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EX-10.1 - EXECUTIVE RETENTION AGREEMENT, DATED APRIL 1, 2010 - STERIS CORPdex101.htm
EX-32.1 - SECTION 906 CEO AND CFO CERTIFICATION - STERIS CORPdex321.htm
EX-15.1 - LETTER RE: UNAUDITED INTERIM FINANCIAL INFORMATION - STERIS CORPdex151.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2010

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File Number 1-14643

 

 

LOGO

STERIS Corporation

(Exact name of registrant as specified in its charter)

 

 

 

Ohio   34-1482024

(State or other jurisdiction of

incorporation or organization)

 

(IRS Employer

Identification No.)

5960 Heisley Road,

Mentor, Ohio

  44060-1834
(Address of principal executive offices)   (Zip code)

440-354-2600

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large Accelerated Filer  x    Accelerated Filer  ¨

Non-Accelerated Filer  ¨

(Do not check if a smaller reporting company)

   Smaller Reporting Company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The number of common shares outstanding as of July 30, 2010: 59,571,275

 

 

 


Table of Contents

STERIS Corporation and Subsidiaries

Form 10-Q

Index

 

          Page

Part I—Financial Information

  

Item 1.

  

Financial Statements

   3

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   25

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   40

Item 4.

  

Controls and Procedures

   40

Part II—Other Information

  

Item 1.

  

Legal Proceedings

   41

Item 1A.

  

Risk Factors

   43

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   44

Item 6.

  

Exhibits

   45
  

Signature

   46

 

2


Table of Contents

PART 1—FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

STERIS CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands)

 

     June 30,
2010
    March 31,
2010
 
     (Unaudited)        
Assets     

Current assets:

    

Cash and cash equivalents

   $ 226,070      $ 214,971   

Accounts receivable (net of allowances of $9,688 and $9,238, respectively)

     185,691        214,940   

Inventories, net

     131,955        121,135   

Deferred income taxes, net

     48,892        6,976   

Prepaid expenses and other current assets

     15,266        18,435   
                

Total current assets

     607,874        576,457   

Property, plant, and equipment, net

     345,288        346,858   

Goodwill and intangibles, net

     302,678        305,311   

Other assets

     9,766        9,776   
                

Total assets

   $ 1,265,606      $ 1,238,402   
                
Liabilities and equity     

Current liabilities:

    

Current portion of long-term indebtedness

   $ —        $ —     

Accounts payable

     64,132        66,035   

Accrued income taxes

     14,003        —     

Accrued payroll and other related liabilities

     29,968        58,986   

Accrued SYSTEM 1 Rebate Program

     110,004        —     

Accrued expenses and other

     68,573        72,108   
                

Total current liabilities

     286,680        197,129   

Long-term indebtedness

     210,000        210,000   

Deferred income taxes, net

     18,571        20,749   

Other liabilities

     54,465        56,030   
                

Total liabilities

     569,716        483,908   

Commitments and contingencies (see note 10)

    

Serial preferred shares, without par value; 3,000 shares authorized; no shares issued or outstanding

     —          —     

Common shares, without par value; 300,000 shares authorized;
70,040 shares issued; 59,578 and 58,452 shares outstanding, respectively

     235,650        237,165   

Common shares held in treasury, 10,461 and 11,588 shares, respectively

     (287,220     (295,251

Retained earnings

     747,040        798,809   

Accumulated other comprehensive (loss) income

     (363     12,991   
                

Total shareholders’ equity

     695,107        753,714   

Noncontrolling interest

     783        780   
                

Total equity

     695,890        754,494   
                

Total liabilities and equity

   $ 1,265,606      $ 1,238,402   
                

See notes to consolidated financial statements.

 

3


Table of Contents

STERIS CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(Unaudited)

 

     Three Months Ended
June 30,
 
     2010     2009  

Revenues:

    

Product

   $ 77,272      $ 173,500   

Service

     111,708        110,043   
                

Total revenues

     188,980        283,543   

Cost of revenues:

    

Product

     106,576        94,277   

Service

     64,338        64,430   
                

Total cost of revenues

     170,914        158,707   
                

Gross profit

     18,066        124,836   

Operating expenses:

    

Selling, general, and administrative

     72,117        74,605   

Research and development

     8,609        7,580   

Restructuring expenses

     341        (211
                

Total operating expenses

     81,067        81,974   
                

(Loss) income from operations

     (63,001     42,862   

Non-operating expenses, net:

    

Interest expense

     3,007        3,083   

Interest and miscellaneous income

     (162     (218
                

Total non-operating expenses, net

     2,845        2,865   

(Loss) income before income tax (benefit) expense

     (65,846     39,997   

Income tax (benefit) expense

     (20,636     14,455   
                

Net (loss) income

   $ (45,210   $ 25,542   
                

Net (loss) income per common share

    

Basic

   $ (0.76   $ 0.44   
                

Diluted

   $ (0.76   $ 0.43   
                

Cash dividends declared per common share outstanding

   $ 0.11      $ 0.11   
                

See notes to consolidated financial statements.

 

4


Table of Contents

STERIS CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

 

     Three Months Ended
June 30,
 
     2010     2009  

Operating activities:

    

Net (loss) income

   $ (45,210   $ 25,542   

Adjustments to reconcile net (loss) income to net cash provided by operating activities:

    

Depreciation, depletion, and amortization

     13,038        13,888   

Deferred income taxes

     (44,476     (4,430

Share-based compensation

     3,913        1,985   

(Gain) loss on the disposal of property, plant, equipment, and intangibles, net

     405        (146

Other items

     (1,343     271   

Changes in operating assets and liabilities:

    

Accounts receivable, net

     25,794        38,334   

Inventories, net

     (14,157     (1,914

Other current assets

     3,002        5,455   

Accounts payable

     (1,137     (18,519

Accrued SYSTEM 1 Rebate Program

     110,004        —     

Accruals and other, net

     (20,139     (27,846
                

Net cash provided by operating activities

     29,694        32,620   

Investing activities:

    

Purchases of property, plant, equipment, and intangibles, net

     (12,411     (8,355

Proceeds from the sale of property, plant, equipment, and intangibles

     3        175   
                

Net cash used in investing activities

     (12,408     (8,180

Financing activities:

    

Cash dividends paid to common shareholders

     (6,546     (6,441

Stock option and other equity transactions, net

     2,226        152   

Tax benefit from stock options exercised

     659        47   
                

Net cash used in financing activities

     (3,661     (6,242

Effect of exchange rate changes on cash and cash equivalents

     (2,526     3,694   
                

Increase in cash and cash equivalents

     11,099        21,892   

Cash and cash equivalents at beginning of period

     214,971        154,180   
                

Cash and cash equivalents at end of period

   $ 226,070      $ 176,072   
                

See notes to consolidated financial statements.

 

5


Table of Contents

STERIS CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

1. Nature of Operations and Summary of Significant Accounting Policies

Nature of Operations

STERIS Corporation, an Ohio corporation, develops, manufactures and markets infection prevention, contamination control, microbial reduction, and surgical and critical care support products and services for healthcare, pharmaceutical, scientific, research, industrial, and governmental Customers throughout the world. As used in this Quarterly Report, STERIS Corporation and its subsidiaries together are called “STERIS,” the “Company,” “we,” “us,” or “our,” unless otherwise noted.

We operate in three reportable business segments: Healthcare, Life Sciences, and STERIS Isomedix Services (“Isomedix”). We describe our business segments in note 11 to our consolidated financial statements titled, “Business Segment Information.” Our fiscal year ends on March 31. References in this Quarterly Report to a particular “year” or “year-end” mean our fiscal year. The significant accounting policies applied in preparing the accompanying consolidated financial statements of the Company are summarized below:

Interim Financial Statements

We prepared the accompanying unaudited consolidated financial statements of the Company according to accounting principles generally accepted in the United States (“U.S. GAAP”) for interim financial information and the instructions to the Quarterly Report on Form 10-Q and Rule 10-01 of Regulation S-X. This means that they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. Our unaudited interim consolidated financial statements contain all material adjustments (including normal recurring accruals and adjustments) management believes are necessary to fairly state our financial condition, results of operations, and cash flows for the periods presented.

These interim consolidated financial statements should be read together with the consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the Securities and Exchange Commission (“SEC”) on May 28, 2010. The Consolidated Balance Sheet at March 31, 2010 was derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

Principles of Consolidation

We use the consolidation method to report our investment in our subsidiaries. Consolidation means that we combine the accounts of our wholly-owned subsidiaries with our accounts. Therefore, the accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. We eliminate inter-company accounts and transactions when we consolidate these accounts.

Use of Estimates

We make certain estimates and assumptions when preparing financial statements according to U.S. GAAP that affect the reported amounts of assets and liabilities at the financial statement dates and the reported amounts of revenues and expenses during the periods presented. These estimates and assumptions involve judgments with respect to many factors that are difficult to predict and are beyond our control. Actual results could be materially different from these estimates. We revise the estimates and assumptions as new information becomes available. This means that operating results for the three-month period ended June 30, 2010 are not necessarily indicative of results that may be expected for future quarters or for the full fiscal year ending March 31, 2011.

 

6


Table of Contents

STERIS CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

Fair Value of Financial Instruments

Except for long-term debt, our financial instruments are highly liquid or have short-term maturities. Therefore, the recorded value is approximately equal to the fair value. We estimate the fair value of our long-term debt using discounted cash flow analyses, based on our current incremental borrowing rates for similar types of borrowing arrangements. We determined that the estimated fair value of our long-term debt is $242,117 at June 30, 2010. The financial instruments that we hold could potentially expose us to a concentration of credit risk. We invest our excess cash in highly rated money market funds and other high-quality short-term investments placed with major banks and financial institutions. We have established guidelines related to diversification and maturities to maintain safety and liquidity.

We provide additional information regarding the fair value of our financial instruments in note 17 titled, “Fair Value Measurements.”

Recently Adopted Accounting Pronouncements

In December 2009, the FASB issued an accounting standard update titled “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities.” The guidance requires entities to determine whether variable interests give it a controlling financial interest in a variable interest entity. It also requires an ongoing assessment of the beneficiary to determine if it is the primary beneficiary of the variable interest entity and eliminates the quantitative approach previously required for determining whether a reporting entity is the primary beneficiary. The guidance also requires enhanced disclosures about an entity’s involvement with a variable interest entity. This guidance was effective for us in the first quarter of fiscal 2011. The adoption did not have a material impact on our consolidated results of operations or financial condition.

In January 2010, the FASB issued an accounting standard update titled “Fair Value Measurements and Disclosures (Topic 820), Improving Disclosures About Fair Value Measurements.” This new guidance requires additional disclosures to be provided, which follow as: 1) transfers in and out of Levels 1 and 2 and the reasons for the transfers, 2) additional breakout of asset and liability categories and 3) purchases, sales, issuances and settlements to be reported separately in the Level 3 rollforward. This guidance was effective for us for the first quarter of fiscal 2011 reporting with the exception of item 3 which is effective beginning with first quarter of fiscal 2012 reporting. The adoption did not have a material impact on our consolidated results of operations or financial condition.

Significant Accounting Policies

A detailed description of our significant and critical accounting policies, estimates, and assumptions is included in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010. Our significant and critical accounting policies, estimates, and assumptions have not changed materially from March 31, 2010.

The Accrued SYSTEM 1 Rebate Program (the “Rebate Program”) recognized during the first quarter of fiscal 2011 is based upon the quantity of SYSTEM 1 processors eligible for rebates and the estimated value of rebates to be provided upon their return. Rebates of $102,313 are recognized as contra-revenue consistent with other returns and allowances offered to Customers. The estimated cost of $7,691 to facilitate the disposal of the returned SYSTEM 1 processors has been recognized as cost of revenues. Both components are recorded as current liabilities. No rebate obligations were settled during the three-months ended June 30, 2010. The key

 

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Table of Contents

STERIS CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

assumptions involved in the estimates associated with the Rebate Program include: the number and age of SYSTEM 1 processors eligible for rebates under the Rebate Program, the number of Customers that will elect to participate in the Rebate Program, the proportion of Customers that will choose each rebate option, and the estimated per unit costs of disposal.

The number and age of SYSTEM 1 processors has been estimated based on our historical sales and service records and we have assumed that 100% of these Customers will elect to participate in the Rebate Program. In order to estimate the portion of Customers that will choose each available rebate option, we first assessed recent trends in sales of the proprietary consumable products utilized in the SYSTEM 1 processor. The 19% decline in shipments during the approximately seven month period ended June 30, 2010 indicates that a portion of our Customers have already transitioned away from the SYSTEM 1 technology. The remaining 81%, provides the best available indication of the portion of Customers likely to elect the rebate for the SYSTEM 1E processor. Order and quote data from the fiscal 2011 first quarter provided indications of the proportion of Customers that are expected to choose each of the other rebate options. The per unit costs associated with disposal were estimated based on the service hours involved and quotes from our vendors which are based on current freight and disposal contracts.

2. Restructuring

The following summarizes our restructuring plans announced in prior fiscal years. We recognize restructuring expenses as incurred. In addition, we assess the property, plant and equipment associated with the related facilities for impairment. Additional information regarding our respective restructuring plans is included in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010.

Fiscal 2010 Restructuring Plan.

During the fourth quarter of fiscal 2010 we adopted a restructuring plan primarily related to the transfer of the remaining operations in our Erie, Pennsylvania facility to the U.S. headquarters in Mentor, Ohio and the consolidation of our European Healthcare manufacturing operations into two central locations within Europe (the “Fiscal 2010 Restructuring Plan”). In addition, we rationalized certain products and eliminated certain positions.

Since the inception of the Fiscal 2010 Restructuring Plan, we have incurred pre-tax expenses totaling $6,641 related to these actions, of which, $5,689 was recorded as restructuring expenses and $952 was recorded in cost of revenues. We also expect to incur an additional $4,000 by the end of fiscal 2012. These actions are intended to enhance profitability and improve efficiencies.

Fiscal 2009 Restructuring Plan.

During the third quarter of fiscal 2009, we adopted a restructuring plan primarily focused on our international operations (the “Fiscal 2009 Restructuring Plan”). As part of this plan, we took actions to improve operations at our Pieterlen, Switzerland manufacturing facility, rationalized certain products, recorded impairment charges for certain assets no longer used, and made targeted workforce reductions. We also consolidated our operations in Japan. These actions impacted approximately 100 employees worldwide. These restructuring actions are intended to enhance our profitability and increase operating efficiencies.

Since the inception of the Fiscal 2009 Restructuring Plan, we have incurred pre-tax expenses totaling $13,679 related to these actions of which $4,266 was recorded as restructuring expenses and $9,413 was recorded in cost of revenues. We do not expect to incur significant additional expenses related to this plan.

 

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Table of Contents

STERIS CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

Fiscal 2008 Restructuring Plan.

During the fourth quarter of fiscal 2008, we adopted a restructuring plan primarily focused on our North American operations (the “Fiscal 2008 Restructuring Plan”). As part of this plan, we announced the closure of two sales offices and the rationalization of certain products. We also reduced the workforce in certain support functions. Across all of our reporting segments, approximately 90 employees, primarily located in North America, were directly impacted. These restructuring actions were designed to enhance profitability and improve efficiency by reducing ongoing operating costs.

In fiscal 2009, we reversed our decision to close one of the sales offices, because we could not achieve a satisfactory exit from our warranty and service obligations. As a result, we reversed restructuring expenses recorded in fiscal 2008 totaling approximately $1,000.

Since the inception of the Fiscal 2008 Restructuring Plan, we have recorded pre-tax expenses totaling $14,333, of which $9,883 was recorded as restructuring expenses and $4,450 was recorded in cost of revenues. We do not expect to incur any significant additional restructuring expenses related to the Fiscal 2008 Restructuring Plan.

The following tables summarize our total pre-tax restructuring expenses for the first quarter of fiscal 2011 and fiscal 2010:

 

Three Months Ended June 30, 2010

   Fiscal 2010
Restructuring
Plan (1)
 

Severance, payroll, and other related costs

   $ (17

Asset impairment and accelerated depreciation

     356   

Other

     7   
        

Total restructuring charges

   $ 346   
        

 

(1) Includes $5 in charges recorded in cost of revenues on Consolidated Statements of Operations.

 

Three Months Ended June 30, 2009

   Fiscal 2009
Restructuring
Plan (1)
 

Severance, payroll, and other related costs

   $ (46

Product rationalization

     (233

Other

     13   
        

Total restructuring charges

   $ (266
        

 

(1) Includes $(55) in charges recorded in cost of revenues on Consolidated Statements of Operations.

 

9


Table of Contents

STERIS CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

Liabilities related to restructuring activities are recorded as current liabilities on the accompanying Consolidated Balance Sheets within “Accrued payroll and other related liabilities” and “Accrued expenses and other.” The following table summarizes our liabilities related to these restructuring activities:

 

     Fiscal 2010 Restructuring Plan
          Fiscal 2011      
     March 31,
2010
   Provision     Payments/
Impairments
    June 30,
2010

Severance and termination benefits

   $ 1,894    $ (17   $ (246   $ 1,631

Asset impairments

     —        356        (356     —  

Lease termination obligations

     1,200      —          —          1,200

Other

     509      7        (44     472
                             

Total

   $ 3,603    $ 346      $ (646   $ 3,303
                             

 

     Fiscal 2008 Restructuring Plan
          Fiscal 2011      
     March 31,
2010
   Provision    Payments/
Impairments
    June 30,
2010

Severance and termination benefits

   $ 102    $ —      $ (70   $ 32

Asset impairments

     289      —        —          289

Lease termination obligations

     411      —        (76     335
                            

Total

   $ 802    $ —      $ (146   $ 656
                            

3. Comprehensive (Loss) Income

Comprehensive (loss) income includes net (loss) income as currently reported under U.S. GAAP and other comprehensive income. Other comprehensive (loss) income considers the effects of additional economic events that are not required to be recorded in determining net (loss) income, but rather are reported as a separate component of shareholders’ equity. The following table illustrates the components of our comprehensive (loss) income:

 

     Three Months Ended
June 30,
 
     2010     2009  

Net (loss) income

   $ (45,210   $ 25,542   

Cumulative foreign currency translation adjustment

     (12,959     23,984   

Amortization of pension and postretirement benefit plans costs, net of taxes

     (276     (159

Unrealized gains (losses) on investments

     (120     117   
                

Total comprehensive (loss) income

   $ (58,565 )   $ 49,484   
                

 

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Table of Contents

STERIS CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

4. Property, Plant and Equipment

Information related to the major categories of our depreciable assets is as follows:

 

     June 30,
2010
    March 31,
2010
 

Land and land improvements (1)

   $ 26,120      $ 26,234   

Buildings and leasehold improvements

     191,530        192,722   

Machinery and equipment

     277,181        276,714   

Information systems

     103,017        103,056   

Radioisotope

     178,028        172,489   

Construction in progress (1)

     30,649        29,614   
                

Total property, plant, and equipment

     806,525        800,829   

Less: accumulated depreciation and depletion

     (461,237     (453,971
                

Property, plant, and equipment, net

   $ 345,288      $ 346,858   
                

 

(1) Land is not depreciated. Construction in progress is not depreciated until placed in service.

5. Inventories, Net

Inventories, net are stated at the lower of cost or market. We use the last-in, first-out (“LIFO”) and first-in, first-out cost methods. An actual valuation of inventory under the LIFO method is made only at the end of the fiscal year based on the inventory levels and costs at that time. Accordingly, interim LIFO calculations are based on management’s estimates of expected year-end inventory levels and are subject to the final fiscal year-end LIFO inventory valuation. Inventory costs include material, labor, and overhead. Inventories, net consisted of the following:

 

     June 30,
2010
   March 31,
2010

Raw materials

   $ 37,737    $ 36,170

Work in process

     23,193      20,668

Finished goods

     71,025      64,297
             

Inventories, net

   $ 131,955    $ 121,135
             

6. Debt

Indebtedness was as follows:

 

     June 30,
2010
   March 31,
2010

Private Placement

   $ 210,000    $ 210,000

Credit facility

     —        —  
             

Total long term debt

   $ 210,000    $ 210,000
             

Additional information regarding our indebtedness is included in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010.

 

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Table of Contents

STERIS CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

7. Additional Consolidated Balance Sheets Information

Additional information related to our Consolidated Balance Sheets is as follows:

 

     June 30,
2010
   March 31,
2010

Accrued payroll and other related liabilities:

     

Compensation and related items

   $ 13,342    $ 15,314

Accrued vacation/paid time off

     6,237      5,734

Accrued bonuses

     2,196      23,457

Accrued employee commissions

     4,175      10,565

Other postretirement benefit obligations-current portion

     3,340      3,340

Other employee benefit plans’ obligations-current portion

     678      576
             

Total accrued payroll and other related liabilities

   $ 29,968    $ 58,986
             

Accrued expenses and other:

     

Deferred revenues

   $ 26,837    $ 27,908

Self-insured risk retention-current portion

     4,111      4,956

Accrued dealer commissions

     7,009      6,972

Accrued warranty

     6,130      6,070

Other

     24,486      26,202
             

Total accrued expenses and other

   $ 68,573    $ 72,108
             

Other liabilities:

     

Self-insured risk retention-long-term portion

   $ 9,987    $ 9,986

Other postretirement benefit obligations-long-term portion

     20,415      21,839

Defined benefit pension plans’ obligations-long-term portion

     10,069      10,179

Other employee benefit plans’ obligations-long-term portion

     2,816      2,336

Accrued long-term income taxes

     11,178      11,690
             

Total other liabilities

   $ 54,465    $ 56,030
             

8. Income Tax (Benefit) Expense

Income tax (benefit) expense includes United States federal, state and local, and foreign income taxes, and is based on reported pre-tax (loss) income. The effective income tax rates for the three-month periods ended June 30, 2010 and 2009 were 31.3% and 36.1%, respectively. Because the accrual established during the three month period ended June 30, 2010 in connection with the SYSTEM 1 Rebate Program was incurred in the United States at a higher effective tax rate, a higher portion of the projected income before income taxes will be subject to taxes in jurisdictions with lower tax rates.

Income tax expense is provided on an interim basis based upon our estimate of the annual effective income tax rate, adjusted each quarter for discrete items. In determining the estimated annual effective income tax rate, we analyze various factors, including projections of our annual earnings and taxing jurisdictions in which the earnings will be generated, the impact of state and local income taxes, our ability to use tax credits and net operating loss carry forwards, and available tax planning alternatives.

As of March 31, 2010, we had $11,788 in unrecognized tax benefits, of which $2,740 would favorably impact the effective tax rate if recognized. As of June 30, 2010, we had $11,193 in unrecognized tax benefits, of

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

which $2,726 would favorably impact the effective tax rate if recognized. The decrease in unrecognized tax benefits for the three months ended June 30, 2010 is primarily due to a decrease in unrecognized tax benefits relating to prior years. We believe that it is reasonably possible that unrecognized tax benefits could decrease by up to $620 within 12 months of June 30, 2010, primarily as a result of audit settlements. As of June 30, 2010, we have recognized a liability for interest of $1,234 and penalties of $141.

We operate in numerous taxing jurisdictions and are subject to regular examinations by various United States federal, state, and local, as well as foreign, jurisdictions. We are no longer subject to United States federal examinations for years before fiscal 2008 and, with limited exceptions, we are no longer subject to United States state and local, or non-United States, income tax examinations by tax authorities for years before fiscal 2006. We remain subject to tax authority audits in various jurisdictions wherever we do business. We do not expect the results of these examinations to have a material adverse affect on our consolidated financial statements.

9. Benefit Plans

We provide defined benefit pension plans for certain manufacturing and plant administrative personnel throughout the world as determined by collective bargaining agreements or employee benefit standards set at the time of acquisition of certain businesses. In addition to providing pension benefits to certain employees, we sponsor an unfunded postretirement welfare benefits plan for two groups of United States employees, including the same employees who receive pension benefits under the United States defined benefit pension plans. Benefits under this plan include retiree life insurance and retiree medical coverage, including prescription drug coverage. Additional information regarding our defined benefit pension plans and other postretirement benefits plan is included in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010.

Components of the net periodic benefit cost for our defined benefit pension plans and other postretirement medical benefits plan were as follows:

 

     Defined Benefit Pension Plans     Other
Postretirement

Benefits Plan
 
     U.S. Qualified     International    

Three Months Ended June 30,

   2010     2009     2010     2009     2010     2009  

Service cost

   $ 47      $ 59      $ 117      $ 79      $ —        $ —     

Interest cost

     654        761        75        81        292        487   

Expected return on plan assets

     (758     (617     (82     (97     —          —     

Recognized losses

     267        290        —          —          97        157   

Amortization of transition obligation

     —          (18     —          —          —          —     

Amortization of prior service cost

     —          —          —          —          (816     (816
                                                

Net periodic benefit cost (income)

   $ 210      $ 475      $ 110      $ 63      $ (427   $ (172
                                                

We contribute amounts to the defined benefit pension plans at least sufficient to meet the minimum requirements as stated in applicable employee benefit laws and local tax laws. We record liabilities for the difference between the fair value of the plan assets and the benefit obligation (the projected benefit obligation for pension plans and the accumulated postretirement benefit obligation for other postretirement benefits plans) on our accompanying Consolidated Balance Sheets.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

10. Contingencies

We are, and will likely continue to be, involved in a number of legal proceedings, government investigations, and claims, which we believe generally arise in the course of our business, given our size, history, complexity, and the nature of our business, products, Customers, regulatory environment, and industries in which we participate. These legal proceedings, investigations and claims generally involve a variety of legal theories and allegations, including, without limitation, personal injury (e.g., slip and falls, burns, vehicle accidents), product liability or regulation (e.g., based on product operation or claimed malfunction, failure to warn, failure to meet specification, or failure to comply with regulatory requirements), product exposure (e.g., claimed exposure to chemicals, asbestos, contaminants, radiation), property damage (e.g., claimed damage due to leaking equipment, fire, vehicles, chemicals), commercial claims (e.g., breach of contract, economic loss, warranty, misrepresentation), financial (e.g., taxes, reporting), employment (e.g., wrongful termination, discrimination, benefits matters), and other claims for damage and relief.

We believe we have adequately reserved for our current litigation and claims that are probable and estimable, and further believe that the ultimate outcome of these pending lawsuits and claims will not have a material adverse affect on our consolidated financial position or results of operations taken as a whole. Due to their inherent uncertainty, however, there can be no assurance of the ultimate outcome or effect of current or future litigation, investigations, claims or other proceedings (including without limitation the matters discussed below). For certain types of claims, we presently maintain product liability insurance coverage and other liability coverages in amounts and with deductibles that we believe are prudent, but there can be no assurance that these coverages will be applicable or adequate to cover adverse outcomes of claims or legal proceedings against us.

As previously disclosed, we received a warning letter (the “warning letter”) from the FDA on May 16, 2008 regarding our SYSTEM 1® sterile processor and the STERIS 20 sterilant used with the processor (sometimes referred to collectively in the FDA letter and in this note 10 as the “device”). Among other matters, the warning letter included the FDA’s assertion that significant changes or modifications had been made in the design, components, method of manufacture, or intended use of the device beyond the FDA’s 1988 clearance, such that the FDA believed a new premarket notification submission (known within FDA regulations as a 510(k) submission) should have been made, and the assertion that our failure to make such a submission resulted in violations of applicable law. On July 30, 2008 (with an Addendum on October 9, 2008), we provided a detailed response contending that the assertions in the warning letter were not correct. On November 4, 2008, we received a letter from the FDA (dated November 3, 2008) in which the FDA stated without elaboration that, after reviewing our response, it disagreed with our position and that a new premarket notification submission was required. After discussions with the FDA regarding the November 3rd letter, we received an additional letter on November 6, 2008 from the FDA. The November 6th letter stated that the intent of the November 3rd letter was to inform us of the FDA’s preliminary disagreement with our response to the warning letter and, before finalizing a position, the FDA reiterated that it wanted to meet with us to discuss the Company’s response, issues related to the warning letter and next steps to resolve any differences between the Company and the FDA. We thereafter met with the FDA and, on January 20, 2009, we announced that we had submitted to the FDA a new liquid chemical sterilant system for 510(k) clearance, and we communicated to Customers that we would continue supporting the existing SYSTEM 1 installed base in the U.S. for at least a two year period from that date.

On December 3, 2009, the FDA provided a notice (“notice”) to healthcare facility administrators and infection control practitioners describing FDA’s “concerns about the SYSTEM 1 Processor, components and accessories, and FDA recommendations.” In the notice, among other things, FDA stated its belief that the SYSTEM 1 device had been significantly modified, that FDA had not cleared or approved the modified device, and that FDA had not determined whether the SYSTEM 1 was safe or effective for its labeled claims. The notice

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

further stated that use of a device that does not properly sterilize or disinfect a medical or surgical device poses risks to patients and users, including the transmission of pathogens, exposure to hazardous chemicals and affect on the quality and functionality of reprocessed instruments. The notice stated that FDA was aware of reports of malfunctions of the SYSTEM 1 that had the potential to cause or contribute to serious injuries to patients, such as infections, or injuries to healthcare staff, such as burns. Included in FDA’s December 3, 2009 notice was a recommendation from FDA that if users had acceptable alternatives to meet sterilization and disinfection needs, they should transition to that alternative as soon as possible. After its December 3, 2009 notice, we engaged in extensive discussions with the FDA regarding a comprehensive resolution of this matter. On February 2, 2010, the FDA notified healthcare facility administrators and infection control practitioners that FDA’s total recommended time period for transitioning from SYSTEM 1 in the U.S. was 18 months from that date. During this transition period in the U.S., we have continued to support the existing SYSTEM 1 installed base by providing accessories, sterilant, service and parts for U.S. Customers.

In April 2010 we reached agreement with the FDA on the terms of a consent decree (“Consent Decree”). On April 19, 2010, a Complaint and Consent Decree were filed in the U.S. District Court for the Northern District of Ohio, and on April 20, 2010, the Court approved the Consent Decree. In general, the Consent Decree addresses regulatory matters regarding SYSTEM 1, restricts further sales of SYSTEM 1 processors in the U.S., defines certain documentation and requirements for continued service and support of SYSTEM 1 in the U.S., prohibits the sale of liquid chemical sterilization or disinfection products in the U.S. that do not have FDA clearance, describes various process and compliance matters, and defines penalties in the event of violation of the Consent Decree.

The Consent Decree also provides that we may continue to support our Customers’ use of SYSTEM 1 in the U.S., including the sale of consumables, parts and accessories and service for a transition period, not to extend beyond August 2, 2011, subject to compliance with requirements for documentation of the Customer’s need for continued support and other conditions and limitations (the “Transition Plan”). Our Transition Plan includes the “SYSTEM 1 Rebate Program” (the “Rebate Program”). In April 2010, we began to offer rebates to qualifying Customers. Generally, U.S. Customers that purchased SYSTEM 1 processors directly from us or who are current users of SYSTEM 1 and who return their units will have the option of either a pro-rated cash rebate or a rebate toward the future purchase of new STERIS capital equipment or consumable products. In addition, we will provide credits for SYSTEM 1 consumables in unbroken packaging and within shelf life and for the unused portion of SYSTEM 1 service contracts. As a result of the Rebate Program, we recorded a pre-tax liability of $110,004 related to the SYSTEM 1 Rebate Program. Of the $110,004, $102,313 is attributable to the Customer Rebate portion of the Program and was recorded as a reduction of revenues, and $7,691 is attributable to the disposal liability of the SYSTEM 1 units to be returned and was recorded as an increase in cost of revenues. This also resulted in a $110,004 reduction in operating income.

Recording the obligations associated with the Rebate Program requires the use of estimates and assumptions. The use of estimates and assumptions involves judgments with respect to factors that may impact the ultimate outcome and may be beyond management’s control. The amount recognized during the first quarter of fiscal 2011 is based upon the quantity of SYSTEM 1 processors eligible for rebates and the estimated value of rebates to be provided upon their return. Rebates of $102,313 are recognized as contra-revenue consistent with other returns and allowances offered to Customers. The estimated cost of $7,691 to facilitate the return and disposal of the processors has been recognized as cost of revenues. Both components are recorded as current liabilities. No rebate obligations were settled during the three months ended June 30, 2010. The key assumptions involved in the estimates associated with the Rebate Program include: the number and age of SYSTEM 1 processors eligible for rebates under the Rebate Program, the number of Customers that will elect to participate in the Rebate Program, the proportion of Customers that will choose each rebate option, and the estimated per unit costs of disposal.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

The number and age of SYSTEM 1 processors has been estimated based on our historical sales and service records and we have assumed that 100% of eligible Customers will elect to participate in the Rebate Program. In order to estimate the portion of Customers that will choose each available rebate option, we first assessed recent trends in sales of the proprietary consumable products utilized in the SYSTEM 1 processor. The 19% decline in shipments during the approximately seven month period ended June 30, 2010 indicates that a portion of our Customers have already transitioned away from the SYSTEM 1 technology. The remaining 81%, provides the best available indication of the portion of Customers likely to elect the rebate for the SYSTEM 1E processor. Order and quote data from the fiscal 2011 first quarter provided indications of the proportion of Customers that are expected to choose each of the other cash and Rebate options. The per unit costs associated with disposal were estimated based on the service hours involved and quotes from our vendors which are based on current freight and disposal contracts.

Our assumptions regarding the response of our Customers to the Rebate Program could be wrong and actual results could be different from these estimates. For example, if all Customers elected the maximum incentive rebate associated with the SYSTEM 1E processor rebate, the total estimated rebate liability of $102,313 would increase to approximately $111,000. Conversely, if all Customers elected the cash rebate option, the total estimated rebate liability would decrease to approximately $52,000.

Also, in April 2010 we voluntarily submitted information regarding modifications to the Reliance™ EPS Endoscope Processing System (the “EPS System”) to the FDA. These incremental modifications to the EPS System were considered minor by us. FDA has recently advised us that it believes a new pre-market notification (510(k)) for those modifications should be submitted. We have submitted the pre-market notification to the FDA. We have suspended shipments of EPS Systems in the U.S. until we receive FDA clearance of the submission. FDA has agreed that we may continue servicing EPS Systems in the field and provide consumables necessary for the continued use of the EPS Systems. We do not believe the impact of these events will be material with respect to our financial results.

The Consent Decree has defined the resolution of a number of issues regarding SYSTEM 1, and we believe our actions since January 2009 with respect to SYSTEM 1, including the Transition Plan, were and are not recalls, corrections or removals under FDA regulations. However, there is no assurance that other claims will not be brought or that judicial, regulatory, administrative or other legal or enforcement actions, notices or remedies will not be pursued, or that action will not be taken in respect of the Consent Decree, the Transition Plan, SYSTEM 1, the EPS System, or otherwise with respect to regulatory or compliance matters, as described in this note 10 or in various portions of Item 1A. of Part I contained in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010. On February 5, 2010, a complaint was filed by a Customer who claims to have purchased two SYSTEM 1 devices from STERIS, Physicians of Winter Haven LLC d/b/a Day Surgery Center v. Steris Corp., Case No. 1:1-cv-00264-CAB (N.D. Ohio). The complaint alleges statutory violations, breaches of various warranties, negligence, failure to warn, and unjust enrichment. Plaintiff seeks class certification, damages, and other legal and equitable relief including, without limitation, attorneys’ fees and an order requiring STERIS to replace, recall or adequately repair the product and/or to take appropriate regulatory action. We are evaluating this matter and expect to defend against these allegations. This proceeding or other civil, criminal, regulatory or other proceedings involving our SYSTEM 1, SYSTEM 1E, EPS System, or other products or services could possibly result in judgments, settlements or administrative or judicial decrees requiring us, among other actions, to pay damages or fines or effect recalls, or be subject to other governmental, Customer or other third party claims or remedies, which could materially affect our business, performance, prospects, value, financial condition, and results of operations.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

For additional information regarding these matters, see the following portions of our Annual Report on Form 10-K for the year ended March 31, 2010: “Business – Information with respect to our Business in General – Recent Events – Government Regulation”, and the “Risk Factor” titled: “We may be adversely affected by product liability claims or other legal actions or regulatory or compliance matters, including the Warning Letter and Consent Decree.”, the “Risk Factor” titled: “Our business may be adversely affected as a result of the U.S. Food and Drug Administration notices to healthcare administrators and device manufacturers, and related matters,” and the “Risk Factor” titled “Compliance with the Consent Decree may be more costly and burdensome than anticipated.”

From time to time, STERIS is also involved in legal proceedings as a plaintiff involving contract, patent protection, and other claims asserted by us. Gains, if any, from these proceedings are recognized when they are realized.

We are subject to taxation from United States federal, state, and local, and foreign jurisdictions. Tax positions are settled primarily through the completion of audits within each individual jurisdiction or the closing of statute of limitation. Changes in applicable tax law or other events may also require us to revise past estimates. We describe income taxes further in Note 8 to our consolidated financial statements titled, “Income Tax (Benefit) Expense”, and in our Annual Report on Form 10-K for the year ended March 31, 2010 filed with the SEC on May 28, 2010.

11. Business Segment Information

We operate and report in three business segments: Healthcare, Life Sciences, and Isomedix. “Corporate and other,” which is presented separately, contains the Defense and Industrial business unit plus costs that are associated with being a publicly traded company and certain other corporate costs.

Our Healthcare segment manufactures and sells infrastructure capital equipment, accessory, consumable, and service solutions to healthcare providers, including acute care hospitals and surgery centers. These solutions aid our Customers in improving the safety, quality, and productivity of their surgical, sterile processing, gastrointestinal, and emergency environments.

Our Life Sciences segment manufactures and sells a broad range of capital equipment, formulated cleaning chemistries, and service solutions to pharmaceutical companies, and private and public research facilities around the globe.

Our Isomedix segment operates through a network of 19 facilities located in North America. We sell a comprehensive array of contract sterilization services using gamma irradiation and ethylene oxide (“EO”) technologies. We provide sterilization and microbial reduction services to companies that supply products to the healthcare, industrial, and consumer products industries.

Financial information for each of our segments is presented in the following table. Operating income (loss) for each segment is calculated as the segment’s gross profit less direct expenses and indirect cost allocations, which results in the full allocation of all distribution and research and development expenses, and the partial allocation of corporate costs. These allocations are based upon variables such as segment headcount and revenues. In addition, the Healthcare segment is responsible for the management of all but one manufacturing facility and uses standard cost to sell products to the Life Sciences segment. “Corporate and other” includes the gross profit and direct expense of the Defense and Industrial business unit, as well as certain unallocated corporate costs related to being a publicly traded company and legacy pension and post-retirement benefits.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

The accounting policies for reportable segments are the same as those for the consolidated Company. For the three month period ended June 30, 2010, revenues from a single Customer did not represent ten percent or more of any reportable segment’s revenues. Additional information regarding our segments is included in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010.

Financial information for each of our segments is presented in the following tables:

 

     Three Months Ended
June 30,
 
     2010     2009  

Revenues:

    

Healthcare (1)

   $ 103,766      $ 200,604   

Life Sciences

     46,614        46,116   

Isomedix

     37,676        35,407   
                

Total reportable segments

     188,056        282,127   

Corporate and other

     924        1,416   
                

Total revenues

   $ 188,980      $ 283,543   
                

Operating income (loss):

    

Healthcare (2)

   $ (77,912   $ 32,102   

Life Sciences

     6,295        4,779   

Isomedix

     10,584        8,339   
                

Total reportable segments

     (61,033     45,220   

Corporate and other

     (1,968     (2,358
                

Total operating (loss) income

   $ (63,001   $ 42,862   
                

 

(1) Includes a reduction of $102,313 resulting from the SYSTEM 1 Rebate Program during the three months ended June 30, 2010.
(2) Includes a reduction of $110,004 resulting from the SYSTEM 1 Rebate Program during the three months ended June 30, 2010.

12. Common Shares

We calculate basic earnings per common share based upon the weighted average number of common shares outstanding. We calculate diluted earnings per share based upon the weighted average number of common shares outstanding plus the dilutive effect of common share equivalents calculated using the treasury stock method. The following is a summary of common shares and common share equivalents outstanding used in the calculations of basic and diluted earnings per share:

 

     Three Months Ended
June 30,
         2010            2009    

Denominator (shares in thousands):

     

Weighted average common shares outstanding—basic

   59,397    58,517

Dilutive effect of common share equivalents

   —      325
         

Weighted average common shares outstanding and common share equivalents—diluted

   59,397    58,842
         

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

The denominator in the computation of earnings per share for the three months ended June 30, 2010 does not include the potentially dilutive effect of common share equivalents because the numerator is a net loss. Inclusion would result in an antidilutive effect.

Options to purchase the following number of common shares were outstanding but excluded from the computation of diluted earnings per share because the combined exercise prices, unamortized fair values, and assumed tax benefits upon exercise were greater than the average market price for the common shares during the periods, so including these options would be anti-dilutive:

 

     Three Months Ended
June 30,
         2010            2009    
     (shares in thousands)

Number of common share options

   380    2,163

13. Repurchases of Common Shares

We did not repurchase any of our common shares during the first three months of fiscal 2011. At June 30, 2010, $203,864 of STERIS common shares remained authorized for repurchase pursuant to a March 2008 Board Authorization. Also, 10,461,229 common shares were held in treasury at June 30, 2010.

14. Share-Based Compensation

We maintain a long-term incentive plan that makes available common shares for grants at the discretion of the Compensation Committee of the Board of Directors to officers, directors, and key employees in the form of stock options, restricted shares, restricted share units, and stock appreciation rights. Stock options provide the right to purchase our common shares at the market price on the date of grant, subject to the terms of the option plans and agreements. Generally, one-fourth of the stock options granted become exercisable for each full year of employment following the grant date. Stock options granted generally expire 10 years after the grant date, or earlier if the option holder is no longer employed by us. Certain option agreements have provisions that provide for an adjustment to the normal vesting schedule allowing the options to vest on a prorated basis, as defined by the agreement in the event of employment termination. Restricted shares and restricted share units generally cliff vest over a three or four year period. As of June 30, 2010, 3,529,396 shares remain available for grant under the long-term incentive plan.

The fair value of share-based compensation awards was estimated at their grant date using the Black-Scholes-Merton option pricing model. This model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, characteristics that are not present in our option grants. If the model permitted consideration of the unique characteristics of employee stock options, the resulting estimate of the fair value of the stock options could be different. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our Consolidated Statements of Income. The expense is classified as cost of goods sold or selling, general and administrative expenses in a manner consistent with the employee’s compensation and benefits.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

The following weighted-average assumptions were used for share-based compensation granted during the first quarter of fiscal 2011 and fiscal 2010:

 

     Fiscal 2011    Fiscal 2010

Risk-free interest rate

   2.73%    1.82%

Expected life of options

   5.52 years    5.43 years

Expected dividend yield of stock

   1.54%    1.49%

Expected volatility of stock

   30.19%    27.94%

The risk-free interest rate is based upon the U.S. Treasury yield curve. The expected life of options is reflective of historical experience, vesting schedules and contractual terms. The expected dividend yield of stock represents our best estimate of the expected future dividend yield. The expected volatility of stock is derived by referring to our historical stock prices over a timeframe similar to that of the expected life of the grant. We applied estimated forfeiture rates of 2.27 percent and 2.39 percent during fiscal 2011 and 2010, respectively. This rate is calculated based upon historical activity and represents an estimate of the granted options not expected to vest. If actual forfeitures differ from this calculated rate, we may be required to make additional adjustments to compensation expense in future periods. The assumptions used above are reviewed at the time of each significant option grant, or at least annually.

A summary of share option activity is as follows:

 

     Number of
Options
    Weighted
Average
Exercise
Price
   Weighted
Average
Remaining
Contractual
Term
   Aggregate
Intrinsic
Value

Outstanding at March 31, 2010

   3,599,221      $ 24.96      

Granted

   243,500        31.87      

Exercised

   (117,899     17.82      

Forfeited

   (4,525     27.13      

Canceled

   (2,953     33.93      
                  

Outstanding at June 30, 2010

   3,717,344      $ 25.63    6.05    $ 20,594

Exercisable at June 30, 2010

   2,515,060      $ 24.83    4.94    $ 15,809

The aggregate intrinsic value in the table above represents the total pre-tax difference between the $31.08 closing price of our common shares on June 30, 2010 over the exercise price of the stock option, multiplied by the number of options outstanding or outstanding and exercisable, as applicable. The aggregate intrinsic value is not recorded for financial accounting purposes and the value changes daily based on the daily changes in the fair market value of our common shares.

The total intrinsic value of stock options exercised during the first three months of fiscal 2011 and fiscal 2010 was $1,695 and $131, respectively. Net cash proceeds from the exercise of stock options were $2,226 and $152 for the first three months of fiscal 2011 and fiscal 2010, respectively. An income tax benefit of $659 and $47 was realized from stock option exercises during the first three months of fiscal 2011 and fiscal 2010, respectively.

The weighted average grant date fair value of stock option grants was $8.82 and $5.52 for the first three months of fiscal 2011 and fiscal 2010, respectively.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

Stock appreciation rights (“SARS”) carry generally the same terms and vesting requirements as stock options except that they are settled in cash upon exercise and therefore, are classified as liabilities. The fair value of the outstanding SARS as of June 30, 2010 and 2009 was $149 and $263, respectively. The fair value of each outstanding SAR is revalued at each reporting date and the related liability and expense are adjusted appropriately.

A summary of the non-vested restricted share and restricted share unit activity is presented below:

 

     Number of
Restricted
Shares
   Number of
Restricted
Share Units
   Weighted-Average
Grant Date
Fair Value

Non-vested at March 31, 2010

   222,590    23,000    $ 26.80

Granted

   233,104    —        31.91

Vested

   —      —        —  

Canceled

   —      —        —  
                

Non-vested at June 30, 2010

   455,694    23,000    $ 29.29
                

Restricted shares and restricted share units granted are valued based on the closing stock price at the grant date and are estimated to cliff vest over a three or four year period based upon the terms of the grants. The value of restricted shares and restricted share units that vested during the first three months of fiscal 2010 was $483.

Cash settled restricted share units carry generally the same terms and vesting requirements as restricted share units except that they are settled in cash upon vesting and therefore, are classified as liabilities. The fair value of outstanding cash-settled restricted share units as of June 30, 2010 and 2009 was $827 and $155, respectively. The fair value of each cash-settled restricted share unit is revalued at each reporting date and the related liability and expense are adjusted appropriately.

As of June 30, 2010, there was a total of $13,101 in unrecognized compensation cost related to nonvested share-based compensation granted under our share-based compensation plans. We expect to recognize the cost over a weighted average period of 2.26 years.

15. Financial and Other Guarantees

We generally offer a limited parts and labor warranty on capital equipment. The specific terms and conditions of those warranties vary depending on the product sold and the countries where we conduct business. We record a liability for the estimated cost of product warranties at the time product revenues are recognized. The amounts we expect to incur on behalf of our Customers for the future estimated cost of these warranties are recorded as a current liability on the accompanying Consolidated Balance Sheets. Factors that affect the amount of our warranty liability include the number and type of installed units, historical and anticipated rates of product failures, and material and service costs per claim. We periodically assess the adequacy of our recorded warranty liabilities and adjust the amounts as necessary.

Changes in our warranty liability during the first three months of fiscal 2011 were as follows:

 

Balance, March 31, 2010

   $ 6,070   

Warranties issued during the period

     2,395   

Settlements made during the period

     (2,335
        

Balance, June 30, 2010

   $ 6,130   
        

 

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STERIS CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

We also sell product maintenance contracts to our Customers. These contracts range in terms from one to five years and require us to maintain and repair the product over the maintenance contract term. We initially record amounts due from Customers under these contracts as a liability for deferred service contract revenue on the accompanying Consolidated Balance Sheets within “Accrued expenses and other.” The liability recorded for such deferred service revenue was $17,512 and $17,709 as of June 30, 2010 and March 31, 2010, respectively. Such deferred revenue is then amortized on a straight-line basis over the contract term and recognized as service revenue on our accompanying Consolidated Statements of Income. The activity related to the liability for deferred service contract revenues is excluded from the table presented above.

16. Forward and Swap Contracts

From time to time, we enter into forward contracts to hedge potential foreign currency gains and losses that arise from transactions denominated in foreign currencies, including inter-company transactions. We also enter into commodity swap contracts to hedge price changes in commodities that impact raw materials included in our cost of revenues. We do not use derivative financial instruments for speculative purposes. These contracts are not designated as hedging instruments and do not receive hedge accounting treatment; therefore, changes in their fair value are not deferred but are recognized immediately in the Consolidated Statements of Income.

 

     Asset Derivatives    Liability Derivatives

Balance Sheet Location

   Fair Value at
June 30, 2010
   Fair Value at
March 31, 2010
   Fair Value at
June 30, 2010
   Fair Value at
March 31, 2010

Prepaid & Other

   $ 174    $ 992    $ —      $ —  

Accrued expenses and other

   $ —      $ —      $ 1,322    $ —  

The following table presents the impact of derivative instruments and their location within the Consolidated Statements of Income:

 

     Location of gain (loss)
recognized in income
   Amount of gain (loss)
recognized in income
        Three months ended
June 30,
            2010             2009    

Foreign currency forward contracts

   Selling, general and
administrative
   $ (834   $ 256

Commodity swap contracts

   Cost of revenues    $ (781   $ —  

 

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STERIS CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)

For the Three Months Ended June 30, 2010 and 2009

(dollars in thousands, except per share amounts)

 

17. Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date. We estimate the fair value of financial instruments using available market information and generally accepted valuation methodologies. The inputs used to measure fair value are classified into three tiers. These tiers include Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring the entity to develop its own assumptions. The following table shows our financial assets and liabilities accounted for at fair value on a recurring basis at June 30, 2010:

 

          Fair Value Measurements at June 30, 2010 Using
     June 30,
2010
   Quoted Prices
in Active Markets
for Identical Assets
   Significant Other
Observable Inputs
   Significant
Unobservable
Inputs
        Level 1    Level 2    Level 3

Assets:

           

Cash and cash equivalents

   $ 226,070    $ 226,070    $ —      $ —  

Forward and swap contracts (1)

     174      —        174      —  

Investments (2)

     1,961      1,961      —        —  

Liabilities:

           

Forward and swap contracts (1)

   $ 1,322    $ —      $ 1,322    $ —  

Deferred compensation plans (2)

     1,966      1,966      —        —  

 

(1) The fair values of forward and swap contracts are based on period-end forward rates and reflect the value of the amount that we would pay or receive for the contracts involving the same notional amounts and maturity dates.
(2) We provide a domestic non-qualified deferred compensation plan covering certain employees, which allows for the deferral of compensation for an employee-specified term or until retirement or termination. Amounts deferred can be allocated to various hypothetical investment options. We hold investments to satisfy the future obligations of the plan. Changes in the value of the investment accounts are recognized each period based on the fair value of the underlying investments. Employees making deferrals are entitled to receive distributions of their hypothetical account balances (amounts deferred, together with earnings (losses)).

18. Subsequent Events

We have evaluated subsequent events through the date the financial statements were filed with the SEC, noting no events that require adjustment of, or disclosure in, the consolidated financial statements for the period ended June 30, 2010. These financial statements should be read in conjunction with the consolidated financial statements and related notes included in the 2010 Annual Report on Form 10-K.

 

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Report of Independent Registered Public Accounting Firm

Board of Directors and Shareholders

STERIS Corporation

We have reviewed the consolidated balance sheet of STERIS Corporation and subsidiaries as of June 30, 2010, and the related consolidated statements of operations and cash flows for the three month periods ended June 30, 2010 and 2009. These financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based upon our review, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of STERIS Corporation and subsidiaries as of March 31, 2010 and the related consolidated statements of income, shareholders’ equity and cash flows for the year then ended, not presented herein, and in our report dated May 28, 2010, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of March 31, 2010, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ Ernst & Young LLP

Cleveland, Ohio

August 9, 2010

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction

In Management’s Discussion and Analysis of Financial Condition and Results of Operations (the “MD&A”), we explain the general financial condition and the results of operations for STERIS including:

 

   

what factors affect our business;

 

   

what our earnings and costs were in each period presented;

 

   

why those earnings and costs were different from prior periods;

 

   

where our earnings came from;

 

   

how this affects our overall financial condition;

 

   

what our expenditures for capital projects were; and

 

   

where cash will come from to fund future growth outside of core operations, pay cash dividends and fund future working capital needs.

As you read the MD&A, it may be helpful to refer to information in our consolidated financial statements, which present the results of our operations for the first quarter of fiscal 2011 and fiscal 2010. It may also be helpful to read the MD&A in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010. In the MD&A, we analyze and explain the period-over-period changes in the specific line items in the Consolidated Statements of Income. Our analysis may be important to you in making decisions about your investments in STERIS.

Financial Measures

In the following sections of the MD&A, we may, at times, refer to financial measures that are not required to be presented in the consolidated financial statements under U.S. GAAP. We sometimes use the following financial measures in the context of this report: backlog; debt-to-total capital; net debt-to-total capital; and days sales outstanding. We define these financial measures as follows:

 

   

Backlog – We define backlog as the amount of unfilled capital equipment purchase orders at a point in time. We use this figure as a measure to assist in the projection of short-term financial results and inventory requirements.

 

   

Debt-to-total capital – We define debt-to-total capital as total debt divided by the sum of total debt and shareholders’ equity. We use this figure as a financial liquidity measure to gauge our ability to borrow, fund growth, and measure the risk of our financial structure.

 

   

Net debt-to-total capital – We define net debt-to-total capital as total debt less cash (“net debt”) divided by the sum of net debt and shareholders’ equity. We also use this figure as a financial liquidity measure and to measure the risk of our financial structure.

 

   

Days sales outstanding (“DSO”) – We define DSO as the average collection period for accounts receivable. It is calculated as net accounts receivable divided by the trailing four quarters’ revenues, multiplied by 365 days. We use this figure to help gauge the quality of accounts receivable and expected time to collect.

We, at times, may also refer to financial measures which are considered to be “non-GAAP financial measures” under the rules of the SEC. Non-GAAP financial measures we may use are as follows:

Free cash flow – We define free cash flow as net cash flows provided by operating activities as presented in the Consolidated Statements of Cash Flows less purchases of property, plant, equipment, and intangibles plus

 

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proceeds from the sale of property, plant, equipment, and intangibles, which is also presented in the Consolidated Statements of Cash Flows. We use this measure to gauge our ability to fund future growth outside of core operations, repurchase common shares, and pay cash dividends. The following table summarizes the calculations of our free cash flow for the three months ended June 30, 2010 and 2009:

 

     Three Months Ended
June 30,
 

(dollars in thousands)

   2010     2009  

Net cash flows provided by operating activities

   $ 29,694      $ 32,620   

Purchases of property, plant, equipment and intangibles, net

     (12,411     (8,355

Proceeds from the sale of property, plant, equipment and intangibles

     3        175   
                

Free cash flow

   $ 17,286      $ 24,440   
                

We may, at times, refer to our results of operations excluding certain transactions or amounts that are non-recurring or are not indicative of future results, in order to provide meaningful comparative analysis between the periods presented. In the discussion that follows, we will refer to revenues, gross profit and operating income excluding the impact of the SYSTEM 1 Rebate Program (“Rebate Program”) to provide meaningful comparisons of our results of operations on a total company basis and for the Healthcare segment.

We have presented these financial measures because we believe that meaningful analysis of our financial performance is enhanced by an understanding of certain additional factors underlying that performance. These financial measures should not be considered alternatives to measures required by accounting principles generally accepted in the United States. Our calculations of these measures may differ from calculations of similar measures used by other companies and you should be careful when comparing these financial measures to those of other companies.

Revenues – Defined

As required by Regulation S-X, we separately present revenues generated as either product revenues or service revenues on our Consolidated Statements of Operations for each period presented. When we discuss revenues, we may, at times, refer to revenues summarized differently than the Regulation S-X requirements. The terminology, definitions, and applications of terms that we use to describe revenues may be different from terms used by other companies. We use the following terms to describe revenues:

 

   

Revenues – Our revenues are presented net of sales returns and allowances.

 

   

Product Revenues – We define product revenues as revenues generated from sales of capital equipment, which includes steam and low temperature liquid sterilizers, washing systems, VHP® technology, water stills, and pure steam generators; integrated OR; surgical lights and tables; and the consumable family of products, which includes SYSTEM 1® consumables, sterility assurance products, skin care products, and cleaning consumables.

 

   

Service Revenues – We define service revenues as revenues generated from parts and labor associated with the maintenance, repair, and installation of our capital equipment, as well as revenues generated from contract sterilization offered through our Isomedix segment.

 

   

Capital Revenues – We define capital revenues as revenues generated from sales of capital equipment, which includes steam and low temperature liquid sterilizers, washing systems, VHP® technology, water stills, and pure steam generators; surgical lights and tables; and integrated OR.

 

   

Consumable Revenues – We define consumable revenues as revenues generated from sales of the consumable family of products, which includes SYSTEM 1® consumables, sterility assurance products, skin care products, and cleaning consumables.

 

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Recurring Revenues – We define recurring revenues as revenues generated from sales of consumable products and service revenues.

 

   

Acquired Revenues – We define acquired revenues as base revenues generated from acquired businesses or assets and additional volumes driven through acquired businesses or assets. We will use such measure for up to a year after acquisition.

General Company Overview and Executive Summary

Our mission is to provide a healthier today and safer tomorrow through knowledgeable people and innovative infection prevention, decontamination and health science technologies, products, and services. Our dedicated employees around the world work together to supply a broad range of solutions by offering a combination of capital equipment, consumables, and services to healthcare, pharmaceutical, industrial, and governmental Customers.

The bulk of our revenues are derived from the healthcare and pharmaceutical industries. Much of the growth in these industries is driven by the aging of the population throughout the world, as an increasing number of individuals are entering their prime healthcare consumption years, and is dependent upon advancement in healthcare delivery, acceptance of new technologies, government policies, and general economic conditions. In addition, each of our core industries is experiencing specific trends that could increase demand. Within healthcare, there is increased concern regarding the level of hospital-acquired infections around the world. The pharmaceutical industry has been impacted by increased FDA scrutiny of cleaning and validation processes, mandating that manufacturers improve their processes. In the contract sterilization industry, the aging population increases the demand for medical procedures, which increases the consumption of single use medical devices and surgical kits.

Beyond our core markets, infection-control issues are becoming a global concern, and emerging threats are prominent in the news. We are actively pursuing new opportunities to adapt our proven technologies to meet the changing needs of the global marketplace.

During the first quarter of fiscal 2011, we recorded a pre-tax liability related to the SYSTEM 1 Rebate Program. The Rebate Program reduced Healthcare revenues by $102.3 million, increased Healthcare cost of revenues by $7.7 million, decreased gross margin and operating margin by $110.0 million, decreased net income by $73.0 million and reduced earnings per diluted share by $1.22. The accrual of these estimated rebates and costs increased current liabilities by $110.0 million and did not impact free cash flow during the period.

Revenues for the first quarter of fiscal 2011 were $189.0 million and gross margin percentage for the period was 9.6%. Excluding the impact of the Rebate Program, fiscal 2011 first quarter revenues were $291.3 million compared to $283.5 million in the first quarter of fiscal 2010, representing an increase of $7.8 million, or 2.7%, driven by increases in all business segments. Excluding the impact of the Rebate Program, our gross margin percentage for the first quarter of fiscal 2011 was 44%, the same as in the first quarter of the prior fiscal year, reflecting the impact of price increases and efficiencies, offset by lower SYSTEM 1 consumable volume and unfavorable changes in foreign exchange.

Free cash flow was $17.3 million in the first quarter of fiscal 2011 compared to $24.4 million in the prior year first quarter due to changes in operating assets and liabilities and higher capital spending levels. Our debt-to-total capital ratio was 23.2% at June 30, 2010 and 21.8% at March 31, 2010. During the first quarter of fiscal 2011, we declared and paid quarterly cash dividends of $0.11 per common share.

Additional information regarding our fiscal 2011 first quarter financial performance is included in the subsection below titled “Results of Operations.”

 

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Matters Affecting Comparability

SYSTEM 1 Rebate Program. In April 2010, we introduced the SYSTEM 1 Rebate Program to Customers as a component of our Transition Plan for SYSTEM 1. Generally, U.S. Customers that purchased SYSTEM 1 processors directly from us or who are current users of SYSTEM 1 and who return their units will have the option of either a pro-rated cash value or rebate toward the future purchase of new STERIS capital equipment or consumable products. In addition, we will provide credits for SYSTEM 1 consumables in unbroken packaging and within shelf life and for the unused portion of prepaid SYSTEM 1 services contracts.

During the first quarter of fiscal 2011, we recorded a pre-tax liability related to the SYSTEM 1 Rebate Program. Of the $110.0 million recorded, $102.3 million is attributable to the Customer Rebate portion of the Program and was recorded as a reduction to revenue, and $7.7 million is attributable to the disposal liability of the SYSTEM 1 units to be returned and was recorded in cost of revenues.

To provide meaningful comparative analysis of our actual results for the period presented, we have excluded the impact of the Rebate Program when discussing revenues, gross profit, income tax expense and business segment results of operations. A reconciliation of amounts reported to the amounts excluding the impact of the Rebate Program which are used in the discussion of our results of operations is provided below.

 

     Three Months Ended
June 30, 2010
 

(dollars in thousands)

   As reported     Impact of Rebate
Program
    Results of
Operations,
excluding Rebate
Program
 

Revenues

      

Product

   $ 77,272      $ (102,313   $ 179,585   

Service

     111,708        —          111,708   
                        

Total revenues

     188,980        (102,313     291,293   

Cost of revenues

      

Product

     106,576        7,691        98,885   

Service

     64,338        —          64,338   
                        

Total cost of revenues

     170,914        7,691        163,223   

Gross profit

     18,066        (110,004     128,070   

Operating expenses

     81,067        —          81,067   
                        

(Loss) income from operations

     (63,001     (110,004     47,003   

Non-operating expenses, net

     2,845        —          2,845   
                        

(Loss) income before income taxes

     (65,846     (110,004     44,158   

Income tax (benefit) expense

     (20,636     (36,955     16,319   
                        

Net (loss) income

   $ (45,210   $ (73,049   $ 27,839   
                        

Net (loss) income per common share:

      

Basic

   $ (0.76   $ (1.23   $ 0.47   
                        

Diluted

   $ (0.76   $ (1.22   $ 0.46   
                        

Weighted average number of common shares outstanding used in EPS computation:

      

Basic

     59,397          59,397   

Diluted

     59,397          60,258   

Effective income tax rate

     31.3     33.6     37.0

(dollars in thousands)

   As reported     Impact of Rebate
Program
    Results of
Operations,
excluding Rebate
Program
 

Healthcare segment:

      

Revenues

   $ 103,766      $ (102,313   $ 206,079   

Operating (loss) income

   $ (77,912   $ (110,004   $ 32,092   

 

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Restructuring. During the first quarter of fiscal 2011, we did not incur any significant additional expenses related to previously announced restructuring actions.

Additional information regarding our restructuring actions is included in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010.

International Operations. Since we conduct operations outside of the United States using various foreign currencies, our operating results are impacted by foreign currency movements relative to the U.S. dollar. During the first quarter of fiscal 2011, our revenues were favorably impacted by $0.9 million, or 0.3%, and income before taxes was favorably impacted by $1.9 million, or 4.3%, as a result of foreign currency movements relative to the U.S. dollar.

Results of Operations

In the following subsections, we discuss our earnings and the factors affecting them for the first quarter of fiscal 2011, excluding the impact of the Rebate Program, compared with the first quarter of fiscal 2010. The impact of the Rebate Program is discussed previously in “Matters Affecting Comparability.” We begin with a general overview of our operating results and then separately discuss earnings for our operating segments.

Revenues. The following table compares our revenues for the three months ended June 30, 2010 to the three months ended June 30, 2009:

 

(dollars in thousands)

   Three Months Ended
June 30,
     Change       Percent
Change
    Percent of Total
Revenues
 
   2010    2009          2010         2009    

Capital Revenues

   $ 103,252    $ 92,703    $ 10,549      11.4   35.4   32.7

Consumable Revenues

     76,333      80,797      (4,464   (5.5 )%    26.2   28.5
                                        

Product Revenues

     179,585      173,500      6,085      3.5   61.7   61.2

Service Revenues

     111,708      110,043      1,665      1.5   38.3   38.8
                                        

Total Revenues

   $ 291,293    $ 283,543    $ 7,750      2.7   100.0   100.0
                                        

Service Revenues

   $ 111,708    $ 110,043    $ 1,665      1.5   38.3   38.8

Consumable Revenues

     76,333      80,797      (4,464   (5.5 )%    26.2   28.5
                                        

Recurring Revenues

     188,041      190,840      (2,799   (1.5 )%    64.6   67.3

Capital Revenues

     103,252      92,703      10,549      11.4   35.4   32.7
                                        

Total Revenues

   $ 291,293    $ 283,543    $ 7,750      2.7   100.0   100.0
                                        

United States

   $ 226,088    $ 223,806    $ 2,282      1.0   77.6   78.9

International

     65,205      59,737      5,468      9.2   22.4   21.1
                                        

Total Revenues

   $ 291,293    $ 283,543    $ 7,750      2.7   100.0   100.0
                                        

Revenues increased $7.8 million, or 2.7%, to $291.3 million for the quarter ended June 30, 2010, as compared to $283.5 million for the same prior year quarter. Capital revenues increased $10.5 million in the first quarter of fiscal 2011, primarily driven by higher demand in North America from Healthcare Customers. Service revenues increased $1.7 million in the first quarter of fiscal 2011 primarily due to an increase in Isomedix, although these increases were partially offset by a decrease within the Healthcare business segment. Consumable revenues decreased $4.5 million for the quarter ended June 30, 2010, primarily driven by decreases within the Healthcare segment attributable to reductions in SYSTEM 1 consumables and lower H1N1 product sales as compared to the prior year quarter.

International revenues increased $5.5 million, or 9.2%, to $65.2 million for the quarter ended June 30, 2010, as compared to $59.7 million for the same prior year quarter. International revenues were favorably affected by

 

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increases in capital equipment revenues, which increased 14.4% primarily due to an increase in Healthcare revenues within Latin America. International recurring revenues increased during the first quarter of fiscal 2011 by 4.7%, reflecting an increase of 9.4% in service revenues.

United States revenues increased $2.3 million, or 1.0%, to $226.1 million for the quarter ended June 30, 2010, as compared to $223.8 million for the same prior year quarter. The increase in United States revenues was primarily driven by a 16.1% increase in Healthcare capital equipment revenues partially offset by a 23.9% decrease in Life Sciences capital equipment revenues. United States recurring revenues decreased 2.7% for the first quarter of fiscal 2011, and reflect a decrease of 7.1% in consumable revenues. The decline is primarily attributable to the decrease in SYSTEM 1 consumables.

Revenues by segment are further discussed in the section of MD&A titled, “Business Segment Results of Operations.”

Gross Profit. The following table compares our gross profit for the three months ended June 30, 2010 to the three months ended June 30, 2009:

 

(dollars in thousands)

   Three Months Ended
June 30,
    Change    Percent
Change
 
   2010     2009       

Gross Profit:

         

Product

   $ 80,700      $ 79,223      $ 1,477    1.9

Service

     47,370        45,613        1,757    3.9
                             

Total Gross Profit

   $ 128,070      $ 124,836      $ 3,234    2.6
                             

Gross Profit Percentage:

         

Product

     44.9     45.7     

Service

     42.4     41.5     
                     

Total Gross Profit Percentage

     44.0     44.0     
                     

Our gross profit (margin) is affected by the volume, pricing, and mix of sales of our products and services, as well as the costs associated with the products and services that are sold. Gross margin in the quarter was flat compared with the prior year at 44.0%. Reductions in SYSTEM 1 consumables volume along with a negative foreign currency impact were offset by productivity improvements and favorable product mix within the Life Sciences and Isomedix segments.

Operating Expenses. The following table compares our operating expenses for the three months ended June 30, 2010 to the three months ended June 30, 2009:

 

(dollars in thousands)

   June 30,     Change     Percent
Change
 
   2010    2009      

Operating Expenses:

         

Selling, General, and Administrative

   $ 72,117    $ 74,605      $ (2,488   (3.3 )% 

Research and Development

     8,609      7,580        1,029      13.6

Restructuring Expenses

     341      (211     552      NM   
                             

Total Operating Expenses

   $ 81,067    $ 81,974      $ (907   (1.1 )% 
                             

 

NM - Not meaningful.

Significant components of total selling, general, and administrative expenses (“SG&A”) are compensation and benefit costs, fees for professional services, travel and entertainment, facilities costs, and other general and administrative expenses. As a percentage of total revenue, SG&A decreased 150 basis points to 24.8% for the first quarter of fiscal 2011 as compared to 26.3% in the first quarter of fiscal 2010. The decrease in SG&A expense as a percentage of total revenue in the first quarter of fiscal 2011 reflects the benefit of cost reduction actions previously implemented as well as improved operating efficiencies.

 

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As a percentage of total revenues, research and development expenses increased 30 basis points to 3.0% for the first quarter of fiscal 2011 as compared to 2.7% in the first quarter of fiscal 2010. Research and development expenses are influenced by the number and timing of in-process projects and labor hours and other costs associated with these projects. Our research and development initiatives continue to emphasize new product development, product improvements, and the development of new technological platform innovations. During the first quarter of fiscal 2011, our investments in research and development continued to be focused on, but were not limited to, enhancing capabilities of sterile processing combination technologies, surgical tables and accessories, and the areas of emerging infectious agents such as Prions and Nanobacteria.

In the first quarters of 2011 and 2010, we did not incur any significant additional expenses related to our previously announced restructuring plans, and we settled certain obligations for less than originally expected. The following tables summarize our total pre-tax restructuring expenses for the first quarter of fiscal 2011 and fiscal 2010:

 

(dollars in thousands)    Fiscal 2010
Restructuring
Plan (1)
 

Three Months Ended June 30, 2010

  

Severance, payroll, and other related costs

   $ (17

Asset impairment and accelerated depreciation

     356   

Other

     7   
        

Total restructuring charges

   $ 346   
        

 

(1) Includes $5 in charges recorded in cost of revenues on Consolidated Statements of Operations.

 

(dollars in thousands)    Fiscal 2009
Restructuring
Plan (1)
 

Three Months Ended June 30, 2009

  

Severance, payroll, and other related costs

   $ (46

Product rationalization

     (233

Other

     13   
        

Total restructuring charges

   $ (266
        

 

(1) Includes $(55) in charges recorded in cost of revenues on Consolidated Statements of Operations.

Liabilities related to restructuring activities are recorded as current liabilities on the accompanying Consolidated Balance Sheets within “Accrued payroll and other related liabilities” and “Accrued expenses and other.” The following table summarizes our liabilities related to these restructuring activities:

 

      Fiscal 2010 Restructuring Plan
      March 31,
2010
   Fiscal 2011     June 30,
2010
         Provision     Payments/
Impairments
   

(dollars in thousands)

         

Severance and termination benefits

   $ 1,894    $ (17   $ (246   $ 1,631

Asset impairments

     —        356        (356     —  

Lease termination obligations

     1,200      —          —          1,200

Other

     509      7        (44     472
                             

Total

   $ 3,603    $ 346      $ (646   $ 3,303
                             

 

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      Fiscal 2008 Restructuring Plan
      March 31,
2010
   Fiscal 2011     June 30,
2010
         Provision    Payments/
Impairments
   

(dollars in thousands)

          

Severance and termination benefits

   $ 102    $ —      $ (70   $ 32

Asset impairments

     289      —        —          289

Lease termination obligations

     411      —        (76     335
                            

Total

   $ 802    $ —      $ (146   $ 656
                            

Non-Operating Expenses, Net. Non-operating expense (income), net consists of interest expense on debt, offset by interest earned on cash, cash equivalents, short-term investment balances, and other miscellaneous income. The following table compares our net non-operating expense for the three months ended June 30, 2010 and 2009:

 

(dollars in thousands)

   Three Months Ended
June 30,
    Change  
       2010             2009        

Non-Operating Expenses, Net:

      

Interest Expense

   $ 3,007      $ 3,083      $ (76

Interest and Miscellaneous Income

     (162     (218     56   
                        

Non-Operating Expenses, Net

   $ 2,845      $ 2,865      $ (20
                        

Interest expense decreased $0.1 million during the first three months of fiscal 2011, as compared to the same prior year period as a result of higher capitalized interest. Interest and miscellaneous income decreased $0.1 million during the first three months of fiscal 2011 compared with the same prior year period.

Income Tax Expense. The following table compares our income tax expense and effective income tax rates for operations, excluding the impact of the Rebate Program, for the three months ended June 30, 2010 to the three months ended June 30, 2009:

 

(dollars in thousands)

   Three Months Ended
June 30,
    Change    Percent
Change
 
   2010     2009       

Income Tax Expense

   $ 16,319      $ 14,455      $ 1,864    12.9

Effective Income Tax Rate

     37.0     36.1     

Income tax expense includes United States federal, state and local, and foreign income taxes, and is based on reported pre-tax income. The effective income tax rates for continuing operations for the three-month periods ended June 30, 2010 and 2009 were 37.0% and 36.1%, respectively. We benefited from the settlement of certain tax years under examination in the United States during the three-month period ended June 30, 2009 and favorable changes in our valuation allowance.

We record income tax expense during interim periods based on our estimate of the annual effective income tax rate, adjusted each quarter for discrete items. We analyze various factors to determine the estimated annual effective income tax rate, including projections of our annual earnings and taxing jurisdictions in which the earnings will be generated, the impact of state and local income taxes, our ability to use tax credits and net operating loss carryforwards, and available tax planning alternatives.

 

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Business Segment Results of Operations. We operate in three reportable business segments: Healthcare, Life Sciences, and Isomedix. “Corporate and other,” which is presented separately, contains the Defense and Industrial business unit plus costs that are associated with being a publicly traded company and certain other corporate costs. These costs include executive office costs, Board of Directors compensation, shareholder services and investor relations, external audit fees, and legacy pension and post-retirement benefit costs from our former Erie, Pennsylvania manufacturing operation. Our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010, provides additional information regarding each business segment. The following table compares business segment revenues, excluding the impact of the Rebate Program, for the three months ended June 30, 2010 to the three months ended June 30, 2009:

 

(dollars in thousands)

   Three Months Ended
June 30,
   Change     Percent
Change
 
       
   2010    2009     

Revenues:

          

Healthcare

   $ 206,079    $ 200,604    $ 5,475      2.7

Life Sciences

     46,614      46,116      498      1.1

Isomedix

     37,676      35,407      2,269      6.4
                            

Total reportable segments

     290,369      282,127      8,242      2.9

Corporate and other

     924      1,416      (492   (34.7 )% 
                            

Total Revenues

   $ 291,293    $ 283,543    $ 7,750      2.7
                            

Healthcare segment revenues were 70.7% of total revenues for the first quarter of fiscal 2011 and fiscal 2010. Healthcare revenues increased $5.5 million, or 2.7%, to $206.1 million for the quarter ended June 30, 2010, as compared to $200.6 million for the same prior year quarter. Capital equipment revenues grew 16.3% in part because of higher demand for our products in North America and Latin America. This increase was partially offset by declines in revenues from consumables and service of 9.4% and 1.4%, respectively. Consumable revenues decreased in all geographies, although the primary driver was lower demand in the United States for SYSTEM 1 consumables and lower H1N1 product related sales. At June 30, 2010, the Healthcare segment’s backlog amounted to $134.2 million, increasing $6.4 million, or 5.0%, compared to the backlog of $127.8 million at March 31, 2010 and increasing $1.8 million, or 1.4%, compared to the backlog of $132.4 million at June 30, 2009. The increase is driven by demand for new products.

Life Sciences segment revenues were 16.0% of total revenues for the first quarter of fiscal 2011 as compared to 16.3% for the same prior year quarter. Life Sciences revenues increased $0.5 million, or 1.1%, to $46.6 million for the quarter ended June 30, 2010, as compared to $46.1 million for the same prior year quarter. The increase in Life Sciences revenues was driven by increases of 12.7% and 4.1% in consumables and service revenues, respectively. The decline in capital equipment revenues occurred primarily in North America, which continues to be impacted by consolidations within the industry limiting the order levels from our pharmaceutical Customers. At June 30, 2010, the Life Sciences segment’s backlog amounted to $37.9 million, decreasing $3.9 million, or 9.3% compared to the backlog of $41.8 million at March 31, 2010 and decreasing $8.3 million, or 18.0%, compared to the backlog of $46.3 million at June 30, 2009.

Isomedix segment revenues were 12.9% of total revenues for the first quarter of fiscal 2011 as compared to 12.5% for the same prior year quarter. The segment’s revenues increased $2.3 million, or 6.4%, to $37.7 million for the quarter ended June 30, 2010, as compared to $35.4 million for the same prior year quarter. Revenues were favorably impacted by increased demand from our medical device Customers.

 

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The following table compares our business segment operating results, excluding the impact of the Rebate Program, for the three months ended June 30, 2010 to the three months ended June 30, 2009:

 

(dollars in thousands)

   Three Months Ended
June 30,
    Change     Percent
Change
 
   2010     2009      

Operating Income (Loss):

        

Healthcare

   $ 32,092      $ 32,102      $ (10   (0.0 )% 

Life Sciences

     6,295        4,779        1,516      31.7

Isomedix

     10,584        8,339        2,245      26.9
                              

Total reportable segments

     48,971        45,220        3,751      8.3

Corporate and other

     (1,968     (2,358     390      16.5
                              

Total Operating Income

   $ 47,003      $ 42,862      $ 4,141      9.7
                              

Segment operating income is calculated as the segment’s gross profit less direct expenses and indirect cost allocations, which results in the full allocation of all distribution and research and development expenses, and the partial allocation of corporate costs. Corporate cost allocations are based on each segment’s percentage of revenues, headcount, or other variables in relation to those of the total Company. In addition, the Healthcare segment is responsible for the management of all but one manufacturing facility and uses standard cost to sell products to the Life Sciences segment. “Corporate and other” includes the gross profit and direct expenses of the Defense and Industrial business unit, as well as certain unallocated corporate costs related to being a publicly traded company and legacy pension and post-retirement benefits, as previously discussed.

The Healthcare segment’s operating income was $32.1 for the first quarter of fiscal 2011 and fiscal 2010. The segment’s operating margins were 15.6% and 16.0% for the quarters ended June 30, 2010 and 2009, respectively. Operating income was flat compared with the prior year primarily due to reductions in SYSTEM 1 consumables volume.

The Life Sciences segment’s operating income increased to $6.3 million for the quarter ended June 30, 2010 from $4.8 million for the quarter ended June 30, 2009. The segment’s operating margins were 13.5% and 10.4% for the quarters ended June 30, 2010 and 2009, respectively. The improvement in operating performance was primarily driven by product mix and efficiency initiatives.

The Isomedix segment’s operating income increased $2.2 million, or 26.9%, to $10.6 million for the first quarter of fiscal 2011 as compared to $8.3 million for the same prior year period. The segment’s operating margins were 28.1% and 23.6% for the quarters ended June 30, 2010 and 2009, respectively, due to increased revenues.

 

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Liquidity and Capital Resources

The following table summarizes significant components of our cash flows for the three months ended June 30, 2010 and 2009:

 

Operating activities:

    

Net (loss) income

   $ (45,210   $ 25,542   

Non-cash items

     (28,463     11,568   

Change in Accrued SYSTEM 1 Rebate Program

     110,004        —     

Changes in operating assets and liabilities

     (6,637     (4,490
                

Net cash provided by operating activities

   $ 29,694      $ 32,620   
                

Investing activities:

    

Purchases of property, plant, equipment, and intangibles, net

   $ (12,411   $ (8,355

Proceeds from the sale of property, plant, equipment, and intangibles

     3        175   
                

Net cash used in investing activities

   $ (12,408   $ (8,180
                

Financing activities:

    

Cash dividends paid to common shareholders

   $ (6,546   $ (6,441

Stock option and other equity transactions, net

     2,226        152   

Tax benefit from stock options exercised

     659        47   
                

Net cash used in financing activities

   $ (3,661   $ (6,242
                

Debt-to-total capital ratio

     23.2     21.6

Free cash flow

   $ 17,286      $ 24,440   

Net Cash Provided by Operating Activities. The net cash provided by our operating activities was $29.7 million for the first three months of fiscal 2011 compared to $32.6 million for the first three months of fiscal 2010. The following discussion summarizes the significant changes in our operating cash flows:

 

   

Non-cash items – Our non-cash items include depreciation, depletion and amortization, share-based compensation expense, changes in deferred income taxes, and other items. Changes in our non-cash items used cash of $28.5 million for the first three months of fiscal 2011 and provided cash of $11.6 million for the first three months of fiscal 2010. Significant changes in these items for the first quarter of fiscal 2011 as compared to the same prior year period are summarized below:

 

   

Depreciation, depletion, and amortization – Depreciation, depletion, and amortization is a significant component of non-cash items. This expense totaled $13.0 million and $13.9 million for the first three months of fiscal 2011 and fiscal 2010, respectively.

 

   

Deferred income taxes – Our deferred income tax benefit was $44.5 million for the first three months of fiscal 2011, compared with a deferred income tax benefit of $4.4 million for the first three months of fiscal 2010. The increase is attributable to the recognition of a deferred tax asset in connection with the recording of the SYSTEM 1 Rebate Program accrual.

 

   

Share-based compensation expense – We recorded share-based compensation expense of $3.9 million and $2.0 million for the first three months of fiscal 2011 and fiscal 2010, respectively.

 

   

Changes in operating assets and liabilities – Changes to our operating assets and liabilities, including the change in Accrued System 1 Rebate Program, provided cash of $103.4 million and used cash of $4.5 million during the first quarters of fiscal 2011 and fiscal 2010, respectively.

 

   

Accounts receivable, net – Changes in our net accounts receivable balances provided cash of $25.8 million and $38.3 million during the first three months of fiscal 2011 and fiscal 2010, respectively. Our accounts receivable balances may change from period to period due to the timing of revenues and Customer payments.

 

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Inventories, net – Increases in our net inventory balances drove uses of cash of $14.2 million and $1.9 million during the first three months of fiscal 2011 and fiscal 2010, respectively. The increase resulted from a higher level of inventory due to higher production volume levels and new product inventory.

 

   

Other current assets – Our other current assets primarily consist of prepaid expenses for insurance, taxes, and other general corporate items. Changes in other current asset balances provided cash of $3.0 million and $5.5 million during the first three months of fiscal 2011 and 2010, respectively.

 

   

Accounts payable – Decreases in our accounts payable balances drove uses of cash of $1.1 million and $18.5 million during the first three months of fiscal 2011 and fiscal 2010, respectively. Cash flows related to accounts payable may change from period to period due to varying payment due dates and other terms of our accounts payable obligations.

 

   

Accrued SYSTEM 1 Rebate Program – The increase results from the establishment of the accrual of $110.0 million for liabilities resulting from the SYSTEM 1 Rebate Program.

 

   

Accruals and other, net – Changes in our net accruals and other liabilities balances used cash of $20.1 million and $27.8 million during the first three months of fiscal 2011 and fiscal 2010, respectively. Cash flows related to our accruals and other liabilities balances may change from period to period primarily due to the timing of accruals and payments under our incentive compensation programs. Accruals under our various incentive compensation programs rise during the course of the fiscal year and decline significantly in the first fiscal quarter as payments are made under these programs. Changes in accruals for deferred revenues also contribute to the increase or decrease in these balances.

Net Cash Used In Investing Activities – The net cash we used in investing activities totaled $12.4 million for the first three months of fiscal 2011 compared with $8.2 million for the first three months of fiscal 2010. The following discussion summarizes the significant changes in our investing cash flows for the first three months of fiscal 2011 and fiscal 2010:

 

   

Purchases of property, plant, equipment, and intangibles, net – Capital expenditures increased $4.0 million to $12.4 million during the first three months of fiscal 2011 as compared to $8.4 million during the same prior year period. Radioisotope purchases were higher during the first three months of fiscal 2011 in comparison to fiscal 2010.

Net Cash Used In Financing Activities – The net cash used in financing activities amounted to $3.7 million for the first three months of fiscal 2011 compared with net cash used in financing activities of $6.2 million for the first three months of fiscal 2010. The following discussion summarizes the significant changes in our financing cash flows for the first three months of fiscal 2011 and fiscal 2010:

 

   

Repurchases of common shares – The Company’s Board of Directors has provided authorization to repurchase the Company’s common shares. During the first three months of fiscal 2011 and fiscal 2010, we did not repurchase any common shares.

 

   

Cash dividends paid to common shareholders – During the first three months of fiscal 2011, we paid total cash dividends of $6.5 million, or $0.11 per outstanding common share. During the first three months of fiscal 2010, we paid total cash dividends of $6.4 million, or $0.11 per outstanding common share.

 

   

Stock option and other equity transactions, net – We receive cash for issuing common shares under our various employee stock compensation programs. During the first three months of fiscal 2011 and fiscal 2010, we received cash proceeds totaling $2.2 million and $0.2 million, respectively, under these programs.

 

   

Tax benefit from stock options exercised – During the first three months of fiscal 2011, our income taxes were reduced by $0.7 million, respectively, as a result of deductions allowed for stock options exercised. The reduction in the fiscal 2010 comparable period was less than $0.1 million.

 

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Cash Flow Measures. Free cash flow was $17.3 million in the first quarter of fiscal 2011 compared to $24.4 million in the prior year first quarter due to changes in operating assets and liabilities and higher capital spending levels. Our debt-to-total capital ratio was 23.2% at June 30, 2010 and 21.8% at March 31, 2010.

Sources of Credit and Contractual and Commercial Commitments. Information related to our sources of credit and contractual and commercial commitments is included in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010. Our commercial commitments were approximately $39.4 million at June 30, 2010 reflecting a net increase of $2.7 million in surety bonds and other commercial commitments from March 31, 2010. In conjunction with facility consolidation projects, we have entered into commitments aggregating approximately $8.1 million with general contractors as of June 30, 2010. These obligations are comprised principally of construction contracts and are generally due within 24 months. The related construction costs are incurred and financed through operating cash flow. The maximum aggregate borrowing limits under our revolving credit facility (“Facility”) have not changed since March 31, 2010. At June 30, 2010, there was $375.8 million available under the Facility for borrowing. The maximum aggregate borrowing limit of $400.0 million under the Facility is reduced by outstanding borrowings and letters of credit issued under a sub-limit within the Facility ($24.2 million at June 30, 2010.)

Cash Requirements. Currently, we intend to use our existing cash and cash equivalent balances, cash generated from operations, and our existing credit facilities for short-term and long-term capital expenditures and our other liquidity needs. We believe that these amounts will be sufficient to meet working capital needs, capital requirements, and commitments for at least the next twelve months. However, our capital requirements will depend on many uncertain factors, including our rate of sales growth, our Customers’ acceptance of our products and services, the costs of obtaining adequate manufacturing capacities, the timing and extent of our research and development projects, and changes in our operating expenses. To the extent that our existing sources of cash are not sufficient to fund our future activities, we may need to raise additional funds through additional borrowings or selling equity securities. We cannot assure you that we will be able to obtain additional funds on terms favorable to us, or at all.

Critical Accounting Policies, Estimates, and Assumptions

Information related to our critical accounting policies, estimates, and assumptions is included in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010. Our critical accounting policies, estimates, and assumptions have not changed materially from March 31, 2010.

SYSTEM 1 Rebate Program

In April 2010, we introduced the Rebate Program to Customers as a component of our transition plan for SYSTEM 1. Generally, U.S. Customers that purchased SYSTEM 1 processors directly from us or who are current users of SYSTEM 1 and who return their units have the option of either a pro-rated cash value or rebate toward the future purchase of new STERIS capital equipment or consumable products. In addition, we will provide credits for SYSTEM 1 consumables in unbroken packaging and within shelf life and for the unused portion of prepaid SYSTEM 1 service contracts.

Recording the obligations associated with the Rebate Program requires the use of estimates and assumptions. The use of estimates and assumptions involves judgments with respect to factors that may impact the ultimate outcome and may be beyond management’s control. The amount recognized during the first quarter of fiscal 2011 is based upon the quantity of SYSTEM 1 processors eligible for rebates and the estimated value of rebates to be provided upon their return. Rebates of $102.3 million are recognized as contra-revenue consistent with other returns and allowances offered to Customers. The estimated cost of $7.7 million to facilitate the disposal of the processors has been recognized as cost of revenues. Both components are recorded as current liabilities. No rebate obligations were settled during the three months ended June 30, 2010. The key assumptions involved in the estimates associated with the Rebate Program include: the number and age of SYSTEM 1

 

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processors eligible for rebates under the program, the number of Customers that will elect to participate in the Rebate Program, the proportion of Customers that will choose each rebate option, and the estimated per unit costs of disposal.

The number and age of SYSTEM 1 processors has been estimated based on our historical sales and service records and we have assumed that 100% of these Customers will elect to participate in the Rebate Program. In order to estimate the portion of Customers that will choose each available rebate option, we first assessed recent trends in sales of the proprietary consumable products utilized in the SYSTEM 1 processor. The 19% decline in shipments during the approximately seven month period ended June 30, 2010 indicates that a portion of our Customers have already transitioned away from the SYSTEM 1 technology. The remaining 81%, provides the best available indication of the portion of Customers likely to elect the rebate for the SYSTEM 1E processor. Order and quote data from the fiscal 2011 first quarter provided indications of the proportion of Customers that are expected to choose each of the other cash and rebate allowance options. The per unit costs associated with disposal were estimated based on the service hours involved and quotes from our vendors which are based on current freight and disposal contracts.

Our assumptions regarding the response of our Customers to the Rebate Program could be wrong and actual results could be different from these estimates. For example, if all Customers elected the maximum incentive rebate associated with the SYSTEM 1E processor rebate, the total estimated rebate liability of $102.3 million would increase to approximately $111.0 million. Conversely, if all Customers elected the cash rebate option, the total estimated rebate liability would decrease to approximately $52.0 million.

Contingencies

We are involved in various patent, product liability, consumer, commercial, environmental, tax proceedings and claims, governmental investigations, and other legal and regulatory proceedings that arise from time to time in the course of our business. We record a liability for such contingencies to the extent that we conclude that their occurrence is both probable and estimable. We consider many factors in making these assessments, including the professional judgment of experienced members of management and our legal counsel. We have made estimates as to the likelihood of unfavorable outcomes and the amounts of such potential losses. In our opinion, the ultimate outcome of these proceedings and of claims that are probable and estimable is not anticipated to have a material adverse affect on our consolidated financial position, results of operations, or cash flows. However, the ultimate outcome of claims, litigation, and other proceedings is unpredictable and actual results could be materially different from our estimates. We record anticipated recoveries under applicable insurance contracts when assured of recovery. Refer to Part II, Item 1, “Legal Proceedings” for additional information.

We are subject to taxation from United States federal, state, and local, and foreign jurisdictions. Tax positions are settled primarily through the completion of audits within each individual tax jurisdiction or the closing of a statute of limitation. Changes in applicable tax law or other events may also require us to revise past estimates. The IRS routinely conducts audits of our federal income tax returns. In the first quarter of fiscal 2009, we reached a settlement with the IRS on all material tax matters for fiscal 2002 through fiscal 2005. In the second quarter of fiscal 2010, we reached a settlement with the IRS on all material tax matters for fiscal 2006 through fiscal 2007. The IRS also began its audit of fiscal 2008 and fiscal 2009 in fiscal 2010. We remain subject to tax authority audits in various other jurisdictions in which we operate. If we prevail in matters for which accruals have been recorded, or are required to pay amounts in excess of recorded accruals, our effective income tax rate in a given financial statement period could be materially impacted.

Additional information regarding our commitments and contingencies is included in note 10 to our consolidated financial statements titled, “Contingencies.”

 

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International Operations

Since we conduct operations outside the United States using various foreign currencies, our operating results are impacted by foreign currency movements relative to the U.S. dollar. During the first quarter of fiscal 2011, our revenues were favorably impacted by 0.9 million, or 0.3%, and income before income taxes was favorably impacted by $1.9 million, or 4.3%, as a result of foreign currency movements relative to the U.S. dollar. We cannot predict future changes in foreign currency exchange rates or the effect they will have on our operations.

Forward-Looking Statements

This Quarterly Report on Form 10-Q may contain statements concerning certain trends, expectations, forecasts, estimates, or other forward-looking information affecting or relating to the Company or its industry that are intended to qualify for the protections afforded “forward-looking statements” under the Private Securities Litigation Reform Act of 1995 and other laws and regulations. Forward-looking statements speak only as to the date of this report, and may be identified by the use of forward-looking terms such as “may,” “will,” “expects,” “believes,” “anticipates,” “plans,” “estimates,” “projects,” “targets,” “forecasts,” “outlook,” “impact,” “potential,” “confidence,” “improve,” “optimistic,” “comfortable,” “trend”, and “seeks,” or the negative of such terms or other variations on such terms or comparable terminology. Many important factors could cause actual results to differ materially from those in the forward-looking statements including, without limitation, disruption of production or supplies, changes in market conditions, political events, pending or future claims or litigation, competitive factors, technology advances, actions of regulatory agencies, and changes in laws or government regulations or the application or interpretation thereof. Other risk factors are described herein and in the Company’s Form 10-K and other securities filings. Many of these important factors are outside STERIS’s control. No assurances can be provided as to any outcome from litigation, regulatory action, administrative proceedings, government investigations, warning letters, cost reductions, business strategies, earnings and revenue trends, expense reduction or other future financial results. Unless legally required, the Company does not undertake to update or revise any forward-looking statements even if events make clear that any projected results, express or implied, will not be realized. Other potential risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements include, without limitation, (a) the potential for increased pressure on pricing that leads to erosion of profit margins, (b) the possibility that market demand will not develop for new technologies, products or applications or the Company’s business initiatives will take longer, cost more or produce lower benefits than anticipated, (c) the possibility that the application of or compliance with laws, court rulings, regulations, regulatory actions, including without limitation previously disclosed FDA warning letters, government investigations, the December 3, 2009 or February 22, 2010 FDA notices, the Consent Decree, Transition Plan, Rebate Program, the EPS System or other requirements or standards may delay or limit or prevent new product introductions, affect the production and marketing of existing products or services or otherwise affect Company performance, results, prospects or value, (d) the potential of international unrest or effects of fluctuations in currencies, tax assessments or rates, raw material costs, benefit or retirement plan costs, or other regulatory compliance costs, (e) the possibility of reduced demand, or reductions in the rate of growth in demand, for the Company’s products and services, (f) the possibility that anticipated growth, cost savings, rebate assumptions, new product acceptance, or other results may not be achieved or that transition, labor, competition, timing, execution, regulatory, governmental, or other issues or risks associated with our business, industry or initiatives including, without limitation, the Consent Decree, the transition to the new liquid chemical sterilant processing system, or those matters described in our Form 10-K for the year ended March 31, 2010 and this Form 10-Q may adversely impact our performance, results, prospects or value, (g) the effect of the contraction in credit availability, as well as the ability of our Customers and suppliers to adequately access the credit markets when needed, and (h) those risks described in our Annual Report on Form 10-K for the year ended March 31, 2010 and this Form 10-Q for the quarter ended June 30, 2010.

Availability of Securities and Exchange Commission Filings

We make available free of charge on or through our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to these reports as soon as reasonably practicable after we file such material with, or furnish such material to, the SEC. You may access these

 

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documents on the Investor Relations page of our website at http://www.steris-ir.com. The information on our website is not incorporated by reference into this report. You may also obtain copies of these documents by visiting the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549, or by accessing the SEC’s website at http://www.sec.gov. You may obtain information on the Public Reference Room by calling the SEC at 1-800-SEC-0330.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In the ordinary course of business, we are subject to interest rate, foreign currency, and commodity risks. Information related to these risks and our management of these exposures is included in Part II, Item 7A, “Quantitative and Qualitative Disclosures about Market Risk,” in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010. Our exposures to market risks have not changed materially since March 31, 2010.

 

ITEM 4. CONTROLS AND PROCEDURES

Under the supervision of and with the participation of our management, including the Principal Executive Officer (“PEO”) and Principal Financial Officer (“PFO”), we evaluated the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as of the end of the period covered by this Quarterly Report. Based on that evaluation, including the assessment and input of our management, the PEO and PFO concluded that, as of the end of the period covered by this Quarterly Report, our disclosure controls and procedures were effective.

There were no changes in our internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) promulgated under the Securities Exchange Act of 1934, that occurred during the quarter ended June 30, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II—OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

We are, and will likely continue to be, involved in a number of legal proceedings, government investigations, and claims, which we believe generally arise in the course of our business, given our size, history, complexity, and the nature of our business, products, Customers, regulatory environment, and industries in which we participate. These legal proceedings, investigations and claims generally involve a variety of legal theories and allegations, including, without limitation, personal injury (e.g., slip and falls, burns, vehicle accidents), product liability or regulation (e.g., based on product operation or claimed malfunction, failure to warn, failure to meet specification, or failure to comply with regulatory requirements), product exposure (e.g., claimed exposure to chemicals, asbestos, contaminants, radiation), property damage (e.g., claimed damage due to leaking equipment, fire, vehicles, chemicals), commercial claims (e.g., breach of contract, economic loss, warranty, misrepresentation), financial (e.g., taxes, reporting), employment (e.g., wrongful termination, discrimination, benefits matters), and other claims for damage and relief.

We believe we have adequately reserved for our current litigation and claims that are probable and estimable, and further believe that the ultimate outcome of these pending lawsuits and claims will not have a material adverse affect on our consolidated financial position or results of operations taken as a whole. Due to their inherent uncertainty, however, there can be no assurance of the ultimate outcome or effect of current or future litigation, investigations, claims or other proceedings (including without limitation the matters discussed below). For certain types of claims, we presently maintain product liability insurance coverage and other liability coverages in amounts and with deductibles that we believe are prudent, but there can be no assurance that these coverages will be applicable or adequate to cover adverse outcomes of claims or legal proceedings against us.

As previously disclosed, we received a warning letter (the “warning letter”) from the FDA on May 16, 2008 regarding our SYSTEM 1® sterile processor and the STERIS 20 sterilant used with the processor (sometimes referred to collectively in the FDA letter and in this Item 1 as the “device”). Among other matters, the warning letter included the FDA’s assertion that significant changes or modifications had been made in the design, components, method of manufacture, or intended use of the device beyond the FDA’s 1988 clearance, such that the FDA believed a new premarket notification submission (known within FDA regulations as a 510(k) submission) should have been made, and the assertion that our failure to make such a submission resulted in violations of applicable law. On July 30, 2008 (with an Addendum on October 9, 2008), we provided a detailed response contending that the assertions in the warning letter were not correct. On November 4, 2008, we received a letter from the FDA (dated November 3, 2008) in which the FDA stated without elaboration that, after reviewing our response, it disagreed with our position and that a new premarket notification submission was required. After discussions with the FDA regarding the November 3rd letter, we received an additional letter on November 6, 2008 from the FDA. The November 6th letter stated that the intent of the November 3rd letter was to inform us of the FDA’s preliminary disagreement with our response to the warning letter and, before finalizing a position, the FDA reiterated that it wanted to meet with us to discuss the Company’s response, issues related to the warning letter and next steps to resolve any differences between the Company and the FDA. We thereafter met with the FDA and, on January 20, 2009, we announced that we had submitted to the FDA a new liquid chemical sterilant system for 510(k) clearance, and we communicated to Customers that we would continue supporting the existing SYSTEM 1installed base in the U.S. for at least a two year period from that date.

On December 3, 2009, the FDA provided a notice (“notice”) to healthcare facility administrators and infection control practitioners describing FDA’s “concerns about the SYSTEM 1 Processor, components and accessories, and FDA recommendations.” In the notice, among other things, FDA stated its belief that the SYSTEM 1 device had been significantly modified, that FDA had not cleared or approved the modified device, and that FDA had not determined whether the SYSTEM 1® was safe or effective for its labeled claims. The notice further stated that use of a device that does not properly sterilize or disinfect a medical or surgical device

 

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poses risks to patients and users, including the transmission of pathogens, exposure to hazardous chemicals and affect on the quality and functionality of reprocessed instruments. The notice stated that FDA was aware of reports of malfunctions of the SYSTEM 1® that had the potential to cause or contribute to serious injuries to patients, such as infections, or injuries to healthcare staff, such as burns. Included in FDA’s December 3, 2009 notice was a recommendation from FDA that if users had acceptable alternatives to meet sterilization and disinfection needs, they should transition to that alternative as soon as possible. After its December 3, 2009 notice, we engaged in extensive discussions with the FDA regarding a comprehensive resolution of this matter. On February 2, 2010, the FDA notified healthcare facility administrators and infection control practitioners that FDA’s total recommended time period for transitioning from SYSTEM 1 in the U.S. was 18 months from that date. During this transition period in the U.S., we have continued to support the existing SYSTEM 1 installed base by providing accessories, sterilant, service and parts for U.S. Customers.

In April 2010 we reached agreement with the FDA on the terms of a consent decree (“Consent Decree”). On April 19, 2010, a Complaint and Consent Decree were filed in the U.S. District Court for the Northern District of Ohio, and on April 20, 2010, the Court approved the Consent Decree. In general, the Consent Decree addresses regulatory matters regarding SYSTEM 1, restricts further sales of SYSTEM 1 processors in the U.S., defines certain documentation and requirements for continued service and support of SYSTEM 1 in the U.S., prohibits the sale of liquid chemical sterilization or disinfection products that do not have FDA clearance, describes various process and compliance matters, and defines penalties in the event of violation of the Consent Decree.

The Consent Decree also provides that we may continue to support our Customers’ use of SYSTEM 1 in the U.S., including the sale of consumables, parts and accessories and service for a transition period, not to extend beyond August 2, 2011, subject to compliance with requirements for documentation of the Customer’s need for continued support and other conditions and limitations (the “Transition Plan”). Our Transition Plan includes the “SYSTEM 1 Rebate Program” (the “Rebate Program”). In April 2010, we began to offer rebates to qualifying Customers. Generally, U.S. Customers that purchased SYSTEM 1 processors directly from us or who are current users of SYSTEM 1 and who return their units will have the option of either a pro-rated cash value or rebate toward the future purchase of new STERIS capital equipment or consumable products. In addition, we will provide credits for SYSTEM 1 consumables in unbroken packaging and within shelf life and for the unused portion of SYSTEM 1 service contracts. As a result of the Rebate Program, we recorded a pre-tax liability of $110.0 million related to the SYSTEM 1 Rebate Program. Of the $110.0 million, $102.3 million is attributable to the Customer Rebate portion of the Program and was recorded as a reduction of revenues, and $7.7 million is attributable to the disposal liability of the SYSTEM 1 units to be returned and was recorded as an increase in cost of revenues. This also resulted in a $110.0 million reduction in operating income.

Addition information regarding the liabilities associated with the Rebate Program is included in the Part I, Item 2 of this Form 10-Q titled, “SYSTEM 1 Rebate Program.”

Also, in April, 2010 we voluntarily submitted information regarding modifications to the Reliance™ EPS Endoscope Processing System (the “EPS System”) to the FDA. These incremental modifications to the EPS System were considered minor by us. FDA has recently advised us that it believes a new pre-market notification (510(k)) for those modifications should be submitted. We have submitted the pre-market notification to the FDA. We have suspended shipments of EPS Systems in the U.S. until we receive FDA clearance of the submission. FDA has agreed that we may continue servicing EPS Systems in the field and provide consumables necessary for the continued use of the EPS Systems. We do not believe the impact of these events will be material with respect to our financial results.

The Consent Decree has defined the resolution of a number of issues regarding SYSTEM 1, and we believe our actions since January 2009 with respect to SYSTEM 1, including the Transition Plan were and are not recalls, corrections or removals under FDA regulations. However, there is no assurance that other claims will not be brought or that judicial, regulatory, administrative or other legal or enforcement actions, notices or remedies will not be pursued, or that action will not be taken in respect of the Consent Decree, the Transition Plan,

 

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SYSTEM 1, the EPS System, or otherwise with respect to regulatory or compliance matters, as described in this Item 1 or in various portions of Item 1A. of Part I contained in our Annual Report on Form 10-K for the year ended March 31, 2010, filed with the SEC on May 28, 2010. On February 5, 2010, a complaint was filed by a Customer who claims to have purchased two SYSTEM 1 devices from STERIS, Physicians of Winter Haven LLC d/b/a Day Surgery Center v. Steris Corp., Case No. 1:1-cv-00264-CAB (N.D. Ohio). The complaint alleges statutory violations, breaches of various warranties, negligence, failure to warn, and unjust enrichment. Plaintiff seeks class certification, damages, and other legal and equitable relief including, without limitation, attorneys’ fees and an order requiring STERIS to replace, recall or adequately repair the product and/or to take appropriate regulatory action. We are evaluating this matter and expect to defend against these allegations. This proceeding or other civil, criminal, regulatory or other proceedings involving our SYSTEM 1, SYSTEM 1E, EPS System or other products or services could possibly result in judgments, settlements or administrative or judicial decrees requiring us, among other actions, to pay damages or fines or effect recalls, or be subject to other governmental, Customer or other third party claims or remedies, which could materially affect our business, performance, prospects, value, financial condition, and results of operations.

For additional information regarding these matters, see the following portions of our Annual Report on Form 10-K for the year ended March 31, 2010: “Business – Information with respect to our Business in General – Recent Events – Government Regulation”, and the “Risk Factor” titled: “We may be adversely affected by product liability claims or other legal actions or regulatory or compliance matters, including the Warning Letter and Consent Decree.”, the “Risk Factor” titled: “Our business may be adversely affected as a result of the U.S. Food and Drug Administration notices to healthcare administrators and device manufacturers, and related matters,” and the “Risk Factor” titled “Compliance with the Consent Decree may be more costly and burdensome than anticipated.”

From time to time, STERIS is also involved in legal proceedings as a plaintiff involving contract, patent protection, and other claims asserted by us. Gains, if any, from these proceedings are recognized when they are realized.

Except as noted above, we believe there have been no material recent developments concerning our legal proceedings since March 31, 2010 and no new material pending legal proceedings that are required to be reported.

 

ITEM 1A. RISK FACTORS

We believe there have been no material changes to the risk factors included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2010, filed with the SEC on May 28, 2010, that would materially affect our business, results of operations, or financial condition.

 

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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

During the first quarter of fiscal 2011, we did not repurchase any of our common shares. A repurchase program approved by the Company’s Board of Directors and announced on March 14, 2008, authorized the repurchase of up to $300,000 of our common shares. As of June 30, 2010, $203,864 in common shares remained authorized for repurchase under this authorization. This common share repurchase authorization does not have a stated maturity date. The following table summarizes the common shares repurchase activity during the first quarter of fiscal 2011 under our common share repurchase program:

 

     (a)
Total Number of
Shares Purchased
    (b)
Average Price Paid
Per Share
    (c)
Total Number of
Shares  Purchased as
Part of Publicly
Announced Plans
   (d)
Maximum Dollar Value of
Shares that May Yet Be
Purchased Under the
Plans at Period End

April 1-30

   —        $ —        —      $ 203,864

May 1-31

   —          —        —        203,864

June 1-30

   —          —        —        203,864
                         

Total

   —   (1)    $ —   (1)    —      $ 203,864

 

(1) Does not include 62 shares purchased during the quarter at an average price of $33.14 per share by the STERIS Corporation 401(k) Plan on behalf of certain executive officers of the Company who may be deemed to be affiliated purchasers.

 

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ITEM 6. EXHIBITS

Exhibits required by Item 601 of Regulation S-K

 

Exhibit

Number

  

Exhibit Description

  3.1    1992 Amended Articles of Incorporation of STERIS Corporation, as amended on May 14, 1996, November 6, 1996, and August 6, 1998 (filed as Exhibit 3.1 to Form 10-K filed for the fiscal year ended March 31, 2000 (Commission File No. 1-14643), and incorporated herein by reference).
  3.2    Amended and Restated Regulations of STERIS Corporation, as amended on July 26, 2007 (filed as Exhibit 3.2 to Form 10-Q for the fiscal quarter ended June 30, 2007 (Commission File No. 1-14643), and incorporated herein by reference).
  4.1    Specimen Form of Common Stock Certificate (filed as Exhibit 4.1 to Form 10-K filed for the fiscal year ended March 31, 2002 (Commission File No. 1-14643), and incorporated herein by reference).
10.1    Executive Retention Agreement, dated April 1, 2010 between STERIS Corporation and Dr. Peter Burke.
15.1    Letter Re: Unaudited Interim Financial Information.
31.1    Certification of the Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2    Certification of the Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1    Certification of the Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant Section 906 of the Sarbanes-Oxley Act of 2002.
EX-101    Instance Document.
EX-101    Schema Document.
EX-101    Calculation Linkbase Document.
EX-101    Definition Linkbase Document.
EX-101    Labels Linkbase Document.
EX-101    Presentation Linkbase Document.

 

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

STERIS Corporation
/s/    MICHAEL J. TOKICH        

Michael J. Tokich

Senior Vice President and Chief Financial Officer

August 9, 2010

 

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EXHIBIT INDEX

 

Exhibit

Number

  

Exhibit Description

  3.1    1992 Amended Articles of Incorporation of STERIS Corporation, as amended on May 14, 1996, November 6, 1996, and August 6, 1998 (filed as Exhibit 3.1 to Form 10-K filed for the fiscal year ended March 31, 2000 (Commission File No. 1-14643), and incorporated herein by reference).
  3.2    Amended and Restated Regulations of STERIS Corporation, as amended on July 26, 2007 (filed as Exhibit 3.2 to Form 10-Q for the fiscal quarter ended June 30, 2007 (Commission File No. 1-14643), and incorporated herein by reference).
  4.1    Specimen Form of Common Stock Certificate (filed as Exhibit 4.1 to Form 10-K filed for the fiscal year ended March 31, 2002 (Commission File No. 1-14643), and incorporated herein by reference).
10.1    Executive Retention Agreement, dated April 1, 2010 between STERIS Corporation and Dr. Peter Burke.
15.1    Letter Re: Unaudited Interim Financial Information.
31.1    Certification of the Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2    Certification of the Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1    Certification of the Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant Section 906 of the Sarbanes-Oxley Act of 2002.
EX-101    Instance Document.
EX-101    Schema Document.
EX-101    Calculation Linkbase Document.
EX-101    Definition Linkbase Document.
EX-101    Labels Linkbase Document.
EX-101    Presentation Linkbase Document.