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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 December 31, 2010
or
o
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
____________________________________________________
 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  o
 
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  o
 
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  o
Non-Accelerated Filer  o
(Do not check if a smaller reporting company)
  
Smaller Reporting Company  o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  x
 
The number of common shares outstanding as of January 31, 2011: 59,341,368

1


STERIS Corporation and Subsidiaries
Form 10-Q
Index
 
 

2


PART 1—FINANCIAL INFORMATION
 
ITEM 1.    FINANCIAL STATEMENTS
 
STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
 
 
 
December 31, 2010
 
March 31,
2010
 
 
(Unaudited)
 
 
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
192,288
 
 
$
214,971
 
Accounts receivable (net of allowances of $8,547 and $9,238, respectively)
 
212,637
 
 
214,940
 
Inventories, net
 
167,258
 
 
121,135
 
Deferred income taxes, net
 
55,166
 
 
6,976
 
Prepaid expenses and other current assets
 
14,361
 
 
18,435
 
Total current assets
 
641,710
 
 
576,457
 
Property, plant, and equipment, net
 
365,354
 
 
346,858
 
Goodwill and intangibles, net
 
318,388
 
 
305,311
 
Other assets
 
26,939
 
 
9,776
 
Total assets
 
$
1,352,391
 
 
$
1,238,402
 
Liabilities and equity
 
 
 
 
Current liabilities:
 
 
 
 
Current portion of long-term indebtedness
 
$
 
 
$
 
Accounts payable
 
73,697
 
 
66,035
 
Accrued income taxes
 
688
 
 
 
Accrued payroll and other related liabilities
 
44,085
 
 
58,986
 
Accrued SYSTEM 1 Rebate Program and class action settlement
 
128,770
 
 
 
Accrued expenses and other
 
66,233
 
 
72,108
 
Total current liabilities
 
313,473
 
 
197,129
 
Long-term indebtedness
 
210,000
 
 
210,000
 
Deferred income taxes, net
 
16,469
 
 
20,749
 
Other liabilities
 
61,049
 
 
56,030
 
Total liabilities
 
600,991
 
 
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; 59,336 and 59,227 shares outstanding, respectively
 
240,436
 
 
237,165
 
Common shares held in treasury, 10,704 and 10,813 shares, respectively
 
(297,734
)
 
(295,251
)
Retained earnings
 
786,737
 
 
798,809
 
Accumulated other comprehensive income
 
21,216
 
 
12,991
 
Total shareholders’ equity
 
750,655
 
 
753,714
 
Noncontrolling interest
 
745
 
 
780
 
Total equity
 
751,400
 
 
754,494
 
Total liabilities and equity
 
$
1,352,391
 
 
$
1,238,402
 
See notes to consolidated financial statements.

3


STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(Unaudited)
 
 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
 
2010
 
2009
 
2010
 
2009
Revenues:
 
 
 
 
 
 
 
 
Product
 
$
212,622
 
 
$
214,072
 
 
$
486,986
 
 
$
586,707
 
Service
 
115,661
 
 
113,760
 
 
342,702
 
 
338,897
 
Total revenues
 
328,283
 
 
327,832
 
 
829,688
 
 
925,604
 
Cost of revenues:
 
 
 
 
 
 
 
 
Product
 
123,381
 
 
122,324
 
 
340,693
 
 
332,559
 
Service
 
67,888
 
 
66,025
 
 
198,860
 
 
196,071
 
Total cost of revenues
 
191,269
 
 
188,349
 
 
539,553
 
 
528,630
 
Gross profit
 
137,014
 
 
139,483
 
 
290,135
 
 
396,974
 
Operating expenses:
 
 
 
 
 
 
 
 
Selling, general, and administrative
 
93,467
 
 
71,776
 
 
237,583
 
 
220,897
 
Research and development
 
7,739
 
 
8,265
 
 
24,391
 
 
24,035
 
Restructuring expenses
 
(23
)
 
14
 
 
423
 
 
(313
)
Total operating expenses
 
101,183
 
 
80,055
 
 
262,397
 
 
244,619
 
Income from operations
 
35,831
 
 
59,428
 
 
27,738
 
 
152,355
 
Non-operating expenses, net:
 
 
 
 
 
 
 
 
Interest expense
 
3,049
 
 
3,291
 
 
9,052
 
 
9,504
 
Interest and miscellaneous income
 
(321
)
 
(535
)
 
(671
)
 
(1,031
)
Total non-operating expenses, net
 
2,728
 
 
2,756
 
 
8,381
 
 
8,473
 
Income before income tax expense
 
33,103
 
 
56,672
 
 
19,357
 
 
143,882
 
Income tax expense
 
11,338
 
 
15,666
 
 
7,091
 
 
45,250
 
Net income
 
$
21,765
 
 
$
41,006
 
 
$
12,266
 
 
$
98,632
 
Net income per common share
 
 
 
 
 
 
 
 
Basic
 
$
0.37
 
 
$
0.70
 
 
$
0.21
 
 
$
1.68
 
Diluted
 
$
0.36
 
 
$
0.69
 
 
$
0.20
 
 
$
1.66
 
Cash dividends declared per common share outstanding
 
$
0.15
 
 
$
2.11
 
 
$
0.41
 
 
$
2.33
 
 
See notes to consolidated financial statements.
 

4


STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
 
 
 
Nine Months Ended December 31,
 
 
2010
 
2009
Operating activities:
 
 
 
 
Net income
 
$
12,266
 
 
$
98,632
 
Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation, depletion, and amortization
 
39,739
 
 
42,027
 
Deferred income taxes
 
(52,652
)
 
1,171
 
Share-based compensation
 
8,489
 
 
5,613
 
Loss on the disposal of property, plant, equipment, and intangibles, net
 
1,217
 
 
1,477
 
Other items
 
3,637
 
 
4,016
 
Changes in operating assets and liabilities:
 
 
 
 
Accounts receivable, net
 
2,205
 
 
38,064
 
Inventories, net
 
(44,855
)
 
9,275
 
Prepaid expenses and other current assets
 
4,188
 
 
3,356
 
Accounts payable
 
7,414
 
 
(14,837
)
Accrued SYSTEM 1 Rebate Program and class action settlement
 
128,770
 
 
 
Accruals and other, net
 
(27,021
)
 
(30,126
)
Net cash provided by operating activities
 
83,397
 
 
158,668
 
Investing activities:
 
 
 
 
Purchases of property, plant, equipment, and intangibles, net
 
(56,390
)
 
(29,839
)
Proceeds from the sale of property, plant, equipment, and intangibles
 
1,298
 
 
574
 
Equity investment in joint venture
 
(16,900
)
 
(1,500
)
Investment in business, net of cash acquired
 
(4,000
)
 
 
Net cash used in investing activities
 
(75,992
)
 
(30,765
)
Financing activities:
 
 
 
 
Proceeds under credit facilities, net
 
 
 
100,000
 
Repurchases of common shares
 
(19,900
)
 
(289
)
Cash dividends paid to common shareholders
 
(24,344
)
 
(137,509
)
Stock option and other equity transactions, net
 
10,813
 
 
12,339
 
Tax benefit from stock options exercised
 
2,197
 
 
1,927
 
Net cash used in financing activities
 
(31,234
)
 
(23,532
)
Effect of exchange rate changes on cash and cash equivalents
 
1,146
 
 
6,868
 
(Decrease) increase in cash and cash equivalents
 
(22,683
)
 
111,239
 
Cash and cash equivalents at beginning of period
 
214,971
 
 
154,180
 
Cash and cash equivalents at end of period
 
$
192,288
 
 
$
265,419
 
 
See notes to consolidated financial statements.
 

5


STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
For the Three and Nine Months Ended December 31, 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 and nine month periods ended December 31, 2010 are not necessarily indicative of results that may be expected for future quarters or for the full fiscal year ending March 31, 2011.
 
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 $241,888 at December 31, 2010. The financial instruments that we hold could

6

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

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”) initially 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. 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.
 
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. We noted a decline of approximately 19% in shipments which 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 for fiscal 2011 year to date provides 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

7

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

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 $7,237 related to these actions, of which $6,060 was recorded as restructuring expenses and $1,177 was recorded in cost of revenues. We also expect to incur an additional $3,400 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.
 
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 $14,044, of which $9,594 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 remaining accrued obligation is expected to be paid within the next year.
 
The following tables summarize our total pre-tax restructuring expenses for the third quarter and first nine months of fiscal 2011 and fiscal 2010:
 
Three Months Ended December 31, 2010
Fiscal 2010
Restructuring
Plan (1)
Fiscal 2008 Restructuring Plan
Total
Severance, payroll, and other related costs
$
489
 
$
 
$
489
 
Asset impairment and accelerated depreciation
 
(289
)
(289
)
Other
7
 
 
7
 
Total restructuring charges
$
496
 
$
(289
)
$
207
 
 

8

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

(1)    
Includes $230 in charges recorded in cost of revenues on Consolidated Statements of Income.
 
Three Months Ended December 31, 2009
Fiscal 2009
Restructuring
Plan (1)
Severance, payroll, and other related costs
$
(23
)
Product rationalization
(232
)
Asset impairment
9
 
Lease termination obligations and other
18
 
Total restructuring charges
$
(228
)
 
(1)    
Includes $(242) in charges recorded in cost of revenues on Consolidated Statements of Income.
 
Nine Months Ended December 31, 2010
Fiscal 2010
Restructuring
Plan (1)
Fiscal 2008 Restructuring Plan
Total
Severance, payroll, and other related costs
$
498
 
$
 
$
498
 
Asset impairment and accelerated depreciation
356
 
(289
)
67
 
Other
88
 
 
88
 
Total restructuring charges
$
942
 
$
(289
)
$
653
 
 
(1) Includes $230 in charges recorded in cost of revenues on Consolidated Statements of Income.
 
 
Nine Months Ended December 31, 2009
Fiscal 2009
Restructuring
Plan (2)
Severance, payroll, and other related costs
$
(36
)
Product rationalization
(466
)
Asset impairment
(5
)
Lease termination obligations and other
(290
)
Total restructuring charges
$
(797
)
 
(2)    
Includes $(484) in charges recorded in cost of revenues on Consolidated Statements of Income.
 
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
 
December 31,
2010
Severance and termination benefits
 
$
1,894
 
 
$
498
 
 
$
(325
)
 
$
2,067
 
Asset impairments
 
 
 
356
 
 
(356
)
 
 
Lease termination obligations
 
1,200
 
 
 
 
 
 
1,200
 
Other
 
509
 
 
88
 
 
(125
)
 
472
 
Total
 
$
3,603
 
 
$
942
 
 
$
(806
)
 
$
3,739
 
 

9

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

 
 
Fiscal 2008 Restructuring Plan
 
 
 
 
Fiscal 2011
 
 
 
 
March 31,
2010
 
Provision
 
Payments/
Impairments
 
December 31,
2010
Severance and termination benefits
 
$
102
 
 
$
 
 
$
(102
)
 
$
 
Asset impairments
 
289
 
 
(289
)
 
 
 
 
Lease termination obligations
 
411
 
 
 
 
(228
)
 
183
 
Total
 
$
802
 
 
$
(289
)
 
$
(330
)
 
$
183
 
 
3. Comprehensive Income
 
Comprehensive income includes net income as currently reported under U.S. GAAP and other comprehensive income. Other comprehensive income considers the effects of additional economic events that are not required to be recorded in determining net income, but rather are reported as a separate component of shareholders’ equity. The following table illustrates the components of our comprehensive income:
 
 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
 
2010
 
2009
 
2010
 
2009
Net income
 
$
21,765
 
 
$
41,006
 
 
$
12,266
 
 
$
98,632
 
Cumulative foreign currency translation adjustment
 
793
 
 
3,073
 
 
8,935
 
 
34,667
 
Amortization of pension and postretirement benefit plans costs, net of taxes
 
(277
)
 
(246
)
 
(828
)
 
(651
)
Unrealized gains on investments
 
109
 
 
7
 
 
118
 
 
276
 
Total comprehensive income
 
$
22,390
 
 
$
43,840
 
 
$
20,491
 
 
$
132,924
 
 
4. Property, Plant and Equipment
 
Information related to the major categories of our depreciable assets is as follows:
 
 
 
December 31,
2010
 
March 31,
2010
Land and land improvements (1)
 
$
29,040
 
 
$
26,234
 
Buildings and leasehold improvements
 
202,458
 
 
192,722
 
Machinery and equipment
 
288,166
 
 
276,714
 
Information systems
 
101,067
 
 
103,056
 
Radioisotope
 
189,946
 
 
172,489
 
Construction in progress (1)
 
36,638
 
 
29,614
 
Total property, plant, and equipment
 
847,315
 
 
800,829
 
Less: accumulated depreciation and depletion
 
(481,961
)
 
(453,971
)
Property, plant, and equipment, net
 
$
365,354
 
 
$
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:
 

10

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

 
 
December 31,
2010
 
March 31,
2010
Raw materials
 
$
55,285
 
 
$
36,170
 
Work in process
 
21,049
 
 
20,668
 
Finished goods
 
90,924
 
 
64,297
 
Inventories, net
 
$
167,258
 
 
$
121,135
 
 
6. Debt
 
Indebtedness was as follows:
 
 
 
December 31,
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.
 
7. Additional Consolidated Balance Sheets Information
 
Additional information related to our Consolidated Balance Sheets is as follows:
 
 
 
December 31,
2010
 
March 31,
2010
Accrued payroll and other related liabilities:
 
 
 
 
Compensation and related items
 
$
15,084
 
 
$
15,314
 
Accrued vacation/paid time off
 
6,783
 
 
5,734
 
Accrued bonuses
 
9,695
 
 
23,457
 
Accrued employee commissions
 
8,516
 
 
10,565
 
Other postretirement benefit obligations-current portion
 
3,340
 
 
3,340
 
Other employee benefit plans obligations-current portion
 
667
 
 
576
 
Total accrued payroll and other related liabilities
 
$
44,085
 
 
$
58,986
 
Accrued expenses and other:
 
 
 
 
Deferred revenues
 
$
30,307
 
 
$
27,908
 
Self-insured risk retention-current portion
 
2,386
 
 
4,956
 
Accrued dealer commissions
 
6,918
 
 
6,972
 
Accrued warranty
 
6,316
 
 
6,070
 
Other
 
20,306
 
 
26,202
 
Total accrued expenses and other
 
$
66,233
 
 
$
72,108
 
Other liabilities:
 
 
 
 
Self-insured risk retention-long-term portion
 
$
9,986
 
 
$
9,986
 
Other postretirement benefit obligations-long-term portion
 
20,267
 
 
21,839
 
Defined benefit pension plans obligations-long-term portion
 
10,116
 
 
10,179
 
Other employee benefit plans obligations-long-term portion
 
3,717
 
 
2,336
 
Accrued long-term income taxes
 
12,153
 
 
11,690
 
Other
 
4,810
 
 
 
Total other liabilities
 
$
61,049
 
 
$
56,030
 
 
8. Income Tax Expense

11

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

 
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 the three-month periods ended December 31, 2010 and 2009 were 34.3% and 27.6%. The effective income tax rates for the nine-month periods ended December 31, 2010 and 2009 were 36.6% and 31.4%, respectively. The lower effective income tax rates for the three-month and nine-month periods ended December 31, 2009 were the result of favorable discrete item adjustments and tax planning initiatives.
 
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 December 31, 2010, we had $12,059 in unrecognized tax benefits, of which $3,869 would favorably impact the effective tax rate if recognized. The increase in unrecognized tax benefits for the nine months ended December 31, 2010 is primarily due to a increase in unrecognized tax benefits relating to prior years. We believe that it is reasonably possible that unrecognized tax benefits could decrease by up to $2,893 within 12 months of December 31, 2010, primarily as a result of settlements with tax authorities. As of December 31, 2010, we have recognized a liability for interest of $1,485 and penalties of $81.
 
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 December 31,
 
2010
 
2009
 
2010
 
2009
 
2010
 
2009
Service cost
 
$
47
 
 
$
59
 
 
$
135
 
 
$
137
 
 
$
 
 
$
 
Interest cost
 
654
 
 
761
 
 
88
 
 
81
 
 
292
 
 
487
 
Expected return on plan assets
 
(758
)
 
(617
)
 
(95
)
 
(89
)
 
 
 
 
Recognized losses
 
267
 
 
290
 
 
 
 
 
 
97
 
 
157
 
Curtailment/settlement
 
 
 
 
 
 
 
(19
)
 
 
 
 
Amortization of transition obligation
 
 
 
(18
)
 
 
 
 
 
 
 
 
Amortization of prior service cost
 
 
 
 
 
 
 
 
 
(816
)
 
(816
)
Net periodic benefit cost (income)
 
$
210
 
 
$
475
 
 
$
128
 
 
$
110
 
 
$
(427
)
 
$
(172
)

12

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

 
 
 
Defined Benefit Pension Plans
 
Other
Postretirement
Benefits Plan
 
 
U.S. Qualified
 
International
 
Nine Months Ended December 31,
 
2010
 
2009
 
2010
 
2009
 
2010
 
2009
Service cost
 
$
142
 
 
$
178
 
 
$
406
 
 
$
354
 
 
$
 
 
$
 
Interest cost
 
1,963
 
 
2,283
 
 
262
 
 
243
 
 
876
 
 
1,461
 
Expected return on plan assets
 
(2,275
)
 
(1,851
)
 
(285
)
 
(276
)
 
 
 
 
Recognized losses
 
801
 
 
869
 
 
 
 
 
 
291
 
 
470
 
Curtailment/settlement
 
 
 
 
 
 
 
(38
)
 
 
 
 
Amortization of transition obligation
 
 
 
(53
)
 
 
 
 
 
 
 
 
Amortization of prior service cost
 
 
 
 
 
 
 
 
 
(2,447
)
 
(2,447
)
Net periodic benefit cost (income)
 
$
631
 
 
$
1,426
 
 
$
383
 
 
$
283
 
 
$
(1,280
)
 
$
(516
)
 
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.
 
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

13

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

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 April 5, 2010, we received FDA clearance of the new liquid chemical sterilant processing system (SYSTEM 1E).)
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 poses risks to patients and users, including the transmission of pathogens, exposure to hazardous chemicals and affect 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 other 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 (including SYSTEM 1E) 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, 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. 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.
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. We noted a decline of approximately 19% in shipments which

14

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

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 for the fiscal 2011 year to date provides 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.
In December of 2010, we began shipping SYSTEM 1E units in limited numbers, after having received FDA clearance for the SYSTEM 1E chemical indicator, which is used in conjunction with the SYSTEM 1E. We have also requested FDA clearance or approval of certain other accessories for SYSTEM 1E, although neither the chemical indicator nor these other accessories are required by regulation to sell or operate the device. No assurance can be made that the FDA will agree with our submissions or requests.
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 subsequently advised us that it believed a new pre-market notification (510(k)) for those modifications should be submitted. We thereafter submitted this pre-market notification to the FDA. We also suspended shipments of EPS Systems in the U.S. pending FDA review of the submission but continued servicing and providing consumables necessary for the continued use of the EPS Systems. We recently received FDA clearance of the modified EPS System and have resumed shipment in the U.S.
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 these or 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 that 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. On February 7, 2011 we entered into a settlement agreement in which we agreed, among other things, to provide various categories of economic relief for members of the settlement class and not object to plaintiff's counsel's application to the court for attorneys' fees and expenses up to a specified amount. Both certification of a settlement class and preliminary and final approval of the settlement require approval of the court and satisfaction of certain other conditions. There is no assurance that the court will take such actions, that such conditions will be satisfied, or that this matter will be resolved, or be resolved consistent with the terms and conditions of such settlement agreement. During the third quarter of fiscal 2011, we recorded in operating expenses a pre-tax charge of approximately $19,796 related to the proposed settlement of these proceedings. The assumptions regarding the amount of this charge include, among others, the portion of class members participating in the settlement and their choice of the categories of economic relief available for such members. These assumptions may be incorrect and the costs of the settlement may be higher or lower than the charge recorded. The actual settlement could be as low as $7,000 and as high as $22,000 depending on the options selected by the class members.
This putative class action 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 - Government Regulation”,

15

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

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 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 on a world wide basis. 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 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 service revenues, 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.
 
The accounting policies for reportable segments are the same as those for the consolidated Company. For the three and nine month periods ended December 31, 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:
 

16

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
 
2010
 
2009
 
2010
 
2009
Revenues:
 
 
 
 
 
 
 
 
Healthcare (1)
 
$
237,843
 
 
$
233,277
 
277
 
$
561,723
 
 
$
656,887
 
Life Sciences
 
51,247
 
 
58,910
 
 
151,374
 
 
159,427
 
Isomedix
 
38,081
 
 
34,987
 
 
113,721
 
 
105,129
 
Total reportable segments
 
327,171
 
 
327,174
 
 
826,818
 
 
921,443
 
Corporate and other
 
1,112
 
 
658
 
 
2,870
 
 
4,161
 
Total revenues
 
$
328,283
 
 
$
327,832
 
 
$
829,688
 
 
$
925,604
 
Operating income:
 
 
 
 
 
 
 
 
Healthcare (2) (3)
 
$
20,389
 
 
$
45,254
 
 
$
(19,460
)
 
$
113,722
 
Life Sciences
 
7,345
 
 
10,123
 
 
23,075
 
 
23,442
 
Isomedix
 
10,250
 
 
6,929
 
 
30,858
 
 
22,669
 
Total reportable segments
 
37,984
 
 
62,306
 
 
34,473
 
 
159,833
 
Corporate and other
 
(2,153
)
 
(2,878
)
 
(6,735
)
 
(7,478
)
Total operating income
 
$
35,831
 
 
$
59,428
 
 
$
27,738
 
 
$
152,355
 
 
(1)    
Includes a reduction of $102,313 resulting from the SYSTEM 1 Rebate Program in the nine months ended December 31, 2010.
(2)    
Includes a reduction of $110,004 resulting from the SYSTEM 1 Rebate Program in the nine months ended December 31, 2010.
(3)    
Includes a reduction of $19,796 resulting from a class action settlement in the three and nine month periods ended December 31, 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 December 31,
 
Nine Months Ended December 31,
 
 
2010
 
2009
 
2010
 
2009
Denominator (shares in thousands):
 
 
 
 
 
 
 
 
Weighted average common shares outstanding—basic
 
59,233
 
 
58,962
 
 
59,329
 
 
58,711
 
Dilutive effect of common share equivalents
 
943
 
 
796
 
 
832
 
 
570
 
Weighted average common shares outstanding and common share equivalents—diluted
 
60,176
 
 
59,758
 
 
60,161
 
 
59,281
 
 
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:
 

17

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
 
2010
 
2009
 
2010
 
2009
 
 
(shares in thousands)
Number of common share options
 
370
 
 
567
 
 
437
 
 
1,292
 
 
13. Repurchases of Common Shares
 
During the third quarter of fiscal 2011, we repurchased 96,259 of our common shares for an aggregate amount of $3,297, representing an average price of $34.25 per common share. We also obtained 654 of our common shares during the third quarter of fiscal 2011 in connection with stock based compensation award programs. At December 31, 2010, $184,378 of STERIS common shares remained authorized for repurchase pursuant to a March 2008 Board Authorization. Also, 10,703,769 common shares were held in treasury at December 31, 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 December 31, 2010, 3,501,553 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.
 
The following weighted-average assumptions were used for share-based compensation granted during the first nine months of fiscal 2011 and fiscal 2010:
 
 
 
Fiscal 2011
 
Fiscal 2010
Risk-free interest rate
 
2.68
%
 
1.89
%
Expected life of options
 
5.65 years
 
 
5.50 years
 
Expected dividend yield of stock
 
1.59
%
 
1.49
%
Expected volatility of stock
 
30.13
%
 
27.96
%
 
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 time frame 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.
 

18

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

A summary of share option activity is as follows:
 
 
 
Number of
Options
 
Weighted
Average
Exercise
Price
 
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
Outstanding at March 31, 2010
 
3,599,221
 
 
$
24.96
 
 
 
 
 
Granted
 
273,578
 
 
31.92
 
 
 
 
 
Exercised
 
(476,403
)
 
22.42
 
 
 
 
 
Forfeited
 
(16,322
)
 
26.58
 
 
 
 
 
Canceled
 
(9,156
)
 
28.02
 
 
 
 
 
Outstanding at December 31, 2010
 
3,370,918
 
 
$
25.87
 
 
5.75
 
 
$
35,713
 
Exercisable at December 31, 2010
 
2,336,998
 
 
$
25.12
 
 
4.65
 
 
$
26,506
 
 
The aggregate intrinsic value in the table above represents the total pre-tax difference between the $36.46 closing price of our common shares on December 31, 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 nine months of fiscal 2011 and fiscal 2010 was $5,655 and $5,350, respectively. Net cash proceeds from the exercise of stock options were $10,813 and $12,339 for the first nine months of fiscal 2011 and fiscal 2010, respectively. An income tax benefit of $2,197 and $1,927 was realized from stock option exercises during the first nine months of fiscal 2011 and fiscal 2010, respectively.
 
The weighted average grant date fair value of stock option grants was $8.80 and $5.69 for the first nine months of fiscal 2011 and fiscal 2010, respectively.
 
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 December 31, 2010 and 2009 was $1,111 and $541, 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
 
259,238
 
 
 
 
31.97
 
Vested
 
(51,402
)
 
(23,000
)
 
28.05
 
Canceled
 
(6,888
)
 
 
 
30.60
 
Non-vested at December 31, 2010
 
423,538
 
 
 
 
$
29.70
 
 
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 nine months of fiscal 2011 was $2,087.
 
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 December 31, 2010 and 2009 was $1,282 and $2,093, 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 December 31, 2010, there was a total of $10,085 in unrecognized compensation cost related to nonvested share-based

19

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

compensation granted under our share-based compensation plans. We expect to recognize the cost over a weighted average period of 2.05 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 nine months of fiscal 2011 were as follows:
 
 
 
Balance, March 31, 2010
$
6,070
 
Warranties issued during the period
2,224
 
Settlements made during the period
(1,978
)
Balance, December 31, 2010
$
6,316
 
 
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 $17,064 and $17,709 as of December 31, 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
 
Fair Value at
 
Fair Value at
 
Fair Value at
 
Fair Value at
Location
 
December 31, 2010
 
March 31, 2010
 
December 31, 2010
 
March 31, 2010
Prepaid & Other
 
$
933
 
 
$
992
 
 
$
 
 
$
 
Accrued expenses and other
 
$
 
 
$
 
 
$
94
 
 
$
 
 
The following table presents the impact of derivative instruments and their location within the Consolidated Statements of Income:
 

20

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2010 and 2009
(dollars in thousands, except per share amounts)
 
 

 
 
Location of gain
recognized in income
 
Amount of gain
recognized in income
Nine Months Ended December 31,
2010
 
2009
Foreign currency forward contracts
 
Selling, general and
administrative
 
$
943
 
 
$
236
 
Commodity swap contracts
 
Cost of revenues
 
$
59
 
 
$
181
 
 
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 December 31, 2010:
 
 
 
 
 
Fair Value Measurements at December 31, 2010 Using
 
 
December 31,
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
 
$
192,288
 
 
$
192,288
 
 
$
 
 
$
 
Forward and swap contracts (1)
 
933
 
 
 
 
933
 
 
 
Investments (2)
 
2,354
 
 
2,354
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
Forward and swap contracts (1)
 
$
94
 
 
$
 
 
$
94
 
 
$
 
Deferred compensation plans (2)
 
2,354
 
 
2,354
 
 
 
 
 
 
(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 December 31, 2010, except for the February 2011 settlement of the SYSTEM 1 class action litigation described in Note 10 to our consolidated financial statements titled, "Contingencies." 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.
 

21


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 December 31, 2010, and the related consolidated statements of income and cash flows for the three and nine month periods ended December 31, 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
February 9, 2011
 

22


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 third quarter and first nine months 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 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 nine months ended December 31, 2010 and 2009:
 

23


 
 
Nine Months Ended December 31,
(dollars in thousands)
 
2010
 
2009
Net cash flows provided by operating activities
 
$
83,397
 
 
$
158,668
 
Purchases of property, plant, equipment and intangibles, net
 
(56,390
)
 
(29,839
)
Proceeds from the sale of property, plant, equipment and intangibles
 
1,298
 
 
574
 
Free cash flow
 
$
28,305
 
 
$
129,403
 
 
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, operating expenses, and operating income excluding the impact of the SYSTEM 1 Rebate Program and class action settlement 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 Income 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 and SYSTEM 1E 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 and SYSTEM 1E consumables, sterility assurance products, skin care products, and cleaning consumables.
•    
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

24


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 can increase 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 nine months 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 $69.5 million and reduced earnings per diluted share by $1.16. The accrual of these estimated rebates and costs increased current liabilities by $110.0 million and did not have a material impact on free cash flow during the period.
 
Fiscal 2011 third quarter revenues were $328.3 million representing an increase of 0.1% over prior year reflecting increases in the Healthcare and Isomedix business segments offset by a decrease in the Life Science business segment. Our gross margin percentage for the fiscal 2011 third quarter was 41.7%, representing a 80 basis point decrease over the prior year period, driven primarily by unfavorable product mix and lower SYSTEM 1 consumable volume. Revenues for the first nine months of fiscal 2011 were $829.7 million and gross margin percentage was 35.0%. Excluding the impact of the Rebate Program, fiscal 2011 first nine months of revenues were $932.0 million compared to $925.6 million in the first nine months of fiscal 2010, representing an increase of $6.4 million, or 0.7%, reflecting increases in the Healthcare and Isomedix business segments offset by a decrease in the Life Science business segment. Excluding the impact of the Rebate Program, our gross margin percentage for the first nine months of fiscal 2011 was 42.9%, consistent with the first nine months of the prior fiscal year. The benefits of productivity improvements and price increases were offset by unfavorable impacts of a shift in product mix and reductions in SYSTEM 1 consumable volumes.
 
Fiscal 2011 third quarter operating expenses include a pre-tax charge of $19.8 million related to the settlement of SYSTEM 1 class action litigation. This settlement is subject to, among other things, certification of the class and approval of the settlement by the court. After tax, the impact of the charge was a reduction in net income of $13.1 million, or $0.22 per diluted share.
 
Free cash flow was $28.3 million in the first nine months of fiscal 2011 compared to $129.4 million in the prior year first nine months, reflecting higher capital spending levels and a higher use of cash to fund changes in operating assets and liabilities. Our debt-to-total capital ratio was 21.9% at December 31, 2010 and 21.8% at March 31, 2010. During the first nine months of fiscal 2011, we declared and paid quarterly cash dividends of $0.41 per common share.
 
Additional information regarding our fiscal 2011 third quarter financial performance is included in the subsection below titled “Results of Operations.”
 
Matters Affecting Comparability
 
SYSTEM 1 Rebate Program and class action settlement. In April 2010, we introduced the SYSTEM 1 Rebate Program ("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.
 
Fiscal 2011 third quarter operating expenses include a pre-tax charge of $19.8 million related to the settlement of SYSTEM 1 class action litigation. This settlement is subject to, among other things, certification of the class and approval of the settlement by the court. After tax, the impact of the charge was a reduction in net income of $13.1 million, or $0.22 per diluted

25


share.
 
To provide meaningful comparative analysis of our actual results for the periods presented, we have excluded the impact of the Rebate Program and class action settlement when discussing revenues, gross profit, operating expenses, income tax expense and business segment results of operations in the section of MD&A titled, "Results of Operations." A reconciliation of amounts reported to the amounts excluding the impact of the Rebate Program and class action settlement is provided below.
 
 
 
Three Months Ended December 31, 2010
(dollars in thousands)
 
As reported
 
Impact of Rebate
Program and class action settlement
 
Results of
Operations,
excluding Rebate
Program and class action settlement
Gross profit
 
$
137,014
 
 
$
 
 
$
137,014
 
Operating expenses
 
101,183
 
 
19,796
 
 
81,387
 
Income from operations
 
35,831
 
 
(19,796
)
 
55,627
 
Non-operating expenses, net
 
2,728
 
 
 
 
2,728
 
Income before income taxes
 
33,103
 
 
(19,796
)
 
52,899
 
Income tax expense (benefit)
 
11,338
 
 
(7,504
)
 
18,842
 
Net income
 
$
21,765
 
 
$
(12,292
)
 
$
34,057
 
Net income per common share:
 
 
 
 
 
 
Basic
 
$
0.37
 
 
$
(0.20
)
 
$
0.57
 
Diluted
 
$
0.36
 
 
$
(0.21
)
 
$
0.57
 
Weighted average number of common shares outstanding used in EPS computation:
 
 
 
 
 
 
Basic
 
59,233
 
 
 
 
59,233
 
Diluted
 
60,176
 
 
 
 
60,176
 
Effective income tax rate
 
34.3
%
 
 
 
35.6
%
(dollars in thousands)
 
As reported
 
Impact of Rebate
Program and class action settlement
 
Results of
Operations,
excluding Rebate
Program and class action settlement
Healthcare segment:
 
 
 
 
 
 
Operating income
 
$
20,389
 
 
$
(19,796
)
 
$
40,185
 
 

26


 
 
Nine Months Ended December 31, 2010
(dollars in thousands)
 
As reported
 
Impact of Rebate Program and class action settlement
 
Results of
Operations,
excluding Rebate
Program and class action settlement
Revenues
 
 
 
 
 
 
Product
 
$
486,986
 
 
$
(102,313
)
 
$
589,299
 
Service
 
342,702
 
 
 
 
342,702
 
Total revenues
 
829,688
 
 
(102,313
)
 
932,001
 
Cost of revenues
 
 
 
 
 
 
Product
 
340,693
 
 
7,691
 
 
333,002
 
Service
 
198,860
 
 
 
 
198,860
 
Total cost of revenues
 
539,553
 
 
7,691
 
 
531,862
 
Gross profit
 
290,135
 
 
(110,004
)
 
400,139
 
Operating expenses
 
262,397
 
 
19,796
 
 
242,601
 
Income from operations
 
27,738
 
 
(129,800
)
 
157,538
 
Non-operating expenses, net
 
8,381
 
 
 
 
8,381
 
Income before income taxes
 
19,357
 
 
(129,800
)
 
149,157
 
Income tax expense (benefit)
 
7,091
 
 
(47,164
)
 
54,255
 
Net income
 
$
12,266
 
 
$
(82,636
)
 
$
94,902
 
Net income per common share:
 
 
 
 
 
 
Basic
 
$
0.21
 
 
$
(1.39
)
 
$
1.60
 
Diluted
 
$
0.20
 
 
$
(1.38
)
 
$
1.58
 
Weighted average number of common shares outstanding used in EPS computation:
 
 
 
 
 
 
Basic
 
59,329
 
 
 
 
59,329
 
Diluted
 
60,161
 
 
 
 
60,161
 
Effective income tax rate
 
36.6
%
 
 
 
36.4
%
(dollars in thousands)
 
As reported
 
Impact of Rebate
Program and class action settlement
 
Results of
Operations,
excluding Rebate
Program and class action settlement
Healthcare segment:
 
 
 
 
 
 
Revenues
 
$
561,723
 
 
$
(102,313
)
 
$
664,036
 
Operating (loss) income
 
$
(19,460
)
 
$
(129,800
)
 
$
110,340
 
 
Restructuring. During the first nine months 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 third quarter of fiscal 2011, our revenues were unfavorably impacted by $1.4 million, or 0.4%, and income before taxes was unfavorably impacted by $0.4 million, or 0.8%, as a result of foreign currency movements relative to the U.S. dollar. During the first nine months of fiscal 2011, our revenues were unfavorably impacted by $2.0 million, or 0.2%, and income before income taxes was unfavorably impacted by $0.2 million, or 0.6% as compared to the same prior year period.
 
Results of Operations
 
In the following subsections, we discuss our earnings and the factors affecting them for the third quarter and first nine months of fiscal 2011, excluding the impact of the Rebate Program and class action settlement, compared with the same fiscal 2010 periods. The impact of the Rebate Program and class action settlement is discussed previously in “Matters Affecting

27


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 and nine months ended December 31, 2010 to the revenues for the three and nine months ended December 31, 2009:
 
 
 
Three Months Ended December 31,
 
 
 
Percent
 
Percent of Total
Revenues
(dollars in thousands)
 
2010
 
2009
 
Change
 
Change
2010
 
2009
Capital Revenues
 
$
135,121
 
 
$
132,541
 
 
$
2,580
 
 
1.9
 %
 
41.2
%
 
40.4
%
Consumable Revenues
 
77,501
 
 
81,531
 
 
(4,030
)
 
(4.9
)%
 
23.6
%
 
24.9
%
Product Revenues
 
212,622
 
 
214,072
 
 
(1,450
)
 
(0.7
)%
 
64.8
%
 
65.3
%
Service Revenues
 
115,661
 
 
113,760
 
 
1,901
 
 
1.7
 %
 
35.2
%
 
34.7
%
Total Revenues
 
$
328,283
 
 
$
327,832
 
 
$
451
 
 
0.1
 %
 
100.0
%
 
100.0
%
Service Revenues
 
$
115,661
 
 
$
113,760
 
 
$
1,901
 
 
1.7
 %
 
35.2
%
 
34.7
%
Consumable Revenues
 
77,501
 
 
81,531
 
 
(4,030
)
 
(4.9
)%
 
23.6
%
 
24.9
%
Recurring Revenues
 
193,162
 
 
195,291
 
 
(2,129
)
 
(1.1
)%
 
58.8
%
 
59.6
%
Capital Revenues
 
135,121
 
 
132,541
 
 
2,580
 
 
1.9
 %
 
41.2
%
 
40.4
%
Total Revenues
 
$
328,283
 
 
$
327,832
 
 
$
451
 
 
0.1
 %
 
100.0
%
 
100.0
%
United States
 
$
239,975
 
 
$
244,067
 
 
$
(4,092
)
 
(1.7
)%
 
73.1
%
 
74.4
%
International
 
88,308
 
 
83,765
 
 
4,543
 
 
5.4
 %
 
26.9
%
 
25.6
%
Total Revenues
 
$
328,283
 
 
$
327,832
 
 
$
451
 
 
0.1
 %
 
100.0
%
 
100.0
%
 
 
 
Nine Months Ended December 31,
 
 
 
Percent
 
Percent of Total
Revenues
(dollars in thousands)
 
2010
 
2009
 
Change
 
Change
 
2010
 
2009
Capital Revenues
 
$
358,681
 
 
$
344,391
 
 
$
14,290
 
 
4.1
 %
 
38.5
%
 
37.2
%
Consumable Revenues
 
230,618
 
 
242,315
 
 
(11,697
)
 
(4.8
)%
 
24.7
%
 
26.2
%
Product Revenues
 
589,299
 
 
586,706
 
 
2,593
 
 
0.4
 %
 
63.2
%
 
63.4
%
Service Revenues
 
342,702
 
 
338,898
 
 
3,804
 
 
1.1
 %
 
36.8
%
 
36.6
%
Total Revenues
 
$
932,001
 
 
$
925,604
 
 
$
6,397
 
 
0.7
 %