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 nine months ended April 30, 2016 compared with the three and nine months ended April 30, 2015.
Liquidity and Capital Resources
provides an overview of our working capital, cash flows, 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
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Endoscopy
: Medical device reprocessing systems, disinfectants, detergents and other supplies used to high-level disinfect flexible endoscopes and disposable infection control products intended to reduce the challenges associated with proper cleaning and high-level disinfection of numerous reusable components used in gastrointestinal (GI) endoscopy procedures. This segment recently commenced the sale of endoscope transport and storage systems, a comprehensive range of endoscopy consumable accessories, and OEM mobile medical carts. Additionally, this segment includes technical maintenance service on its products.
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Water Purification and Filtration
: Water purification equipment and services, filtration and separation products, and disinfectants, sterilization and decontamination products and services for the medical, pharmaceutical, biotech, beverage and commercial industrial markets.
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Healthcare Disposables
: Single-use, infection prevention and control healthcare products including face masks, sterilization pouches, towels and bibs, tray covers, saliva ejectors, germicidal wipes, plastic cups and disinfectants, as well as a filter system for maintaining safe dental unit waterlines. This segment also manufactures and sells biological and chemical indicators for sterility assurance monitoring services in the acute-care, alternate-care, dental and industrial markets.
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·
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Dialysis
: Medical device reprocessing systems, sterilants/disinfectants, dialysate concentrates and other supplies for renal dialysis.
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In addition, we had another operating segment through April 7, 2015, known as Specialty Packaging. This segment included specialty packaging and thermal control products, as well as related compliance training, for the transport of infectious and biological specimens and thermally sensitive pharmaceutical, medical and other products. The Specialty Packaging operating segment, which comprised the Other reporting segment for financial reporting purposes, was divested on April 7, 2015 as further described in Note 16 to the Condensed Consolidated Financial Statements. Since the operating results of the Specialty Packaging segment were not significant in relation to our overall consolidated operating results, the divestiture of this business did not have a major effect on our operations and financial results, and accordingly, has not been classified as a discontinued operation for any of the periods presented.
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, 2015 (the “2015 Form 10-K”) and our Condensed Consolidated Financial Statements for additional financial information regarding our reporting segments.
Significant Activity
(i)
Some of our key financial results for the three and nine months ended April 30, 2016 compared with the three and nine months ended April 30, 2015 were as follows:
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Net sales increased by 22.8% to $173,703,000 from $141,508,000 for the three months ended April 30, 2016, and 17.4% to $485,753,000 from $413,749,000 for the nine months ended April 30, 2016; organic sales (i.e. excluding acquisitions, a divestiture and foreign currency translation) increased by 17.6% and 12.6% for the three and nine months ended April 30, 2016, respectively.
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Gross profit as a percentage of net sales increased to 46.2% from 44.9% for the three months ended April 30, 2016, and 46.1% from 44.6% for the nine months ended April 30, 2016.
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Net income under United States generally accepted accounting principles (GAAP) increased by 13.5% to $14,019,000 from $12,356,000 for the three months ended April 30, 2016, and 25.9% to $43,662,000 from $34,680,000 for the nine months ended April 30, 2016.
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After adjusting net income for amortization expense and atypical items, non-GAAP adjusted net income increased by 24.1% to $18,243,000 from $14,697,000 for the three months ended April 30, 2016, and 20.0% to $52,776,000 from $43,979,000 for the nine months ended April 30, 2016, as further described and reconciled to net income in “Non-GAAP Financial Measures” in this MD&A.
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Adjusted earnings before interest, taxes, depreciation, amortization and stock-based compensation expense (“Adjusted EBITDAS”) increased by 24.6% to $34,822,000 from $27,946,000 for the three months ended April 30, 2016, and 21.1% to $100,315,000 from $82,855,000 for the nine months ended April 30, 2016, as further described and reconciled to net income in “Non-GAAP Financial Measures” in this MD&A.
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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:
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significantly higher sales and profitability in our Endoscopy segment principally due to (i) increases in demand for endoscope reprocessing equipment as well as higher margin products such as disposable infection control products used in GI endoscopy procedures and endoscope reprocessing disinfectants and service as a result of the increased field population of equipment and (ii) the inclusion of sales of our recent acquisitions,
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enhanced profitability in our Healthcare Disposables segment mainly due to (i) increased sales of higher margin products such as sterility assurance and waterline disinfection products, (ii) lower manufacturing costs and (iii) lower amortization expense, partially offset by elevated demand of our face masks and sterility assurance products in the first half of the prior year as a result of (a) customers buying products in advance of certain sales price increases and (b) customer response to the Ebola virus, and
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higher sales and improved profitability in our Dialysis segment primarily due to an increase in demand for our lower margin concentrate product.
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The above factors were partially offset by:
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our strategic decision to invest in various growth initiatives designed to expand into new markets and gain or maintain market share in our three largest segments,
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the impact of atypical items relating to acquisitions, costs associated with the future retirement of our Chief Executive Officer and the prior year impairment of an acquired license, as further described within Non-GAAP Financial Measures elsewhere in this MD&A,
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the divestiture of our specialty packaging business in April 2015, and
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an increase in warranty costs associated with our water purification equipment.
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(ii)
We sell our dialysis products to a concentrated number of customers. Sales in our Dialysis segment have been adversely impacted in recent years by the decrease in demand for our products that are used by dialysis centers that reuse dialyzers, such as our sterilant products and RENATRON
®
reprocessing equipment. With the exception of the current period which had increased sales of low margin concentrate products not used in dialyzer reprocessing, this reduction in dialysis sales has reduced overall profitability in this segment relative to 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 re-use dialyzers is more economical than single-use dialyzers. Based on discussions with customers, we expect the downward trend in re-use dialyzers in the United States will continue and likely accelerate during the remainder of fiscal 2016 and thereafter. A substantial reduction of our dialysis re-use business will likely have a significant adverse effect on our dialysis segment and reduce our margins and net income in that segment as well as result in potential future impairments of long-lived assets. Such reduction would also adversely affect our consolidated results of operations. See “Risk Factors” in the 2015 Form 10-K.
(iii)
In our current fiscal year, we acquired (i) all of the issued and outstanding stock of Medical Innovations Group Holdings Limited and certain affiliated companies (collectively, “MI”) on September 14, 2015 (the “MI Acquisition”) and (ii) certain net assets of North American Science Associates, Inc.’s Sterility Assurance Monitoring Products division (“NAMSA”) on March 1, 2016 (the “NAMSA Acquisition”), as more fully described in Note 3 to the Condensed Consolidated Financial Statements. With the exception of acquisition related costs as more fully described in the Non-GAAP Financial Measures section below, the businesses of MI (the “MI Business”) and NAMSA (the “NAMSA Business”) did not have a significant effect on our consolidated results of operations for the three and nine months ended April 30, 2016 due to the size of the businesses in relation to our overall consolidated results of operations. The MI Business is included in our Endoscopy segment and NAMSA Business is included in the Healthcare Disposables segment.
(iv)
In our prior fiscal year, we acquired (i) all of the issued and outstanding stock of MRLB International, Inc. (“MRLB”) on February 20, 2015 (the “DentaPure Acquisition”), (ii) certain net assets of Pure Water Solutions, Inc. (“PWS”) on January 1, 2015 (the “PWS Acquisition”) and (iii) all of the issued and outstanding stock of International Medical Service S.r.l. (“IMS”) on November 3, 2014 (the “IMS Acquisition”), as more fully described in Note 3 to the Condensed Consolidated Financial Statements. The businesses of MRLB (the “DentaPure Business”), PWS (the “PWS Business”) and IMS (the “IMS Business”) did not have a significant effect on our consolidated results of operations for the three and nine months ended April 30, 2016 and 2015 due to the size of the businesses in relation to our overall consolidated results of operations. The DentaPure Business is included in our Healthcare Disposables segment, the PWS Business is included in our Water Purification and Filtration segment and the IMS Business is included in our Endoscopy segment. Subsequent to its acquisition, we changed the name of International Medical Service S.r.l. to Cantel Medical (Italy) S.r.l.
(v)
In December 2015, a law was enacted that included a two-year moratorium on the medical device excise tax, which favorably impacts our gross profit, as more fully described elsewhere in this MD&A.
(vi)
On October 16, 2015, our Board of Directors approved a 20% increase in the semiannual cash dividend to $0.06 per share of outstanding common stock, which was paid on January 29, 2016 to shareholders of record at the close of business on January 15, 2016, as more fully described elsewhere in this MD&A.
Results of Operations
The results of operations described below reflect the operating results of Cantel and its wholly-owned subsidiaries. The following tables give information as to the net sales by reporting segment and geography (which
represent the geographic area from which the Company derives its net sales from external customers), as well as the related percentage of such sales to the total net sales.
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Three Months Ended
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Nine Months Ended
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April 30,
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April 30,
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2016
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2015
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2016
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2015
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(Dollar amounts in thousands)
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(Dollar amounts in thousands)
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$
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%
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$
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%
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$
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%
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$
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%
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Net Sales by Segment
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Endoscopy
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$
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91,892
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52.9
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$
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63,734
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45.0
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$
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244,992
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50.4
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$
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178,636
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43.2
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Water Purification and Filtration
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44,645
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25.7
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44,975
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31.8
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132,609
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27.3
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129,699
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31.3
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Healthcare Disposables
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29,779
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17.1
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24,754
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17.5
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83,157
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17.1
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79,288
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19.2
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Dialysis
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7,387
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4.3
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6,970
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4.9
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24,995
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5.2
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21,770
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5.3
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Other
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—
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—
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1,075
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0.8
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—
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—
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4,356
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1.0
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Total net sales
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$
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173,703
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100.0
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$
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141,508
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100.0
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$
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485,753
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100.0
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$
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413,749
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100.0
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Net Sales by Geography
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United States
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$
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134,690
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77.5
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$
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110,528
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78.1
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$
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377,405
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77.7
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$
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329,101
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79.5
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International
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39,013
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22.5
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30,980
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21.9
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108,348
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22.3
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84,648
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20.5
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Total net sales
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$
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173,703
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100.0
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$
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141,508
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100.0
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$
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485,753
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100.0
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$
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413,749
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100.0
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Net Sales
Total net sales increased by $32,195,000, or 22.8%, to $173,703,000 for the three months ended April 30, 2016 from $141,508,000 for the three months ended April 30, 2015. The 22.8% increase in net sales for the three months ended April 30, 2016 includes (i) a 17.6% increase in organic sales, (ii) a 5.8% increase in sales due to acquisitions, partially offset by the divestiture of our specialty packaging segment, and (iii) a 0.6% decrease due to foreign currency translation.
Net sales increased by $72,004,000, or 17.4%, to $485,753,000 for the nine months ended April 30, 2016 from $413,749,000 for the nine months ended April 30, 2015. The 17.4% increase in net sales for the nine months ended April 30, 2016 includes (i) a 12.6% increase in organic sales, (ii) a 5.4% increase in sales due to acquisitions, partially offset by the divestiture of our specialty packaging segment, and (iii) a 0.6% decrease due to foreign currency translation.
International net sales increased by $8,033,000, or 25.9%, and $23,700,000, or 28.0%, for the three and nine months ended April 30, 2016, respectively, compared with the three and nine months ended April 30, 2015. The 25.9% and 28.0% increases in net sales consist of (i) increases of 10.6% and 19.1% in organic net sales, (ii) increases of 18.1% and 11.9% in net sales due to acquisitions and (iii) decreases of 2.8% and 3.0% in net sales due to foreign currency translation, respectively.
The increase in both domestic and international organic net sales for the three and nine months ended April 30, 2016 was primarily attributable to increases in net sales of our endoscopy products and services.
Net sales of endoscopy products and services increased by $28,158,000, or 44.2%, and $66,356,000, or 37.2%, for the three and nine months ended April 30, 2016, respectively, compared with the three and nine months ended April 30, 2015. The 44.2% and 37.2% increases in net sales consist of (i) increases of 33.1% and 27.4% in organic net sales, (ii) increases of 12.0% and 10.5% in net sales due to acquisitions and (iii) decreases of 0.9% and 0.7% in net sales due to foreign currency translation, respectively. The increase in organic net sales for the three and nine months ended April 30, 2016 was primarily due to increases in demand in the United States and internationally for our (i) procedure room products (disposable infection control products used in GI endoscopy procedures) due to sales and marketing efforts, (ii) endoscope reprocessing equipment due to our sales and marketing programs and (iii) disinfectants and service due to the increase in the installed base of endoscope reprocessing equipment. We expect sales of disinfectants, service, filters and equipment accessories, most of 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 endoscopy reprocessing equipment and procedure room products as a result of our strategic growth plan and increased competition.
Net sales of water purification and filtration products and services were similar for the three months ended April 30, 2016, and increased by $2,910,000, or 2.2%, for the nine months ended April 30, 2016, compared with the three and nine months ended April 30, 2015 due to an increase in demand for sterilants and speciality filter products, partially offset by lower demand during the three months ended April 30, 2016 for our water purification equipment used for commercial and industrial (large capital) applications.
Net sales of healthcare disposables products increased by $5,025,000, or 20.3%, and $3,869,000, or 4.9%, for the three and nine months ended April 30, 2016, respectively, compared with the three and nine months ended April 30, 2015. The 20.3% and 4.9% increases in net sales consist of (i) increases of 13.4% and 0.4% in organic net sales and (ii) increases of 6.9% and 4.5% in net sales due to acquisitions. Organic net sales for the nine months ended April 30, 2016 were similar to the nine months ended April 30, 2015 as the increase in sales of sterility assurance and waterline disinfection products in the current year were offset by the elevated demand during the first half of the prior year for our face masks and certain sterilization products as a result of (i) customers buying products in advance of certain sales price increases and (ii) customer response to the Ebola virus. For the three months ended April 30, 2016, the increase in organic sales was primarily due to increased demand for our sterility assurance and waterline disinfection products, and the impact in the three months ended April 30, 2015 of low demand for our face masks and certain sterilization products due to customers having adequate inventory levels as a result of their earlier purchases during the first half of the prior year, as explained above.
Net sales of dialysis products and services increased by $417,000, or 6.0%, and $3,225,000, or 14.8%, for the three and nine months ended April 30, 2016, respectively, compared with the three and nine months ended April 30, 2015, principally due to (i) an increase in demand for our lower margin concentrate product by a single customer, which demand is expected to decline in fiscal 2017, partially offset by a decrease in demand for our sterilant product due to the market shift from reusable to single-use dialyzers, as further described elsewhere in this MD&A.
Gross Profit
Gross profit increased by $16,722,000, or 26.3%, to $80,321,000 for the three months ended April 30, 2016 from $63,599,000 for the three months ended April 30, 2015. Gross profit as a percentage of net sales for the three months ended April 30, 2016 and 2015 was 46.2% and 44.9%, respectively. Excluding the impact of acquisition accounting charges, gross profit as a percentage of net sales for the three months ended April 30, 2016 and 2015 was 46.5% and 45.2%, respectively.
Gross profit increased by $39,152,000, or 21.2%, to $223,856,000 for the nine months ended April 30, 2016 from $184,704,000 for the nine months ended April 30, 2015. Gross profit as a percentage of net sales for the nine months ended April 30, 2016 and 2015 was 46.1% and 44.6%, respectively. Excluding the impact of acquisition accounting charges, gross profit as a percentage of net sales for the nine months ended April 30, 2016 and 2015 was 46.3% and 45.1%, respectively.
The higher gross profit as a percentage of net sales for the three and nine months ended April 30, 2016 compared with the three and nine months ended April 30, 2015, respectively, was primarily attributable to (i) more favorable sales mix due to increases in sales volume of certain products that carry higher gross margin percentages such as our procedure room products and disinfectants in our Endoscopy segment and sterilants and filters in our Water Purification and Filtration segment, (ii) the inclusion of higher margin sales in our Endoscopy and Healthcare Disposables segments as a result of the MI and DentaPure acquisitions, respectively, (iii) lower manufacturing costs and (iv) decreases of $1,076,000 and $1,141,000, respectively, in medical device excise tax due to the recent moratorium, as further explained below, partially offset by an increase in net sales of lower margin capital equipment primarily in our Endoscopy segment and higher charges for warranty primarily relating to our water purification equipment.
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 price competition, (iii) the market shift from reusable to single-use dialyzers in our Dialysis segment as further explained elsewhere in this MD&A, or (iv) if raw materials and distribution costs increase and we are unable to implement offsetting price increases.
In December 2015, the Consolidated Appropriations Act of 2016 was signed into law and included a two-year moratorium effective January 1, 2016 on the medical device excise tax, which was a tax on medical device makers in the form of a 2.3% excise tax on all U.S. medical device sales. A significant portion of our net sales are considered U.S. medical device sales and therefore our gross profit percentage will continue to be favorably impacted by this moratorium
until the two-year moratorium expires. However, we are investing a significant portion of the savings from this moratorium into sales and marketing and product development initiatives.
Operating Expenses
Selling expenses increased by $6,561,000, or 32.3%, to $26,887,000 for the three months ended April 30, 2016 from $20,326,000 for the three months ended April 30, 2015. For the nine months ended April 30, 2016, selling expenses increased by $11,973,000, or 20.3%, to $70,967,000 from $58,994,000 for the nine months ended April 30, 2015. For the three and nine months ended April 30, 2015, operating expenses increased primarily due to (i) higher commission expense relating to increased net sales in our Endoscopy segment, (ii) increased sales and marketing initiatives to expand into new markets, including international markets, and to gain or maintain market share by hiring and training additional sales and marketing personnel and increasing travel budgets in our Endoscopy, Water Purification and Filtration and Healthcare Disposables segments, (iii) the inclusion of selling and marketing expenses of acquisitions, and (iv) increases in annual salaries. These increases were partially offset by decreases of $210,000 and $884,000 in selling expense for the three and nine months ended April 30, 2016, respectively, relating to our specialty packaging business divested in April 2015.
Selling expenses as a percentage of net sales were 15.5% and 14.4% for the three months ended April 30, 2016 and 2015, respectively, and 14.6% and 14.3% for the nine months ended April 30, 2016 and 2015, respectively.
General and administrative expenses increased by $7,650,000, or 41.5%, to $26,106,000 for the three months ended April 30, 2016 from $18,456,000 for the three months ended April 30, 2015. For the nine months ended April 30, 2016, general and administrative expenses increased by $13,770,000, or 24.3%, to $70,555,000 from $
56,785,000
for the nine months ended April 30, 2015. General and administrative expenses increased primarily due to (i) the inclusion of general and administrative expenses of our acquisitions, (ii) the impact of atypical items relating to acquisitions, costs associated with the future retirement of our Chief Executive Officer and the prior year impairment of an acquired license, as further described below and within Non-GAAP Financial Measures elsewhere in this MD&A, and (iii) increases in annual salaries and incentive compensation including stock-based compensation.
Excluding (i) current and prior year amortization expense, (ii) current and prior year acquisition related items such as transaction and integration charges and fair value adjustments, (iii) current year costs associated with the future retirement of our Chief Executive Officer and (iv) the prior year impairment of an acquired license, as further described within Non-GAAP Financial Measures elsewhere in this MD&A, general and administrative expenses increased by $3,860,000, or 23.5%, to $20,304,000 for the three months ended April 30, 2016 and $10,786,000, or 23.1%, to $57,402,000 for the nine months ended April 30, 2016. Almost half of these increases are attributable to the inclusion of general and administrative expenses of our acquisitions.
General and administrative expenses as a percentage of net sales were 15.0% and 13.0% for the three months ended April 30, 2016 and 2015, respectively, and 14.5% and 13.7% for the nine months ended April 30, 2016 and 2015, respectively.
Research and development expenses (which include continuing engineering costs) increased by $529,000, or 15.0%, to $4,065,000 for the three months ended April 30, 2016 from $3,536,000 for the three months ended April 30, 2015. For the nine months ended April 30, 2016, research and development expenses increased by $603,000, or 5.9%, to $10,899,000, from $10,296,000 for the nine months ended April 30, 2015. The increase for the three and nine months ended April 30, 2016 was primarily due to additional product development initiatives primarily in our Endoscopy segment, including the inclusion of projects relating to recent acquisitions.
Research and development expense as a percentage of net sales were 2.3% and 2.5% for the three months ended April 30, 2016 and 2015, respectively, and 2.2% and 2.5% for the nine months ended April 30, 2016 and 2015, respectively.
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.
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Three Months Ended
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Nine Months Ended
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April 30,
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April 30,
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2016
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2015
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2016
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2015
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(Dollar amounts in thousands)
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(Dollar amounts in thousands)
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Operating
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% of
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Operating
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% of
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Operating
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% of
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Operating
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% of
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Income
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Net sales
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Income
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Net sales
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Income
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Net sales
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Income
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Net sales
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Endoscopy
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$
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16,279
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17.7
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%
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$
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12,978
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20.4
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%
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$
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43,402
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17.7
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%
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$
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28,832
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16.1
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%
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Water Purification and Filtration
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6,934
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15.5
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%
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7,540
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16.8
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%
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22,336
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|
16.8
|
%
|
|
|
23,317
|
|
18.0
|
%
|
|
Healthcare Disposables
|
|
|
6,162
|
|
20.7
|
%
|
|
|
3,432
|
|
13.9
|
%
|
|
|
18,195
|
|
21.9
|
%
|
|
|
14,255
|
|
18.0
|
%
|
|
Dialysis
|
|
|
1,795
|
|
24.3
|
%
|
|
|
1,620
|
|
23.2
|
%
|
|
|
6,216
|
|
24.9
|
%
|
|
|
4,551
|
|
20.9
|
%
|
|
Other
|
|
|
—
|
|
—
|
%
|
|
|
211
|
|
19.6
|
%
|
|
|
—
|
|
—
|
%
|
|
|
1,118
|
|
25.7
|
%
|
|
Operating income by segment
|
|
|
31,170
|
|
17.9
|
%
|
|
|
25,781
|
|
18.2
|
%
|
|
|
90,149
|
|
18.6
|
%
|
|
|
72,073
|
|
17.4
|
%
|
|
General corporate expenses
|
|
|
(7,907)
|
|
|
|
|
|
(4,500)
|
|
|
|
|
|
(18,714)
|
|
|
|
|
|
(13,444)
|
|
|
|
|
Income from operations
|
|
$
|
23,263
|
|
13.4
|
%
|
|
$
|
21,281
|
|
15.0
|
%
|
|
$
|
71,435
|
|
14.7
|
%
|
|
$
|
58,629
|
|
14.2
|
%
|
|
The Endoscopy segment’s operating income increased by $3,301,000, or 25.4%, and $14,570,000, or 50.5%, for the three and nine months ended April 30, 2016, respectively, compared with the three and nine months ended April 30, 2015, primarily due to increases in sales in the United States and internationally for our endoscopy products and services, as further explained above, and to a lesser extent, the inclusion of operating income from acquisitions. These items were partially offset by (i) higher commission expense and other incentive compensation (ii) increased investment in our sales team and other selling initiatives, which is expected to continue to increase through the remainder of fiscal 2016, (iii) a net unfavorable impact from atypical items, as further described below and within Non-GAAP Financial Measures elsewhere in this MD&A, (iv) a modest decrease in gross profit as a percentage of sales primarily due to an increase in lower margin sales of capital equipment and lower selling prices and (v) an increase in annual salaries. Excluding amortization expense as well as atypical items relating to current and prior year acquisition related items and a prior year license impairment, as further described within Non-GAAP Financial Measures elsewhere in this MD&A, the Endoscopy segment’s operating income increased by $5,590,000, or 42.5%, and $16,187,000, or 46.5%, for the three and nine months ended April 30, 2016, respectively, compared with the three and nine months ended April 30, 2015.
The Water Purification and Filtration segment’s operating income decreased by $606,000, or 8.0%, and $981,000, or 4.2%, for the three and nine months ended April 30, 2016, respectively, compared with the three and nine months ended April 30, 2015,
primarily as a result of increases in annual salaries and incentive compensation, the hiring of additional sales personnel and higher charges for warranty on water purification equipment, partially offset by an increase in sales in the first half of the nine months ended April 30, 2016, as further explained above.
The Healthcare Disposables segment’s operating income increased by $2,730,000, or 79.6% and $3,940,000, or 27.6%, for the three and nine months ended April 30, 2016, respectively, compared with the three and nine months ended April 30, 2015, primarily due to
(i) increases in sales in the United States for our healthcare disposables products, as further explained above, (ii) less amortization expense and (iii) lower manufacturing costs, partially offset by increases to annual salaries and the hiring of additional sales personnel. Excluding amortization expense, and to a much lesser extent acquisition related items, as further described within Non-GAAP Financial measures elsewhere in this MD&A, the Healthcare Disposables segment’s operating income increased by $2,289,000, or 46.5%, and $2,436,000, or 13.6%, for the three and nine months ended April 30, 2016, respectively, compared with the three and nine months ended April 30, 2015.
The Dialysis segment’s operating income increased by $175,000, or 10.8%, and $1,665,000, or 36.6%, for the three and nine months ended April 30, 2016, respectively, compared with the three and nine months ended April 30, 2015,
primarily due to (i) an increase in sales for our low margin concentrate product to a single customer and (ii) successful cost control initiatives, partially offset by a decrease in demand for our sterilant product.
With the exception of the three and nine months ended April 30, 2016 which had increased sales of low margin concentrate products not used in dialyzer reprocessing, sales in our Dialysis segment in recent years have been adversely impacted by the decrease in demand for our sterilants and RENATRON
®
reprocessing equipment principally due to the shift from reusable to single-use dialyzers as a result of the declining 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 re-use to single-use facilities. In addition, DaVita, a customer who accounted for approximately 19.1% of net sales in this segment, has been evaluating the economics and other factors associated with single-use versus re-use on a regional basis. This evaluation has resulted in the conversion by DaVita of certain clinics from re-use to single-use and in many cases the opening of new clinics as single-use clinics. Based on discussions with customers, we expect the downward trend in re-use dialyzers in the United States will continue and likely accelerate during the remainder of fiscal 2016 and thereafter. A substantial 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. Such reduction would also adversely affect our consolidated results of operations. See “Risk Factors” in our 2015 Form 10-K.
General corporate expenses relate to unallocated corporate costs primarily related to executive management personnel as well as costs associated with certain facets of our acquisition program and being a publicly traded company.
Such expenses increased by $3,407,000, or 75.7%, and $5,270,000, or
39.2%, for the three and nine months ended April 30, 2016, respectively, compared with the three and nine months ended April 30, 2015, primarily due to (i) $1,162,000 of costs recorded in our third quarter associated with the future retirement of our Chief Executive Officer, (ii) increases in costs associated with our acquisition program of $942,000 and $897,000, respectively, (iii) the addition of internal and external resources to address various growth initiatives and compliance requirements and (iv) increases in annual salaries and incentive compensation.
Interest
Interest expense increased by $254,000 to $890,000 for the three months ended April 30, 2016 from $636,000 for the three months ended April 30, 2015. For the nine months ended April 30, 2016, interest expense increased by $702,000 to $2,549,000 from $1,847,000 for the nine months ended April 30, 2015. These increases were due to an increase in the average outstanding borrowings due to the funding of the MI and NAMSA acquisitions in September 2015 and March 2016, respectively.
Interest income was $19,000 and $17,000 for the three months ended April 30, 2016 and 2015, respectively, and $62,000 and $48,000 for the nine months ended April 30, 2016 and 2015, respectively.
Income Taxes
The consolidated effective tax rate was 36.7% and 36.5% for the nine months ended April 30, 2016 and 2015, respectively. Almost all of our income before income taxes for both periods was generated from our United States operations, which had an overall effective tax rate of 36.5% and 36.7%, respectively.
As further described within Non-GAAP Financial Measures elsewhere in this MD&A, the consolidated effective tax rates for the nine months ended April 30, 2016 and 2015 were impacted by (i) non-deductible acquisition related items in the current and prior periods, (ii) the divestiture of our Specialty Packaging business in the prior period and (iii) the enactment of favorable tax legislation in the United States and internationally in the current period. Additionally, our consolidated effective tax rate is impacted by the operating results of our international operations, which are located in lower tax rate jurisdictions.
A reconciliation of the consolidated effective income tax rate for the nine months ended April 30, 2016 to the nine months ended April 30, 2015 is as follows:
|
|
|
|
|
|
|
Consolidated
|
|
|
|
|
Effective
|
|
|
|
|
Income Tax Rate
|
|
|
April 30, 2015
|
|
36.5
|
%
|
|
Differential attributable to:
|
|
|
|
|
Loss on sale of business
|
|
(1.3)
|
%
|
|
New tax legislation
|
|
(0.5)
|
%
|
|
Acquisition related items, net
|
|
2.0
|
%
|
|
International operations
|
|
0.1
|
%
|
|
Other
|
|
(0.1)
|
%
|
|
April 30, 2016
|
|
36.7
|
%
|
|
We concluded an audit by the Internal Revenue Service for fiscal years 2013 and 2012. With respect to state or foreign income tax examinations, we are generally no longer subject to examinations for fiscal years ended prior to July 31, 2008.
Non-GAAP Financial Measures
In evaluating our operating performance, we supplement the reporting of our financial information determined under accounting principles generally accepted in the United States (“GAAP”) with certain internally driven non-GAAP financial measures, namely (i) adjusted net income, (ii) adjusted diluted earnings per share (“EPS”), (iii) income before interest, taxes, depreciation, amortization and stock-based compensation expense (“EBITDAS”), (iv) EBITDAS adjusted for atypical items (“Adjusted EBITDAS”) and (v) net debt. These non-GAAP financial measures are indicators of the Company’s performance that are not required by, or presented in accordance with, GAAP. They are presented with the intent of providing greater transparency to financial information used by us in our financial analysis and operational decision-making. We believe that these non-GAAP measures provide meaningful information to assist investors, shareholders and other readers of our Condensed Consolidated Financial Statements in making comparisons to our historical operating results and analyzing the underlying performance of our results of operations. These non-GAAP financial measures are not intended to be, and should not be, considered separately from, or as an alternative to, the most directly comparable GAAP financial measures.
We define adjusted net income and adjusted diluted EPS as net income and diluted EPS, respectively, adjusted to exclude amortization, acquisition related items, significant reorganization and restructuring charges, major tax events and other significant items management deems atypical or non-operating in nature.
For the three and nine months ended April 30, 2016, we made adjustments to net income and diluted EPS to exclude (i) amortization expense, (ii) significant acquisition related items impacting current operating performance including transaction and integration charges and ongoing fair value adjustments, (iii) costs associated with the future retirement of our Chief Executive Officer and (iv) with respect to the nine months ended April 30, 2016, the impact of favorable tax legislation to arrive at our non-GAAP financial measures, adjusted net income and adjusted EPS.
For the three and nine months ended April 30, 2015, we made adjustments to net income and diluted EPS to exclude (i) amortization expense, (ii) significant acquisition related items impacting current operating performance including transaction and integration charges and ongoing fair value adjustments, (iii) the loss on sale of our Speciality Packaging business and (iv) the impairment of an acquired license to arrive at our non-GAAP financial measures, adjusted net income and adjusted EPS.
Amortization expense is a non-cash expense related to intangibles that were primarily the result of business acquisitions. Our history of acquiring businesses has resulted in significant increases in amortization of intangible assets that reduced the Company’s net income. The removal of amortization from our overall operating performance helps in assessing our cash generated from operations including our return on invested capital, which we believe is an important analysis for measuring our ability to generate cash and invest in our continued growth.
Acquisition related items consist of (i) fair value adjustments to contingent consideration and other contingent liabilities resulting from acquisitions, (ii) due diligence, integration, legal fees and other transaction costs associated with our acquisition program and (iii) acquisition accounting charges for the amortization of the initial fair value adjustments of acquired inventory and deferred revenue. The adjustments of contingent consideration and other contingent liabilities are periodic adjustments to record such amounts at fair value at each balance sheet date. Given the subjective nature of the assumptions used in the determination of fair value calculations, fair value adjustments may potentially cause significant earnings volatility that are not representative of our operating results. Similarly, due diligence, integration, legal and other acquisition costs associated with our acquisition program, including acquisition accounting charges relating to recording acquired inventory and deferred revenue at fair market value, can be significant and also adversely impact our effective tax rate as certain costs are often not tax-deductible. Since all of these acquisition related items are atypical and often mask underlying operating performance, we excluded these amounts for purposes of calculating these non-GAAP financial measures to facilitate an evaluation of our current operating performance and a comparison to past operating performance.
During our three months ended April 30, 2016, we announced the future retirement of our Chief Executive Officer and recorded a portion of the costs associated with his retirement in our Condensed Consolidated Financial Statements. Since these costs are atypical and masks our underlying operating performance,
we made an adjustment to our net income and EPS for the three and nine months ended April 30, 2016 to exclude such costs to arrive at our non-GAAP financial measures.
Tax legislation was enacted in the United States and internationally that enabled us to record favorable tax benefits in our second quarter of fiscal 2016 relating to the entire calendar 2015. Since these favorable tax benefits are largely unrelated to our current year’s income before taxes and is unrepresentative of our normal effective tax rate, we excluded its impact on net income and EPS for purposes of calculating these non-GAAP financial measures to facilitate an evaluation of our current performance and a comparison to past performance.
On April 7, 2015, we completed the sale of our Specialty Packaging business to a global packaging and service company, as further described in Note 16 to the Condensed Consolidated Financial Statements. Overall, this transaction, including costs associated with the disposition and the recognition of a foreign currency translation gain, resulted in a $2,206,000 loss, or $0.04 in diluted earnings per share, which was recorded in loss on sale of business in our Condensed Consolidated Statements of Income for the three and nine months ended April 30, 2015. Since the divestiture of a business is atypical and non-operating in nature and the loss on sale masks our underlying operating performance, we excluded the loss on sale of business for purposes of calculating these non-GAAP financial measures.
In September 2013, we acquired a license from a third party granting us the exclusive right to manufacture, commercialize, distribute and sell an endoscopy product in its beginning stage of commercialization in exchange for a series of payments, which totaled $1,000,000 by our second quarter of fiscal 2015 and was recorded in other assets in our Condensed Consolidated Balance Sheets. We evaluated this long-lived asset in fiscal 2015 for potential impairment and determined that the future use of this acquired license was unlikely based on a recent product analysis. Accordingly, we deemed the acquired license, together with related fixed assets of $287,000 to be fully impaired and recorded a loss of $1,287,000 during the three and nine months ended April 30, 2015, which was recorded in general and administrative expenses and as reductions in other assets and property and equipment in the Condensed Consolidated Financial Statements. Since the acquisition of the license and subsequent impairment were outside our standard endoscopy business operations, we excluded the impairment of the acquired license
for purposes of calculating these non-GAAP financial measures to facilitate an evaluation of our current operating performance and a comparison to past operating performance.
The reconciliations of net income to adjusted net income were calculated as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
|
April 30,
|
|
April 30,
|
|
(Amounts in Thousands)
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income, as reported
|
|
$
|
14,019
|
|
$
|
12,356
|
|
$
|
43,662
|
|
$
|
34,680
|
|
Intangible amortization (1)
|
|
|
3,346
|
|
|
3,460
|
|
|
9,737
|
|
|
9,648
|
|
Acquisition related items (2)
|
|
|
1,682
|
|
|
(2,327)
|
|
|
3,213
|
|
|
1,185
|
|
CEO retirement costs (1)
|
|
|
1,162
|
|
|
—
|
|
|
1,162
|
|
|
—
|
|
Loss on sale of business
|
|
|
—
|
|
|
2,206
|
|
|
—
|
|
|
2,206
|
|
Impairment of acquired license (1)
|
|
|
—
|
|
|
1,287
|
|
|
—
|
|
|
1,287
|
|
Income tax benefit on above adjustments (3)
|
|
|
(1,966)
|
|
|
(2,285)
|
|
|
(4,198)
|
|
|
(5,027)
|
|
Tax legislative changes (3)
|
|
|
—
|
|
|
—
|
|
|
(800)
|
|
|
—
|
|
Adjusted net income
|
|
$
|
18,243
|
|
$
|
14,697
|
|
$
|
52,776
|
|
$
|
43,979
|
|
|
(1)
|
|
Amounts are recorded in general and administrative expenses.
|
|
(2)
|
|
For the three and nine months ended April 30, 2016, acquisition related items of $388 and $959, respectively, were recorded in cost of sales and $1,294 and $2,254, respectively, were recorded in general administrative expenses. For the three and nine months ended April 30, 2015, acquisition related items of $408 and $1,951, respectively, were recorded in cost of sales and ($2,735) and ($766), respectively, were recorded in general administrative expenses.
|
|
(3)
|
|
Amounts are recorded in income taxes.
|
The reconciliations of diluted EPS to adjusted diluted EPS were calculated as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
|
April 30,
|
|
April 30,
|
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted EPS, as reported
|
|
$
|
0.34
|
|
$
|
0.30
|
|
$
|
1.05
|
|
$
|
0.83
|
|
Intangible amortization, net of tax
|
|
|
0.06
|
|
|
0.05
|
|
|
0.16
|
|
|
0.15
|
|
Acquistion related items, net of tax
|
|
|
0.03
|
|
|
(0.06)
|
|
|
0.05
|
|
|
0.01
|
|
CEO retirement costs, net of tax
|
|
|
0.02
|
|
|
—
|
|
|
0.02
|
|
|
—
|
|
Loss on sale of business, net of tax
|
|
|
—
|
|
|
0.04
|
|
|
—
|
|
|
0.04
|
|
Impairment of acquired license, net of tax
|
|
|
—
|
|
|
0.02
|
|
|
—
|
|
|
0.02
|
|
Tax legislative changes
|
|
|
—
|
|
|
—
|
|
|
(0.02)
|
|
|
—
|
|
Adjusted diluted EPS
|
|
$
|
0.44
|
(1)
|
$
|
0.35
|
|
$
|
1.26
|
|
$
|
1.06
|
(1)
|
|
(1)
|
|
The summation of diluted EPS does not equal the adjusted diluted EPS by $0.01 due to rounding.
|
We believe EBITDAS is an important valuation measurement for management and investors given the increasing effect that non-cash charges, such as stock-based compensation, amortization related to acquisitions and depreciation of capital equipment, has on the Company’s net income. In particular, acquisitions have historically resulted in significant increases in amortization of intangible assets that reduce the Company’s net income. Additionally, we regard EBITDAS as a useful measure of operating performance and cash flow before the effect of interest expense and is a complement to operating income, net income and other GAAP financial performance measures.
We define Adjusted EBITDAS as EBITDAS excluding the same atypical items as previously described as adjustments to net income. We use Adjusted EBITDAS when evaluating the operating performance of the Company because we believe the exclusion of such atypical items, of which a significant portion are non-cash items, is necessary to provide the most accurate measure of on-going core operating results and to evaluate comparative results period over period.
The reconciliations of EBITDAS and Adjusted EBITDAS with net income were calculated
as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
|
April 30,
|
|
April 30,
|
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income, as reported
|
|
$
|
14,019,000
|
|
$
|
12,356,000
|
|
$
|
43,662,000
|
|
$
|
34,680,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest expense, net
|
|
|
871,000
|
|
|
619,000
|
|
|
2,487,000
|
|
|
1,799,000
|
|
Income taxes
|
|
|
8,373,000
|
|
|
6,100,000
|
|
|
25,286,000
|
|
|
19,944,000
|
|
Depreciation
|
|
|
3,061,000
|
|
|
2,720,000
|
|
|
8,754,000
|
|
|
7,573,000
|
|
Amortization
|
|
|
3,346,000
|
|
|
3,460,000
|
|
|
9,737,000
|
|
|
9,648,000
|
|
Loss on disposal of fixed assets
|
|
|
66,000
|
|
|
172,000
|
|
|
177,000
|
|
|
209,000
|
|
Stock-based compensation expense
|
|
|
2,242,000
|
|
|
1,353,000
|
|
|
5,837,000
|
|
|
4,354,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
EBITDAS
|
|
|
31,978,000
|
|
|
26,780,000
|
|
|
95,940,000
|
|
|
78,207,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Acquisition related items
|
|
|
1,682,000
|
|
|
(2,327,000)
|
|
|
3,213,000
|
|
|
1,185,000
|
|
CEO retirement costs
|
|
|
1,162,000
|
|
|
—
|
|
|
1,162,000
|
|
|
—
|
|
Loss on sale of business
|
|
|
—
|
|
|
2,206,000
|
|
|
—
|
|
|
2,206,000
|
|
Impairment of acquired license
|
|
|
—
|
|
|
1,287,000
|
|
|
—
|
|
|
1,287,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Adjusted EBITDAS
|
|
$
|
34,822,000
|
|
$
|
27,946,000
|
|
$
|
100,315,000
|
|
$
|
82,885,000
|
|
We define net debt as long-term debt less cash and cash equivalents. Each of the components of net debt appears in the Condensed Consolidated Balance Sheets. We believe that the presentation of net debt provides useful information to investors because we review net debt as part of our management of our overall liquidity, financial flexibility, capital structure and leverage.
The reconciliations of debt with net debt were calculated as follows:
|
|
|
|
|
|
|
|
|
|
April 30,
|
|
July 31,
|
|
|
|
2016
|
|
2015
|
|
|
|
|
|
|
|
|
|
Long-term debt
|
|
$
|
132,000,000
|
|
$
|
78,500,000
|
|
Less cash and cash equivalents
|
|
|
(25,498,000)
|
|
|
(31,720,000)
|
|
Net debt
|
|
$
|
106,502,000
|
|
$
|
46,780,000
|
|
The increase in net debt w
as the result of an increase in the average outstanding borrowings due to the funding of the MI acquisition in September 2015 and the NAMSA acquisition in March 2016, partially offset by repayments.
Liquidity and Capital Resources
Working Capital
At April 30, 2016, our working capital was $134,655,000, compared with $117,737,000 at July 31, 2015. The increase was primarily due to the impact of the MI and NAMSA acquisitions, as further explained in Note 3 to the Condensed Consolidated Financial Statements.
Cash Flows from Operating, Investing and Financing Activities
The significant components of our cash flows were calculated as follows:
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|
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|
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Nine Months Ended
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|
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April 30,
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|
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2016
|
|
2015
|
|
|
|
|
|
|
|
|
|
Net cash provided by operating activities
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|
$
|
51,803,000
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|
$
|
33,374,000
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|
Net cash used in investing activities
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|
$
|
(106,916,000)
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|
$
|
(47,633,000)
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Net cash provided by financing activities
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|
$
|
49,033,000
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|
$
|
8,443,000
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Cash Flows from Operating Activities
Net cash provided by operating activities increased by $18,429,000, or 55.2%, for the nine months ended April 30, 2016, compared with the nine months ended April 30, 2015, primarily due to the increase in net income (after adjusting for depreciation, amortization, stock-based compensation expense, fair value adjustments of acquisition related liabilities, loss on sale of business, impairment of assets and deferred income taxes) and increases in accounts payable and other current liabilities (due to the timing of payments), partially offset by an increase in inventories (due to planned strategic increases in stock levels of certain products primarily in our Endoscopy segment).
Cash Flows from Investing Activities
Net cash used in investing activities increased by $59,283,000 for the nine months ended April 30, 2016, compared with the nine months ended April 30, 2015, primarily due to more acquisition related cash consideration in the current period compared to the prior period.
Cash Flows from Financing Activities
Net cash provided by financing activities increased by $40,590,000 for the nine months ended April 30, 2016, compared with the nine months ended April 30, 2015, primarily due to larger borrowings under our credit facility to fund the MI and NAMSA acquisitions in the current period, compared to borrowing to fund the IMS, Pure Water Solutions and DentaPure acquisitions in the prior period.
Cash Dividends
On October 16, 2015, our Board of Directors approved a 20% increase in the semiannual cash dividend to $0.06 per share of outstanding common stock, which was paid on January 29, 2016 to shareholders of record at the close of business on January 15, 2016. 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.
Credit Facility
On March 4, 2014, we entered into a $250,000,000 Third Amended and Restated Credit Agreement (the “2014 Credit Agreement”). The 2014 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 “2014 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 2014 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 2014 Credit Agreement expires on March 4, 2019. Additionally, subject to certain restrictions and conditions (i) any of our domestic or foreign subsidiaries may become borrowers and (ii) borrowings may occur in multi-currencies.
Borrowings under the 2014 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 2014 Credit Agreement (“Consolidated EBITDA”). At May 31, 2016, the lender’s base rate was 3.50% and the LIBOR rates ranged from 0.43% to 0.90%. The margins applicable to our outstanding borrowings were 0.50% above the lender’s base rate or 1.50% above LIBOR. All of our outstanding borrowings were under LIBOR contracts at May 31, 2016. The 2014 Credit Agreement also provides for fees on the unused portion of our facility at rates ranging from 0.20% to 0.40%, depending upon our Consolidated Leverage Ratio; such rate was 0.25% at May 31, 2016.
The 2014 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 2014 Credit Agreement.
On April 30, 2016, we had $132,000,000 of outstanding borrowings under the 2014 Credit Agreement. Subequent to April 30, 2016, we repaid $3,500,000 resulting in total outstanding borrowings of $128,500,000 at June 9, 2016, none of which is required to be repaid until March 2019.
Bank of Italy Obligation
In relation to the IMS Acquisition on November 3, 2014, we assumed an $843,000 liability to the Bank of Italy as part of funding provided by an Italian government agency, of which $187,000 and $656,000 were recorded in accrued expenses and other long-term liabilities, respectively. Such amount was a portion of the financial support obtained from the Italian government’s Ministry of Education, Universities and Research to fund research and development activity relating to IMS’s automated endoscope reprocessors. The liability is payable in semi-annual installments, bears interest at 0.25% per annum and has a maturity date of January 1, 2019. At April 30, 2016, $510,000 is outstanding, of which $169,000 is recorded in accrued expense and $341,000 is recorded in other long-term liabilities.
Financing Needs
Our operating segments generate significant cash from operations. At April 30, 2016 we had a cash balance of $25,498,000, of which $8,183,000 was held by foreign subsidiaries. Our foreign cash is needed by our foreign subsidiaries for working capital purposes as well as for current international growth initiatives. Accordingly, our foreign unremitted earnings are considered permanently reinvested and unavailable for repatriation.
We believe that our current cash position, anticipated cash flows from operations and the funds available under our 2014 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 June 9, 2016, $121,500,000 was available under our 2014 Credit Agreement.
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 and dialysis products, shipment terms are generally FOB origin for common carrier and when our distribution fleet is utilized (except
for a single 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 and endoscopy 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. 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.
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, installation and consumable components based upon vendor specific objective evidence, which includes comparable historical transactions of similar equipment, installation and consumables 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 and consumables components are recognized as the equipment or consumable is shipped to customers and title passes. Revenue on the installation component is recognized when the installation is complete.
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.
None of our sales contain right-of-return provisions. Customer claims for credit or return due to damage, defect, shortage or other reasons 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 product sales in each segment. 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 $1,538,000 and $4,426,000 for the three and nine months ended April 30, 2016, respectively, and $1,432,000 and $4,201,000 for the three and nine months ended April 30, 2015, 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 directly to hospitals and other end-users in the United States and primarily to distributors internationally except for the United Kingdom, Italy, Netherlands, Singapore, China and Germany where we sell directly to hospitals and other end-users; water purification and filtration products and services are sold directly to hospitals, dialysis clinics, pharmaceutical and biotechnology companies, laboratories, medical products and service companies and other end-users, as well as through third-party distributors; 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; and the majority of our dialysis products are sold to dialysis clinics and hospitals. 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 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 3 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.
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, 2015, because we determined through qualitative factors that the fair values of our Endoscopy, Water Purification and Filtration and Healthcare Disposables 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 Dialysis (due to the decreasing operating results). 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, where applicable. The first step is a review for potential impairment, and the second step measures the amount of impairment, if any.
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, 2015, because we determined through qualitative factors that the fair values of our indefinite lived intangible assets in our Endoscopy, Water Purification and Filtration and Healthcare Disposables 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 Dialysis segment, for the same reasons stated above for our goodwill impairment test. 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.
Management concluded that none of our intangible assets or goodwill were impaired as of July 31, 2015.
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, 2015, the fair value of all of our reporting units exceeded book value by substantial amounts, except our Dialysis segment, which had an estimated fair value that exceeded book value by 17%. We believe the most significant assumptions impacting the impairment assessment of Dialysis relate to the assumed annual sales estimates and future operating efficiencies included in our projections of future operating results and cash flows of this segment. If future operating results and cash flows are substantially less than our projections, future impairment charges may be recorded. On April 30, 2016, management concluded that no events or changes in circumstances have occurred during the three and nine months ended April 30, 2016 that would indicate that the carrying amount 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. With the exception of the prior year impairment of an acquired license as further described in our 2015 Form 10-K, 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 subjective. On April 30, 2016, 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, although certain Endoscopy and Water Purification and Filtration products that require installation may carry a warranty period of up to fifteen months. Additionally, many of our consumables, accessories and parts have a 90 day 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
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 0.2%), 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.
Income
Taxes
Our provision for income taxes is based on our current period income, changes in deferred income tax assets and liabilities, statutory income tax rates, changes in uncertain tax benefits and the deductibility of expenses or availability of tax credits in various taxing jurisdictions. Tax laws are complex, subject to different interpretations by the taxpayer and the respective governmental taxing authorities and are subject to future modification, expiration or repeal by government legislative bodies. We use significant judgment on a quarterly basis in determining our annual effective income tax rate and evaluating our tax positions.
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 income tax rates were to change in the future, particularly in the United States and to a lesser extent Canada, the United Kingdom and Italy, 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. Historically, we have not had significant unrecognized tax benefits.
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. Such initial fair value amounts as well as other acquired assets and liabilities, including deferred tax assets and liabilities, are sometimes refined requiring subsequent adjustments.
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 deferred income tax liabilities, income tax and sales and use tax exposures, including tax liabilities related to our foreign subsidiaries, as well as reserves for accounts receivable, inventories, warranties and contingent obligations. We account for contingent consideration relating to business combinations as a liability and an increase to goodwill at the date of the acquisition. We 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 acquisition related liabilities 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 acquisition related liabilities described in Note 7 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 current 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 2015 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.
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
There have been no material changes in information reported in Part II, Item 7A, Quantitative and Qualitative Disclosures About Market Risk, in our 2015 Form 10-K.
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 September 14, 2015, we acquired MI, as more fully described in Note 3 to the Condensed Consolidated Financial Statements. During the initial transition period following the acquisition, we enhanced our internal control process to ensure that all financial information related to this acquisition was properly reflected in our Condensed Consolidated Financial Statements. We expect that all aspects of the MI business will be fully integrated into our existing overall internal control structure by early fiscal 2017.