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AGILENT TECHNOLOGIES INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (UNAUDITED)(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Form 10-Q and our Annual Report on Form 10-K. This report contains forward-looking statements including, without limitation, statements regarding trends, seasonality, cyclicality and growth in, and drivers of, the markets we sell into, our strategic direction, our future effective tax rate and tax valuation allowance, earnings from our foreign subsidiaries, remediation activities, new product and service introductions, the ability of our products to meet market needs, changes to our manufacturing processes, the use of contract manufacturers, the impact of local government regulations on our ability to pay vendors or conduct operations, our liquidity position, our ability to generate cash from operations, growth in our businesses, our investments, the potential impact of adopting new accounting pronouncements, our financial results, our purchase commitments, our contributions to our pension plans, the selection of discount rates and recognition of any gains or losses for our benefit plans, our cost-control activities, savings and headcount reduction recognized from our restructuring programs and other cost saving initiatives, uncertainties relating to Food and Drug Administration ("FDA") and other regulatory approvals, the integration of our acquisitions and other transactions, the separation of the electronic measurement business, pre-separation expenses, transaction expenses related to the separation, post-separation expenses, our stock repurchase program, our declared dividends, annual meeting of stockholders ' proposals, our transition to lower-cost regions, and the existence of economic instability, that involve risks and uncertainties. Our actual results could differ materially from the results contemplated by these forward-looking statements due to various factors, including those discussed in Part II Item 1A and elsewhere in this Form 10-Q. Basis of Presentation The financial information presented in this Form 10-Q is not audited and is not necessarily indicative of our future consolidated financial position, results of operations, comprehensive income or cash flows. Our fiscal year-end is October 31, and our fiscal quarters end on January 31, April 30 and July 31. Unless otherwise stated, these dates refer to our fiscal year and fiscal periods. Executive Summary Agilent Technologies, Inc. ("we", "Agilent" or the "company"), incorporated in Delaware in May 1999, is the world's premier measurement company providing core bio-analytical and electronic measurement solutions to the life sciences, diagnostics and genomics, chemical analysis, communications and electronics industries. On September 19, 2013, Agilent announced plans to separate into two publicly traded companies, one comprising of the life sciences, diagnostics and chemical analysis businesses that will retain the Agilent name, and the other one that will be comprised of the electronic measurement business that will be renamed Keysight Technologies, Inc. ("Keysight"). Keysight was incorporated in Delaware as a wholly-owned subsidiary of Agilent on December 6, 2013. As the next part of the separation, Agilent transferred substantially all of the assets, liabilities and operations of the electronic measurement business to Keysight as of August 1, 2014. The separation is expected to occur through a tax-free pro rata distribution of Keysight shares to Agilent shareholders and is expected to be completed early in November 2014. We expect to incur pre-separation expenses of approximately $180 million in fiscal 2014 and have incurred approximately $123 million of pre-separation expense in the nine months ended July 31, 2014. Pre-separation costs include all incremental expenses incurred or expected to be incurred by Agilent in order to effect the separation until the planned distribution date, early in November 2014. They also include the cost of all new employees recruited in fiscal 2014 to operate the two separate companies. In the nine months ended July 31, 2014, we incurred $21 million of non-operating expenses related to the redemption of Agilent's debt obligations as part of our debt repositioning ahead of the distribution of Keysight. We also expect to incur, upon separation, transaction expenses, which, among other things, relate to investment banking and other advisory fees as well as tax costs related to the distribution. Finally, we expect to incur some post-separation expenses until the final separation of and optimization of all IT systems during fiscal 2015. In addition to the announcement to separate into two companies, we formed a new operating segment in the fourth fiscal quarter of 2013. The new life sciences and diagnostics segment was formed by the combination of the life sciences business plus the diagnostics and genomics business. Following this reorganization, Agilent has three business segments comprised of the life sciences and diagnostics business, the chemical analysis business and the electronic measurement business. The historical segment financial information for the life sciences and diagnostics segment has been recast to conform to this new reporting structure in our financial statements. Total orders for the three and nine months ended July 31, 2014 increased 9 percent and 5 percent, respectively, compared to the same periods last year. Foreign currency movements for the three and nine months ended July 31, 2014, had a favorable impact of approximately 1 percentage point and no impact, respectively, when compared to the same periods last year. For the 28-------------------------------------------------------------------------------- Table of Contents three months ended July 31, 2014, life sciences and diagnostics increased 11 percent, chemical analysis orders increased 8 percent and electronic measurement orders increased 7 percent when compared to the same period last year. For the nine months ended July 31, 2014, life sciences and diagnostics increased 5 percent, chemical analysis orders increased 6 percent and electronic measurement orders increased 4 percent when compared to the same period last year. Net revenue of $1,766 million and $5,176 million for the three and nine months ended July 31, 2014, respectively, increased 7 percent and 2 percent, respectively, when compared to the same periods last year. Foreign currency movements for the three and nine months ended July 31, 2014 had a favorable impact of approximately 1 percentage point and an unfavorable impact of approximately 1 percentage point, respectively, when compared to the same periods last year. Revenue grew 5 percent and 4 percent in the life sciences and diagnostics business for the three and nine months ended July 31, 2014, respectively, when compared to the same periods last year. Increased revenue in the three and nine months ended July 31, 2014 was led by demand for products, consumables and services in pharmaceutical and biotechnology as well as the clinical and diagnostics markets. Also within the life sciences and diagnostics business life science research into academic and government markets showed slight growth in the three months ended July 31, 2014, but declined in the nine months ended July 31, 2014 when compared to same periods last year. Revenue increased 8 percent and 5 percent within the chemical analysis business in the three and nine months ended July 31, 2014, respectively, when compared to the same periods last year. Revenue generated within food safety, forensics and environmental markets increased in both the three and nine months ended July 31, 2014 when compared to the same periods last year. Revenue from chemical and energy markets was more mixed with a slight decline in the three months ended July 31, 2014 and modest growth in the nine months ended July 31, 2014. Electronic measurement revenue increased 8 percent and decreased 1 percent in the three and nine months ended July 31, 2014, respectively, when compared to the same periods last year. Within electronic measurement, revenue from aerospace and defense markets increased in the three months ended July 31, 2014, but decreased in the nine months ended July 31, 2014 when compared to the same periods last year. The remainder of the general purpose market (computers, semiconductor and industrial) was flat in the in the three months ended July 31, 2014 and grew slightly in the nine months ended July 31, 2014 when compared to the same periods last year. In addition, electronic measurement saw growth in revenue within the wireless R&D test market in the three months ended July 31, 2014 whereas the nine months ended July 31, 2014 showed a slight decline when compared to the same periods last year. The revenue within the wireless manufacturing market increased strongly in the three months ended July 31, 2014 and showed moderate growth in the nine months ended July 31, 2014 when compared to the same periods last year. Net income for the three and nine months ended July 31, 2014 was $147 million and $481 million, respectively, compared to $168 million and $513 million, respectively, for the corresponding periods last year. In the nine months ended July 31, 2014, we generated $547 million of cash from operations compared with $775 million generated in the same period last year. For the nine months ended July 31, 2014, cash dividends of $132 million were paid on the company's outstanding common stock. For the nine months ended July 31, 2013, cash dividends of $117 million were paid on the company's outstanding common stock. The timing and amounts of any future dividends are subject to determination and approval by our board of directors. On July 14, 2014, we settled the redemption of all $500 million outstanding aggregate principal amount of our 5.5% senior notes ("2015 senior notes") due September 14, 2015 that had been called for redemption on June 12, 2014. The redemption price of approximately $528 million included a $28 million prepayment penalty offset by the amortization of a deferred gain on the terminated interest rate swap related to those senior notes of approximately $8 million. We also paid accrued and unpaid interest of $9 million on the 2015 senior notes up to but not including the redemption date. On November 22, 2013 we announced that our board of directors had authorized a new share repurchase program. The new program is designed to reduce or eliminate dilution resulting from issuance of stock under the company's employee equity incentive programs to target maintaining a weighted average share count of approximately 335 million diluted shares. For the nine months ended July 31, 2014, we repurchased 4 million shares for $200 million. Looking forward, we expect that our electronic measurement business will continue to maintain its growth position for the remainder of this fiscal year. We expect positive trends to continue in our other businesses as we continue to invest in research and development and to improve our applications and solutions portfolio through the introduction of new products. At our 2015 annual meeting of stockholders, our board of directors expects to submit to our stockholders a proposal for an amendment to our certificate of incorporation seeking the declassification of our board of directors. 29-------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates Management's Discussion and Analysis of Financial Condition and Results of Operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles ("GAAP") in the U.S. The preparation of condensed consolidated financial statements in conformity with GAAP in the U.S. requires management to make estimates, judgments and assumptions that affect the amounts reported in our condensed consolidated financial statements and accompanying notes. Our critical accounting policies are those that affect our financial statements materially and involve difficult, subjective or complex judgments by management. Those policies are revenue recognition, inventory valuation, restructuring, share-based compensation, retirement and post-retirement benefit plan assumptions, goodwill and purchased intangible assets and accounting for income taxes. There have been no significant changes to our critical accounting policies as described in our Annual Report on Form 10-K for the fiscal year ended October 31, 2013. A number of our critical accounting policies are described in the following paragraphs. Management bases its estimates on historical experience and various other assumptions believed to be reasonable. Although these estimates are based on management's best knowledge of current events and actions that may impact the company in the future, actual results may be different from the estimates. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably likely to occur could materially change the financial statements. Share-based compensation. We estimate the stock price volatility using the historical volatility of Agilent's stock options over the most recent historical period equivalent to the expected life of stock options. In reaching this conclusion, we have considered many factors including the extent to which our options are currently traded and our ability to find traded options in the current market with similar terms and prices to the options we are valuing. A 10 percent increase in our estimated historical volatility from 38 percent to 48 percent for our most recent employee stock option grant would generally increase the value of an award and the associated compensation cost by approximately 22 percent if no other factors were changed. In estimating the expected life of our options granted we considered the historical option exercise behavior of our executive employees, which we believe is representative of future behavior. Goodwill and Purchased Intangible Assets. Under the authoritative guidance we have the option to perform a qualitative assessment to determine whether further impairment testing is necessary. The accounting standard gives an entity the option to first assess qualitative factors to determine whether performing the two-step test is necessary. If an entity believes, as a result of its qualitative assessment, that it is more-likely-than-not (i.e. greater than 50% chance) that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test will be required. Otherwise, no further testing will be required. The guidance includes examples of events and circumstances that might indicate that a reporting unit's fair value is less than its carrying amount. These include macro-economic conditions such as deterioration in the entity's operating environment or industry or market considerations; entity-specific events such as increasing costs, declining financial performance, or loss of key personnel; or other events such as an expectation that a reporting unit will be sold or a sustained decrease in the stock price on either an absolute basis or relative to peers. If it is determined, as a result of the qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, the provisions of authoritative guidance require that we perform a two-step impairment test on goodwill. In the first step, we compare the fair value of each reporting unit to its carrying value. The second step (if necessary) measures the amount of impairment by applying fair-value-based tests to the individual assets and liabilities within each reporting unit. As defined in the authoritative guidance, a reporting unit is an operating segment, or one level below an operating segment. We aggregate components of an operating segment that have similar economic characteristics into our reporting units. In October 2013, we combined the life sciences and diagnostics and genomics segments to form the life sciences and diagnostics segment. As a result, Agilent has three segments, life sciences and diagnostics, chemical analysis, and electronic measurement segments. In fiscal year 2013, we assessed goodwill impairment for our four reporting units which consisted of two segments: chemical analysis and electronic measurement; and two reporting units under the life sciences and diagnostics segment. The first of these two reporting units related to our life sciences business and the second related to our diagnostics business. We performed a qualitative test for goodwill impairment of the following three reporting units, as of September 30, 2013: the chemical analysis segment, the electronic measurement segment, and the reporting unit relating to life sciences. Based on the results of our qualitative testing, we believe that it is more-likely-than-not that the fair value of these reporting units are greater than their respective carrying values. We performed a quantitative test for goodwill impairment of the reporting unit related to our diagnostics business as of September 30, 2013. Based on the results of our quantitative testing, the fair value was significantly in excess of the carrying value. Each quarter we review the events and circumstances to determine if goodwill impairment is indicated. There was no impairment of goodwill during the three and nine months ended July 31, 2014 and 2013. 30-------------------------------------------------------------------------------- Table of Contents Purchased intangible assets consist primarily of acquired developed technologies, proprietary know-how, trademarks, and customer relationships and are amortized using the best estimate of the asset's useful life that reflect the pattern in which the economic benefits are consumed or used up or a straight-line method ranging from 6 months to 15 years. In-process research and development ("IPR&D") is initially capitalized at fair value as an intangible asset with an indefinite life and assessed for impairment thereafter. When the IPR&D project is complete, it is reclassified as an amortizable purchased intangible asset and is amortized over its estimated useful life. If an IPR&D project is abandoned, Agilent will record a charge for the value of the related intangible asset to Agilent's condensed consolidated statement of operations in the period it is abandoned. In July 2012, the Financial Accounting Standards Board simplified the guidance for testing impairment of indefinite-lived intangible assets other than goodwill. The changes are to reduce compliance costs. Agilent's indefinite-lived intangible assets are IPR&D intangible assets. The revised guidance allows a qualitative approach for testing indefinite-lived intangible assets for impairment, similar to the issued impairment testing guidance for goodwill and allowed the option to first assess qualitative factors (events and circumstances) that could have affected the significant inputs used in determining the fair value of the indefinite-lived intangible asset to determine whether it is more-likely-than-not (i.e. greater than 50% chance) that the indefinite-lived intangible asset is impaired. An organization may choose to bypass the qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to calculating its fair value. We performed a qualitative test for impairment of indefinite-lived intangible assets as of September 30, 2013. Based on the results of our qualitative testing, we believe that it is more-likely-than-not that the fair value of these indefinite-lived intangible assets is greater than their respective carrying values. Each quarter we review the events and circumstances to determine if impairment of indefinite-lived intangible asset is indicated. There was no impairment of indefinite-lived intangible asset during the three and nine months ended July 31, 2014. In the three and nine months ended July 31, 2013, we recorded an impairment of zero and $1 million, respectively, due to the cancellation of an IPR&D project within our electronic measurement business. Accounting for income taxes. We must make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of tax credits, benefits and deductions, and in the calculation of certain tax assets and liabilities which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes, as well as interest and penalties related to uncertain tax positions. Significant changes to these estimates may result in an increase or decrease to our tax provision in a subsequent period. Significant management judgment is also required in determining whether deferred tax assets will be realized in full or in part. When it is more-likely-than-not that all or some portion of specific deferred tax assets such as net operating losses or foreign tax credit carryforwards will not be realized, a valuation allowance must be established for the amount of the deferred tax assets that cannot be realized. We consider all available positive and negative evidence on a jurisdiction-by-jurisdiction basis when assessing whether it is more likely than not that deferred tax assets are recoverable. We consider evidence such as our past operating results, the existence of losses in recent years and our forecast of future taxable income. In the fourth quarter of fiscal 2012 we released the valuation allowance for the majority of our U.S. deferred tax assets. At July 31, 2014, we continue to recognize a valuation allowance for certain U.S. state and foreign deferred tax assets. We intend to maintain a valuation allowance in these jurisdictions until sufficient positive evidence exists to support its reversal. We have not provided for all U.S. federal income and foreign withholding taxes on the undistributed earnings of some of our foreign subsidiaries because we intend to reinvest such earnings indefinitely. Should we decide to remit this income to the U.S. in a future period, our provision for income taxes will increase materially in that period. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax law and regulations in a multitude of jurisdictions. Although the guidance on the accounting for uncertainty in income taxes prescribes the use of a recognition and measurement model, the determination of whether an uncertain tax position has met those thresholds will continue to require significant judgment by management. In accordance with the guidance on the accounting for uncertainty in income taxes, for all U.S. and other tax jurisdictions, we recognize potential liabilities for anticipated tax audit issues based on our estimate of whether, and the extent to which, additional taxes and interest will be due. The ultimate resolution of tax uncertainties may differ from what is currently estimated, which could result in a material impact on income tax expense. If our estimate of income tax liabilities proves to be less than the ultimate assessment, a further charge to expense would be required. If events occur and the payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. We include interest and penalties related to unrecognized tax benefits within the provision for income taxes on the consolidated statements of operations. As a part of our accounting for business combinations, intangible assets are recognized at fair values and goodwill is measured as the excess of consideration transferred over the net estimated fair values of assets acquired. Impairment charges associated with goodwill are generally not tax deductible and will result in an increased effective income tax rate in the period 31-------------------------------------------------------------------------------- Table of Contents that any impairment is recorded. Amortization expenses associated with acquired intangible assets are generally not tax deductible and therefore deferred tax liabilities have been recorded for non-deductible amortization expenses as a part of the accounting for business combinations. Adoption of New Pronouncements See Note 2, "New Accounting Pronouncements," to the condensed consolidated financial statements for a description of new accounting pronouncements. Restructuring In the second quarter of 2013, we accrued for a targeted restructuring program to reduce Agilent's total headcount by approximately 450 regular employees, representing approximately 2 percent of our global workforce. In the fourth quarter of fiscal year 2013, Agilent announced plans to separate the electronic measurement business from Agilent which is expected to be completed early in November 2014. As a result, approximately 50 employees from the targeted restructuring plan have been redeployed within the company, reducing the total headcount under this plan to 400 employees. The timing and scope of workforce reductions will vary based on local legal requirements. When completed, the restructuring program is expected to result in an approximately $50 million reduction in annual cost of sales and operating expenses. In addition we have been streamlining our manufacturing operations. As part of this action, we anticipate the reduction of approximately 250 positions to reduce our annual cost of sales. For the nine months ended July 31, 2014 we reversed $4 million associated with employees that have been redeployed within the company. Within the U.S, we have substantially completed these restructuring activities. Internationally, we expect to complete the majority of these restructuring activities by the end of the first quarter of fiscal 2015. As of July 31, 2014, approximately 140 employees are pending termination and approximately $43 million was been paid under the above actions. In the three and nine months ended July 31, 2014 we have realized the expected savings within our business operations as a result of these restructuring activities. Foreign Currency Our revenues, costs and expenses, and monetary assets and liabilities are exposed to changes in foreign currency exchange rates as a result of our global operating and financing activities. We hedge revenues, expenses and balance sheet exposures that are not denominated in the functional currencies of our subsidiaries on a short term and anticipated basis. We do experience some fluctuations within individual lines of the condensed consolidated statement of operations and balance sheet because our hedging program is not designed to offset the currency movements in each category of revenues, expenses, monetary assets and liabilities. Our hedging program is designed to hedge currency movements on a relatively short-term basis (up to a rolling twelve month period). Therefore, we are exposed to currency fluctuations over the longer term. To the extent that we are required to pay for all, or portions, of an acquisition price in foreign currencies, Agilent may enter into foreign exchange contracts to reduce the risk that currency movements will impact the U.S. dollar cost of the transaction. Results from Operations Orders and Net Revenue Three Months Ended Nine Months Ended Year over Year Change July 31, July 31, Three Nine 2014 2013 2014 2013 Months Months (in millions) Orders $ 1,739 $ 1,600 $ 5,229 $ 4,998 9% 5% Net revenue: Products $ 1,438 $ 1,335 $ 4,209 $ 4,139 8% 2% Services and other 328 317 967 925 3% 5% Total net revenue $ 1,766 $ 1,652 $ 5,176 $ 5,064 7% 2% Total orders for the three and nine months ended July 31, 2014 increased 9 percent and 5 percent, respectively, compared to the same periods last year. Foreign currency movements for the three and nine months ended July 31, 2014, had a favorable impact of approximately 1 percentage point and no impact, respectively, when compared to the same periods last year. For the three months ended July 31, 2014, life sciences and diagnostics increased 11 percent, chemical analysis orders increased 8 percent 32-------------------------------------------------------------------------------- Table of Contents and electronic measurement orders increased 7 percent when compared to the same period last year. For the nine months ended July 31, 2014, life sciences and diagnostics increased 5 percent, chemical analysis orders increased 6 percent and electronic measurement orders increased 4 percent when compared to the same period last year. Net revenue of $1,766 million and $5,176 million for the three and nine months ended July 31, 2014, respectively, increased 7 percent and 2 percent, respectively, when compared to the same periods last year. Foreign currency movements for the three and nine months ended July 31, 2014 had a favorable impact of approximately 1 percentage point and an unfavorable impact of approximately 1 percentage point, respectively, when compared to the same periods last year. Revenue grew 5 percent and 4 percent in the life sciences and diagnostics business for the three and nine months ended July 31, 2014, respectively, when compared to the same periods last year. Increased revenue in the three and nine months ended July 31, 2014 was led by demand for products, consumables and services in pharmaceutical and biotechnology as well as the clinical and diagnostics markets. Also within the life sciences and diagnostics business life science research into academic and government markets showed slight growth in the three months ended July 31, 2014, but declined in the nine months ended July 31, 2014 when compared to same periods last year. Revenue increased 8 percent and 5 percent within the chemical analysis business in the three and nine months ended July 31, 2014, respectively, when compared to the same periods last year. Revenue generated within food safety, forensics and environmental markets increased in both the three and nine months ended July 31, 2014 when compared to the same periods last year. Revenue from chemical and energy markets was more mixed with a slight decline in the three months ended July 31, 2014 and modest growth in the nine months ended July 31, 2014. Electronic measurement revenue increased 8 percent and decreased 1 percent in the three and nine months ended July 31, 2014, respectively, when compared to the same periods last year. Within electronic measurement, revenue from aerospace and defense markets increased in the three months ended July 31, 2014, but decreased in the nine months ended July 31, 2014 when compared to the same periods last year. The remainder of the general purpose market (computers, semiconductor and industrial) was flat in the in the three months ended July 31, 2014 and grew slightly in the nine months ended July 31, 2014 when compared to the same periods last year. In addition, electronic measurement saw growth in revenue within the wireless R&D test market in the three months ended July 31, 2014 whereas the nine months ended July 31, 2014 showed a slight decline when compared to the same periods last year. The revenue within the wireless manufacturing market increased strongly in the three months ended July 31, 2014 and showed moderate growth in the nine months ended July 31, 2014 when compared to the same periods last year. Services and other revenue include revenue generated from servicing our installed base of products, warranty extensions and consulting. Services and other revenue increased 3 percent and 5 percent in the three and nine months ended July 31, 2014, respectively, compared to the same periods last year. The service and other revenue growth is impacted by a portion of the revenue being driven by the current and previously installed product base. Service and other revenue increased in the three and nine months ended July 31, 2014 when compared to the same periods last year due to increased service contract renewals and laboratory productivity services, but revenue from the sale of extended warranties within our electronic measurement business declined due to the extension of standard terms from one year to three years in 2013. Operating Results Three Months Ended Nine Months Ended Year over Year Change July 31, July 31, Three Nine 2014 2013 2014 2013 Months Months Total gross margin 51.7 % 51.8 % 52.1 % 51.9 % - - Operating margin 13.0 % 14.3 % 12.7 % 13.2 % (1)ppt (1)ppt (in millions) Research and development $ 177 $ 171 $ 530 $ 531 4% - Selling, general and administrative $ 508 $ 449 $ 1,509 $ 1,430 13% 6% Total gross margins for the three and nine months ended July 31, 2014 were flat in both periods when compared to the same periods last year. Gross margins in our life sciences and diagnostics business were flat, up in our chemicals analysis business and down slightly within our electronic measurement business in the three and nine months ended July 31, 2014 when compared to the same periods last year. There were changes in gross margin due product mix, including a refreshed product portfolio within the chemical analysis business, offset by increases in inventory charges and the impact of wages and benefits which resulted in gross margins being unchanged from the prior periods. Operating margins declined by 1 percentage point in both the three and nine months ended July 31, 2014 when compared to the same periods last year. The overall decline in operating margin for the three and nine months ended July 31, 2014 was partially due to pre-separation costs. Operating margins within our life sciences and diagnostics business was flat and in the chemical analysis business operating margins increased in the three and nine months 33-------------------------------------------------------------------------------- Table of Contents ended July 31, 2014. Within electronic measurement operating margins increased in the three months but was flat for the nine months ended July 31, 2014 when compared to the same periods last year. Research and development expenses increased 4 percent and was flat in the three and nine months ended July 31, 2014, respectively, compared to the same periods last year. For both the three and nine months ended July 31, 2014 R&D expenditure increased within our life sciences and diagnostics and chemical analysis businesses with investments for product and software R&D together with wage increases. Within our electronic measurement business R&D costs increased slightly in the three months ended July, 31 2014 as discretionary expenditure increased partially offset by lower wages and benefits. In the nine months ended July 31, 2014 there was a reduction in R&D expenditure within electronic measurement business due to savings from prior year's restructuring. We remain committed to invest approximately 10 percent of revenues in research and development and have focused our development efforts on key strategic opportunities in order to align our business with available markets and position ourselves to capture market share. Selling, general and administrative expenses increased 13 percent and 6 percent for the three and nine months ended July 31, 2014, respectively, compared to the same periods last year. Selling, general and administrative expenditure increased mostly due to pre-separation costs with other increases in wages, higher commissions and investments in sales channel coverage partially offset by the gain on sale of land and savings due to restructuring charges incurred in the prior year. For the three and nine months ended July 31, 2014, pre-separation costs had a 13 percentage point and 9 percentage point impact, respectively, on the increase in selling, general and administrative expenses. At July 31, 2014, our headcount was approximately 21,200 as compared to approximately 20,600 at July 31, 2013. Other income (expense) In the three and nine months ended July 31, 2014 other income (expense), net includes a net loss on the early redemption of the 2015 senior notes of $21 million consisting of the prepayment penalty of $28 million, $1 million of amortization of debt issuance costs and discount and the amortization of interest rate swap gain of $8 million. Income Taxes The company's effective tax rate was 20 percent and 14 percent for the three and nine months ended July 31, 2014, respectively. The company's effective tax rate was 21 percent and 15 percent for the three and nine months ended July 31, 2013, respectively. The income tax provision for the three months and nine months ended July 31, 2014 included a net discrete expense of $1 million and a net discrete benefit of $13 million, respectively. The net discrete tax expense for the three months ended July 31, 2014 included $7 million of tax expense related to non-deductible pre-separation costs for the spin-off of Keysight, $4 million of tax expense related primarily to the return to provision adjustments in the U.S., and a $4 million tax benefit resulting from a deduction generated by the redemption of senior notes. In addition, we recorded out of period adjustments consisting of a $9 million tax benefit related to the correction of tax basis of land in the U.K. and a $3 million tax expense to correct tax related balance sheet accounts. In the nine months ended July 31, 2014, the net discrete tax benefit included $15 million of tax expense related to non-deductible pre-separation costs for the spin-off of Keysight, $35 million tax benefit primarily due to the settlement of an Internal Revenue Service ("IRS") audit in the U.S. and the recognition of tax expense related to the repatriation of dividends to the U.S. There were out of period adjustments totaling $6 million of net tax expense composed of $12 million tax expense recorded in the second quarter of fiscal 2014 for corrections to transfer pricing for tax years 2012 and 2013 in addition to the out of period adjustments totaling $6 million net tax benefit mentioned in the paragraph above. The corrections are not considered material to current or prior periods. The income tax provision for the three and nine months ended July 31, 2013 included net discrete tax expense of $18 million and $22 million, respectively. The net discrete tax expense for the three months ended July 31, 2013 was primarily driven by a $7 million decrease in deferred tax assets due to a reduction in the statutory tax rate in the U.K. and $7 million additional tax expense due to return to provision adjustments associated with the filing of the 2012 tax returns in various jurisdictions. The net discrete tax expense for the nine months ended July 31, 2013 was primarily driven by the above mentioned $18 million discrete charges recognized in the third quarter of 2013 and a $12 million out of period adjustment to tax expense, recognized in the second quarter of 2013, associated with the write off of deferred tax assets related to foreign tax credits incorrectly claimed in prior years; partially offset by a $7 million discrete tax benefit, recognized in the first quarter of 2013, due to research and development tax credits relating to the company's prior fiscal year. 34-------------------------------------------------------------------------------- Table of Contents At July 31, 2014, our estimate of annual effective tax rate is 16.5 percent excluding discrete items and 15.7 percent including discrete items. We determine our interim tax provision using an estimated annual effective tax rate methodology except in jurisdictions where we anticipate a full year loss or we have a year-to-date ordinary loss for which no tax benefit can be recognized. In these jurisdictions, tax expense is computed separately. Our effective tax rate differs from the U.S. statutory rate primarily due to the impact of foreign tax credits, research and development credits, business acquisitions and dispositions, changes to valuation allowances and the mix of earnings in non-U.S. jurisdictions taxed at lower statutory rates; in particular Singapore where we enjoy tax holidays. In the U.S., tax years remain open back to the year 2008 for federal income tax purposes and the year 2000 for significant states. On January 29, 2014 we reached an agreement with the IRS for the tax years 2006 through 2007. The settlement resulted in the recognition of previously unrecognized tax benefits of $160 million, offset by a tax liability on foreign distributions of approximately $125 million principally related to additional foreign earnings that was recognized in conjunction with the settlement. Agilent's U.S. federal income tax returns for 2008 through 2011 are currently under audit by the IRS. In connection with the settlement of the 2006-2007 IRS audit, we identified during the first quarter of fiscal year 2014 an overstatement of approximately $65 million in our long-term tax liabilities. The overstatement was recorded in 2008 as a cumulative effect of a change in accounting principle when we adopted Accounting Standard Codification 740-10, Income Taxes. Accordingly, we corrected the error by reducing long-term tax liabilities and increasing retained earnings by $65 million in the first quarter of fiscal 2014. The correction had no impact on net income or cash flows in any prior period and is not considered material to total liabilities or equity in any prior period. In other major jurisdictions where the company conducts business, the tax years generally remain open back to the year 2003. With these jurisdictions and the U.S., it is reasonably possible that there could be significant changes to our unrecognized tax benefits in the next twelve months due to either the expiration of a statute of limitation or a tax audit settlement. Given the number of years and numerous matters that remain subject to examination in various tax jurisdictions, management is unable to estimate the range of possible changes to the balance of our unrecognized tax benefits. Segment Overview We formed a new operating segment in the fourth fiscal quarter of 2013. The new life sciences and diagnostics segment was formed by the combination of the life sciences business plus the diagnostics and genomics business. Following this reorganization, we have three business segments comprised of the life sciences and diagnostics business, the chemical analysis business and the electronic measurement business. The historical segment financial information for the life sciences and diagnostics segment has been recast to conform to this new reporting structure in our financial statements. Life Sciences and Diagnostics Our life sciences and diagnostics business provides application-focused solutions that include reagents, instruments, software, consumables, and services that enable customers to identify, quantify and analyze the physical and biological properties of substances and products, as well as enable customers in the clinical and life sciences research areas to interrogate samples at the molecular level. Key product categories include: liquid chromatography ("LC") systems, columns and components; liquid chromatography mass spectrometry ("LCMS") systems; laboratory software and informatics systems; laboratory automation and robotic systems; dissolution testing; nucleic acid solutions; Nuclear Magnetic Resonance, and X-Ray Diffraction systems; services and support for the aforementioned products; immunohistochemistry; In Situ Hybridization; Hematoxylin and Eosin staining; special staining, DNA mutation detection; genotyping; gene copy number determination; identification of gene rearrangements; DNA methylation profiling; gene expression profiling; next generation sequencing target enrichment; and automated gel electrophoresis-based sample analysis systems. We also collaborate with a number of major pharmaceutical companies to develop new potential pharmacodiagnostics, also called companion diagnostics, with the potential of identifying patients most likely to benefit from a specific targeted therapy. 35-------------------------------------------------------------------------------- Table of Contents Orders and Net Revenue Three Months Ended Nine Months Ended Year over Year Change July 31, July 31, Three Nine 2014 2013 2014 2013 Months Months (in millions) Orders $ 597 $ 536 $ 1,759 $ 1,677 11% 5% Net revenue $ 592 $ 564 $ 1,760 $ 1,699 5% 4% Life sciences and diagnostics order growth for the three and nine months ended July 31, 2014 was 11 percent and 5 percent compared to the same periods last year. Foreign currency movements had a favorable impact of 1 percentage point on order growth for the three months ended July 31, 2014, while currency movements for the nine months ended July 31, 2014 was negligible when compared to the same periods last year. Solid order results for the three months ended July 31, 2014 reflected broad strength across all product portfolios. Geographically, orders for the three months ended July 31, 2014 grew 14 percent in the Americas and 13 percent in Europe compared to the same period last year, with economic recovery and government funding driving the growth in these regions. Asia Pacific excluding Japan grew 8 percent, and Japan declined 2 percent due to unfavorable currency impact compared to the same period last year. Order growth for the nine months ended July 31, 2014 was led by strength in services and consumables, LCMS, nucleic acid solutions, and genomics portfolio. For the nine months ended July 31, 2014, orders grew 4 percent in the Americas, 10 percent in Europe, 2 percent in Asia Pacific excluding Japan, and declined 6 percent in Japan due to unfavorable currency impact when compared to the same period last year. Order growth for the nine months ended July 31, 2014 reflected softness in the first half of fiscal year 2014 from government spending restrictions and softer instrument demand in China, but was partially offset by the reversal in government spending trends in the U.S. and Europe in the third quarter. Life sciences and diagnostics net revenue for the three and nine months ended July 31, 2014 grew 5 percent and 4 percent, respectively, compared to the same periods last year. Foreign currency movements had a favorable impact of 1 percentage point on revenue growth for the three months ended July 31, 2014, while currency movements for the nine months ended July 31, 2014 was negligible when compared to the same periods last year. Revenue improved as growth in services and consumables offset continued softness in instrumentation. Geographically, for the three months ended July 31, 2014, revenue grew 4 percent in the Americas, 8 percent in Europe and 5 percent in Asia Pacific excluding Japan, while Japan declined 5 percent compared to the same period last year. For the nine months ended July 31, 2014, revenues grew 2 percent in the Americas, 8 percent in Europe, 2 percent in Asia Pacific excluding Japan, and Japan was relatively flat as the unfavorable impact of currency accounted for 13 percentage points, compared to the same period last year. For both periods, strength in the Americas and Europe was driven by good demand in life science research market and the services portfolio. Revenue in Asia Pacific was impacted by softness in China, as China continues to work through government reform. End market revenue performance reflected broad strength across all markets, highlighted by increased government and pharmaceutical demand, and improvement in the U.S. market. Strength in the pharmaceutical and biotech market was led by continued demand from mid-sized and specialized pharmaceutical customers. Life science research returned to growth this quarter, driven by increased government spending on capital equipment in the U.S. and Europe. Sustained growth in the diagnostics and clinical market was led by demand in CGH microarray and target enrichment solutions, as well as strength in pathology in the U.S. and Europe. Growth in the applied markets reflected increased government spending, partially offset by the continued impact of the CFDA restructuring in China. Looking forward, we are optimistic about our growth opportunities in the life sciences and diagnostics markets as our broad portfolio of products and solutions are well suited to address customer needs. We continue to invest in expanding and improving our applications and solutions portfolio. We expect spending levels similar to the third quarter to continue in the remainder of the year for the pharmaceutical and life science research markets. We also remain positive about the growth potential in our clinical research and diagnostics markets, for both our Dako advanced staining solutions as well as our microarray and next-generation sequencing target enrichment solutions. 36-------------------------------------------------------------------------------- Table of Contents Operating Results Three Months Ended Nine Months Ended Year over Year Change July 31, July 31, Three Nine 2014 2013 2014 2013 Months Months Gross margin 53.6 % 53.6 % 54.1 % 54.1 % - - Operating margin 15.7 % 16.0 % 15.3 % 15.4 % - - (in millions) Research and development $ 61 $ 56 $ 183 $ 168 8% 9% Selling, general and administrative $ 164 $ 156 $ 501 $ 489 5% 3% Gross margins for products and services for both the three and nine months ended July 31, 2014, were unchanged compared to the same periods last year. Gross margins reflect higher infrastructure expenses and wage increases, entirely offset by favorable product mix, lower inventory charges and lower benefit costs. Research and development expenses for the three and nine months ended July 31, 2014 increased 8 percent and 9 percent, respectively, compared to the same periods last year. The increase was due to greater investment in software and next generation products, higher infrastructure expenses and wage increases. Selling, general and administrative expenses for the three and nine months ended July 31, 2014 increased 5 percent and 3 percent, respectively, compared to the same periods last year. The increase was due to higher commissions, higher infrastructure expenses, wage increases, and investments in sales channel coverage with a continued focus on emerging markets. Operating margins for products and services for both the three months and nine months ended July 31, 2014, were relatively flat, compared to the same periods last year on higher revenue offset by increased operating expenses. Income from Operations Income from operations for the three and nine months ended July 31, 2014, increased $2 million and $7 million, respectively, on corresponding revenue increases of $28 million and $61 million. Chemical Analysis Our chemical analysis business provides application-focused solutions that include instruments, software, consumables, and services that enable customers to identify, quantify and analyze the physical and biological properties of substances and products. Key product categories in chemical analysis include: gas chromatography ("GC") systems, columns and components; gas chromatography mass spectrometry ("GC-MS") systems; inductively coupled plasma mass spectrometry ("ICP-MS") instruments; atomic absorption ("AA") instruments; inductively coupled plasma optical emission spectrometry ("ICP-OES") instruments; molecular spectroscopy instruments; software and data systems; vacuum pumps and measurement technologies; services and support for our products. Orders and Net Revenue Three Months Ended Nine Months Ended Year over Year Change July 31, July 31, Three Nine 2014 2013 2014 2013 Months Months (in millions) Orders $ 420 $ 390 $ 1,267 $ 1,197 8% 6% Net revenue $ 417 $ 387 $ 1,245 $ 1,182 8% 5% Chemical analysis orders for the three and nine months ended July 31, 2014 increased 8 percent and 6 percent, respectively, compared to the same periods last year. Foreign currency movements for the three and nine months ended July 31, 2014 had a favorable currency impact on orders of 1 percentage point and no impact, respectively. Order results were led by solid performance in high end GC's and ICP-MS instruments, along with consumables and services. Geographically, we saw order growth in all regions; orders grew 9 percent in the Americas, 12 percent in Europe, 12 percent in Japan, and 3 percent in Asia Pacific excluding 37-------------------------------------------------------------------------------- Table of Contents Japan for the three months ended July 31, 2014 compared to the same period last year. Orders rebounded across regions, mainly due to improved government spending in the US, continued growth in Europe and China improved late in the quarter. In addition, India showed signs of recovery with the new government taking charge after elections. For the nine months ended July 31, 2014 orders grew 3 percent in the Americas, grew 13 percent in Europe, were flat in Japan, and grew 4 percent in Asia Pacific excluding Japan compared to the same period last year. Though Japan has had positive growth in local currency, growth has been impacted by unfavorable currency exchange. The unfavorable currency impact in Japan was 3 percentage points in the three months ended July 31, 2014 and 12 percentage points for the nine months ended July 31, 2014. Chemical analysis revenues for the three and nine months ended July 31, 2014 increased 8 percent and 5 percent respectively compared to the same periods last year. Foreign currency movements for the three and nine months ended July 31, 2014 had a favorable currency impact on revenues of 1 percentage point and an unfavorable currency impact of 1 percentage point, respectively compared to the same periods last year. Solid revenue growth was seen virtually across the portfolio with strength in consumables, services, spectroscopy, and gas phase offset by weakness isolated to our vacuum business. The vacuum business declined low single digit for the three months ended July 31, 2014 due to soft industrial markets and weakness in China and Asia. Services growth was highlighted by strong aftermarket sales of service contracts as well as education related business. Geographically, revenues grew 10 percent in the Americas and Europe, declined 8 percent in Japan (including an unfavorable currency impact of 3 percentage points), and grew 7 percent in Asia Pacific excluding Japan for the three months ended July 31, 2014 compared to the same period last year. The Americas improved and Europe showed continued strength in the three months ended July 31, 2014. However, Japan declined due to currency issues and lack of stimulus money versus the same period last year. Revenues grew 3 percent in the Americas, grew 12 percent in Europe, grew 2 percent in Japan (including an unfavorable currency impact of 12 percentage points), and grew 2 percent in Asia Pacific excluding Japan for the nine months ended July 31, 2014 compared to the same period last year. In the three months ended July 31, 2014 applied markets saw solid growth in forensics and environmental reflecting significant improvement in government spending. Food testing markets continued to be strong, while chemical and energy grew slightly, largely due to softer demand from China. Investments in the food market continue across geographies given the increasing focus on ensuring the safety of global food imports and exports. Hydraulic fracturing remains the big story in the energy sector; increased activity in this area is providing footing for growth. Opportunities in forensics are expanding globally for drugs of abuse testing, including test of new designer drugs, especially for the identification of new synthetic designer drugs. Worldwide focus in these areas will provide a boost to the longer term growth engines for chemical analysis. Operating Results Three Months Ended Nine Months Ended Year over Year Change July 31, July 31, Three Nine 2014 2013 2014 2013 Months Months Gross margin 52.7 % 51.0 % 52.5 % 51.2 % 2 ppts 1 ppt Operating margin 23.3 % 21.5 % 22.6 % 21.4 % 2 ppts 1 ppt (in millions) Research and development $ 26 $ 23 $ 76 $ 70 14% 9%Selling, general and administrative $ 96 $ 91 $ 295 $ 282 6% 5% Gross margins for products and services for the three months ended July 31, 2014 increased 2 percentage points compared to the same period last year. The increase was mainly due to a refreshed spectroscopy portfolio with multiple new products over the past year; lower logistics costs, and controlled overhead spending. Gross margins for products and services for the nine months ended July 31, 2014 increased 1 percentage point compared to the same period last year. The increase was mainly due to manufacturing transfers to lower cost locations, materials savings, as well as product mix. Research and development expenses for the three and nine months ended July 31, 2014 increased 14 percent and 9 percent compared to the same periods last year, however, remained relatively flat as a percentage of revenue, as we continue to invest in R&D for current and future products. Selling, general and administrative expenses for the three months ended July 31, 2014 increased 6 percent compared to the 38-------------------------------------------------------------------------------- Table of Contents same period last year. Selling, general and administrative expenses for the nine months ended July 31, 2014 increased 5 percent compared to the same period last year. The increase was mainly due to higher infrastructure expenses, higher commissions, wage increases and higher variable pay. Operating margins for products and services for the three months ended July 31, 2014 increased 2 percentage points compared to the same periods last year. Operating margins increased 1 percentage point for the nine months ended July 31, 2014. The increases were mainly due to favorable gross margin performance outpacing operating expense growth. Income from Operations Income from operations for the three and nine months ended July 31, 2014, increased $14 million and $28 million, respectively, on corresponding revenue increases of $30 million and $63 million. The resulting year-over-year operating margin incremental was 47 percent and 45 percent for the three and nine months ended July 31, 2014. Operating margin incremental is measured by the increase in income from operations compared to the prior period divided by the increase in revenue compared to the prior period. Electronic Measurement Our electronic measurement business provides electronic measurement solutions to communications and electronics industries. We provide electronic measurement instruments and systems and related software, software design tools and related services that are used in the design, development, manufacture, installation, deployment and operation of electronic components and equipment. Related services include start-up assistance, instrument productivity and application services and instrument calibration and repair. We also offer customization, consulting and optimization services throughout the customer's product lifecycle. Orders and Net Revenue Three Months Ended Nine Months Ended Year over Year Change July 31, July 31, Three Nine 2014 2013 2014 2013 Months Months (in millions) Orders $ 722 $ 674 $ 2,203 $ 2,124 7% 4% Net revenue $ 757 $ 701 $ 2,171 $ 2,183 8% (1)% Electronic measurement orders for the three and nine months ended July 31, 2014, increased 7 percent and 4 percent, respectively, when compared to the same periods last year. There was no foreign currency impact on order growth for the three months ended July 31, 2014, and an unfavorable impact of 1 percentage points for the nine months ended July 31, 2014. The year-over-year increase in orders for the three months ended July 31, 2014, reflected stronger growth in general purpose business driven by aerospace and defense demand, and a moderate increase in communications test. For the three and nine period ending July 31, 2014, orders from Asia Pacific excluding Japan increased 16 percent and 11 percent, respectively, when compared to the same periods last year. There was growth in all market segments with particular strength in computers and semiconductors and aerospace and defense. Europe orders for the three and nine-month periods increased 14 percent and 10 percent with strength in communications offset by declines in industrial, computers and semiconductors. Orders for the Americas was flat and increased 1 percent, respectively, when compared to the same periods last year with strength in aerospace and defense offset by declines in communications, computer and semiconductor test business. Japan orders decreased 5 percent year-over-year in the three months ended July 31, 2014, including 2 percentage points from unfavorable currency movements and decreased 16 percent year-over-year in the nine months ended July 31, 2014 with 8 percentage points from unfavorable currency impact; the market weakness was primarily in aerospace and defense. Electronic measurement revenue for the three and nine months ended July 31, 2014, increased 8 percent and decreased 1 percent, respectively, when compared to the same periods last year. There was no foreign currency impact on revenue growth for the three months ended July 31, 2014, and an unfavorable impact of 1 percentage points for the nine months ended July 31, 2014. Asia Pacific excluding Japan increased 11 percent and 12 percent year-over-year for the three and nine months ended July 31, 2014, respectively, with growth in all market segments. Europe revenue increased 16 percent and 5 percent year-over-year for 39-------------------------------------------------------------------------------- Table of Contents the three and nine months ended July 31, 2014, with strength in communications and aerospace and defense partially offset by declines in industrial, computers and semiconductors. Americas revenue increased 8 percent for the three months ended July 31, 2014 driven by growth in aerospace and defense and communications for the three months ending July 31, 2014. For the nine months ended July 31, 2014, the Americas declined 9 percent due to aerospace and defense and the communication test businesses. Japan revenue declined 13 percent for both the three month and nine months ended July 31, 2014, with 2 points and 9 points from unfavorable currency movements respectively with declines in the aerospace and defense and communications markets. General purpose test, representing approximately 63 percent of electronic measurement revenue, reflected moderate growth in the three months ending July 31, 2014, with a slight decline for the nine month period. Aerospace and defense had strong growth in the three month period with growth in all regions except Japan. In spite of the current three month growth, aerospace and defense revenue for the nine month period declined when compared to the same periods last year. Industrial, computer and semiconductor revenue was flat and up slightly, for the three and nine months ended July 31, 2014. There was continued strength in semiconductor driven by investments in manufacturing capacity which was offset by lower demand in the computer segment. Communications test, representing approximately 37 percent of electronic measurement revenue increased year-over-year for the three and nine months ended July 31, 2014. Wireless R&D grew in the three months ended July 31, 2014, with strength from China 4G related investments, though there is still a slight decline for the nine month period. Wireless manufacturing grew with strength in 4G base station/infrastructure manufacturing offset by continued weakness in handset/device manufacturing. Looking forward, the macroeconomic indicators support modest growth. The geopolitical situation does represent risk, particularly related to the situation in Russia. We expect modest seasonal improvement in aerospace and defense business next quarter driven by U.S. government related spending. The communication test market projections continues to be mixed with base station spending expected to remain steady and handset/device manufacturing projected to remain soft in the short-term. Operating Results Three Months Ended Nine Months Ended Year over Year Change July 31, July 31, Three Nine 2014 2013 2014 2013 Months Months Gross margin 55.3 % 56.6 % 55.7 % 57.0 % (1) ppt (1) ppt Operating margin 19.7 % 18.5 % 18.4 % 18.8 % 1 ppt - (in millions) Research and development $ 90 $ 89 $ 269 $ 277 1% (3)%Selling, general and administrative $ 179 $ 178 $ 541 $ 557 - (3)% Gross margins for products and services for the three and nine months ended July 31, 2014, decreased 1 percentage point for both periods, compared to the same periods last year. The decline was impacted by a change in product mix and an increase in inventory charges. Research and development expenses for the three and nine months ended July 31, 2014, increased 1 percent and decreased 3 percent, respectively, compared to the same periods last year. The increase in discretionary expenses from development spending was partially offset by lower wages and benefits for the three months period ending July 31, 2014. The decrease for the nine month period was driven by lower wages and benefits impacted by cost savings from prior restructuring. Selling, general and administrative expenses for the three and nine months ended July 31, 2014, was flat and decreased 3 percent, respectively, compared to the same periods last year. Reductions from lower infrastructure costs were partially offset by wage increases. Operating margins for products and services for the three and nine months ended July 31, 2014, increased 1 percentage point and was flat, respectively, compared to the same periods last year. Income from Operations Income from operations for the three and nine months ended July 31, 2014, increased $20 million and decreased $11 million, respectively, on a corresponding revenue increases of $56 million and decreases of $12 million. The resultant year-over-year operating margin incremental was 36 percent and a decrement of 94 percent for these periods, respectively. 40-------------------------------------------------------------------------------- Table of Contents FINANCIAL CONDITION Liquidity and Capital Resources Our financial position as of July 31, 2014 consisted of cash and cash equivalents of $2,391 million as compared to $2,675 million as of October 31, 2013. As of July 31, 2014, approximately $ 2,266 million of our cash and cash equivalents is held outside of the U.S. in our foreign subsidiaries. Most of the amounts held outside of the U.S. could be repatriated to the U.S. but, under current law, would be subject to U.S. federal and state income taxes, less applicable foreign tax credits. Agilent has accrued for U.S. federal and state tax liabilities on the earnings of its foreign subsidiaries except when the earnings are considered indefinitely reinvested outside of the U.S. Repatriation could result in additional material U.S. federal and state income tax payments in future years. We utilize a variety of funding strategies in an effort to ensure that our worldwide cash is available in the locations in which it is needed. We believe our cash and cash equivalents, cash generated from operations, and ability to access capital markets and credit lines will satisfy, for the foreseeable future, our liquidity requirements, both globally and domestically, including the following: working capital needs, capital expenditures, business acquisitions, stock repurchases, cash dividends, contractual obligations, commitments, principal and interest payments on debt, and other liquidity requirements associated with our operations. Net Cash Provided by Operating Activities Net cash provided by operating activities was $547 million for the nine months ended July 31, 2014 compared to cash provided of $775 million for the same period in 2013. In the nine months ended July 31, 2014, we paid approximately $89 million under our variable and incentive pay programs, as compared to $98 million paid out during the same period of 2013. Net cash paid for income taxes was approximately $71 million and $93 million in the nine months ended July 31, 2014 and 2013, respectively. For the nine months ended July 31, 2014 and 2013, other assets and liabilities used cash of $208 million and provided cash of $10 million, respectively. The usage of cash in other assets and liabilities was largely the result of changes in prepaid assets, defined benefit plan liabilities, interest accruals, restructuring accruals and income and transaction tax assets and liabilities. In the nine months ended July 31, 2014, accounts receivable provided cash of less than $1 million compared to cash provided of $31 million for the same period in 2013. Revenue increased by approximately 2 percent in the nine months ended July 31, 2014 as compared to the same period in 2013. Days' sales outstanding decreased to 45 days as of July 31, 2014 from 48 days a year ago. Accounts payable used cash of $ 29 million for the nine months ended July 31, 2014 compared to cash used of $47 million in the same period in 2013. Cash used for inventory was $73 million for the nine months ended July 31, 2014 compared to cash used of $81 million for the same period in 2013. Inventory days on-hand decreased to 116 days as of July 31, 2014 compared to 119 days as of the end of the same period last year. Net cash provided by operating activities within the nine months ended July 31, 2014 was negatively impacted by: advanced accounts payable payments of approximately $60 million made to suppliers prior to the separation activities related to Keysight, the prepayment penalty of $28 million for the redemption of the 2015 senior notes and approximately $18 million associated with accelerated interest payments related to the redemption of 2015 senior notes and additional interest payments on 2023 senior notes issued in June 2013. We contributed approximately $84 million and $102 million to our defined benefit plans in the nine months ended July 31, 2014 and 2013, respectively. Our annual contributions are highly dependent on the relative performance of our assets versus our projected liabilities, among other factors. We expect to contribute approximately $19 million to our defined benefit plans during the remainder of 2014. Net Cash Used in Investing Activities Net cash used in investing activities was $172 million for the nine months ended July 31, 2014 as compared to net cash used in investing activities of $197 million for the same period of 2013. Investments in property, plant and equipment were $162 million for the nine months ended July 31, 2014 compared to $163 million in the same period of 2013. We expect that total capital expenditures for the current year will be approximately $210 million. In the nine months ended July 31, 2014, there were $25 million of purchases of equity method investments including a $3.5 million loan converted to equity compared with $36 million of purchases of investments including $21 million for equity method investments in the same period last year. Proceeds from the sale of investments was $1 million and $11 million in the nine months ended July 31, 2014 and 2013, respectively. In the nine 41-------------------------------------------------------------------------------- Table of Contents months ended July 31, 2014, there were $3 million of business acquisitions and intangibles assets, net of cash acquired, compared to $11 million in same period last year. On April 30, 2014, Agilent entered into a binding sales contract with real estate developers to sell land in the U.K. The contract calls for proportionate transfers and payments of three separate land tracts totaling approximately $34 million in May 2014, November 2015 and November 2016. Under the authoritative accounting guidance the full accrual method will be used to account for these transactions and gains on the sales recognized at each sale and payment date. In the three and nine months ended July 31, 2014 we recognized $11 million gain on sale of land in respect of the first of three land tracts in selling, general and administrative expenses. The property transfers to Keysight at distribution and the two remaining future payments in November 2015 and November 2016 from the developers will become due to and collected by Keysight. Net Cash Used in Financing Activities Net cash used in financing activities for the nine months ended July 31, 2014 was $ 658 million compared to cash used of $560 million for the same period of 2013. Treasury stock repurchases On January 16, 2013, our board of directors approved a share-repurchase program (the "2013 repurchase program"). The 2013 repurchase program authorized the use of up to $500 million to repurchase shares of the company's common stock in open market transactions. On May 14, 2013, we announced that our board of directors authorized an increase of $500 million to the 2013 repurchase program bringing the cumulative authorization to $1 billion. As of July 31, 2014, there were no remaining amounts to be repurchased under the 2013 program. On November 22, 2013 we announced that our board of directors had authorized a new share repurchase program effective upon the conclusion of the company's $1 billion repurchase program. The new program is designed to reduce or eliminate dilution resulting from issuance of stock under the company's employee equity incentive programs to target maintaining a weighted average share count of approximately 335 million diluted shares. For the nine months ended July 31, 2014, we repurchased 4 million shares for $200 million. For the nine months ended July 31, 2013, 20 million shares were repurchased for $900 million. All such shares and related costs are held as treasury stock and accounted for using the cost method. Dividends During the nine months ended July 31, 2014, we paid cash dividends of $0.396 per common share or $132 million on the company's common stock. During the nine months ended July 31, 2013, we paid cash dividends of $0.34 per common share or $117 million on the company's common stock. The timing and amounts of any future dividends are subject to determination and approval by our board of directors. Credit Facilities and Short-term loans On October 20, 2011, we entered into a five-year credit agreement, which provides for a $400 million unsecured credit facility that will expire on October 20, 2016. The company may use amounts borrowed under the facility for general corporate purposes. For the nine months ended July 31, 2014 we borrowed $50 million under the facility and repaid $50 million by July 31, 2014. As of July 31, 2014 the company had no borrowings outstanding under the facility. We were in compliance with the covenants for the credit facilities during the nine months ended July 31, 2014. As a result of the Dako acquisition, we have a credit facility in Danish Krone equivalent of $9 million with a Danish financial institution. As of July 31, 2014 the company had no borrowings outstanding under the facility. On July 10, 2014, a wholly owned subsidiary of Agilent in India entered into a short-term loan agreement with a financial institution, which provides up to $50 million of unsecured borrowings. On July 25, 2014, we borrowed $35 million against the loan agreement at an interest rate of 9.95 percent per annum. The loan will be used for general corporate purposes on a short-term basis and interest will be paid monthly. 42-------------------------------------------------------------------------------- Table of Contents Long-term debt On July 14, 2014, we settled the redemption of the outstanding aggregate principal amount of our 5.5% senior notes ("2015 senior notes") due September 14, 2015, that had been called for redemption on June 12, 2014. The redemption price of approximately $528 million included the $500 million principal amount and a $28 million prepayment penalty. The prepayment penalty less full amortization of previously deferred interest rate swap gain of approximately $8 million was disclosed in other income (expense), net in the condensed consolidated statement of operations. The amortization of the interest rate swap gain has been recognized as an adjustment to reconcile net income to net cash provided by operating activities in the condensed consolidated statement of cash flows. We also paid accrued and unpaid interest of $9 million on the 2015 senior notes up to but not including the redemption date. There have been no changes to the principal, maturity, interest rates and interest payment terms of the outstanding senior notes and mortgage debt in the nine months ended July 31, 2014 as compared to the senior notes and mortgage debt as described in our Annual Report on Form 10-K for the fiscal year ended October 31, 2013, except for the repayment of the 2015 senior notes mentioned above. Other As of July 31, 2014 our contractual obligations under "other purchase commitments" were approximately $96 million for the next fiscal year as compared to $70 million at October 31, 2013. The increase is due to additional contracts associated with our pre-separation expenditures and the duplication of a number of contracts related to the separation activities of our electronic measurement business on August 1, 2014. There were no other material changes from our 2013 Annual Report on Form 10-K, to our contractual commitments in the first nine months of 2014. We have contractual commitments for non-cancelable operating leases. We have no other material non-cancelable guarantees or commitments. Other long-term liabilities include $321 million and $341 million of liabilities related to uncertain tax positions as of July 31, 2014 and October 31, 2013, respectively. We are unable to accurately predict when these amounts will be realized or released. However, it is reasonably possible that there could be significant changes to our unrecognized tax benefits in the next twelve months due to either the expiration of a statute of limitations or a tax audit adjustment. |