STE 09.30.2012 10-Q
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
 
FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012
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 and posted 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 October 26, 2012: 58,472,547

1

Table of Contents

STERIS Corporation and Subsidiaries
Form 10-Q
Index
 
 
 
Page
 
 
 
 
 


2

Table of Contents

PART 1—FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS

STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
 
 
 
September 30,
2012
 
March 31,
2012
 
 
(Unaudited)
 
 
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
156,609

 
$
150,821

Accounts receivable (net of allowances of $8,570 and $11,428, respectively)
 
231,034

 
280,324

Inventories, net
 
160,537

 
157,712

Deferred income taxes, net
 
28,403

 
43,211

Prepaid expenses and other current assets
 
29,103

 
19,815

Total current assets
 
605,686

 
651,883

Property, plant, and equipment, net
 
413,763

 
386,409

Goodwill and intangibles, net
 
584,328

 
337,784

Other assets
 
28,955

 
29,620

Total assets
 
$
1,632,732

 
$
1,405,696

Liabilities and equity
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable
 
$
70,575

 
$
83,188

Accrued income taxes
 

 

Accrued payroll and other related liabilities
 
35,741

 
29,899

Accrued SYSTEM 1 Rebate Program and class action settlement
 
26,446

 
69,065

Accrued expenses and other
 
98,946

 
96,243

Total current liabilities
 
231,708

 
278,395

Long-term indebtedness
 
434,340

 
210,000

Deferred income taxes, net
 
36,799

 
42,703

Other liabilities
 
48,259

 
51,934

Total liabilities
 
$
751,106

 
$
583,032

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; 58,423 and 57,733 shares outstanding, respectively
 
241,601

 
244,091

Common shares held in treasury, 11,617 and 12,307 shares, respectively
 
(333,212
)
 
(350,718
)
Retained earnings
 
963,954

 
914,401

Accumulated other comprehensive income
 
8,018

 
13,627

Total shareholders’ equity
 
880,361

 
821,401

Noncontrolling interest
 
1,265

 
1,263

Total equity
 
881,626

 
822,664

Total liabilities and equity
 
$
1,632,732

 
$
1,405,696

See notes to consolidated financial statements.

3

Table of Contents

STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(Unaudited)
 
 
 
Three Months Ended September 30,
 
Six Months Ended September 30,
 
 
2012
 
2011
 
2012
 
2011
Revenues:
 
 
 
 
 
 
 
 
Product
 
$
231,650

 
$
223,502

 
$
445,403

 
$
425,515

Service
 
124,671

 
119,205

 
247,878

 
235,831

Total revenues
 
356,321

 
342,707

 
693,281

 
661,346

Cost of revenues:
 
 
 
 
 
 
 
 
Product
 
127,147

 
138,805

 
252,629

 
256,238

Service
 
76,053

 
70,593

 
150,279

 
138,874

Total cost of revenues
 
203,200

 
209,398

 
402,908

 
395,112

Gross profit
 
153,121

 
133,309

 
290,373

 
266,234

Operating expenses:
 
 
 
 
 
 
 
 
Selling, general, and administrative
 
81,040

 
76,652

 
160,814

 
153,661

Research and development
 
9,852

 
8,915

 
19,164

 
17,672

Restructuring expenses
 
(48
)
 
99

 
(184
)
 
357

Total operating expenses
 
90,844

 
85,666

 
179,794

 
171,690

Income from operations
 
62,277

 
47,643

 
110,579

 
94,544

Non-operating expenses, net:
 
 
 
 
 
 
 
 
Interest expense
 
3,406

 
3,081

 
6,379

 
6,078

Interest income and miscellaneous expense
 
(31
)
 
(682
)
 
(291
)
 
(575
)
Total non-operating expenses, net
 
3,375

 
2,399

 
6,088

 
5,503

Income before income tax expense
 
58,902

 
45,244

 
104,491

 
89,041

Income tax expense
 
18,757

 
15,680

 
33,992

 
30,746

Net income
 
$
40,145

 
$
29,564

 
$
70,499

 
$
58,295

Net income per common share
 
 
 
 
 
 
 
 
Basic
 
$
0.69

 
$
0.50

 
$
1.21

 
$
0.99

Diluted
 
$
0.68

 
$
0.50

 
$
1.20

 
$
0.98

Cash dividends declared per common share outstanding
 
$
0.19

 
$
0.17

 
$
0.36

 
$
0.32


See notes to consolidated financial statements.


4

Table of Contents

STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
(Unaudited)

 
 
Three Months Ended September 30,
 
Six Months Ended September 30,
 
 
2012
 
2011
 
2012
 
2011
Net income
 
$
40,145

 
$
29,564

 
70,499

 
58,295

Unrealized gain (loss) on available for sale securities
 
80

 
(261
)
 
(18
)
 
(255
)
Amortization of pension and postretirement benefit plans costs, net of taxes
 
(184
)
 
(270
)
 
(359
)
 
(539
)
Change in cumulative foreign currency translation adjustment
 
8,946

 
(23,266
)
 
(5,232
)
 
(13,953
)
Total other comprehensive income (loss)
 
8,842

 
(23,797
)
 
(5,609
)
 
(14,747
)
Comprehensive income
 
$
48,987

 
$
5,767

 
$
64,890

 
$
43,548


See notes to consolidated financial statements.




5

Table of Contents

STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
 
 
 
Six Months Ended September 30,
 
 
2012
 
2011
Operating activities:
 
 
 
 
Net income
 
$
70,499

 
$
58,295

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation, depletion, and amortization
 
30,188

 
30,187

Deferred income taxes
 
8,545

 
17,283

Share-based compensation expense
 
4,125

 
3,811

Loss on the disposal of property, plant, equipment, and intangibles, net
 
240

 
313

Other items
 
1,297

 
(1,166
)
Changes in operating assets and liabilities, net of effects of acquisitions:
 
 
 
 
Accounts receivable, net
 
56,060

 
36,545

Inventories, net
 
3,135

 
(15,955
)
Other current assets
 
(8,432
)
 
(11,525
)
Accounts payable
 
(14,183
)
 
(20,363
)
Accrued SYSTEM 1 Rebate Program and class action settlement
 
(42,619
)
 
(15,921
)
Accruals and other, net
 
3,168

 
(20,967
)
Net cash provided by operating activities
 
112,023

 
60,537

Investing activities:
 
 
 
 
Purchases of property, plant, equipment, and intangibles, net
 
(45,062
)
 
(34,445
)
Proceeds from the sale of property, plant, equipment, and intangibles
 
22

 

Acquisition of business, net of cash acquired
 
(276,595
)
 
(22,269
)
Net cash used in investing activities
 
(321,635
)
 
(56,714
)
Financing activities:
 
 
 
 
Proceeds under credit facilities, net
 
224,340

 

Repurchases of common shares
 
(2,688
)
 
(43,679
)
Cash dividends paid to common shareholders
 
(20,946
)
 
(18,928
)
Stock option and other equity transactions, net
 
11,709

 
3,172

Tax benefit from stock options exercised
 
1,772

 
745

Net cash provided by (used in) financing activities
 
214,187

 
(58,690
)
Effect of exchange rate changes on cash and cash equivalents
 
1,213

 
(4,038
)
Increase (decrease) in cash and cash equivalents
 
5,788

 
(58,905
)
Cash and cash equivalents at beginning of period
 
150,821

 
193,016

Cash and cash equivalents at end of period
 
$
156,609

 
$
134,111


See notes to consolidated financial statements.


6

Table of Contents

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
For the Three and Six Months Ended September 30, 2012 and 2011
(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, 2012 dated May 29, 2012. The Consolidated Balance Sheet at March 31, 2012 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. Therefore, the accompanying consolidated financial statements include the accounts of the Company and its wholly-owned and majority-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 six month periods ended September 30, 2012 are not necessarily indicative of results that may be expected for future quarters or for the full fiscal year ending March 31, 2013.

Recently Adopted Accounting Pronouncements

In June 2011, the FASB issued an accounting standard update titled "Presentation of Comprehensive Income," amending Accounting Standards Codification ASC Topic 220, "Comprehensive Income." This guidance requires that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This guidance became effective retrospectively for the interim periods and annual periods beginning after December 15, 2011; however, the FASB agreed to an indefinite deferral of the reclassification requirement as defined in accounting standard update titled "Deferral of the Effective Date for Amendments to the Presentation of

7

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



Reclassifications of Items Out of Accumulated Other Comprehensive Income," issued in December 2011. As required by the standard, Consolidated Statements of Comprehensive Income have been presented. The adoption of this standard did not have an impact on our consolidated financial position, results of operations or cash flows.
    
In July 2012, the FASB issued an accounting standards update titled "Testing Indefinite-Lived Intangible Assets for Impairment," amending certain sections of Subtopic 350-30 Intangibles-Goodwill and Other-General Intangibles Other than Goodwill. This amended guidance allows an entity to first assess qualitative factors to determine if it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount. If based on its qualitative assessment an entity concludes it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount, quantitative impairment testing is required. However, if an entity concludes otherwise, quantitative impairment testing is not required. The standards update is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. The anticipated adoption of this standard is not expected to impact our consolidated financial position, results of operations or cash flows.

Significant Accounting Policies

A detailed description of our significant and critical accounting policies, estimates, and assumptions is included in our consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2012 dated May 29, 2012. Our significant and critical accounting policies, estimates, and assumptions have not changed materially from March 31, 2012 with the exception of the estimation of the SYSTEM 1 Rebate Program.

SYSTEM 1 Rebate Program. The SYSTEM 1 Rebate Program (the “Rebate Program”) was initially recognized during the first quarter of fiscal 2011. The rebate portion of the Rebate Program is recognized as contra-revenue consistent with other returns and allowances offered to Customers. The estimated costs to facilitate the disposal of the returned SYSTEM 1 processors portion of the Rebate Program is recognized as cost of revenues. Both components are recorded as current liabilities. The key assumptions involved in the estimates associated with the Rebate Program included: the number and age of SYSTEM 1 processors eligible for rebates under the Rebate Program, the number of Customers that would elect to participate in the Rebate Program, the proportion of Customers that would choose each rebate option, and the estimated per unit costs of disposal.

The Rebate Program ended August 2, 2012. Through September 30, 2012, Customers have utilized or committed to utilize rebates totaling approximately $66,600 on orders placed since the initiation of the Rebate Program. Additional Customer orders utilizing rebates are not anticipated although exceptions can be made at the discretion of the Company and existing orders may be modified or canceled by Customers. Remaining disposal costs are based on the actual costs experienced to date. During the second quarter of fiscal 2013, we adjusted the liability related to the SYSTEM 1 Rebate Program. The total pre-tax adjustment was $21,500, of which $20,400 was recorded as an increase to revenue for the Customer Rebate portion, and $1,100 was recorded as a reduction to cost of revenues related to the disposal portion of the liability. This adjustment resulted primarily from a lower number of eligible Customers electing to participate in the Rebate Program than previously estimated. While the remaining recorded accrual of $9,044 as of September 30, 2012 is still an estimate, it is based on actual experience to date. No further material adjustments are expected.


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 restructuring plans is included in our Annual Report on Form 10-K for the year ended March 31, 2012 dated May 29, 2012.

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.

8

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)




Since the inception of the Fiscal 2010 Restructuring Plan, we have incurred pre-tax expenses totaling $8,557 related to these actions, of which $7,451 was recorded as restructuring expenses and $1,106 was recorded in cost of revenues. We do not expect to incur any significant restructuring expenses related to this plan. These actions are intended to enhance profitability and improve efficiencies.

The following table summarizes our total pre-tax restructuring expenses for the second quarter of fiscal 2013 and fiscal 2012: 
 
Fiscal 2010
Restructuring
Plan
Three Months Ended September 30,
2012
2011 (1)

Severance and other compensation related costs
$
(48
)
$
(26
)
Asset impairment and accelerated depreciation

92

Total restructuring charges
$
(48
)
$
66

(1)
Includes $(33) in charges recorded in cost of revenues on Consolidated Statements of Income for 2011.

The following table summarizes our total pre-tax restructuring expenses for the first half of fiscal 2013 and fiscal 2012:   
 
Fiscal 2010
Restructuring
Plan
Fiscal 2008
Restructuring
Plan
Total
Six Months Ended September 30,
2012
2011 (1)

2012
2011
2012
2011 (1)

Severance and other compensation related costs
$
(167
)
$
(80
)
$

$

$
(167
)
$
(80
)
Product rationalization

335




335

Asset impairment and accelerated depreciation
(17
)
183



(17
)
183

Lease termination obligation and other



(152
)

(152
)
Total restructuring charges
$
(184
)
$
438

$

$
(152
)
$
(184
)
$
286

(1) Includes $(71) in charges recorded in cost of revenues on Consolidated Statements of Income for 2011.

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 2013
 
 
 
 
March 31,
2012
 
Provision (1)
 
Payments/
Impairments (2)
 
September 30,
2012
Severance and termination benefits
 
$
659

 
$
(167
)
 
$
(58
)
 
$
434

Asset impairments and accelerated depreciation
 

 
(17
)
 
17

 

Lease termination obligations
 
947

 

 
(670
)
 
277

Other
 
76

 

 

 
76

Total
 
$
1,682

 
$
(184
)
 
$
(711
)
 
$
787

(1) Includes curtailment benefit of $125 related to International defined benefit plan. Additional information is included in note 9, "Benefit Plans."
(2) Certain amounts reported include the impact of foreign currency movements relative to the U.S. dollar.
 
3. Property, Plant and Equipment

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

9

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



 
 
September 30,
2012
 
March 31,
2012
Land and land improvements (1)
 
$
35,032

 
$
33,099

Buildings and leasehold improvements
 
236,734

 
230,823

Machinery and equipment
 
306,858

 
301,665

Information systems
 
107,625

 
110,130

Radioisotope
 
226,616

 
210,899

Construction in progress (1)
 
41,904

 
22,811

Total property, plant, and equipment
 
954,769

 
909,427

Less: accumulated depreciation and depletion
 
(541,006
)
 
(523,018
)
Property, plant, and equipment, net
 
$
413,763

 
$
386,409

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


4. Business Acquisitions

On August 15, 2012, the Company completed the previously announced acquisition of all the outstanding shares of capital stock of United States Endoscopy Group, Inc. (“US Endoscopy”) pursuant to a Stock Purchase Agreement dated July 16, 2012 with US Endoscopy and its shareholders. US Endoscopy is a leader in the design, manufacture and sale of therapeutic and diagnostic medical devices and support accessories used in the gastrointestinal (GI) endoscopy markets worldwide and will be integrated into the Healthcare business segment.
The purchase price was approximately $270,000, subject to a customary working capital adjustment. In addition, STERIS purchased all real estate used in the US Endoscopy business for approximately $7,000, including properties owned by two US Endoscopy affiliates. STERIS did not assume any existing debt in connection with the purchases. The purchases were financed by a combination of cash on hand and borrowings under STERIS’s existing credit facility.
The following table summarizes the preliminary allocation of the purchase price to the net assets acquired based on fair values at the acquisition date.
Cash
$
767

Accounts receivable
8,291

Inventory
7,228

Property, plant and equipment
12,457

Other assets
913

Intangible assets
144,000

Goodwill
109,116

Total assets acquired
282,772

 
 
Accounts payable
(2,167
)
Other liabilities
(3,243
)
Total liabilities assumed
(5,410
)
 
 
Net assets acquired
$
277,362


The Company recorded acquisition related costs of $3,205, before tax, which are reported in selling, general and administrative expense. The Company anticipates that the acquisition will qualify for a joint election tax benefit under Section 338(h)(10) of the Internal Revenue Code, which allows goodwill and intangibles to be fully deductible for tax purposes. The intangible assets acquired consist of trademarks, trade names and developed technologies, which will be amortized on an straight line basis over thirteen to fifteen years, with the exception of the US Endoscopy trade name which will be treated as indefinite lived.

10

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



The Consolidated Financial Statements include the operating results US Endoscopy from the date of acquisition. Pro forma results of operations for fiscal 2013 and 2012 periods have not been presented because the effects of the acquisition were not material to the Company's financial results.

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:
 
 
September 30,
2012
 
March 31,
2012
Raw materials
 
$
55,957

 
$
56,525

Work in process
 
28,499

 
25,236

Finished goods
 
105,701

 
109,422

LIFO reserve
 
(15,783
)
 
(18,158
)
Reserve for excess and obsolete inventory
 
(13,837
)
 
(15,313
)
Inventories, net
 
$
160,537

 
$
157,712


6. Debt

Indebtedness was as follows: 
 
 
September 30,
2012
 
March 31,
2012
Private Placement
 
$
210,000

 
$
210,000

Credit facility
 
224,340

 

Total long term debt
 
$
434,340

 
$
210,000


During the first half of fiscal 2013, the Company borrowed $224.3 million under our credit facility. These borrowings were used to partially fund the acquisition of privately-owned US Endoscopy.

Additional information regarding our indebtedness is included in the notes to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2012 dated May 29, 2012.

7. Additional Consolidated Balance Sheet Information

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

11

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



 
 
September 30,
2012
 
March 31,
2012
Accrued payroll and other related liabilities:
 
 
 
 
Compensation and related items
 
$
11,657

 
$
9,273

Accrued vacation/paid time off
 
6,047

 
6,583

Accrued bonuses
 
7,821

 
750

Accrued employee commissions
 
6,687

 
9,845

Other postretirement benefit obligations-current portion
 
3,256

 
3,255

Other employee benefit plans' obligations-current portion
 
273

 
193

Total accrued payroll and other related liabilities
 
$
35,741

 
$
29,899

Accrued expenses and other:
 
 
 
 
Deferred revenues
 
$
52,309

 
$
51,412

Self-insured risk reserves-current portion
 
3,342

 
3,006

Accrued dealer commissions
 
8,048

 
9,171

Accrued warranty
 
12,714

 
11,189

Other
 
22,533

 
21,465

Total accrued expenses and other
 
$
98,946

 
$
96,243

Other liabilities:
 
 
 
 
Self-insured risk reserves-long-term portion
 
$
8,786

 
$
8,786

Other postretirement benefit obligations-long-term portion
 
20,124

 
21,639

Defined benefit pension plans obligations-long-term portion
 
7,817

 
9,881

Other employee benefit plans obligations-long-term portion
 
4,529

 
4,486

Accrued long-term income taxes
 
1,981

 
1,925

Other
 
5,022

 
5,217

Total other liabilities
 
$
48,259

 
$
51,934


8. Income Tax Expense

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 September 30, 2012 and 2011 were 31.8% and 34.7%, respectively. The effective income tax rates for the six-month periods ended September 30, 2012 and 2011 were 32.5% and 34.5%, respectively. During the first half of fiscal 2013, we benefited from higher projected income in lower tax rate jurisdictions and discrete item adjustments.

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, 2012, we had $1,527 in unrecognized tax benefits, of which $1,242 would favorably impact the effective tax rate if recognized. As of September 30, 2012, we had $1,648 in unrecognized tax benefits, of which $1,363 would favorably impact the effective tax rate if recognized. We believe that it is reasonably possible that unrecognized tax benefits could decrease by up to $1,245 within 12 months of September 30, 2012, primarily as a result of settlements with tax authorities. As of September 30, 2012, we have recognized a liability for interest of $1,062 and penalties of $64.

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 2009 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 2008. 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.


12

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



9. Benefit Plans

We provide defined benefit pension plans for certain current and former 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 plan. 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 consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2012, dated May 29, 2012.

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 September 30,
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
Service cost
 
$
37

 
$
51

 
$
20

 
$
119

 
$

 
$

Interest cost
 
523

 
609

 
18

 
69

 
217

 
248

Expected return on plan assets
 
(834
)
 
(821
)
 
(24
)
 
(70
)
 

 

Amortization of loss
 
333

 
267

 

 

 
181

 
106

Amortization of prior service cost
 

 

 

 

 
(816
)
 
(816
)
Net periodic benefit cost (income)
 
$
59

 
$
106

 
$
14

 
$
118

 
$
(418
)
 
$
(462
)

 
 
Defined Benefit Pension Plans
 
Other
Postretirement
Benefits Plan
 
 
U.S. Qualified
 
International
 
Six Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
Service cost
 
$
75

 
$
103

 
$
41

 
$
238

 
$

 
$

Interest cost
 
1,046

 
1,219

 
36

 
138

 
434

 
496

Expected return on plan assets
 
(1,669
)
 
(1,642
)
 
(48
)
 
(140
)
 

 

Amortization of loss
 
667

 
533

 

 

 
362

 
212

Curtailment
 

 

 
(125
)
 

 

 

Amortization of prior service cost
 

 

 

 

 
(1,631
)
 
(1,631
)
Net periodic benefit cost (income)
 
$
119

 
$
213

 
$
(96
)
 
$
236

 
$
(835
)
 
$
(923
)

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. Commitments and 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

13

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



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 insurance coverage for personal injury and property damage and other liability coverages in amounts and with deductibles that we believe are prudent, but there can be no assurance that these coverages will be applicable or adequate to cover adverse outcomes of claims or legal proceedings against us.
As previously disclosed, we received a warning letter (the “warning letter”) from the FDA on May 16, 2008 regarding our SYSTEM 1® sterile processor and the STERIS 20 sterilant used with the processor (sometimes referred to collectively in the FDA letter and in this note 10 as the “device”). Among other matters, the warning letter included the FDA's assertion that significant changes or modifications had been made in the design, components, method of manufacture, or intended use of the device beyond the FDA's 1988 clearance, such that the FDA believed a new premarket notification submission (known within FDA regulations as a 510(k) submission) should have been made, and the assertion that our failure to make such a submission resulted in violations of applicable law. On July 30, 2008 (with an Addendum on October 9, 2008), we provided a detailed response contending that the assertions in the warning letter were not correct. On November 4, 2008, we received a letter from the FDA (dated November 3, 2008) in which the FDA stated without elaboration that, after reviewing our response, it disagreed with our position and that a new premarket notification submission was required. After discussions with the FDA regarding the November 3rd letter, we received an additional letter on November 6, 2008 from the FDA. The November 6th letter stated that the intent of the November 3rd letter was to inform us of the FDA's preliminary disagreement with our response to the warning letter and, before finalizing a position, the FDA reiterated that it wanted to meet with us to discuss the Company's response, issues related to the warning letter and next steps to resolve any differences between the Company and the FDA. We thereafter met with the FDA and, on January 20, 2009, we announced that we had submitted to the FDA a new liquid chemical sterilant processing system for 510(k) clearance, and we communicated to Customers that we would continue supporting the existing SYSTEM 1 installed base in the U.S. for at least a two year period from that date.
On December 3, 2009, the FDA provided a notice (“notice”) to healthcare facility administrators and infection control practitioners describing FDA's “concerns about the SYSTEM 1 Processor, components and accessories, and FDA recommendations.” In the notice, among other things, FDA stated its belief that the SYSTEM 1 device had been significantly modified, that FDA had not cleared or approved the modified device, and that FDA had not determined whether the SYSTEM 1 was safe or effective for its labeled claims. The notice 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 may 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.
On April 5, 2010, we received FDA clearance of the new liquid chemical sterilant processing system (SYSTEM 1E). Also 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 (later extended by FDA to August 2, 2012), 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 included the “SYSTEM 1 Rebate Program” (the “Rebate Program”). In April 2010, we began to offer rebates to qualifying Customers.

14

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



Generally, U.S. Customers that purchased SYSTEM 1 processors directly from us or who were users of SYSTEM 1 at the time the Rebate Program was introduced and who returned their units had 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 provided credits for the return of SYSTEM 1 consumables in unbroken packaging and within shelf life and for the unused portion of SYSTEM 1 service contracts.
The Rebate Program ended August 2, 2012. Through September 30, 2012, Customers have utilized or committed to utilize rebates totaling approximately $66,600 on orders placed since the initiation of the Rebate Program. Additional Customer orders utilizing rebates are not anticipated although exceptions can be made at the discretion of the Company and existing orders may be modified or canceled by Customers. Remaining disposal costs are based on the actual costs experienced to date. During the second quarter of fiscal 2013, we adjusted the liability related to the Rebate Program. The total pre-tax adjustment was $21,500, of which $20,400 was recorded as an increase to revenue for the Customer Rebate portion, and $1,100 was recorded as a reduction to cost of revenues related to the disposal portion of the liability. This adjustment resulted primarily from a lower number of eligible Customers electing to participate in the Rebate Program than previously estimated. While the remaining recorded accrual of $9,044 as of September 30, 2012 is still an estimate, it is based on actual experience to date. No further material adjustments are expected.
The Consent Decree has defined the resolution of a number of issues regarding SYSTEM 1, and we believe our actions 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, or otherwise with respect to regulatory or compliance matters, as described in this note 10 and in various portions of Item 1A. of Part I of our Annual Report on Form 10-K for the year ended March 31, 2012 dated May 29, 2012.
In December of 2010, we began shipping SYSTEM 1E units, after having received FDA clearance for the SYSTEM 1E chemical indicator, which is used in conjunction with the SYSTEM 1E. We also submitted a 510(k) to FDA for an optional spore-based indicator strip for use with SYSTEM 1E. Thereafter, as a result of discussions with FDA, we filed a de novo submission requesting classification of this strip in accordance with Section 513(f)(2) of the Federal Food Drug & Cosmetic Act. The de novo process is part of the initial classification for new devices. This spore-based monitoring strip received FDA clearance on March 30, 2012. This new clearance does not affect the prior clearance of the SYSTEM 1E processor or the SYSTEM 1E chemical indicator.
On February 5, 2010, a complaint was filed by a Customer that claimed 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 alleged statutory violations, breaches of various warranties, negligence, failure to warn, and unjust enrichment and Plaintiff sought 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. Certification of a settlement class was approved and final approval of the settlement was given by the court in the first quarter of fiscal 2012. During the third quarter of fiscal 2011, we recorded in operating expenses a pre-tax charge of approximately $19,796 related to the settlement of these proceedings. The assumptions regarding the amount of this charge included, 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. Estimates of the actual settlement range from as low as $7,000 and as high as $22,000 depending on the options selected by the class members. Claims under the settlement must be submitted by Customers no later than December 31, 2012.
On May 31, 2012, our Albert Browne Limited subsidiary received a warning letter from the FDA regarding chemical indicators manufactured in the United Kingdom. These devices are intended for the monitoring of certain sterilization and other processes. The FDA warning letter states that the agency has concerns regarding operational business processes. We do not believe that the FDA's concerns are related to product performance, or that they result from Customer complaints. We do not currently believe that the impact of this event will have a material adverse effect on our financial results.
Other civil, criminal, regulatory or other proceedings involving our products or services also 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

15

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



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 fiscal year ended March 31, 2012: “Business - Information with respect to our Business in General - Government Regulation”, and the “Risk Factor” titled “We may be adversely affected by product liability claims or other legal actions or regulatory or compliance matters, including the Warning Letter and Consent Decree” 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 statutes of limitation. Changes in applicable tax law or other events may also require us to revise past estimates.
Additional information regarding our contingencies is included in Item 7 of Part II titled, “Management's Discussion and Analysis of Financial Conditions and Results of Operations,” of our Annual Report on Form 10-K for the year ended March 31, 2012 dated May 29, 2012, and in Item 1 of Part II of this Form 10-Q titled, “Legal Proceedings.”

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 capital equipment, accessory, consumable, and service solutions to healthcare providers, including acute care hospitals and surgery centers. These solutions aid our Customers in improving the safety, quality, and productivity of their surgical, sterile processing, gastrointestinal, and emergency environments.
Our Life Sciences segment manufactures and sells engineered 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 facilities located in North America. We sell a comprehensive array of contract sterilization services using gamma irradiation, and ethylene oxide (“EO”) technologies. We provide sterilization and microbial reduction services to companies that supply products to the healthcare, industrial, and consumer products industries.
Financial information for each of our segments is presented in the following table. Operating income (loss) for each segment is calculated as the segment’s gross profit less direct expenses and indirect cost allocations, which results in the full allocation of all distribution and research and development expenses, and the partial allocation of corporate costs. These allocations are based upon variables such as segment headcount and revenues. In addition, the Healthcare segment is responsible for the management of all but one manufacturing facility and uses standard cost to sell products to the Life Sciences segment. Corporate and other includes the gross profit and direct expenses of the Defense and Industrial business unit, as well as certain unallocated corporate costs related to being a publicly traded company and legacy pension and post-retirement benefits.
The accounting policies for reportable segments are the same as those for the consolidated Company. For the three and six month periods ended September 30, 2012, 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 consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2012, dated with the SEC on May 29, 2012.
Financial information for each of our segments is presented in the following tables:

16

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



 
 
 
Three Months Ended September 30,
 
Six Months Ended September 30,
 
 
2012
 
2011
 
2012
 
2011
Revenues:
 
 
 
 
 
 
 
 
Healthcare (1)
 
$
256,820

 
$
243,176

 
$
486,334

 
$
466,400

Life Sciences
 
54,577

 
58,915

 
115,073

 
111,783

Isomedix
 
44,284

 
39,999

 
90,340

 
82,002

Total reportable segments
 
355,681

 
342,090

 
691,747

 
660,185

Corporate and other
 
640

 
617

 
1,534

 
1,161

Total revenues
 
$
356,321

 
$
342,707

 
$
693,281

 
$
661,346

Operating income:
 
 
 
 
 
 
 
 
Healthcare (2)
 
$
42,147

 
$
27,994

 
$
64,877

 
$
54,262

Life Sciences
 
10,549

 
11,064

 
22,403

 
20,523

Isomedix
 
12,667

 
11,215

 
28,245

 
24,174

Total reportable segments
 
65,363

 
50,273

 
115,525

 
98,959

Corporate and other
 
(3,086
)
 
(2,630
)
 
(4,946
)
 
(4,415
)
Total operating income
 
$
62,277

 
$
47,643

 
$
110,579

 
$
94,544

(1) Includes an increase of $20,400 in the fiscal 2013 periods resulting from the SYSTEM 1 Rebate Program.
(2) Includes an increase of $21,500 in the fiscal 2013 periods resulting from the SYSTEM 1 Rebate Program.


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 September 30,
 
Six Months Ended September 30,
 
 
2012
 
2011
 
2012
 
2011
Denominator (shares in thousands):
 
 
 
 
 
 
 
 
Weighted average common shares outstanding—basic
 
58,264

 
58,744

 
58,088

 
59,000

Dilutive effect of common share equivalents
 
528

 
636

 
464

 
741

Weighted average common shares outstanding and common share equivalents—diluted
 
58,792

 
59,380

 
58,552

 
59,741


Options to purchase the following number of common shares were outstanding but excluded from the computation of diluted earnings per share because the combined exercise prices, unamortized fair values, and assumed tax benefits upon exercise were greater than the average market price for the common shares during the periods, so including these options would be anti-dilutive: 
 
 
Three Months Ended September 30,
 
Six Months Ended September 30,
 
 
2012
 
2011
 
2012
 
2011
(shares in thousands)
 
 
 
 
 
 
Number of common share options
 
670

 
585

 
897

 
445


13. Repurchases of Common Shares

During the first half of fiscal 2013, we repurchased 46,949 of our common shares as part of our Board authorized repurchase program and obtained 46,076 of our common shares in connection with stock based compensation award programs.

17

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



At September 30, 2012, $116,888 of STERIS common shares remained authorized for repurchase pursuant to the most recent Board approved repurchase authorization (the March 2008 Board Authorization). Also, 11,616,847 common shares were held in treasury at September 30, 2012.

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. Restricted shares and restricted share units generally may cliff vest after a three or four year period or vest in tranches of one-fourth of the number granted for each full year of employment after the grant date. As of September 30, 2012, 3,911,745 shares remained 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 options granted during the first half of fiscal 2013 and fiscal 2012: 
 
 
Fiscal 2013
 
Fiscal 2012
Risk-free interest rate
 
1.21
%
 
2.41%
Expected life of options
 
5.79 years

 
5.65 years
Expected dividend yield of stock
 
2.15
%
 
1.78%
Expected volatility of stock
 
31.24
%
 
29.78%

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. An estimated forfeiture rate of 1.83% and 2.08% was applied in fiscal 2013 and 2012, respectively. This rate is calculated based upon historical activity and represents an estimate of the granted options not expected to vest. If actual forfeitures differ from this calculated rate, we may be required to make additional adjustments to compensation expense in future periods. The assumptions used above are reviewed at the time of each significant option grant, or at least annually.

A summary of share option activity is as follows:
 

18

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



 
 
Number of
Options
 
Weighted
Average
Exercise
Price
 
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
Outstanding at March 31, 2012
 
3,312,602

 
$
27.16

 
 
 
 
Granted
 
299,665

 
30.25

 
 
 
 
Exercised
 
(509,271
)
 
23.89

 
 
 
 
Forfeited
 
(5,933
)
 
30.12

 
 
 
 
Canceled
 
(3,970
)
 
19.95

 
 
 
 
Outstanding at September 30, 2012
 
3,093,093

 
$
28.00

 
5.58
 years
 
$
23,292

Exercisable at September 30, 2012
 
2,320,680

 
$
27.05

 
4.59
 years
 
$
19,601


We estimate that 758,578 of the non-vested stock options outstanding at September 30, 2012 will ultimately vest.

The aggregate intrinsic value in the table above represents the total pre-tax difference between the $35.47 closing price of our common shares on September 30, 2012 over the exercise prices of the stock options, 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 half of fiscal 2013 and fiscal 2012 was $4,594 and $1,927, respectively. Net cash proceeds from the exercise of stock options were $11,709 and $3,172 for the first half of fiscal 2013 and fiscal 2012, respectively. The tax benefit from stock option exercises was $1,772 and $745 for the first half of fiscal 2013 and fiscal 2012, respectively.

The weighted average grant date fair value of stock option grants was $7.31 and $9.84 for the first half of fiscal 2013 and fiscal 2012, 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 September 30, 2012 and 2011 was $928 and $807, respectively. The fair value of outstanding SARs is revalued at each reporting date and the related liability and expense are adjusted appropriately.

A summary of the non-vested restricted share activity is presented below: 
 
 
Number of
Restricted
Shares
 
Weighted-Average
Grant Date
Fair Value
Non-vested at March 31, 2012
 
533,027

 
$
32.10

Granted
 
273,767

 
30.51

Vested
 
(100,320
)
 
24.78

Canceled
 
(8,385
)
 
33.15

Non-vested at September 30, 2012
 
698,089

 
$
32.52


Restricted shares granted are valued based on the closing stock price at the grant date. The value of restricted shares that vested during the first half of fiscal 2013 was $2,486.

Cash settled restricted share units carry generally the same terms and vesting requirements as stock settled 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 September 30, 2012 and 2011 was $1,233 and $1,239, 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 September 30, 2012, there was a total of $17,662 in unrecognized compensation cost related to nonvested share-based compensation granted under our share-based compensation plans. We expect to recognize the cost over a weighted average

19

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



period of 2.65 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 half of fiscal 2013 were as follows:
 
 
Balance, March 31, 2012
$
11,189

Warranties issued during the period
9,926

Settlements made during the period
(8,401
)
Balance, September 30, 2012
$
12,714


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 $43,600 and $43,252 as of September 30, 2012 and March 31, 2012, 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. At September 30, 2012, we held foreign currency forward contracts to buy 106.3 million Mexican pesos. At September 30, 2012, we held commodity swap contracts to buy 286,000 pounds of nickel.

 
 
Asset Derivatives
 
Liability Derivatives
 
 
Fair Value at
 
Fair Value at
 
Fair Value at
 
Fair Value at
Balance Sheet Location
 
September 30, 2012
 
March 31, 2012
 
September 30, 2012
 
March 31, 2012
Prepaid & Other
 
$
480

 
$
12

 
$

 
$

Accrued expenses and other
 
$

 
$

 
$
187

 
$
863


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

20

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



 
 
Location of gain (loss) recognized in income
 
Amount of gain (loss)
recognized in income
Six Months Ended September 30,
2012
 
2011
Foreign currency forward contracts
 
Selling, general and administrative
 
$
115

 
$
(2,520
)
Commodity swap contracts
 
Cost of revenues
 
$
(43
)
 
$
(1,576
)

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 assets and liabilities 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 the fair value of our financial assets and liabilities at September 30, 2012:
 
 
 
 
 
 
Fair Value Measurements at September 30, Using
 
 
Carrying Value
 
Quoted Prices
in Active Markets
for Identical Assets
 
Significant Other
Observable Inputs
 
Significant
Unobservable
Inputs
 
 
Level 1
 
Level 2
 
Level 3
2012
2011
2012
2011
 
2012
2011
 
2012
2011
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
156,609

$
134,111

 
$
156,609

$
134,111

 
$

$

 
$

$

Forward and swap contracts (1)
 
480

9

 


 
480

9

 


Investments (2)
 
2,959

2,586

 
2,959

2,586

 


 


Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
Forward and swap contracts (1)
 
$
187

$
3,897

 
$

$

 
$
187

$
3,897

 
$

$

Deferred compensation plans (2)
 
3,041

2,586

 
3,041

2,586

 


 


Long term debt (3)
 
434,340

210,000

 


 
473,186

247,962

 


Contingent consideration obligations (4)
 
6,585

9,819

 


 


 
6,585

9,819

(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 maintain 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 (compensation deferrals have been frozen under the plan). 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)).
(3)
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.
(4)
Contingent consideration obligations arise from prior business acquisitions. The fair values are based on discounted cash flow analyses reflecting the possible achievement of specified performance measures or events and captures the contractual nature of the contingencies, commercial risk, and the time value of money. Contingent consideration obligations are classified in the consolidated balance sheets as accrued expense (short-term) and other liabilities (long-term), as appropriate based on the contractual payment dates.

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis at September 30, 2012 are summarized

21

Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Six Months Ended September 30, 2012 and 2011
(dollars in thousands)



as follows:
 
Contingent Consideration
Balance at March 31, 2012
$
6,953

Settlements
(9
)
Foreign currency translation adjustments (1)
(359
)
Balance at September 30, 2012
$
6,585

(1) Reported in other comprehensive income (loss).

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 September 30, 2012, except for the matters noted below. These financial statements should be read in conjunction with the consolidated financial statements and related notes included in our 2012 Annual Report on Form 10-K dated May 29, 2012.
On October 12, 2012, our credit facility was amended to increase the total commitment amount from $300 million to $400 million.
On October 16, 2012, we purchased, in an all cash transaction, two privately-owned businesses: Spectrum Surgical Instruments Corp (Spectrum) and Total Repair Express (TRE), leading providers of surgical instrument repair services and instrument care products to hospitals and surgery centers in the United States. The purchase price of approximately $110 million including contingent consideration, was financed with borrowings under the existing credit facility. These two businesses will be integrated into the Healthcare segment as part of the Healthcare Specialty Service business, which provides a variety of niche services to Customers, including space decontamination solutions, chamber cleanings and instrument repairs.









22

Table of Contents

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 September 30, 2012, the related consolidated statements of income for the three and six-month periods ended September 30, 2012 and 2011, the consolidated statements of comprehensive income for the three and six-month periods ended September 30, 2012 and 2011, and consolidated statements of cash flows for the six-month periods ended September 30, 2012 and 2011. 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, 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 on our review, we are not aware of any material modifications that should be made to the consolidated interim 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, 2012, 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 29, 2012, 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, 2012 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
November 8, 2012


23

Table of Contents


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 debt principal repayments, growth outside of core operations, repurchase common shares, 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 second quarter and first six months of fiscal 2013 and fiscal 2012. It may also be helpful to read the MD&A in our Annual Report on Form 10-K for the year ended March 31, 2012, dated May 29, 2012. 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 and fund growth.
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 to gauge our ability to borrow and fund growth.
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 SEC rules. 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 an alternative 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. Additional information regarding these financial measures, including reconciliations of each non- GAAP financial measure, is available in the subsection of MD&A titled, "Non-GAAP Financial Measures."

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.

24

Table of Contents

Product Revenues – We define product revenues as revenues generated from sales of capital equipment, which includes steam sterilizers, low temperature liquid chemical sterilant processing systems, 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 1E consumables, V-Pro 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 sterilizers, low temperature liquid chemical sterilant processing systems, including SYSTEM 1 and 1E, 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 1E consumables, V-Pro consumables, gastrointestinal endoscopy devices and support accessories, 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 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. The aging population increases the demand for medical procedures, which increases the consumption of single use medical devices and surgical kits processed by our Isomedix segment.
Beyond our core markets, infection-control issues are a growing 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.
In August 2012, we acquired all the outstanding shares of privately-owned United States Endoscopy Group, Inc. (US Endoscopy). US Endoscopy is a leader in the design, manufacture and sale of therapeutic and diagnostic medical devices and support accessories used in the gastrointestinal (GI) endoscopy markets worldwide. We paid approximately $270 million in an all cash transaction to acquire US Endoscopy. We also purchased certain land and buildings utilized by the US Endoscopy business for approximately $7 million. The business will be integrated into STERIS's Healthcare business segment. Revenues of $10.2 million are included in Healthcare consumable revenues for the fiscal 2013 second quarter.
Fiscal 2013 second quarter revenues were $356.3 million representing an increase of 4.0% over the fiscal 2012 second quarter revenues of $342.7 million. Fiscal 2013 first half revenues were $693.3 million representing an increase of 4.8% over the first half of fiscal 2012 revenues of $661.3 million. The increases are primarily attributable to the fiscal 2013 second quarter SYSTEM 1 Rebate Program adjustment of $20.4 million. Excluding the positive impact of the adjustment related to the SYSTEM 1 Rebate Program made during the quarter, adjusted revenues were $335.9 million and $672.9 million for the fiscal 2013 second quarter and first half of fiscal 2013 respectively (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Fiscal 2013 second quarter adjusted revenues decreased 2.0% compared to the fiscal 2012 second quarter, reflecting decreases in the Healthcare and Life Sciences business segments partially offset by an increase in the Isomedix business segment; and adjusted revenues for the first half of fiscal 2013 increased 1.7% compared to the first half of fiscal 2012, reflecting increases in the Life Sciences and Isomedix business segments partially offset by a decrease in the Healthcare business segment mainly due to lower sales volume as a result of the expected post-transition decline in SYSTEM 1E units sales.

25

Table of Contents

Fiscal 2013 second quarter gross margin percentage was 43.0% compared with 38.9% for the fiscal 2012 second quarter, while fiscal 2013 first half gross margin percentage was 41.9% compared with 40.3% for the first half of fiscal 2012. The primary driver of the increases in gross margin percentage is the positive impact of the $21.5 million SYSTEM 1 Rebate Program adjustment during the fiscal 2013 second quarter. Excluding the impact of the SYSTEM 1 Rebate program adjustment, the adjusted gross margin percentage was 39.2% in the fiscal 2013 second quarter compared to 38.9% in the fiscal 2012 second quarter (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). The favorable impact of product mix and foreign currency movement offset the negative impact of lower volumes of SYSTEM 1 consumables and SYSTEM 1E units. The adjusted gross margin percentage for the first half of 2013 was 40.0% compared to 40.3% in the first half of fiscal 2012 driven primarily by lower SYSTEM 1 consumable volumes (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures).
Fiscal 2013 second quarter operating income was $62.3 million, an increase of 30.7% over the fiscal 2012 second quarter operating income of $47.6 million. Fiscal 2013 first half operating income was $110.6 million representing an increase of 17.0% compared to the fiscal 2012 first half operating income of $94.5 million. The driver of the increase in operating income is the positive impact of the $21.5 million SYSTEM 1 Rebate Program adjustment during the fiscal 2013 second quarter. Excluding the SYSTEM 1 Rebate Program adjustment made in the fiscal 2013 second quarter, adjusted operating income was $40.8 million in the fiscal 2013 second quarter, a decrease of 14.4% over the fiscal 2012 second quarter operating income of $47.6 million, driven primarily by the declines in SYSTEM 1 consumables volumes and SYSTEM 1E unit sales (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Adjusted operating income during the first half of fiscal 2013 was $89.1 million, a decrease of 5.8% compared to the first half of fiscal 2012 driven primarily by the declines in SYSTEM 1 consumable volumes and SYSTEM 1E unit sales (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures).
Cash flows from operations were $112.0 million and free cash flow was $67.0 million in the first six months of fiscal 2013 compared to cash flows from operations of $60.5 million and free cash flow of $26.1 million in the first six months of fiscal 2012, reflecting lower working capital requirements, specifically the anticipated reduction of SYSTEM 1E related inventory, lower days sales outstanding and lower cash usage to fund compensation related obligations (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Our debt-to-total capital ratio was 33.0% at September 30, 2012 and 20.4% at March 31, 2012. During the first six months of fiscal 2013, we declared and paid quarterly cash dividends of $0.36 per common share.
Additional information regarding our financial performance during the fiscal second quarter and first six months of 2013 is included in the subsection below titled “Results of Operations.”

Matters Affecting Comparability

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 second quarter of fiscal 2013, our revenues were unfavorably impacted by $3.5 million, or 1.0%, and income before taxes was favorably impacted by $1.9 million, or 3.3%, as a result of foreign currency movements relative to the U.S. dollar. During the first half of fiscal 2013, our revenues were unfavorably impacted by $7.3 million, or 1.0%, and income before taxes was favorably impacted by $5.1 million, or 5.1%, as a result of foreign currency movements relative to the U.S. dollar.
NON-GAAP FINANCIAL MEASURES
We, at times, refer to financial measures which are considered to be “non-GAAP financial measures” under SEC rules. We, at times, also 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 comparisons between the periods presented.
These non-GAAP financial measures are not intended to be, and should not be, considered separately from or as an alternative to the most directly comparable GAAP financial measures.
These non-GAAP financial measures are presented with the intent of providing greater transparency to supplemental financial information used by management and the Board of Directors in their financial analysis and operational decision-making. These amounts are disclosed so that the reader has the same financial data that management uses with the belief that it will assist investors and other readers in making comparisons to our historical operating results and analyzing the underlying performance of our operations for the periods presented.
We believe that the presentation of these non-GAAP financial measures, when considered along with our GAAP financial

26

Table of Contents

measures and the reconciliation to the corresponding GAAP financial measures, provide the reader with a more complete understanding of the factors and trends affecting our business than could be obtained absent this disclosure. It is important for the reader to note that the non-GAAP financial measure used may be calculated differently from, and therefore may not be comparable to, a similarly titled measure used by other companies.
We define free cash flow as net cash 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 are also presented in the Consolidated Statements of Cash Flows. We use this as a measure to gauge our ability to fund future debt principal repayments, growth outside of core operations, repurchase common shares, and pay cash dividends. The following table summarizes the calculation of our free cash flow for the six month periods ended September 30, 2012 and 2011:
 
 
Six Months Ended September 30,
(dollars in thousands)
 
2012
 
2011
Net cash flows provided by operating activities
 
$
112,023

 
$
60,537

Purchases of property, plant, equipment and intangibles, net
 
(45,062
)
 
(34,445
)
Proceeds from the sale of property, plant, equipment and intangibles
 
22

 

Free cash flow
 
$
66,983

 
$
26,092


To supplement our financial results presented in accordance with U.S. GAAP, we have sometimes referred to certain measures of revenues, gross profit, gross profit percentage, and the Healthcare segment results of operations in the section of MD&A titled, "Results of Operations" excluding the impact of adjustments recorded in connection with the SYSTEM 1 Rebate Program in the second quarter and first half of fiscal 2013. These items had a significant impact on the fiscal 2013 measures and the corresponding trend in each of these measures. We provide adjusted measures to give the reader a more complete understanding of the factors and trends affecting our business than could be obtained absent this disclosure. These measures are used by management and the Board of Directors in making comparisons to our historical operating results and analyzing the underlying performance of our operations. The tables below provide a reconciliation of each of these measures to its most directly comparable GAAP financial measure.

27

Table of Contents

 
Three Months Ended September 30,
Six Months Ended September 30,
(dollars in thousands)
2012
2011
2012
2011
Reported revenues
$
356,321

$
342,707

$
693,281

$
661,346

Impact of the SYSTEM 1 Rebate Program
(20,400
)

(20,400
)

Adjusted revenues
$
335,921

$
342,707

$
672,881

$
661,346

 
 
 
 
 
Reported capital equipment revenues
$
149,676

$
149,225

$
288,094

$
273,844

Impact of the SYSTEM 1 Rebate Program
(20,400
)

(20,400
)

Adjusted capital equipment revenues
$
129,276

$
149,225

$
267,694

$
273,844

 
 
 
 
 
Reported United States revenues
$
271,788

$
257,635

$
534,192

$
502,471

Impact of the SYSTEM 1 Rebate Program
(20,400
)

(20,400
)

Adjusted United States Revenues
$
251,388

$
257,635

$
513,792

$
502,471

 
 
 
 
 
Reported Healthcare revenues
$
256,820

$
243,176

$
486,334

$
466,400

Impact of the SYSTEM 1 Rebate Program
(20,400
)

(20,400
)

Adjusted Healthcare revenues
$
236,420

$
243,176

$
465,934

$
466,400

 
 
 
 
 
Healthcare capital revenues
$
132,936

$
127,077

$
247,369

$
233,969

Impact of SYSTEM 1 Rebate Program
(20,400
)

(20,400
)

Adjusted Healthcare capital revenues
$
112,536

$
127,077

$
226,969

$
233,969

 
 
 
 
 
Reported gross profit
$
153,121

$
133,309

$
290,373

$
266,234

Impact of the SYSTEM 1 Rebate Program
(21,500
)

(21,500
)

Adjusted gross profit
$
131,621

$
133,309

$
268,873

$
266,234

 
 
 
 
 
Reported gross profit percentage
43.0
 %
38.9
%
41.9
 %
40.3
%
Impact of the SYSTEM 1 Rebate Program
(3.8
)%
%
(1.9
)%
%
Adjusted gross profit percentage
39.2
 %
38.9
%
40.0
 %
40.3
%
 
 
 
 
 
Reported operating income
$
62,277

$
47,643

$
110,579

$
94,544

Impact of the SYSTEM 1 Rebate Program
(21,500
)

(21,500
)

Adjusted operating income
$
40,777

$
47,643

$
89,079

$
94,544

 
 
 
 
 
Reported Healthcare operating income
$
42,147

$
27,994

$
64,877

$
54,262

Impact of the SYSTEM 1 Rebate Program
(21,500
)

(21,500
)

Adjusted Healthcare operating income
$
20,647

$
27,994

$
43,377

$
54,262

 
 
 
 
 
Reported income tax expense
$
18,757

$
15,680

$
33,992

$
30,746

Impact of the SYSTEM 1 Rebate Program
(8,385
)

(8,385
)

Adjusted income tax expense
$
10,372

$
15,680

$
25,607

$
30,746

 
 
 
 
 
Reported effective income tax rate
31.8
 %
34.7
%
32.5
 %
34.5
%
Impact of the SYSTEM 1 Rebate Program
(4.1
)%
%
(1.6
)%
%
Adjusted effective income tax rate
27.7
 %
34.7
%
30.9
 %
34.5
%


28

Table of Contents

Results of Operations

In the following subsections, we discuss our earnings and the factors affecting them for the second quarter and the first half of fiscal 2013 compared with the same fiscal 2012 periods. We begin with a general overview of our operating results and then separately discuss earnings for our operating segments.

Revenues. The following tables compare our revenues for the three and six months ended September 30, 2012 to the revenues for the three and six months ended September 30, 2011:
 
 
Three Months Ended September 30,
 
  
 
Percent
 
(dollars in thousands)
2012
 
2011
 
Change
 
Change
 
Total revenues
$
356,321

 
$
342,707

 
$
13,614

 
4.0
 %
 
 
 
 
 
 
 
 
 
 
Revenues by type:
 
 
 
 
 
 
 
 
Capital equipment revenues
149,676

 
149,225

 
451

 
0.3
 %
 
Consumable revenues
81,974

 
74,277

 
7,697

 
10.4
 %
 
Service revenues
124,671

 
119,205

 
5,466

 
4.6
 %
 
 
 
 
 
 
 
 
 
 
Revenues by geography:
 
 
 
 
 
 
 
 
United States revenues
271,788

 
257,635

 
14,153

 
5.5
 %
 
International revenues
84,533

 
85,072

 
(539
)
 
(0.6
)%
 

 
Six Months Ended September 30,
 
 
 
Percent
(dollars in thousands)
2012
 
2011
 
Change
 
Change
Total revenues
$
693,281

 
$
661,346

 
$
31,935

 
4.8
%
 
 
 
 
 
 
 
 
Revenues by type:
 
 
 
 
 
 
 
Capital equipment revenues
288,094

 
273,844

 
14,250

 
5.2
%
Consumable revenues
157,309

 
151,671

 
5,638

 
3.7
%
Service revenues
247,878

 
235,831

 
12,047

 
5.1
%
 
 
 
 
 
 
 
 
Revenues by geography:
 
 
 
 
 
 
 
United States revenues
534,192

 
502,471

 
31,721

 
6.3
%
International revenues
159,089

 
158,875

 
214

 
0.1
%
Quarter over Quarter Comparison

Revenues increased $13.6 million, or 4.0%, to $356.3 million for the quarter ended September 30, 2012, as compared to $342.7 million for the same quarter prior year period. The increase is primarily attributable to the fiscal 2013 second quarter SYSTEM 1 Rebate Program adjustment of $20.4 million. Adjusted revenues for the quarter, excluding the impact of the $20.4 million adjustment related to the SYSTEM 1 Rebate Program, were $335.9 million, a 2.0% decrease over the same prior year quarter (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Capital equipment revenues for the quarter ended September 30, 2012 were flat compared to the prior year period. Capital equipment revenues in the fiscal 2013 second quarter were favorably impacted by the $20.4 million adjustment related to the SYSTEM 1 Rebate Program. Adjusted capital equipment revenues of $129.3 million in the second quarter of fiscal 2013 represent a 13.4% decrease over the second quarter of fiscal 2012 driven by lower capital equipment revenues in both the Healthcare and Life Sciences business segments (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Consumable revenues increased 10.4% for the quarter ended September 30, 2012, as compared to the prior year quarter, as declines in SYSTEM 1 consumable volumes were more than offset by increases within the Healthcare and Life Sciences segments. Service revenues increased 4.6% in the second

29

Table of Contents

quarter of fiscal 2013 primarily driven by an increase of 10.7% in the Isomedix business segment, although both the Healthcare and Life Sciences business segments also experienced some growth in service revenues.
United States revenues increased $14.2 million, or 5.5%, to $271.8 million for the quarter ended September 30, 2012, as compared to $257.6 million for the same prior year quarter. The increase is attributable to the fiscal 2013 second quarter SYSTEM 1 Rebate Program adjustment of $20.4 million. Adjusted United States revenues for the quarter, excluding the impact of the adjustment related to the SYSTEM 1 Rebate Program, were $251.4 million, a 2.4% decrease over the same prior year quarter, mainly attributable to a lower volumes of SYSTEM 1 consumables and SYSTEM 1E units (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures).
International revenues decreased $0.5 million, or 0.6%, to $84.5 million for the quarter ended September 30, 2012, as compared to $85.1 million for the same prior year quarter.
First Half over First Half Comparison

Revenues increased $31.9 million or 4.8% to $693.3 million for the first half of fiscal 2013, as compared to $661.3 million for the same prior year period. The increase is primarily attributable to the fiscal 2013 second quarter SYSTEM 1 Rebate Program adjustment of $20.4 million. Adjusted revenues for the first six months, excluding the impact of the adjustment related to the SYSTEM 1 Rebate Program, were $672.9 million, a 1.7% increase over the same prior year period (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Capital equipment revenues for the first half of fiscal 2013 increased $14.3 million or 5.2% compared to the prior year period. Capital equipment revenues for the first half of fiscal 2013 were favorably impacted by the $20.4 million adjustment related to the SYSTEM 1 Rebate Program. Adjusted capital equipment revenues for the first half of fiscal 2013 were $267.7 million, a 2.2% decrease over the first half of fiscal 2012 driven by the lower volume of SYSTEM 1E unit sales compared to the prior year and lower International capital equipment revenues (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Consumable revenues for the first half of fiscal 2013 increased 3.7% over the first half of fiscal 2012 as declines in SYSTEM 1 consumable volumes were more than offset by increases within the Healthcare and Life Sciences segments. Service revenues during the first half of fiscal 2013 increased 5.1% over the first half of fiscal 2012 primarily driven by growth of 10.2% in the Isomedix business segment, along with growth of 2.2% and 1.9% in the Healthcare and Life Sciences business segments, respectively.
United States revenues for the first half of fiscal 2013 were $534.2 million, an increase of