|
|
Net sales
|
|
Income
|
|
Net sales
|
|
|
Endoscopy
|
|
$
|
8,218
|
|
18.4
|
%
|
$
|
9,469
|
|
24.0
|
%
|
$
|
16,402
|
|
18.6
|
%
|
$
|
17,145
|
|
22.5
|
%
|
|
Water Purification and Filtration
|
|
7,108
|
|
17.5
|
%
|
3,719
|
|
11.5
|
%
|
13,165
|
|
16.4
|
%
|
8,346
|
|
12.7
|
%
|
|
Healthcare Disposables
|
|
4,563
|
|
18.5
|
%
|
4,709
|
|
19.3
|
%
|
10,282
|
|
20.2
|
%
|
8,800
|
|
19.9
|
%
|
|
Dialysis
|
|
1,996
|
|
26.2
|
%
|
2,312
|
|
26.4
|
%
|
3,760
|
|
25.2
|
%
|
4,488
|
|
26.5
|
%
|
|
Other
|
|
231
|
|
16.4
|
%
|
125
|
|
8.5
|
%
|
236
|
|
8.6
|
%
|
338
|
|
10.7
|
%
|
|
Operating income
|
|
22,116
|
|
18.6
|
%
|
20,334
|
|
19.1
|
%
|
43,845
|
|
18.5
|
%
|
39,117
|
|
19.0
|
%
|
|
General corporate expenses
|
|
(3,907
|
)
|
|
|
(3,471
|
)
|
|
|
(7,324
|
)
|
|
|
(6,282
|
)
|
|
|
|
Income before interest and income taxes
|
|
$
|
18,209
|
|
15.3
|
%
|
$
|
16,863
|
|
15.9
|
%
|
$
|
36,521
|
|
15.4
|
%
|
$
|
32,835
|
|
15.9
|
%
|
The Endoscopy segment’s operating income decreased by $1,251,000, or 13.2%, and $743,000, or 4.3%, for the three and six months ended January 31, 2014, respectively, compared with the three and six months ended January 31, 2013, primarily due to (i) an unfavorable net change of $1,909,000 and $2,178,000, respectively, in our Endoscopy segment due to favorable fair value adjustments of contingent consideration and a price floor financial instrument that were more favorable in the prior periods compared with the current periods, as more fully described in Note 6 to the Condensed Consolidated Financial Statements, (ii) lower selling prices of certain endoscopy products, (iii) the recording of medical device excise taxes beginning in January 2013, (iv) increased investment in our sales team and other selling initiatives, (v) an increase in bad debt expense primarily associated with a single customer, (vi) the inclusion of the initial operating expenses relating to the November 5, 2013 acquisition of the Jet Prep Business and (vii) increases in annual salaries and stock-based compensation. These items were partially offset by higher sales and improved gross profit percentage principally due to a shift of product mix to higher margin products, as further explained above, and the prior year inclusion of severance related charges in the three months ended January 31, 2013 as part of the prior year cost reduction initiatives.
The Water Purification and Filtration segment’s operating income increased by $3,389,000, or 91.1%, and $4,819,000, or 57.7%, for the three and six months ended January 31, 2014, respectively, compared with the three and six months ended January 31, 2013, primarily due to increased demand for our water purification capital equipment, consumables and service in the dialysis industry and our water purification equipment used for commercial and industrial (large capital) applications and improved gross profit percentage, partially offset by lower sales volume of hemoconcentrator products, as further explained above. Additionally, operating income was adversely affected by increases in annual salaries and stock-based compensation, the inclusion of an excise tax on qualified U.S. medical device sales beginning January 2013, the hiring of additional sales personnel and an increase in warranty expense per unit relating to certain water purification capital equipment.
44
The Healthcare Disposables segment’s operating income decreased by $146,000, or 3.1%, for the three months ended January 31, 2014, compared with the three months ended January 31, 2013, primarily due to (i) the inclusion of an excise tax on qualified U.S. medical device sales beginning January 2013, (ii) increases in marketing and advertising expense and (iii) increases in annual salaries and stock-based compensation, partially offset by (i) an increase in sales of $377,000, (ii) the prior year inclusion of a $177,000 one-time acquisition accounting charge recorded in the three months ended January 31, 2013 relating to the acquired inventory in the SPS Acquisition and (iii) an improved gross profit percentage, as further explained above.
The Healthcare Disposables segment’s operating income increased by $1,482,000, or 16.8%, for the six months ended January 31, 2014, compared with the six months ended January 31, 2013, primarily due to the inclusion of only three months of operating results of the SPS Business in the six months ended January 31, 2013 as a result of acquiring the SPS Business on November 1, 2012 and improved sales and gross profit percentage, as explained above, partially offset by (i) the inclusion of an excise tax on qualified U.S. medical device sales beginning January 2013, (ii) increases in marketing and advertising expense and (iii) increases in annual salaries and stock-based compensation.
The Dialysis segment’s operating income decreased by $316,000, or 13.7%, and $728,000, or 16.2%, for the three and six months ended January 31, 2014, respectively, compared with the three and six months ended January 31, 2013, primarily due to decreases in sales, as further explained above, as well as the inclusion of an excise tax on qualified U.S. medical device sales beginning January 2013.
General corporate expenses increased by $436,000, or 12.6%, and $1,042,000, or 16.6%, for the three and six months ended January 31, 2014, respectively, compared with the three and six months ended January 31, 2013. General corporate expenses relate to certain unallocated corporate costs primarily related to executive management personnel and being a publicly traded company. The increase in such costs for the three and six months ended January 31, 2014, compared with the three and six months ended January 31, 2013, is primarily due to the addition of internal and external resources to address various growth initiatives and new compliance requirements, as well as increases in annual salaries, stock-based compensation and costs associated with our acquisition program.
Interest
Interest expense decreased by $146,000 to $645,000 for the three months ended January 31, 2014, from $791,000 for the three months ended January 31, 2013. For the six months ended January 31, 2014, interest expense decreased by $135,000 to $1,302,000 from $1,437,000 for the six months ended January 31, 2013. These decreases were primarily due to a decrease in the average outstanding borrowings, partially offset by the recording of a $113,000 charge for the ineffective hedge on our term credit facility, as further explained in Note 5 to the Condensed Consolidated Financial Statements.
Interest income was $15,000 and $16,000 for the three months ended January 31, 2014 and 2013, respectively, and $28,000 and $29,000 for the six months ended January 31, 2014 and 2013, respectively.
Income taxes
The consolidated effective tax rate was 36.7% and 36.3% for the six months ended January 31, 2014 and 2013, respectively. The increase in the consolidated effective tax rate was principally due to the geographic mix of pre-tax income and the impact of Federal tax legislation re-enacted in January 2013, as described below.
45
For the six months ended January 31, 2014 and 2013, approximately 96% and 97%, respectively, of our income before income taxes was generated from our United States operations, which had an overall effective tax rate of 37.4% and 36.8%, respectively. The higher overall effective tax rate for the six months ended January 31, 2014 was principally caused by Federal tax legislation that had expired in December 2011, but was re-enacted retroactively in January 2013, that enabled us to record the research and experimentation tax credit relating to the entire calendar 2012 in the six months ended January 31, 2013. Additionally, this same Federal tax legislation expired in December 2013 preventing us from recording a full research and experimentation tax credit for the six months ended January 31, 2014.
For the six months ended January 31, 2014 and 2013, approximately 4% and 3%, respectively, of our income before income taxes was generated from our operations in Canada, Singapore, the Netherlands, and for the six months ended January 31, 2014 as a result of the Jet Prep Acquisition, Israel. Collectively, these operations had an overall effective tax rate of 22.1% and 19.8% for the six months ended January 31, 2014 and 2013, respectively. All of these locations have lower statutory income tax rates compared to the United States.
We record liabilities for an unrecognized tax benefit when a tax benefit for an uncertain tax position is taken or expected to be taken on a tax return, but is not recognized in our Condensed Consolidated Financial Statements because it does not meet the more-likely-than-not recognition threshold that the uncertain tax position would be sustained upon examination by the applicable taxing authority. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon settlement with the tax authorities. Any adjustments upon resolution of income tax uncertainties are recognized in our results of operations. However, if our unrecognized tax benefits are recognized in our financial statements in future periods, there would not be a significant impact to our overall effective tax rate due to the size of the unrecognized tax benefits in relation to our income before income taxes. We do not expect such unrecognized tax benefits to significantly decrease or increase in the next twelve months.
A reconciliation of the beginning and ending amounts of gross unrecognized tax benefits is as follows:
|
|
|
Unrecognized
|
|
|
|
|
Tax Benefits
|
|
|
|
|
|
|
|
Unrecognized tax benefits on July 31, 2012
|
|
$
|
124,000
|
|
|
Activity during fiscal 2013
|
|
—
|
|
|
Unrecognized tax benefits on July 31, 2013
|
|
124,000
|
|
|
Activity during the six months ended January 31, 2014
|
|
—
|
|
|
Unrecognized tax benefits on January 31, 2014
|
|
$
|
124,000
|
|
Generally, the Company is no longer subject to federal, state or foreign income tax examinations for fiscal years ended prior to July 31, 2005.
Our policy is to record potential interest and penalties related to income tax positions in interest expense and general and administrative expense, respectively, in our Condensed Consolidated Financial Statements. However, such amounts have been relatively insignificant due to the amount of our unrecognized tax benefits relating to uncertain tax positions.
46
Stock-Based Compensation
The following table shows the income statement components of stock-based compensation expense recognized in the Condensed Consolidated Statements of Income:
|
|
|
Three Months Ended
|
|
Six Months Ended
|
|
|
|
|
January 31,
|
|
January 31,
|
|
|
|
|
2014
|
|
2013
|
|
2014
|
|
2013
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost of sales
|
|
$
|
109,000
|
|
$
|
37,000
|
|
$
|
171,000
|
|
$
|
92,000
|
|
|
Operating expenses:
|
|
|
|
|
|
|
|
|
|
|
Selling
|
|
191,000
|
|
82,000
|
|
301,000
|
|
181,000
|
|
|
General and administrative
|
|
1,090,000
|
|
802,000
|
|
2,054,000
|
|
1,594,000
|
|
|
Research and development
|
|
18,000
|
|
8,000
|
|
30,000
|
|
20,000
|
|
|
Total operating expenses
|
|
1,299,000
|
|
892,000
|
|
2,385,000
|
|
1,795,000
|
|
|
Stock-based compensation before income taxes
|
|
1,408,000
|
|
929,000
|
|
2,556,000
|
|
1,887,000
|
|
|
Income tax benefits
|
|
(493,000
|
)
|
(336,000
|
)
|
(905,000
|
)
|
(676,000
|
)
|
|
Total stock-based compensation expense, net of tax
|
|
$
|
915,000
|
|
$
|
593,000
|
|
$
|
1,651,000
|
|
$
|
1,211,000
|
|
The above stock-based compensation expense before income taxes was recorded in the Condensed Consolidated Financial Statements as stock-based compensation expense and an increase to additional paid-in capital. The related income tax benefits were recorded as an increase to long-term deferred income tax assets (which are netted with long-term deferred income tax liabilities) and a reduction to income tax expense. All of our stock options and stock awards (which consist only of restricted shares) are expected to be deductible for tax purposes, except for certain options and restricted shares granted to employees residing outside of the United States, and were tax-effected using the Company’s estimated U.S. effective tax rate at the time of grant.
The stock-based compensation expense recorded in the Condensed Consolidated Financial Statements may not be representative of the effect of stock-based compensation expense in future periods due to the level of awards issued in past years (which level may not be similar in the future),modifications of existing awards, accelerated vesting related to certain employment terminations and assumptions used in determining expected lives and estimated forfeitures. The fair value of each option grant is determined on the date of grant using the Black-Scholes option valuation model. We determine the fair value of each stock award using the closing market price of our common stock on the date of grant. If the market price of our common stock increases or factors change and we employ different assumptions in the application of Accounting Standards Codification (“ASC”) Topic 718,
“Compensation — Stock Compensation,”
(“ASC 718”), the compensation expense that we would record for future stock awards may differ significantly from what we have recorded in the current period.
All of our stock options and stock awards are subject to graded vesting in which portions of the award vest at different times during the vesting period, as opposed to awards that vest at the end of the vesting period. We recognize compensation expense for awards subject to graded vesting using the straight-line basis over the vesting period, reduced by estimated forfeitures. At January 31, 2014, total unrecognized stock-based compensation expense, before income taxes, related to total nonvested stock options and stock awards was $10,187,000 with a remaining weighted average period of 22 months over which such expense is expected to be recognized. Most of our nonvested awards relate to stock awards.
47
If certain criteria are met when options are exercised or restricted stock becomes vested, the Company is allowed a deduction on its United States income tax return. Accordingly, we account for the income tax effect on such income tax deductions as a reduction of previously recorded long-term deferred income tax assets (which are netted with long-term deferred income tax liabilities) and as a reduction of income taxes payable in the year of the deduction. Excess tax benefits arise when the ultimate tax effect of the deduction for tax purposes is greater than the tax benefit on stock compensation expense which was determined based upon the award’s fair value at the time the award was granted. The differences noted above between actual tax deductions and the previously recorded long-term deferred income tax assets are recorded as additional paid-in capital. For the six months ended January 31, 2014 and 2013, income tax deductions of $4,516,000 and $2,923,000, respectively, were generated and increased additional paid-in capital by $3,297,000 and $1,868,000, respectively. We classify the cash flows resulting from excess tax benefits as financing cash flows in our Condensed Consolidated Statements of Cash Flows.
Liquidity and Capital Resources
Working Capital
At January 31, 2014, our working capital was $100,439,000, compared with $91,509,000 at July 31, 2013. The increase was primarily due to the modification of our credit facilities as further explained below and in Note 9 to the Condensed Consolidated Financial Statements.
Cash Flows from Operating Activities
Net cash provided by operating activities was $21,549,000 and $19,051,000 for the six months ended January 31, 2014 and 2013, respectively. For the six months ended January 31, 2014, the net cash provided by operating activities was primarily due to net income (after adjusting for depreciation, amortization, stock-based compensation expense and deferred taxes), partially offset by an increase in accounts receivable (due to strong sales in the three months ended January 31, 2014 and the timing of sales transactions and payments by certain large customers in our Healthcare Disposables and Water Purification and Filtration segments).
For the six months ended January 31, 2013, the net cash provided by operating activities was primarily due to net income (after adjusting for depreciation, amortization, stock-based compensation expense and deferred taxes), partially offset by a decrease in accounts payable and other current liabilities (due primarily to the timing associated with incentive compensation and vendor payments).
Cash Flows from Investing Activities
Net cash used in investing activities was $12,840,000 and $39,409,000 for the six months ended January 31, 2014 and 2013, respectively. For the six months ended January 31, 2014 and 2013, the net cash used in investing activities was primarily for acquisitions and to a lesser extent, capital expenditures.
Cash Flows from Financing Activities
Net cash used in financing activities was $22,911,000 for the six months ended January 31, 2014 compared with $16,911,000 provided by financing activities for the six months ended January 31, 2013. For the six months ended January 31, 2014, the net cash used in financing activities was primarily due to repayments under our credit facilities and purchases of treasury
48
shares. For the six months ended January 31, 2013, the net cash provided by financing activities was primarily due to borrowings under our revolving credit facility relating to the acquisition of the SPS Business, partially offset by repayments under our credit facilities.
Stock Dividends
On July 12, 2013, the Company issued 15,044,000 additional shares of common stock in connection with a three-for-two stock split effected in the form of a 50% stock dividend paid on July 12, 2013 to stockholders of record on July 1, 2013.
Cash Dividends
On October 16, 2013, our Board of Directors approved a 22% increase in the semiannual cash dividend to $0.045 per share of outstanding common stock, which was paid on January 31, 2014 to shareholders of record on January 17, 2014. Future declaration of dividends and the establishment of future record and payment dates are subject to the final determination of the Company’s Board of Directors.
Long-Term Contractual Obligations
As of January 31, 2014, aggregate annual payments over the remaining fiscal year, the next four years and thereafter under our contractual obligations that have long-term components were as follows:
|
|
|
Six Months
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ending
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
July 31,
|
|
Year Ending July 31,
|
|
|
|
|
2014
|
|
2015
|
|
2016
|
|
2017
|
|
2018
|
|
Thereafter
|
|
Total
|
|
|
|
|
(Amounts in thousands)
|
|
|
Maturity of the credit facility (1)
|
|
$
|
—
|
|
$
|
—
|
|
$
|
—
|
|
$
|
—
|
|
$
|
—
|
|
$
|
74,500
|
|
$
|
74,500
|
|
|
Expected interest payments under the credit facility (2)
|
|
595
|
|
1,189
|
|
1,189
|
|
1,189
|
|
1,189
|
|
694
|
|
6,045
|
|
|
Minimum commitments under noncancelable operating leases
|
|
1,902
|
|
3,041
|
|
2,142
|
|
1,484
|
|
1,261
|
|
3,679
|
|
13,509
|
|
|
Contingent consideration (3)
|
|
—
|
|
170
|
|
518
|
|
915
|
|
1,279
|
|
2,868
|
|
5,750
|
|
|
Compensation agreements
|
|
2,293
|
|
3,436
|
|
988
|
|
425
|
|
350
|
|
846
|
|
8,338
|
|
|
Deferred compensation and other
|
|
28
|
|
77
|
|
43
|
|
41
|
|
36
|
|
27
|
|
252
|
|
|
Total contractual obligations
|
|
$
|
4,818
|
|
$
|
7,913
|
|
$
|
4,880
|
|
$
|
4,054
|
|
$
|
4,115
|
|
$
|
82,614
|
|
$
|
108,394
|
|
(1) The maturity of the credit facility reflects the terms under the March 4, 2014 modification, as further explained below.
(2) The expected interest payments under our credit facility reflect an interest rate of 1.60%, which was our weighted average interest rate on outstanding borrowings at January 31, 2014.
(3) The future potential payments of contingent consideration are shown at present value using a discount rate of 11.5%.
Credit Facility
In March 2014, we modified our existing $100,000,000 senior secured revolving credit facility (the “Existing Revolving Credit Facility”) and $50,000,000 senior secured term loan facility (the “Existing Term Loan Facility”) by entering into a $250,000,000 Third Amended and Restated Credit Agreement dated as of March 4, 2014 (the “New Credit Agreement”). The New Credit Agreement includes a five-year $250,000,000 senior secured revolving facility with sublimits of up to $100,000,000 for borrowings in foreign currencies, $30,000,000 for letters of credit and $10,000,000 for swing line loans (the “New Revolving Credit Facility”). The Existing
49
Term Loan Facility was terminated after the outstanding balance was reassigned to the New Revolving Credit Facility. Subject to the satisfaction of certain conditions precedent including the consent of the lenders, the Company may from time to time increase the New Revolving Credit Facility by an aggregate amount not to exceed $100,000,000. The senior lenders include Bank of America N.A. (the lead bank and administrative agent), PNC Bank, National Association, and Wells Fargo Bank, National Association. The New Credit Agreement expires on March 4, 2019. Additionally, subject to certain restrictions and conditions (i) any of Cantel’s domestic or foreign subsidiaries may become borrowers and (ii) borrowings may occur in multi-currencies. Unamortized debt issuance costs recorded in other assets amounted to $619,000 at January 31, 2014, of which $90,000 related to the Existing Term Loan Facility and were expensed in March 2014. The remaining unamortized debt issuance cost relating to the Existing Revolving Credit Facility plus additional debt issuance cost of approximately $1,304,000 relating to the New Credit Agreement will be recorded in other assets and amortized over the life of the New Credit Agreement.
Borrowings under the New Credit Agreement bear interest at rates ranging from 0.25% to 1.25% above the lender’s base rate, or at rates ranging from 1.25% to 2.25% above the London Interbank Offered Rate (“LIBOR”), depending upon the Company’s “Consolidated Leverage Ratio,” which is defined as the consolidated ratio of total funded debt to earnings before interest, taxes, depreciation and amortization, and as further adjusted under the terms of the New Credit Agreement (“Consolidated EBITDA”). At January 31, 2014, the lender’s base rate was 3.25% and the LIBOR rates ranged from 0.16 % to 0.70%. The margins applicable to our outstanding borrowings were 0.25% above the lender’s base rate or 1.25% above LIBOR. Substantially all of our outstanding borrowings were under LIBOR contracts at January 31, 2014. The New Credit Agreement also provides for fees on the unused portion of our facilities at rates ranging from 0.20% to 0.40%, depending upon our Consolidated Leverage Ratio; such rate was 0.25% at January 31, 2014 and 0.20% at March 4, 2014.
In order to protect our interest rate exposure in future years, we entered into forward starting interest rate swap agreements in February 2012 in which we agree to exchange our variable interest cash flows with fixed interest cash flows provided by one of our existing senior lenders. With respect to our Existing Term Loan Facility, the interest rate swap is for the period that began August 8, 2012 and ends July 31, 2015, initially covering $40,000,000 of borrowings based on one-month LIBOR and thereafter reducing in quarterly $2,500,000 increments consistent with the mandatory repayment schedule, and the fixed interest cash flow is at a one month LIBOR rate of 0.664%. As a result of the termination of our Existing Term Loan Facility, this interest rate swap will no longer be considered effective in mitigating the adverse impact on interest expense of increases in LIBOR. With respect to our Existing Revolving Credit Facility, the interest rate swap was for the period that began August 8, 2012 and ended January 31, 2014, initially covering $25,000,000 of borrowings based on one-month LIBOR and thereafter reducing semi-annually by increments of $5,000,000, and the fixed interest cash flow is at a one month LIBOR rate of 0.496%.
The New Credit Agreement contains affirmative and negative covenants reasonably customary for similar credit facilities and is secured by (i) substantially all assets of Cantel and its United States-based subsidiaries, (ii) a pledge by Cantel of all of the outstanding shares of its United States-based subsidiaries and 65% of the outstanding shares of certain of Cantel’s foreign-based subsidiaries and (iii) a guaranty by Cantel’s domestic subsidiaries. We are in compliance with all financial and other covenants under the New Credit Agreement.
50
On January 31, 2014, we had $74,500,000 of outstanding borrowings, which consisted of $25,000,000 and $49,500,000 under the Existing Term Loan Facility and the Existing Revolving Credit Facility, respectively. Subsequent to January 31, 2014, the outstanding balance under the Existing Term Loan Facility was reassigned to the New Revolving Credit Facility and we repaid $2,500,000 resulting in total outstanding borrowings of $72,000,000 at March 4, 2014, none of which is required to be repaid until March 2019.
Operating Leases
Minimum commitments under operating leases include minimum rental commitments for our leased manufacturing facilities, warehouses, office space and equipment.
Contingent Consideration
As part of the Jet Prep Acquisition on November 5, 2013, we recorded a $4,760,000 liability for the estimated fair value of contingent consideration payable to the sellers and a $990,000 liability for the estimated fair value of an assumed contingent obligation payable to the Israeli Government, as further described in Notes 3 and 6 to the Condensed Consolidated Financial Statements, which will be payable based on future sales of the Jet Prep Business (above a minimum threshold with respect to the contingent consideration liability.) As such, the estimates of the annual required payments as well as the fair value of these contingent liabilities are subjective in nature and highly dependent on future sales projections. Additionally, since we will be continually re-measuring the contingent consideration liability and the assumed contingent obligation at each balance sheet date and recording changes in the respective fair values through our Condensed Consolidated Statements of Income, we may potentially have significant earnings volatility in our future results of operations until the completion of the seven year period with respect to the contingent consideration liability and until the assumed contingent obligation is satisfied, or until the sales of the Jet Prep Ltd. products no longer exist.
Compensation Agreements
We have previously entered into various severance contracts with executives of the Company, including our Corporate executive officers and our subsidiary Chief Executive Officers, which define certain compensation arrangements relating to various employment termination scenarios. In conjunction with the acquisitions of the endoscopy procedural product business of Byrne Medical, Inc. (the “Byrne Medical Business” or the “Byrne Acquisition”) on August 1, 2011, the SPS Business on November 1, 2012, the Eagle Pure Water Business on December 31, 2012 and the Sterilator Business on January 7, 2014, we entered into multi-year employment agreements with certain executive officers of the acquired businesses.
Deferred Compensation and Other
Deferred compensation and other primarily includes deferred compensation arrangements for certain former Medivators directors and officers and is recorded in other long-term liabilities.
Financing Needs
Our four largest operating segments generate significant cash from operations. At January 31, 2014, we had a cash balance of $19,706,000, of which $3,555,000 was held by foreign subsidiaries. Such foreign cash is needed by our foreign subsidiaries for working capital purposes and current international growth initiatives. In the recent past, such international growth initiatives have included the funding of $5,332,000 for the November 5, 2013 Jet Prep Acquisition as further described in Note 3 to the Condensed Consolidated Financials. Accordingly, our foreign unremitted earnings are considered permanently reinvested and unavailable for repatriation.
51
We believe that our current cash position, anticipated cash flows from operations and the funds available under our New Credit Agreement will be sufficient to satisfy our worldwide cash operating requirements for the foreseeable future based upon our existing operations, particularly given that we historically have not needed to borrow for working capital purposes. At March 4, 2014, $178,000,000 was available under our New Credit Agreement.
Foreign Currency
The financial statements of our Canadian subsidiaries are translated using the accounting policies described in Note 2 to the 2013 Form 10-K and therefore are impacted by changes in the Canadian dollar exchange rate. Additionally, changes in the value of the Canadian dollar against the United States dollar affect our results of operations because a portion of our Canadian subsidiaries’ inventories and operating costs (which are reported in the Water Purification and Filtration and Specialty Packaging segments) are purchased in the United States and a significant amount of their sales are to customers in the United States. Furthermore, certain cash bank accounts, accounts receivable and liabilities of our Canadian and United States subsidiaries are denominated and ultimately settled in United States dollars or Canadian dollars but must be converted into their functional currency.
Changes in the value of the Euro, Singapore dollar and British pound against the United States dollar affect our results of operations because certain cash bank accounts, accounts receivable and liabilities of our subsidiaries are denominated and ultimately settled in Euros, Singapore dollars or British pounds but must be converted into their functional currency. Furthermore, the financial statements of our Netherlands subsidiary are translated using the accounting policies described in Note 2 to the 2013 Form 10-K and therefore are impacted by changes in the Euro exchange rate relative to the United States dollar.
In order to hedge against the impact of fluctuations in the value of (i) the Euro relative to the United States dollar, (ii) the Singapore dollar relative to the United States dollar and (iii) the British pound relative to the United States dollar on the conversion of such net assets into the functional currencies, we enter into short-term contracts to purchase Euros, Singapore dollars and British pounds forward, which contracts are one month in duration. These short-term contracts are designated as fair value hedge instruments. There were three foreign currency forward contracts with an aggregate value of $11,140,000 at February 28, 2014, which covered certain assets and liabilities that were denominated in currencies other than our subsidiaries’ functional currencies. Such contracts expire on March 31, 2014. These foreign currency forward contracts are continually replaced with new one-month contracts as long as we have significant net assets at our subsidiaries that are denominated and ultimately settled in currencies other than their functional currencies. Gains and losses related to these hedging contracts to buy Euros, Singapore dollars and British pounds forward are immediately realized within general and administrative expenses due to the short-term nature of such contracts. For the three and six months ended January 31, 2014, such forward contracts substantially offset the impact on operations related to certain assets and liabilities that are denominated in currencies other than our subsidiaries’ functional currencies. We do not currently hedge against the impact of fluctuations in the value of the Canadian dollar relative to the United States dollar because the currency impact on our Canadian or United States subsidiaries’ assets closely offset the currency impact on our Canadian or United States subsidiaries’ liabilities effectively minimizing realized gains and losses.
52
Overall, fluctuations in the rates of currency exchange had an insignificant impact upon our net income for the three and six months ended January 31, 2014 compared with the three and six months ended January 31, 2013.
For purposes of translating the balance sheet at January 31, 2014 compared with July 31, 2013, the total of the foreign currency movements resulted in a foreign currency translation loss of $1,674,000 for the six months ended January 31, 2014, thereby decreasing stockholders’ equity.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an ongoing basis, we continually evaluate our estimates. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our Condensed Consolidated Financial Statements.
Revenue Recognition
Revenue on product sales is recognized as products are shipped to customers and title passes. The passing of title is determined based upon the FOB terms specified for each shipment. With respect to endoscopy, dialysis and specialty packaging products, shipment terms are generally FOB origin for common carrier and when our distribution fleet is utilized (except for one large customer in dialysis whereby all products are shipped FOB destination). With respect to water purification and filtration and healthcare disposable products, shipment terms may be either FOB origin or destination. Customer acceptance for the majority of our product sales occurs at the time of delivery. With respect to a portion of water purification and filtration product sales, equipment is sold as part of a system for which the equipment is functionally interdependent or the customer’s purchase order specifies “ship-complete” as a condition of delivery; revenue recognition on such sales is deferred until all equipment has been delivered, or post-delivery obligations such as installation have been substantially fulfilled such that the products are deemed functional by the end-user.
A portion of our endoscopy, water purification and filtration and dialysis sales are recognized as multiple element arrangements, whereby revenue is allocated to the equipment and installation components based upon vendor specific objective evidence, which includes comparable historical transactions of similar equipment and installation sold as stand-alone components. If vendor-specific objective evidence of selling price is not available, we allocate revenue to the elements of the bundled arrangement using the estimated selling price method in order to qualify the components as separate units of accounting. Revenue on the equipment component is recognized as the equipment is shipped to customers and title passes. Revenue on the installation component is recognized when the installation is complete.
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A portion of our healthcare disposables sales relating to the mail-in spore test kit is recorded as deferred revenue when initially sold. We recognize the revenue on these test kits using an estimate based on historical experience of the amount of time that elapses from the point of sale to when the kit is returned to us and we communicate to the customer the results of the required laboratory test. The related cost of the kits is recorded in inventory and recognized in cost of sales as the revenue is earned.
Revenue on service sales is recognized when repairs are completed at the customer’s location or when repairs are completed at our facilities and the products are shipped to customers. With respect to certain service contracts in our Endoscopy and Water Purification and Filtration operating segments, service revenue is recognized on a straight-line basis over the contractual term of the arrangement. All shipping and handling fees invoiced to customers, such as freight, are recorded as revenue (and related costs are included within cost of sales) at the time the sale is recognized.
None of our sales contain right-of-return provisions. Customer claims for credit or return due to damage, defect, shortage or other reason must be pre-approved by us before credit is issued or such product is accepted for return. No cash discounts for early payment are offered except with respect to a small portion of our sales of dialysis, healthcare disposable and water purification and filtration products. We do not offer price protection, although advance pricing contracts or required notice periods prior to implementation of price increases exist for certain customers with respect to many of our products. With respect to certain of our dialysis, healthcare disposables, water purification and filtration and endoscopy customers, rebates are provided; such rebates, which consist primarily of volume rebates, are provided for as a reduction of sales at the time of revenue recognition and amounted to $1,181,000 and $2,126,000 for the three and six months ended January 31, 2014, respectively, and $1,120,000 and $2,281,000 for the three and six months ended January 31, 2013, respectively. Such allowances are determined based on estimated projections of sales volume for the entire rebate periods. If it becomes known that sales volume to customers will deviate from original projections, the rebate provisions originally established would be adjusted accordingly.
Our endoscopy products and services are sold primarily to distributors internationally and directly to hospitals and other end-users in the United States; water purification and filtration products and services are sold directly and through third-party distributors to hospitals, dialysis clinics, pharmaceutical and biotechnology companies, laboratories, medical products and service companies and other end-users; the majority of our healthcare disposable products are sold to third party distributors and with respect to some of our sterility assurance products, to hospitals, surgery centers, physician and dental offices, dental schools, medical research companies, laboratories and other end-users; the majority of our dialysis products are sold to dialysis clinics and hospitals; and specialty packaging products are sold to third-party distributors, medical research companies, laboratories, pharmaceutical companies, hospitals, government agencies and other end-users. Sales to all of these customers follow our revenue recognition policies.
Accounts Receivable and Allowance for Doubtful Accounts
Accounts receivable consist of amounts due to us from normal business activities. Allowances for doubtful accounts are reserves for the estimated loss from the inability of customers to make required payments. We use historical experience as well as current market information in determining the estimate. While actual losses have historically been within
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management’s expectations and provisions established, if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Alternatively, if certain customers paid their delinquent receivables, reductions in allowances may be required.
Inventories
Inventories consist of raw materials, work-in-process and finished products which are sold in the ordinary course of our business and are stated at the lower of cost (first-in, first-out) or market. In assessing the value of inventories, we must make estimates and judgments regarding reserves required for product obsolescence, aging of inventories and other issues potentially affecting the saleable condition of products. In performing such evaluations, we use historical experience as well as current market information. With few exceptions, the saleable value of our inventories has historically been within management’s expectation and provisions established, however, rapid changes in the market due to competition, technology and various other factors could have an adverse effect on the saleable value of our inventories, resulting in the need for additional reserves.
Goodwill and Intangible Assets
Certain of our identifiable intangible assets, including customer relationships, technology, brand names, non-compete agreements and patents, are amortized using the straight-line method over their estimated useful lives which range from 2 to 20 years. Additionally, we have recorded goodwill and trademarks and trade names, all of which have indefinite useful lives and are therefore not amortized. All of our intangible assets and goodwill are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, and goodwill and intangible assets with indefinite lives are reviewed for impairment at least annually
.
Our management is responsible for determining if impairment exists and considers a number of factors, including third-party valuations, when making these determinations.
In accordance with Accounting Standards Update (“ASU”) 2011-08,
“Intangibles — Goodwill and Other,”
(“ASU 2011-08”), we first assess qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than the carrying amount before proceeding to step one of the two-step quantitative goodwill impairment test, if necessary. Such qualitative factors that are assessed include evaluating a segment’s financial performance, industry and market conditions, macroeconomic conditions and specific issues that can directly affect the segment such as changes in business strategies, competition, supplier relationships, operating costs, regulatory matters, litigation and the composition of the segment’s assets due to acquisitions or other events. At July 31, 2013, because we determined through qualitative factors that the fair values of our Endoscopy, Water Purification and Filtration and Dialysis segments were unlikely to be less than the carrying value, we did not proceed to step one of the two-step quantitative goodwill impairment test for those three segments. We performed step one of the two-step quantitative goodwill impairment test for Healthcare Disposables (due to the increase in assets related to the SPS Medical Acquisition) and Specialty Packaging (due to fair value exceeding book value by a nominal amount in the prior year). In performing a detailed quantitative review for goodwill impairment, management uses a two-step process that begins with an estimation of the fair value of the related operating segments by using weighted fair value results of the discounted cash flow methodology, as well as the market multiple and comparable transaction methodologies. The first step is a review for potential impairment, and the second step measures the amount of impairment, if any.
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In accordance with ASU 2012-02,
“Intangibles — Goodwill and Other,”
(“ASU 2012-02”), we perform our annual impairment review for indefinite lived intangibles by first assessing qualitative factors, such as those described above, to determine whether it is more likely than not that the fair value of such assets is less than the carrying values, and if necessary, we perform a quantitative analysis comparing the current fair value of our indefinite lived intangibles assets to their carrying values. At July 31, 2013, because we determined through qualitative factors that the fair values of our indefinite lived intangible assets in our Endoscopy and Water Purification and Filtration segments were unlikely to be less than the carrying value, we did not perform a quantitative analysis for those assets. We performed a quantitative analysis for indefinite lived intangible assets in our Healthcare Disposables and Specialty Packaging segments, for the same reasons stated above for our goodwill impairment test, as well as such intangible assets in our Dialysis segment (due to fair value of its indefinite lived intangible assets exceeding book value by a nominal amount in the prior year).With respect to amortizable intangible assets when impairment indicators are present, management would determine whether expected future non-discounted cash flows would be sufficient to recover the carrying value of the assets; if not, the carrying value of the assets would be adjusted to their fair value. On July 31, 2013, management concluded that none of our intangible assets or goodwill was impaired.
While the results of these annual reviews have historically not indicated impairment, impairment reviews are highly dependent on management’s projections of our future operating results and cash flows (which management believes to be reasonable), discount rates based on the Company’s weighted average cost of capital and appropriate benchmark peer companies. Assumptions used in determining future operating results and cash flows include current and expected market conditions and future sales and earnings forecasts. Subsequent changes in these assumptions and estimates could result in future impairment. Although we consistently use the same methods in developing the assumptions and estimates underlying the fair value calculations, such estimates are uncertain by nature and can vary from actual results. At July 31, 2013, the average fair value of all of our reporting units exceeded book value by substantial amounts, except our Specialty Packaging segment, which had an average estimated fair value that approximated book value. At January 31, 2014, goodwill relating to our Specialty Packaging reporting unit was $6,438,000. We believe the most significant assumptions impacting the impairment assessment of Specialty Packaging relate to an assumed compounded annual sales growth of 10.7% and future operating efficiencies included in our projections of future operating results and cash flows of this segment, which projections are in excess of historical run rates. If future operating results and cash flows are substantially less than our projections, future impairment charges may be recorded. On January 31, 2014, management concluded that no events or changes in circumstances have occurred during the three and six months ended January 31, 2014 that would indicate that the carrying value of our intangible assets and goodwill may not be recoverable.
Long-Lived Assets
We evaluate the carrying value of long-lived assets including property, equipment and other assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. An assessment is made to determine if the sum of the expected future non-discounted cash flows from the use of the assets and eventual disposition is less than the carrying value. If the sum of the expected non-discounted cash flows is less than the carrying value, an impairment loss is recognized based on fair value. Our historical assessments of our long-lived assets have not differed significantly from the actual amounts realized. However, the determination of fair value requires us to make certain assumptions and estimates and is highly
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subjective. On January 31, 2014, management concluded that no events or changes in circumstances have occurred that would indicate that the carrying amount of our long-lived assets may not be recoverable.
Warranties
We provide for estimated costs that may be incurred to remedy deficiencies of quality or performance of our products at the time of revenue recognition. Most of our products have a one year warranty. We record provisions for product warranties as a component of cost of sales based upon an estimate of the amounts necessary to settle existing and future claims on products sold. The historical relationship of warranty costs to products sold is the primary basis for the estimate. A significant increase in third party service repair rates, the cost and availability of parts or the frequency of claims could have a material adverse impact on our results for the period or periods in which such claims or additional costs materialize. Management reviews its warranty exposure periodically and believes that the warranty reserves are adequate; however, actual claims incurred could differ from original estimates, requiring adjustments to the reserves.
Stock-Based Compensation
We account for stock options and stock awards in which stock compensation expense is recognized for any option or stock award grant based upon the award’s fair value. All of our stock options and stock awards (which consist only of restricted stock) are subject to graded vesting in which portions of the award vest at different times during the vesting period, as opposed to awards that vest at the end of the vesting period. We recognize compensation expense for awards subject to graded vesting using the straight-line basis, reduced by estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based on historical experience.
The stock-based compensation expense recorded in our Condensed Consolidated Financial Statements may not be representative of the effect of stock-based compensation expense in future periods due to the level of awards issued in past years (which level may not be similar in the future), modifications to existing awards, accelerated vesting related to certain employment terminations and assumptions used in determining fair value, expected lives and estimated forfeitures. We determine the fair value of each stock award using the closing market price of our common stock on the date of grant. We estimate the fair value of each option grant on the date of grant using the Black-Scholes option valuation model. The determination of fair value using an option-pricing model is affected by our stock price as well as assumptions regarding a number of subjective variables. These variables include, but are not limited to, the expected stock price volatility over the term of the expected option life (which is determined by using the historical closing prices of our common stock), the expected dividend yield (which is approximately 0.3%), and the expected option life (which is based on historical exercise behavior).
Legal Proceedings
In the normal course of business, we are subject to pending and threatened legal actions. It is our policy to accrue for amounts related to these legal matters if it is probable that a liability has been incurred and an amount of anticipated exposure can be reasonably estimated. We do not believe that any of these pending claims or legal actions will have a material adverse effect on our business, financial condition, results of operations or cash flows.
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Income
Taxes
We recognize deferred tax assets and liabilities based on differences between the financial statement carrying amounts and the tax basis of assets and liabilities. Deferred tax assets and liabilities also include items recorded in conjunction with the purchase accounting for business acquisitions as well as net operating loss carryforwards. We regularly review our deferred tax assets for recoverability and establish a valuation allowance, if necessary, based on historical taxable income, projected future taxable income, and the expected timing of the reversals of existing temporary differences. Although realization is not assured, management believes it is more likely than not that the recorded deferred tax assets, as adjusted for valuation allowances, will be realized. Additionally, deferred tax liabilities are regularly reviewed to confirm that such amounts are appropriately stated. A review of our deferred tax items considers known future changes in various income tax rates, principally in the United States. If the income tax rate were to change in the future, particularly in the United States and to a lesser extent Canada, our items of deferred tax could be materially affected. All of such evaluations require significant management judgments.
We record liabilities for an unrecognized tax benefit when a tax benefit for an uncertain tax position is taken or expected to be taken on a tax return, but is not recognized in our Condensed Consolidated Financial Statements because it does not meet the more-likely-than-not recognition threshold that the uncertain tax position would be sustained upon examination by the applicable taxing authority. Any adjustments upon resolution of income tax uncertainties are recognized in our results of operations. Unrecognized tax benefits are analyzed periodically and adjustments are made as events occur to warrant adjustment to the related liability.
Medical Device Taxes
The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 imposes significant new taxes on medical device makers in the form of an excise tax on certain U.S. medical device sales that began in January 2013. A significant portion of our sales are considered medical device sales under this new legislation. We calculate medical device excise taxes based on the latest available regulations and IRS notices and recognize the excise taxes in cost of sales at the time the medical device revenue is recognized in our Condensed Consolidated Statements of Income. For the three and six months ended January 31, 2014, we recorded excise taxes of $936,000 and $1,892,000 in cost of sales. For the three and six months ended January 31, 2013, we recorded excise taxes of $322,000 in cost of sales relating to the month of January. The regulations regarding the calculations of the medical device taxes are complicated in nature and certain aspects can be subject to interpretation causing the IRS to issue notices clarifying various aspects of these new taxes. Although we have made all reasonable efforts to record accurate excise taxes, the determination of the tax requires us to make certain assumptions and estimates. Actual taxes for the period could differ from original estimates requiring adjustments to our Condensed Consolidated Financial Statements.
Business Combinations
Acquisitions require significant estimates and judgments related to the fair value of assets acquired and liabilities assumed. We determine fair value based on the estimated price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
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Certain liabilities and reserves are subjective in nature. We reflect such liabilities and reserves based upon the most recent information available. In conjunction with our acquisitions, such subjective liabilities and reserves principally include contingent consideration, certain income tax and sales and use tax exposures, including tax liabilities related to our foreign subsidiaries, as well as reserves for accounts receivable, inventories and warranties. We account for contingent consideration relating to business combinations in accordance with ASC 805,
“Business Combinations,”
which requires us to record the fair value of contingent consideration as a liability and an increase to goodwill at the date of the acquisition and continually re-measure the liability at each balance sheet date by recording changes in the fair value through our Condensed Consolidated Statements of Income. We determine the fair value of contingent consideration based on future operating projections under various potential scenarios and weight the probability of these outcomes. Similarly, other components of an acquisition’s purchase price can be required to be recorded at fair value at the date of the acquisition and continually re-measured at each balance sheet date, such as the three year price floor relating to the Byrne Acquisition which fair value was determined using an option valuation model or the assumed contingent obligation relating to the Jet Prep Acquisition, as further described in Note 6 to the Condensed Consolidated Financial Statements. The ultimate settlement of liabilities relating to business combinations may be for amounts which are materially different from the amounts initially recorded and may cause volatility in our results of operations.
Other Matters
We do not have any off balance sheet financial arrangements, other than future commitments under operating leases and executive severance and license agreements.
Forward Looking Statements
This quarterly report on Form 10-Q contains “forward-looking statements” as that term is defined under the Private Securities Litigation Reform Act of 1995. These statements are based on current expectations, estimates, or forecasts about our businesses, the industries in which we operate, and the beliefs and assumptions of management; they do not relate strictly to historical or current facts.
Without limiting the foregoing, words or phrases such as “expect,” “anticipate,” “goal,” “will continue,” “project,” “intend,” “plan,” “believe,” “seek,” “may,” “could,” and variations of such words and similar expressions generally identify forward-looking statements. In addition, any statements that refer to predictions or projections of our future financial performance, anticipated growth and trends in our businesses, and other characterizations of future events or circumstances are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions about future events, activities or developments and are subject to numerous risks, uncertainties, and assumptions that are difficult to predict. We caution that undue reliance should not be placed on such forward-looking statements, which speak only as of the date made. Some of the factors which could cause results to differ from those expressed in any forward-looking statement are set forth under Item 1A of the 2013 Form 10-K, entitled Risk Factors. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.
All forward-looking statements herein speak only as of the date of this report. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.
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For these statements, we claim the protection of the safe harbor for forward-looking statements contained in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Foreign Currency Market Risk
A portion of our products in all of our business segments are exported to and imported from a variety of geographic locations, and our business could be materially and adversely affected by the imposition of trade barriers, fluctuations in the rates of exchange of various currencies, tariff increases and import and export restrictions, affecting all of such geographies including but not limited to the United States, Canada, the European Union, the United Kingdom and the Far East.
A portion of our Canadian subsidiaries’ inventories and operating costs (which are reported in the Water Purification and Filtration and Specialty Packaging segments) are purchased in the United States and a significant amount of their sales are to customers in the United States. The businesses of our Canadian subsidiaries could be materially and adversely affected by the imposition of trade barriers, fluctuations in the rate of currency exchange, tariff increases and import and export restrictions between the United States and Canada. Changes in the value of the Canadian dollar against the United States dollar also affect our results of operations because certain cash bank accounts, accounts receivable and liabilities of our Canadian and United States subsidiaries are denominated and ultimately settled in United States dollars or Canadian dollars but must be converted into their functional currency. Additionally, the financial statements of our Canadian subsidiaries are translated using the accounting policies described in Note 2 to the 2013 Form 10-K.
Changes in the value of the Euro, Singapore dollar and British pound against the United States dollar affect our results of operations because certain cash bank accounts, accounts receivable and liabilities of our subsidiaries are denominated and ultimately settled in Euros, Singapore dollars or British pounds but must be converted into their functional currency. Furthermore, the financial statements of our Netherlands subsidiary are translated using the accounting policies described in Note 2 to the 2013 Form 10-K and therefore are impacted by changes in the Euro exchange rate relative to the United States dollar.
In order to hedge against the impact of fluctuations in the value of (i) the Euro relative to the United States dollar, (ii) the Singapore dollar relative to the United States dollar and (iii) the British pound relative to the United States dollar on the conversion of such net assets into the functional currencies, we enter into short-term contracts to purchase Euros, Singapore dollars and British pounds forward, which contracts are one month in duration. These short-term contracts are designated as fair value hedge instruments. There were two foreign currency forward contracts with an aggregate value of $6,264,000 at January 31, 2014, which covered certain assets and liabilities that were denominated in currencies other than our subsidiaries’ functional currencies. Such contracts expired on February 28, 2014. These foreign currency forward contracts are continually replaced with new one-month contracts as long as we have significant net assets at our subsidiaries that are denominated and ultimately settled in currencies other than their functional
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currencies. For the three and six months ended January 31, 2014, such forward contracts substantially offset the impact on operations relating to certain assets and liabilities that were denominated in currencies other than our subsidiaries’ functional currencies. We do not currently hedge against the impact of fluctuations in the value of the Canadian dollar relative to the United States dollar because the currency impact on our Canadian and United States subsidiaries’ assets closely offset the currency impact on our Canadian and United States subsidiaries’ liabilities effectively minimizing realized gains and losses.
Overall, fluctuations in the rates of currency exchange had an insignificant impact on our net income for the three and six months ended January 31, 2014 and 2013.
For the purpose of translating the balance sheet at January 31, 2014 compared with July 31, 2013, the total of the foreign currency movements resulted in a foreign currency translation loss of $1,674,000, net of tax, for the six months ended January 31, 2014, thereby decreasing stockholders’ equity.
Interest Rate Market Risk
Effective March 4, 2014, we have modified our credit facilities, as described elsewhere in Liquidity and Capital Resources. The modification of our credit facilities increased our borrowing capacity and decreased our margins applied to the lender’s base rate and LIBOR. The interest rate on outstanding borrowings is variable and substantially all of our outstanding borrowings are under LIBOR contracts. Therefore, interest expense is affected by the general level of interest rates in the United States as well as LIBOR interest rates.
Market Risk Sensitive Transactions
We are exposed to market risks arising principally from adverse changes in interest rates and foreign currency.
With respect to interest rate risk, our outstanding debt is under our New Revolving Credit Facility as of March 4, 2014, described elsewhere in Liquidity and Capital Resources. Such credit facility consists of outstanding debt at prevailing market rates of interest, principally under LIBOR contracts ranging from one to twelve months. Therefore, our market risk with respect to such debt is the increase in interest expense which would result from higher interest rates associated with LIBOR.
Based on our outstanding Revolving Credit Facility balance of $72,000,000 at March 4, 2014, a 100 basis point increase in average LIBOR interest rates would result in incremental annual interest expense of $720,000. However, we also maintained a cash balance of $19,706,000 at January 31, 2014 which is maintained in cash or invested in low return cash equivalents such as United States money market funds with leading banking institutions. An increase in interest rates would generate additional interest income as well as increase the fair value of our remaining ineffective interest rate swap agreement, which would both partially offset the adverse impact of additional interest expense. Additionally, substantially all of our outstanding borrowings were under LIBOR contracts that had expiration dates ranging from 1 to 12 months at fixed interest rates for the contract periods, and therefore would mitigate the adverse impact of an increase in interest rates.
Additional information related to market risk sensitive transactions from foreign currency is contained in Part II, Item 7A, Quantitative and Qualitative Disclosures About Market Risk, in our 2013 Form 10-K.
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ITEM 4.
CONTROLS AND PROCEDURES.
We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the SEC and that such information is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.
Under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer each concluded that the design and operation of these disclosure controls and procedures were effective and designed to ensure that material information relating to the Company, including our consolidated subsidiaries, required to be disclosed in our SEC reports is (i) recorded, processed, summarized and reported within the time periods specified by the SEC and (ii) accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure.
We have evaluated our internal controls over financial reporting and determined that no changes occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting, except as described below.
On January 7, 2014 and November 5, 2013, we acquired the Sterilator Business and Jet Prep Business, respectively, as more fully described in Note 3 to the Condensed Consolidated Financial Statements. During the initial transition period following the acquisitions, we enhanced our internal control processes at our Crosstex subsidiary and Medivators subsidiary to ensure that all financial information related to these acquisitions were properly reflected in our Condensed Consolidated Financial Statements. We expect all aspects of the Sterilator Business and Jet Prep Business will be fully integrated into our existing internal control structure by July 31, 2014.
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