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OWENS & MINOR INC/VA/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis describes results of operations and material changes in the financial condition of Owens & Minor, Inc. and its subsidiaries since December 31, 2013. Trends of a material nature are discussed to the extent known and considered relevant. This discussion should be read in conjunction with the consolidated financial statements, related notes thereto, and management's discussion and analysis of financial condition and results of operations included in our Annual Report on Form 10-K for the year ended December 31, 2013. Overview Owens & Minor, Inc., along with its subsidiaries, (we, us, or our) is a leading national distributor of name-brand medical and surgical supplies and a healthcare logistics company. We report our business under two segments: Domestic and International. The Domestic segment includes all services in the United States relating to our role as a medical supply logistics company serving healthcare providers and manufacturers. The International segment provides third-party logistics for the pharmaceutical and medical device industries in the European market. Segment financial information is provided in Note 13 of Notes to Consolidated Financial Statements included in this quarterly report. Financial highlights. The following table provides a reconciliation of reported operating earnings, net income and net income per diluted common share to non-GAAP measures used by management. GAAP and non-GAAP results discussed below for the six months ended June 30, 2014 include a recovery of $5.3 million recorded in other operating income, net related to the settlement of a direct purchaser anti-trust class action lawsuit. Three Months Ended June 30, Six Months Ended June 30, (Dollars in thousands except per share data) 2014 2013 2014 2013 Operating earnings, as reported (GAAP) $ 37,101 $ 50,050 $ 83,387 $ 97,934 Acquisition-related and exit and realignment charges 7,593 638 10,855 2,648 Operating earnings, adjusted (non-GAAP) (Adjusted Operating Earnings) $ 44,694 $ 50,688 $ 94,242 $ 100,582 Adjusted Operating Earnings as a percent of revenue (non-GAAP) 1.94 % 2.27 % 2.07 % 2.24 % Net income, as reported (GAAP) $ 19,876 $ 28,872 $ 45,362 $ 54,970 Acquisition-related and exit and realignment charges, net of tax 5,095 412 7,317 1,933 Net income, adjusted (non-GAAP) (Adjusted Net Income) $ 24,971 $ 29,284 $ 52,679 $ 56,903 Net income per diluted common share, as reported (GAAP) $ 0.32 $ 0.46 $ 0.72 $ 0.87 Acquisition-related and exit and realignment charges, per diluted common share 0.08 - 0.12 0.03 Net income per diluted common share, adjusted (non-GAAP)(Adjusted EPS) $ 0.40 $ 0.46 $ 0.84 $ 0.90 21 -------------------------------------------------------------------------------- Table of Contents Adjusted EPS (non-GAAP) was $0.40 and $0.84 for the second quarter and first six months of 2014, $0.06 below the prior year for both periods. For the second quarter of 2014, Domestic segment operating earnings decreased from the prior year by $2.9 million to $48.3 million. The International segment had an operating loss of $3.6 million for the three months ended June 30, 2014 compared to a loss of $0.6 million for the comparable prior year period. Use of Non-GAAP Measures This management's discussion and analysis contains financial measures that are not calculated in accordance with U.S. generally accepted accounting principles (GAAP). In general, the measures exclude items and charges that (i) management does not believe reflect our core business and relate more to strategic, multi-year corporate activities; or (ii) relate to activities or actions that may have occurred over multiple or in prior periods without predictable trends. Management uses these non-GAAP financial measures internally to evaluate our performance, evaluate the balance sheet, engage in financial and operational planning and determine incentive compensation. Management provides these non-GAAP financial measures to investors as supplemental metrics to assist readers in assessing the effects of items and events on our financial and operating results and in comparing our performance to that of our competitors. However, the non-GAAP financial measures used by us may be calculated differently from, and therefore may not be comparable to, similarly titled measures used by other companies. The non-GAAP financial measures disclosed by us should not be considered a substitute for, or superior to, financial measures calculated in accordance with GAAP, and the financial results calculated in accordance with GAAP and reconciliations to those financial statements set forth above should be carefully evaluated. Acquisition-related charges were $3.5 million and $4.1 million for the three and six months ended June 30, 2014 compared to $0.2 million and $0.9 million for the same periods of 2013. Current year charges consist of transaction costs incurred to perform due diligence and analysis related to targeted acquisitions, as well as costs in Movianto to resolve certain contingencies with the former owner and finalize the transition of certain information technology and administrative functions. Exit and realignment charges of $4.1 million and $6.7 million for the three and six months ended June 30, 2014 are associated with optimizing our operations and include the consolidation of distribution and logistics centers and closure of offsite warehouses in the United States and Europe, as well as other costs associated with our strategic organizational realignment. Similar charges in 2013 totaled $0.4 million and $1.8 million in the comparable periods. These charges have been tax effected in the preceding table using a blended income tax rate depending on the amount of charges incurred in different tax jurisdictions. Unless otherwise stated, our analysis hereinafter excludes acquisition-related and exit and realignment charges. More information about these charges is provided in Note 5 of Notes to Consolidated Financial Statements included in this quarterly report. Acquisition Update. During the second quarter, we entered into a definitive agreement to acquire all outstanding shares of Medical Action Industries Inc. (Medical Action) for $13.80 per share in cash, representing a total transaction value of approximately $208 million, including assumed debt, net of cash. The transaction, which is expected to close in the fourth quarter of 2014, is subject to customary closing conditions, including Medical Action shareholder approval and regulatory clearances. Results of Operations Net revenue. Three Months Ended June 30, Change (Dollars in thousands) 2014 2013 $ % Domestic $ 2,187,535 $ 2,143,691 $ 43,844 2.0 % International 118,323 92,386 25,937 28.1 % Net revenue $ 2,305,858 $ 2,236,077 $ 69,781 3.1 % Six Months Ended June 30, Change (Dollars in thousands) 2014 2013 $ % Domestic $ 4,336,451 $ 4,298,406 $ 38,045 0.9 % International 225,788 184,055 41,733 22.7 % Net revenue $ 4,562,239 $ 4,482,461 $ 79,778 1.8 % Consolidated net revenue improved in our two segments for both the three and six months ended June 30, 2014. In the Domestic segment, the continued trend of growth in our existing large healthcare provider customer accounts and new 22-------------------------------------------------------------------------------- Table of Contents business exceeded declines from smaller customers in both periods when compared to prior year. Domestic segment growth rates are largely impacted by ongoing market trends including healthcare utilization rates. The increases in the International segment were a result of new buy/sell contracts and growth in fee-for-service business as well as positive impacts from foreign exchange. Fee-for-service business generally represents approximately two-thirds of net revenue in the International segment. Gross margin. Three Months Ended June 30, Change (Dollars in thousands) 2014 2013 $ % Gross margin $ 282,272 $ 273,431 $ 8,841 3.2 % As a % of net revenue 12.24 % 12.23 % Six Months Ended June 30, Change (Dollars in thousands) 2014 2013 $ % Gross margin $ 563,468 $ 552,482 $ 10,986 2.0 % As a % of net revenue 12.35 % 12.33 % The growth in fee-for-service activity drove the overall improvement in gross margin as the International segment showed $12.0 million and $23.4 million increases over the comparable prior year quarter and year to date periods. This was partially offset by declines in the Domestic segment gross margin mainly as a result of lower benefits from supplier price changes in the second quarter and year to date period of 2014 when compared to the prior year, as well as lower margins on new and renewed contracts. Operating expenses. Three Months Ended June 30, Change (Dollars in thousands) 2014 2013 $ % SG&A expenses $ 225,838 $ 212,548 $ 13,290 6.3 % As a % of net revenue 9.79 % 9.51 % Depreciation and amortization $ 13,892 $ 12,276 $ 1,616 13.2 % Other operating income, net $ (2,152 ) $ (2,081 ) $ (71 ) 3.4 % Six Months Ended June 30, Change (Dollars in thousands) 2014 2013 $ % SG&A expenses $ 451,448 $ 430,269 $ 21,179 4.9 % As a % of net revenue 9.90 % 9.60 %Depreciation and amortization $ 27,756 $ 24,905 $ 2,851 11.4 % Other operating income, net $ (9,978 ) $ (3,274 ) $ (6,704 ) 204.8 % Selling, general and administrative (SG&A) expenses include labor, warehousing, handling and delivery costs associated with our distribution and logistics services and all costs associated with our fee-for-service arrangements. The costs to convert new customers to our information systems are generally incurred prior to the recognition of revenues from the new customers. International segment SG&A increased over the prior year for the three and six month periods ended June 30, 2014 by $14.0 million and $24.6 million, respectively, due mainly to increased salaries and delivery costs associated with higher fee-for-service activity as well as increased costs associated with integrating a significant new customer in the United Kingdom. These increases were partially offset by declines in the Domestic segment driven by cost benefits realized from our strategic initiatives to improve productivity and efficiency. Depreciation and amortization expense increased for both periods primarily in the International segment due to increases in computer software amortization for assets placed in service and amortization from purchase price accounting adjustments. 23-------------------------------------------------------------------------------- Table of Contents Other operating income, net for the second quarter is comparable to the prior year. The increase in other operating income, net for the six month period ended June 30, 2014 is attributed primarily to the recovery of $5.3 million from the settlement of a direct purchaser anti-trust class action lawsuit relating to the recovery of costs from purchases of medical devices over a multi-year period, as well as a gain on the sale of an investment and an increase in finance charge income. Interest expense, net Three Months Ended June 30, Change (Dollars in thousands) 2014 2013 $ % Interest expense, net $ 3,342 $ 3,248 $ 94 2.9 % Effective interest rate 6.12 % 6.00 % Six Months Ended June 30, Change (Dollars in thousands) 2014 2013 $ % Interest expense, net $ 6,589 $ 6,446 $ 143 2.2 % Effective interest rate 6.10 % 6.00 % Interest expense is consistent with the prior year period. Income taxes. Three Months Ended June 30, Change (Dollars in thousands) 2014 2013 $ % Income tax provision $ 13,883 $ 17,930 $ (4,047 ) (22.6 )% Effective tax rate 41.1 % 38.3 % Six Months Ended June 30, Change (Dollars in thousands) 2014 2013 $ % Income tax provision $ 31,436 $ 36,518 $ (5,082 ) (13.9 )% Effective tax rate 40.9 % 39.9 % The increase in the effective tax rate, including income taxes on acquisition-related and exit and realignment charges, increased from the prior year periods largely due to the impact of foreign taxes and the effect of certain acquisition-related costs which are not deductible for tax purposes. 24 -------------------------------------------------------------------------------- Table of Contents Financial Condition, Liquidity and Capital Resources Financial condition. We monitor operating working capital through days sales outstanding (DSO) and merchandise inventory turnover. We estimate a hypothetical increase (decrease) in DSO of one day would result in a decrease (increase) in our cash balances, an increase (decrease) in borrowings against our revolving credit facility, or a combination thereof of approximately $25 million. The majority of our cash and cash equivalents are held in cash depository accounts with major banks in the United States and Europe or invested in high-quality, short-term liquid investments. Changes in our working capital can vary in the normal course of business based upon the timing of inventory purchases, collection of accounts receivable, and payment to suppliers. Change (Dollars in thousands) June 30, 2014 December 31, 2013 $ % Cash and cash equivalents $ 92,027 $ 101,905 $ (9,878 ) (9.7 )% Accounts and notes receivable, net of allowances $ 545,179 $ 572,854 $ (27,675 ) (4.8 )% Consolidated DSO (1) 20.6 22.1 Merchandise inventories $ 820,882 $ 771,663 $ 49,219 6.4 % Consolidated inventory turnover (2) 10.2 10.4 Accounts payable $ 698,648 $ 643,872 $ 54,776 8.5 % (1) Based on period end accounts receivable and net revenue for the quarter (2) Based on average annual inventory and annualized cost of goods sold based on the quarter ended June 30, 2014 and December 31, 2013 Liquidity and capital expenditures. The following table summarizes our consolidated statements of cash flows for the six months ended June 30, 2014 and 2013: (Dollars in thousands) 2014 2013 Net cash provided by (used for): Operating activities $ 73,472 $ 179,179 Investing activities (36,841 ) (30,979 ) Financing activities (45,329 ) (39,130 ) Effect of exchange rate changes (1,180 ) 868 Increase (decrease) in cash and cash equivalents $ (9,878 ) $ 109,938 Cash provided by operating activities was $73.5 million in the first six months of 2014, compared to $179.2 million in the same period of 2013. The decrease in cash from operating activities for the first six months of 2014 compared to the same period in 2013 was primarily due to routine changes in working capital including timing of payments. Cash used for investing activities was $36.8 million in the first six months of 2014, compared to $31.0 million in the same period of 2013. Investing activities in 2014 and 2013 relate to capital expenditures for our strategic and operational efficiency initiatives, particularly initiatives relating to information technology enhancements and optimizing our distribution network. Cash used for financing activities in the first six months of 2014 was $45.3 million, compared to $39.1 million used in the same period of 2013. During the first six months of 2014, we paid dividends of $31.6 million, repurchased common stock under a share repurchase program for $9.4 million of cash, received proceeds of $1.0 million from the exercise of stock options and purchased the noncontrolling interest in a subsidiary for $1.5 million. Capital resources. Our sources of liquidity include cash and cash equivalents and a revolving credit facility. We have a five-year $350 million Credit Agreement with Wells Fargo Bank, N.A., JPMorgan Chase Bank, N.A. and a syndicate of financial institutions (the Credit Agreement). Under the Credit Agreement, we have the ability to request two one-year extensions and to request an increase in aggregate commitments by up to $150 million. The interest rate, which is subject to adjustment quarterly, is based on the London Interbank Offered Rate (LIBOR), the Federal Funds Rate or the Prime Rate, plus an adjustment based on the better of our debt ratings or leverage ratio (Credit Spread) as defined by the Credit Agreement. We are charged a commitment fee of between 17.5 and 42.5 basis points on the unused portion of the facility. The terms of the Credit Agreement limit the amount of indebtedness that we may incur and require us to maintain ratios for leverage and interest coverage, including on a pro forma basis in the event of an acquisition. At June 30, 2014, we had no borrowings and letters of credit of approximately $5.0 million outstanding on the revolving credit facility, leaving $345.0 million available for borrowing. 25-------------------------------------------------------------------------------- Table of Contents We may utilize the revolving credit facility for long-term strategic growth, capital expenditures, working capital and general corporate purposes. If we were unable to access the revolving credit facility, it could impact our ability to fund these needs. During the first six months of 2014, we had no borrowings or repayments under the credit facility. Based on our leverage ratio at June 30, 2014, the interest rate under the credit facility is LIBOR plus 1.375%. We have $200 million of senior notes outstanding, which mature in 2016 and bear interest at 6.35%, payable semi-annually on April 15 and October 15. The revolving credit facility and senior notes contain cross-default provisions which could result in the acceleration of payments due in the event of default of either agreement. We believe we were in compliance with the debt covenants at June 30, 2014. In the second quarter of 2014, we paid cash dividends on our outstanding common stock at the rate of $0.25 per share, which represents a 4% increase over the rate of $0.24 per share paid in the second quarter of 2013. We anticipate continuing to pay quarterly cash dividends in the future. However, the payment of future dividends remains within the discretion of the Board of Directors and will depend upon our results of operations, financial condition, capital requirements and other factors. In February 2014, the Board of Directors authorized a share repurchase program of up to $100 million of our outstanding common stock to be executed at the discretion of management over a three-year period, expiring in February 2017. The timing of purchases and the number of shares of common stock to be repurchased will be determined by management based upon market conditions and other factors. The program is intended to offset shares issued in conjunction with our stock incentive plan and return capital to shareholders. The program may be suspended or discontinued at any time. During the first six months of 2014, we repurchased approximately 0.3 million shares for $9.5 million under this program. The remaining amount authorized for repurchases under this program is $90.5 million at June 30, 2014. We earn a portion of our operating earnings in foreign jurisdictions outside the U.S., which we consider to be indefinitely reinvested. Accordingly, no U.S. federal and state income taxes and withholding taxes have been provided on these earnings. Our cash, cash-equivalents, short-term investments, and marketable securities held by our foreign subsidiaries totaled $22.1 million and $22.2 million as of June 30, 2014 and December 31, 2013. We do not intend, nor do we foresee a need, to repatriate these funds or other assets held outside the U.S. In the future, should we require more capital to fund discretionary activities in the U.S. than is generated by our domestic operations and is available through our borrowings, we could elect to repatriate cash or other assets from foreign jurisdictions that have previously been considered to be indefinitely reinvested. Upon distribution of these assets, we could be subject to additional U.S. federal and state income taxes and withholding taxes payable to foreign jurisdictions, where applicable. The IRS on January 10, 2014 released final regulations relating to the adjustment of inventory costs for certain sales-based vendor charge-backs and the allowable treatment of these charge-backs in tax LIFO calculations. We are currently analyzing the impact of this regulatory change on our tax LIFO position, which could cause our related deferred tax liability to become due and payable, impacting future cash flow. We believe available financing sources, including cash generated by operating activities and borrowings under the revolving credit facility, will be sufficient to fund our working capital needs, capital expenditures, long-term strategic growth, payments under long-term debt and lease arrangements, payments of quarterly cash dividends, share repurchases and other cash requirements. While we believe that we will have the ability to meet our financing needs in the foreseeable future, changes in economic conditions may impact (i) the ability of financial institutions to meet their contractual commitments to us, (ii) the ability of our customers and suppliers to meet their obligations to us and/or (iii) our cost of borrowing. Recent Accounting Pronouncements For a discussion of recent accounting pronouncements, see Note 15 in the Notes to Consolidated Financial Statements, included in this Quarterly Report on Form 10-Q for the quarterly period ended on June 30, 2014. Forward-looking Statements Certain statements in this discussion constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Although we believe our expectations with respect to the forward-looking statements are based upon reasonable assumptions within the bounds of our knowledge of our business and operations, all forward-looking statements involve risks and uncertainties and, as a result, actual results could differ materially from those projected, anticipated or implied by these statements. Such forward-looking statements involve known and unknown risks, including, but not limited to: • competitive pressures in the marketplace, including intense pricing pressure; • our ability to retain existing and attract new customers in a market characterized by significant customer consolidation and intense cost-containment initiatives; • our dependence on sales to certain customers or the loss or material reduction in purchases by key customers; • our dependence on distribution of product of certain suppliers; 26-------------------------------------------------------------------------------- Table of Contents • our ability to successfully identify, manage or integrate acquisitions, including the management and integration of our acquisition of Movianto and our pending acquisition of Medical Action; • our ability to successfully manage our international operations, including risks associated with changes in international trade regulations, foreign currency volatility, changes in regulatory conditions, deteriorating economic conditions, adverse tax consequences, and other risks of operating in international markets; • uncertainties related to and our ability to adapt to changes in government regulations, including healthcare laws and regulations (including the Affordable Care Act); • risks arising from possible violations of legal, regulatory or licensing requirements of the markets in which we operate; • uncertainties related to general economic, regulatory and business conditions; • our ability to successfully implement our strategic initiatives; • the availability of and modifications to existing supplier funding programs and our ability to meet the terms to qualify for certain of these programs; • our ability to adapt to changes in product pricing and other terms of purchase by suppliers of product; • the ability of customers and suppliers to meet financial commitments due to us; • changes in manufacturer preferences between direct sales and wholesale distribution; • changing trends in customer profiles and ordering patterns and our ability to meet customer demand for additional value-added services; • our ability to manage operating expenses and improve operational efficiencies in response to changing customer profiles; • our ability to meet performance targets specified by customer contracts under contractual commitments; • availability of and our ability to access special inventory buying opportunities; • the ability of business partners and financial institutions to perform their contractual responsibilities; • the effect of price volatility in the commodities markets, including fuel price fluctuations, on our operating costs and supplier product prices; • our ability to continue to obtain financing at reasonable rates and to manage financing costs and interest rate risk; • the risk that information systems are interrupted or damaged or fail for any extended period of time or that there is a data security breach; • the risk that a decline in business volume or profitability could result in an impairment of goodwill or other long-lived assets; • our ability to timely or adequately respond to technological advances in the medical supply industry; • the costs associated with and outcome of outstanding and any future litigation, including product and professional liability claims; • adverse changes in U.S. and foreign tax laws and the outcome of outstanding tax contingencies and legislative and tax proposals; and • other factors described in "Item 1A. Risk Factors" of our Annual Report on Form 10-K for the year ended December 31, 2013. We undertake no obligation to update or revise any forward-looking statements, except as required by applicable law. Item 3. Quantitative and Qualitative Disclosures About Market Risk We are exposed to market risk from changes in interest rates related to our revolving credit facility. We had no outstanding borrowings and approximately $5 million in letters of credit under the revolving credit facility at June 30, 2014. A hypothetical increase in interest rates of 100 basis points would result in a potential reduction in future pre-tax earnings of approximately $0.1 million per year for every $10 million of outstanding borrowings under the revolving credit facility. Due to the nature and pricing of our Domestic segment distribution services, we are exposed to potential volatility in fuel prices. Our strategies for helping to mitigate our exposure to changing domestic fuel prices have included entering into leases for trucks with improved fuel efficiency and entering into fixed-price agreements for diesel fuel. We benchmark our 27-------------------------------------------------------------------------------- Table of Contents domestic diesel fuel purchase prices against the U.S. Weekly Retail On-Highway Diesel Prices (benchmark) as quoted by the U.S. Energy Information Administration. The benchmark averaged $3.94 per gallon in the first six months of 2014, an increase from $3.87 per gallon in the first six months of 2013. Based on our fuel consumption in the first six months of 2014, we estimate that every 10 cents per gallon increase in the benchmark would reduce our Domestic segment operating earnings by approximately $300,000 on an annualized basis. In the normal course of business, we are exposed to foreign currency translation and transaction risks. Our business transactions outside of the United States are primarily denominated in the Euro and British Pound. We may use foreign currency forwards, swaps and options, where possible, to manage our risk related to certain foreign currency fluctuations. However, we believe that our foreign currency transaction risks are low since our revenues and expenses are typically denominated in the same currency. Item 4. Controls and Procedures We carried out an evaluation, with the participation of management, including our principal executive officer and principal financial officer, of the effectiveness of our disclosure controls and procedures (pursuant to Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based upon that evaluation, the principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of June 30, 2014. There has been no change in our internal control over financial reporting during the quarter ended June 30, 2014, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Part II. Other Information Item 1. Legal Proceedings Certain legal proceedings pending against us are described in our Annual Report on Form 10-K for the year ended December 31, 2013. Through June 30, 2014, there have been no material developments in any legal proceedings reported in such Annual Report. Item 1A. Risk Factors Certain risk factors that we believe could affect our business and prospects are described in our Annual Report on Form 10-K for the year ended December 31, 2013. Through June 30, 2014, there have been no material changes in the risk factors described in such Annual Report. Item 2. Unregistered Sales of Equity Securities, Use of Proceeds and Issuer Purchases of Equity Securities In February 2014, our Board of Directors authorized a share repurchase program of up to $100 million of our outstanding common stock to be executed at the discretion of management over a three-year period, expiring in February 2017. The program is intended to offset shares issued in conjunction with our stock incentive plan and return capital to shareholders. The program may be suspended or discontinued at any time. For the three months ended June 30, 2014, we repurchased in open-market transactions and retired 0.1 million shares of our common stock for an aggregate of $4.5 million, or an average price per share of $33.70. The following table summarizes share repurchase activity by month during the three months ended June 30, 2014. Total number of Maximum dollar shares purchased value of shares Total number as part of a that may yet of shares Average price paid publicly announced be purchased Period purchased per share program under the program April 2014 - $ - - $ 95,000,018 May 2014 95,145 $ 33.25 95,145 $ 91,836,793 June 2014 39,286 $ 34.35 39,286 $ 90,487,451 Total 134,431 134,431 28 -------------------------------------------------------------------------------- Table of Contents |