AVANOS MEDICAL, INC. - Quarter Report: 2018 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2018

OR

For the transition period from ________ to ________

Commission file number 001-36440

AVANOS MEDICAL, INC.

(Exact name of registrant as specified in its charter)

5405 Windward Parkway

Suite 100 South

Alpharetta, Georgia

30004

(Address of principal executive offices)

(Zip code)

(678) 425-9273

(Registrant's telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒    No  ☐

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

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

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

As of October 31, 2018 there were 47,428,448 shares of the Corporation’s common stock outstanding.

Table of Contents

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PART I – FINANCIAL INFORMATION

AVANOS MEDICAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED INCOME STATEMENTS

(in millions, except per share amounts)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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AVANOS MEDICAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in millions)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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AVANOS MEDICAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in millions, except share data)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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AVANOS MEDICAL, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED CASH FLOW STATEMENTS

(in millions)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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AVANOS MEDICAL, INC. AND SUBSIDIARIES

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Background and Basis of Presentation

Avanos Medical, Inc., formerly Halyard Health, Inc., is a medical technology company that operates its business through its Medical Devices business segment. References to “Avanos,” “Company,” “we,” “our” and “us” refer to Avanos Medical, Inc.

On April 30, 2018, we closed the sale of our S&IP business, including the name “Halyard Health” (and all variations thereof and related intellectual property rights). Accordingly, the Company’s name was changed from “Halyard Health, Inc.” to “Avanos Medical, Inc.” effective June 30, 2018.

Avanos is a medical technology company focused on delivering clinically superior breakthrough medical device solutions to improve patients’ quality of life. We are committed to addressing some of today’s most important healthcare needs, such as reducing the use of opioids while helping patients move from surgery to recovery.

Interim Financial Statements

We prepared the accompanying condensed consolidated financial statements according to accounting principles generally accepted in the United States (“GAAP”) for interim financial information and the instructions to the Quarterly Report on Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements, and the condensed consolidated financial statements in this Quarterly Report on Form 10-Q should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2017. Our unaudited interim condensed consolidated financial statements contain all necessary material adjustments, which are of a normal and recurring nature, to fairly state our financial condition, results of operations and cash flows for the periods presented.

Use of Estimates

Preparation of our condensed consolidated financial statements in accordance with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net sales and expenses during the reporting periods. Estimates are used in accounting for, among other things, distributor rebate accruals, future cash flows associated with impairment testing for goodwill and long-lived assets, loss contingencies, and deferred tax assets and potential income tax assessments. Actual results could differ from these estimates, and the effect of the difference could be material to our financial statements. Changes in these estimates are recorded when known.

Annual Goodwill Impairment Test

We test goodwill for impairment annually or more frequently whenever events or circumstances more likely than not indicate that the fair value of the reporting unit may be below its carrying amount. We operate as a single operating segment with one reporting unit, and accordingly, the goodwill impairment test was based on an evaluation of the fair value of our Company as a whole, using a market capitalization approach.

We completed our annual impairment test as of July 1, 2018, and based on a market capitalization approach, we determined that our fair value substantially exceeds the net carrying value of our reporting unit.

Revenue Recognition

Sales revenue is recognized at a point in time, which is upon shipment or upon delivery of our products to unaffiliated customers, depending on shipping terms. Accordingly, control of the products transfers to the customer in accordance with the transaction's shipping terms. Sales revenue is recognized for the amount of consideration that we expect to be entitled to in exchange for our products. Sales are reported net of estimated cash discounts, returns, rebates and incentives, each as described below, and freight allowed. Taxes imposed by governmental authorities, such as sales taxes or value-added taxes, are excluded from net sales.

We provide medical products to distributors or end-user customers under supply agreements under which customers may place purchase orders for a variety of our products at specified pricing over a specified term, usually three years. While our sales and marketing efforts are directed to hospitals or other healthcare providers, our products are generally sold through third-party distribution channels.

Under our contracts with customers, our performance obligations are normally limited to shipment or delivery of products to a customer upon receipt of a purchase order. We bill our customers, depending on shipping terms, upon shipment or delivery of the products to the customer.

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Amounts billed are typically due within 30 days, with a 1% discount allowed for distributors if payment is made within 15 days. We estimate cash discounts based on historical experience and record the cash discounts as an allowance to trade receivables. The differences between estimated and actual cash discounts are normally not material.

We allow for returns within a specified period of time following the customers' receipt of the goods and estimate an allowance to trade receivables for returns based on historical experience. The differences between estimated and actual returns are normally not material.

Our contracts provide for forms of variable consideration including rebates, incentives and pricing tiers, each of which are described below:

Rebates - We provide for rebates to distributors for estimated historical differences between list prices and average end-user customer prices and the quantity of products expected to be sold to specific end-user customers. We maintain a liability for the estimated rebates that have been earned but unpaid. Differences between estimated and actual rebates are normally not material.

Incentives - Incentives include fees paid to group purchasing organizations ("GPOs") or distributors in conjunction with the sales of our products to end-user customers. We estimate our incentive liability based on historical experience. Differences between estimated and actual incentives are normally not material.

Pricing tiers - In certain of our contracts, pricing is dependent on volumes purchased. Pricing is lower for customers who purchase higher volumes. Customers are placed in a pricing tier based on expected purchase volume, which is developed primarily using the customer's purchase history. Depending on the customer's purchases, we may move the customer up or down a tier. Pricing in the new pricing tier is applied to purchase orders prospectively. There are no retrospective adjustments based on movements between pricing tiers.

See Note 5, "Supplemental Balance Sheet Information" for disclosure of our allowances for cash discounts, sales returns and doubtful accounts, and accrued rebates and incentives as of September 30, 2018 and December 31, 2017.

Recently Adopted Accounting Pronouncements

Effective January 1, 2018, we adopted Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers, which provides a principles-based, five-step approach to measure and recognize revenue from contracts with customers. Adoption of this ASU requires substantial additional disclosures, but did not have a material effect on our financial position, results of operations or cash flows.

Recently Issued Accounting Pronouncements

In August 2018, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2018-15, Intangibles – Goodwill and Other – Internal Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That is a Service Contract. This ASU is intended to reduce complexity by aligning the requirements for capitalizing implementation costs incurred in cloud-based arrangements with the requirements for capitalization of costs incurred to develop internal-use software. Any implementation costs in cloud-based arrangements would then be amortized over the term of the service contract. This ASU is effective for annual periods, and interim periods within those annual periods beginning after December 15, 2019, with early adoption permitted. We do not expect adoption of this ASU to have a material effect on our financial position, results of operations or cash flows.

In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement. This ASU removes certain disclosure requirements regarding the amounts and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy and the policy for timing of transfers between the levels. The ASU also adds disclosure requirements regarding unrealized gains and losses included in Other Comprehensive Income for recurring Level 3 fair value measurements and regarding the range and weighted average of unobservable inputs used in Level 3 fair value measurements. This ASU is effective for annual periods and interim periods within those annual periods beginning after December 15, 2019. The removal of certain disclosures is to be applied retrospectively for all periods presented, but the additional required disclosures are to be prospectively applied, and early application is permitted. We do not expect any transfers between Level 1 and Level 2 of the fair value hierarchy, and as of September 30, 2018, we have no assets or liabilities with fair value measurements in Level 3 of the fair value hierarchy. Accordingly, we do not expect adoption of this ASU to have a material effect on our financial position, results of operations or cash flows.

In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting. This ASU expands the scope of Topic 718 to include accounting for share-based payments for acquiring goods and services from non-employees except for specific guidance on assumptions used in an option pricing model and expense attribution. ASU 2018-07 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018, with early adoption permitted. We currently do not have any stock-based instruments outstanding to non-employees and do not anticipate any such awards in the foreseeable future. Accordingly, we do not expect adoption of this ASU to have a material effect on our financial position, results of operations or cash flows.

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In February 2018, the FASB issued ASU No. 2018-02, Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This ASU is intended to help companies reclassify certain stranded income tax effects in accumulated other comprehensive income (“AOCI”) resulting from the Tax Cuts and Jobs Act of 2017 (the “Act”), which was enacted in December 2017. ASU 2018-02 provides for the elimination of stranded tax effects of the Act by allowing reclassification of stranded tax effects from AOCI to retained earnings. This ASU is applicable only to tax effects relating to the Act, and the existing guidance regarding effects of other changes in tax laws is not affected. This ASU is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018, with early adoption permitted in any interim period for which financial statements have not yet been issued. Adoption of this ASU is not expected to have a material effect on our financial position, results of operations and cash flows.

In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging - Targeted Improvements to Accounting for Hedging Activities. This ASU is intended to improve the financial reporting and presentation of hedging relationships and the economic results of risk management activities in financial statements. The amendments in ASU 2017-12 better align risk management activities and financial reporting for hedging relationships through changes to both the designation and measurement guidance for qualifying hedging relationships and the presentation of hedge results. In addition, the amendments permit hedge accounting for risk components involving non-financial and interest rate risks and contains other targeted improvements to simplify the application of hedge accounting. This ASU is effective for annual periods, and interim periods within those annual periods beginning after December 15, 2018, with early adoption permitted in any interim period following the issuance of this ASU. The provisions of this ASU should be applied to existing hedging relationships as of the beginning of the fiscal year of adoption. All other presentation and disclosure requirements are to be applied prospectively. We do not expect adoption of this ASU to have a material effect on our financial position, results of operations and cash flows.

In February 2016, the FASB issued ASU No. 2016-02, Leases. This ASU, along with subsequent amendments, requires the recognition of assets and liabilities for leases with lease terms of more than twelve months. The recognition, measurement and presentation of expenses and cash flows arising from a lease will depend primarily on its classification as a finance or an operating lease, with the classification criteria for distinguishing between the two being similar to the classification criteria for distinguishing between capital and operating leases under current GAAP. However, unlike current GAAP, recognition of finance and operating leases on the balance sheet is required, and additional disclosures are required to help financial statement users better understand the amount, timing and uncertainty of cash flows arising from leases. This ASU requires modified retrospective application for existing leases. This ASU will be effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018, however, earlier application is permitted. The adoption of this ASU will have a material effect on our financial position, requiring us to recognize assets and liabilities for operating leases we have entered into for our principal executive offices as well as certain warehouse, manufacturing and distribution facilities globally. We have begun to evaluate and quantify the impact of our real estate and other leases, representing a majority of our future minimum lease payments. We will continue to evaluate the full impact that recognition of right-of-use assets and liabilities will have on our financial position, results of operations and cash flows.

On April 30, 2018, we closed the sale of our S&IP business, which included the name “Halyard Health” (and all variations thereof and related intellectual property rights) and our information technology (“IT”) system (the “Divestiture”) pursuant to an Amended and Restated Purchase Agreement (“Amended and Restated Purchase Agreement”) dated April 30, 2018 by and among us and certain of our affiliates and Owens & Minor, Inc. (“Buyer”). The purchase price paid for the Divestiture was $710.0 million in cash plus certain adjustments as provided in the Amended and Restated Purchase Agreement, and resulted in a gain of $89.9 million. A portion of the net proceeds have been used to retire the remainder of our senior secured term loan (see Note 7, “Debt”). The remaining net proceeds will continue to be invested in the business through acquisitions (see Note 4, “Business Acquisitions”) and organic growth.

We have entered into certain commercial agreements, including transition services agreements with the Buyer, pursuant to which we and the Buyer, and each company’s respective affiliates, will provide to each other various transitional services. The services will terminate no later than two years after the Divestiture. We have also entered into distribution agreements with the Buyer under which we will remain a limited risk distributor for S&IP products on the Buyer’s behalf for sales outside of the United States and Canada. As a result, we have $37.2 million of S&IP products included in “Prepaid expenses and other current assets” in the accompanying condensed consolidated balance sheet as of September 30, 2018. We anticipate the transition services and limited risk distributor arrangements will terminate no later than two years following the Divestiture.

As a result of the Divestiture, the results of operations from our S&IP business are reported in the accompanying condensed consolidated income statements as “Income from discontinued operations, net of tax” for the three and nine months ended September 30, 2018 and 2017, and the related assets and liabilities are classified as held-for-sale as of December 31, 2017 in the accompanying balance sheet. The remaining business is managed with one reportable business segment, the Medical Devices business.

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The following table summarizes the financial results of our discontinued operations for all periods presented herein (in millions):

In accordance with accounting principles generally accepted in the United States (“GAAP”), only expenses specifically identifiable and related to a business to be disposed may be allocated to discontinued operations. Accordingly, certain expenses that were historically presented as a component of the S&IP business were kept in continuing operations. There were no such expenses following the Divestiture in the three months ended September 30, 2018, and on a pre-tax basis, were $37.0 million in the nine months ended September 30, 2018. In the three and nine months ended September 30, 2017, these expenses, on a pretax basis, were $29.0 million and $86.3 million, respectively.

Details on assets and liabilities classified as held for sale in the accompanying condensed consolidated balance sheet as of December 31, 2017 are presented in the following table (in millions):

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Assets and liabilities held for sale as of December 31, 2017 were classified as current since we anticipated the closing of the Divestiture within one year. Other assets and liabilities held for sale that were not related to discontinued operations related primarily to our IT system. There were no assets or liabilities held for sale following the Divestiture on April 30, 2018.

The following table provides operating and investing cash flow information for our discontinued operations (in millions):

Organizational Alignment

In December 2017, in conjunction with the Divestiture (see Note 2, “Discontinued Operations”), we initiated the first phase of a multi-year restructuring plan (the “Plan”). The initial phase of the Plan is intended to align our organizational and management structure with our remaining Medical Devices business.

We now expect to incur up to $15.0 million of pre-tax costs, of which $6.0 million to $7.0 million is for employee severance and benefits and the remainder for third-party services and other related costs. These are cash costs that will be incurred as we execute the Plan, which we expect to substantially complete by the end of 2019.

Program-to-date, we have incurred $11.8 million of expenses, of which $1.9 million and $6.4 million, primarily for consulting services, were incurred in the three and nine months ended September 30, 2018, respectively, and are included in “Selling and general expenses” in the accompanying condensed consolidated income statement.

We have a liability associated with employee severance and benefits related to the organizational alignment phase of the Plan. The following table summarizes the accrual and payment activity (in millions):

Information Technology Systems

The sale price the Company received upon closing the Divestiture included the sale of the Company’s IT systems. The sale of the IT systems enables the Company to migrate to an IT platform that is more appropriate for its business and size. Accordingly, in March 2018, we launched the phase of the Plan to restructure and enhance the Company’s IT systems (the “ITS Plan”).

The Company expects to incur between $40 million and $50 million to implement the ITS Plan, of which $30 million to $35 million is expected to qualify for capitalization and the remainder, primarily consulting and other costs, will be expensed as incurred. The Company expects to substantially complete the ITS Plan by the end of 2019. We have incurred $3.2 million and $5.5 million of costs related to the ITS Plan in the three and nine months ended September 30, 2018 which are included in “Selling and general expenses” in the accompanying condensed consolidated income statement. In addition, as of September 30, 2018, we have capitalized $18.4 million of costs, including $1.8 million of capitalized internal labor costs, under the ITS Plan that are included in “Property, Plant and Equipment, net” in the accompanying condensed consolidated balance sheet.

On July 1, 2018, Avanos acquired Cool Systems, Inc. (the “Acquisition”) for $65.6 million, net of cash acquired, which was based on a purchase price of $65.0 million plus certain adjustments as provided in the purchase agreement. Cool Systems, Inc. is marketed as Game Ready® and is hereinafter referred to as “Game Ready.”

Game Ready develops, manufactures and markets the Game Ready® product line, used in pain management and rehabilitation of patients recovering from orthopedic surgery or sports-related injuries. Its product line includes the GRPro® 2.1 cold and

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compression therapy system; Med4 Elite^TM multi-modality therapy unit; ATX® Wraps; and a variety of product accessories, all of which complement our existing acute pain management portfolio.

The preliminary allocation of the purchase price was as follows (in millions):

The identifiable intangible assets include the following (in millions):

Game Ready’s results for the three months ended September 30, 2018 have been included in the accompanying condensed consolidated income statement. Game Ready’s net sales of $9.4 million and net loss of $0.5 million is included in the accompanying condensed consolidated income statement for the three months ended September 30, 2018. Efforts to fully integrate Game Ready into our business will be ongoing through the end of 2019.

The following unaudited pro forma information is presented in the table below for the three and nine months ended September 30, 2018 and 2017 as if the Acquisition had occurred on January 1, 2017 (in millions, except per share amounts):

The pro forma financial information has been adjusted to include the effects of the Acquisition, including acquisition-related costs, amortization of acquired intangibles and related tax effects. The pro-forma financial information is not necessarily indicative of the results of operations that would have been achieved had the Acquisition occurred on January 1, 2017.

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Accounts Receivable

Accounts receivable consist of the following (in millions):

Inventories

Inventories at the lower of cost (determined on the LIFO/FIFO or weighted-average cost methods) or market consist of the following (in millions):

Property, Plant and Equipment

Property, plant and equipment consists of the following (in millions):

As of September 30, 2018, construction in progress includes $18.4 million of costs capitalized in connection with migration to a new IT platform and enhancements to our IT environment. See Note 3 for further discussion of our IT-related restructuring and enhancement activities.

Depreciation expense was $3.5 million and $9.8 million for the three and nine months ended September 30, 2018 compared to $4.9 million and $14.9 million for the three and nine months ended September 30, 2017, respectively.

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Goodwill and Intangible Assets

The changes in the carrying amount of goodwill are as follows (in millions):

Intangible assets subject to amortization consist of the following (in millions):

As of December 31, 2017, we had $5.7 million of acquired in-process research and development projects which is now being amortized over its expected useful life following the deployment of the related products in the market during 2018. Amortization expense for intangible assets was $5.4 million and $14.6 million for the three and nine months ended September 30, 2018 compared to $5.1 million and $15.5 million for the three and nine months ended September 30, 2017, respectively. We estimate amortization expense for the remainder of 2018 and the following four years and beyond will be as follows (in millions):

Accrued Expenses

Accrued expenses consist of the following (in millions):

Accrued rebates represent amounts accrued for estimated incentives earned by customers.

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Other Long-Term Liabilities

Other long-term liabilities consist of the following (in millions):

The following fair value information is based on a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The three levels in the hierarchy used to measure fair value are:

Level 1: Unadjusted quoted prices in active markets accessible at the reporting date for identical assets and liabilities.

Level 2: Quoted prices for similar assets or liabilities in active markets. Quoted prices for identical or similar assets and liabilities in markets that are not considered active or financial instruments for which all significant inputs are observable, either directly or indirectly.

Level 3: Prices or valuations that require inputs that are significant to the valuation and are unobservable.

A financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant to the fair value measurement.

In the three months ended September 30, 2018, there were no transfers among Level 1, 2 or 3 fair value determinations.

The following table includes the fair value of our financial instruments for which disclosure of fair value is required (in millions):

Cash equivalents are recorded at cost, which approximates fair value due to their short-term nature. The fair value of the senior unsecured notes was based on observable market prices based on trading activity on a primary exchange. The fair value of our senior secured term loan was based on observed trading prices in a secondary market. In the second quarter of 2018, we repaid the remaining amount owed on our senior secured term loan. See Note 7, “Debt” for further details on the retirement of our senior secured term loan.

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As of September 30, 2018 and December 31, 2017, our debt balances were as follows (in millions):

Senior Secured Term Loan and Revolving Credit Facility

The senior secured term loan (the “Term Loan Facility”) is under a credit agreement that also includes a senior secured revolving credit facility that matures on October 31, 2019 which allows for borrowings up to $250 million, with a letter of credit sub-facility in an amount of $75 million and a swingline sub-facility in an amount of $25 million (the “Revolving Credit Facility,” and together with the Term Loan Facility, the “Senior Credit Facilities”).

In October 2018, we executed an amendment to the Term Loan Facility (the “Amendment”), under which the term of the Revolving Credit Facility has been extended by five years. In addition, the Amendment also provides for a reduction in the margin or “spread” that is charged over the available floating interest rates by 0.25% and a reduction in commitment fees for any unused portion of the line. In conjunction with the Amendment, we paid fees of $1.7 million which will be amortized over the term of the Revolving Credit Facility.

We repaid $40.0 million of our Term Loan Facility in the first quarter of 2018 pursuant to an excess cash flow provision in the credit agreement, resulting in an early debt extinguishment loss of $0.6 million. Using a portion of the proceeds from the Divestiture, we repaid the remaining amount owed during the second quarter of 2018, resulting in an early debt extinguishment loss of $4.2 million. Accordingly, early debt extinguishment losses of $4.8 million are included in “Interest expense” in the accompanying condensed consolidated income statements for the nine months ended September 30, 2018. Notwithstanding the retirement of the Term Loan Facility, the Revolving Credit Facility remains and is secured by substantially all of our assets located in the United States and a certain percentage of our foreign subsidiaries’ capital stock.

Borrowings under the Revolving Credit Facility bear interest, at our option, at either (i) a reserve-adjusted LIBOR rate, plus a margin ranging between 1.75% to 2.50% per annum (1.50% to 2.25% after the Amendment), depending on our consolidated total leverage ratio, or (ii) the base rate plus a margin ranging between 0.75% to 1.50% per annum (0.50% to 1.25% after the Amendment), depending on our consolidated total leverage ratio. The unused portion of the Revolving Credit Facility is subject to a commitment fee equal to (i) 0.25% per annum, when our consolidated total leverage ratio is less than 2.25 to 1.00 or (ii) 0.40% per annum (0.375% after the Amendment), otherwise.

To the extent we remain in compliance with certain financial covenants in our credit agreement, we have the ability to access our Revolving Credit Facility. As of September 30, 2018, we had no borrowings and letters of credit of $1.0 million outstanding under the Revolving Credit Facility.

Senior Unsecured Notes

The senior unsecured notes (the “Notes”) will mature on October 15, 2022 and interest accrues at a rate of 6.25% per annum and is payable semi-annually in arrears on April 15 and October 15 of each year. Unamortized debt discount and issuance costs are being amortized over the life of the Notes using the interest method, resulting in an effective interest rate of 6.52% as of September 30, 2018.

On December 22, 2017, new federal tax reform, the Tax Cuts and Jobs Act (the “Act”), was enacted in the United States, resulting in significant changes from previous tax law. The new legislation reduced the federal corporate income tax rate to 21% from 35% effective January 1, 2018. In the fourth quarter of 2017, we recorded a net benefit of $10.0 million on the date of enactment of the new legislation. The provisional amount related to the re-measurement of certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future was $16.0 million of benefit. The provisional

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amount related to the one-time transition tax on the mandatory deemed repatriation of foreign earnings was $7.0 million based on cumulative foreign earnings of $101.0 million. We also recorded a $1.0 million benefit related to the treatment of current year cash dividends in relation to the repatriation tax.

The adjustments to the deferred tax assets and liabilities, and the liability related to the transition tax are provisional amounts based on information available as of September 30, 2018. These amounts are subject to change as we obtain information necessary to complete the calculations. We continue to evaluate the provisional estimates, but as of September 30, 2018, we have not modified our original estimates made as of December 31, 2017. We will update the provisional amounts as we refine our estimates of cumulative temporary differences and our interpretations of the application of the new legislation. We expect to complete our analysis of the provisional items during the fourth quarter of 2018. As of September 30, 2018, updates to information available at December 31, 2017 have been obtained, but our updates to the provisional estimates do not differ significantly from amounts previously recorded.

On December 22, 2017, Staff Accounting Bulletin No. 118 (“SAB 118”) was issued to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Act. In accordance with SAB 118, we have determined that the $16.0 million of deferred tax benefit recorded in connection with the re-measurement of certain deferred tax assets and liabilities, the $7.0 million of current tax expense recorded in connection with the transition tax on the mandatory deemed repatriation of foreign earnings and the $1.0 million benefit related to the treatment of current year cash dividends in relation to the repatriation tax are provisional amounts and reasonable estimates at December 31, 2017. The impact of the Act may differ from this estimate, due to, among other things, changes in interpretations we have made, guidance that may be issued and actions we may take as a result of the Act. Additional work is necessary for a more detailed analysis of our deferred tax assets and liabilities and our historical foreign earnings as well as potential correlative adjustments.

The Act subjects a U.S. shareholder to tax on Global Intangible Low Tax Income (“GILTI”) earned by certain foreign subsidiaries. The FASB Staff Q&A, Topic 740, No. 5, Accounting for GILTI, states that an entity can make an accounting policy election to either recognize deferred taxes for temporary basis differences expected to reverse as GILTI in future years or to provide for the tax expense related to GILTI in the year the tax is incurred as a period expense only. Given the complexity of the GILTI provisions, the Company is still evaluating the effects of the GILTI provisions and has not yet determined its accounting policy. As of September 30, 2018, the Company has included estimated GILTI effects in our calculation of tax expense for the quarter. The Company has not provided deferred taxes related to GILTI as of September 30, 2018.

At December 31, 2017, prior to the calculation of the transition tax on the mandatory deemed repatriation, U.S. income taxes and foreign withholding taxes had not been provided on $151.0 million of current and prior year undistributed earnings of subsidiaries operating outside the U.S. These earnings, which are considered to be invested indefinitely, would become subject to income tax if they were remitted as dividends, were lent to one of our U.S. entities or if we were to sell our stock in the subsidiaries.

While the provisional transition tax of approximately $7.0 million resulted in the reduction of the excess amount of financial reporting over the tax basis in our foreign subsidiaries, we have not completed our analysis of the Act’s impact as an actual repatriation from our non-U.S. subsidiaries could still be subject to additional foreign withholding taxes and U.S. state taxes. We have not completed our analysis of our global working capital and cash requirements and the potential tax liabilities attributable to a repatriation. Therefore, we have not made a provisional estimate of the deferred taxes attributable to repatriation. We will record the tax effects of any change in our prior assertion with respect to these investments, and disclose any unrecognized deferred tax liability for temporary differences related to our foreign investments, if practicable, in the period that we are first able to make a reasonable estimate, no later than December 2018.

The income tax provision was $0.8 million compared to a benefit of $7.6 million in the three months ended September 30, 2018 and 2017, respectively, and the corresponding effective tax rates were 16.0% and 42.7%, respectively. The income tax benefit was $2.9 million compared to a benefit of $25.5 million in the nine months ended September 30, 2018 and 2017, respectively, and the corresponding effective tax rates were 33.3% and 41.1%, respectively. The changes in the tax rate are primarily due to the effects of the Act.

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The changes in the components of Accumulated Other Comprehensive Income (“AOCI”), net of tax, are as follows (in millions):

The changes in the components of AOCI, including the tax effect, are as follows (in millions):

Aggregate stock-based compensation expense for the three and nine months ended September 30, 2018 was $2.4 million and $8.0 million, respectively. The expense for the nine months ended September 30, 2018 is net of a Divestiture-related forfeiture benefit of $1.9 million that was recognized when employees conveyed to the Buyer upon closing. Stock-based compensation expense was $2.1 million and $11.9 million in the three and nine months ended September 30, 2017, respectively.

Stock-based compensation expense related to stock options in the three and nine months ended September 30, 2018 was $0.3 million and $1.9 million, respectively. Year-to-date expense is net of $0.4 million of Divestiture-related forfeitures. Stock-based compensation expense from stock options was $0.1 million and $3.5 million in the three and nine months ended September 30, 2017, respectively.

Expense related to time-based restricted share units in the three and nine months ended September 30, 2018 was $0.7 million and $2.8 million, respectively. Year-to-date expense is net of $0.9 million of Divestiture-related forfeitures. Expense from time-based restricted share units was not material in the three months ended September 30, 2017 and was $3.1 million in the nine months ended September 30, 2017.

Stock-based compensation expense related to performance-based restricted share units in the three and nine months ended September 30, 2018 was $1.4 million and $3.3 million, respectively. Year-to-date expense is net of $0.6 million of Divestiture-related forfeitures. Expense from performance-based restricted share units was $2.0 million and $5.3 million in the three and nine months ended September 30, 2017, respectively.

The stock-based compensation expense amounts above include amounts allocated to discontinued operations. Most of the Divestiture-related benefit is included in discontinued operations. Accordingly, stock-based compensation expense allocated to discontinued operations was a net benefit of $1.9 million in the nine months ended September 30, 2018. Stock-based compensation expense allocated to discontinued operations was $0.5 million and $1.2 million in the three and nine months ended September 30, 2017, respectively.

We are subject to various legal proceedings, claims and governmental inspections, audits or investigations pertaining to issues such as contract disputes, product liability, tax matters, patents and trademarks, advertising, governmental regulations, employment and other matters, including the matters described below. Under the terms of the distribution agreement we entered into with Kimberly-Clark Corporation (“Kimberly-Clark”) prior to the spin-off, legal proceedings, claims and other liabilities that are primarily related to our business are generally our responsibility and we are obligated to indemnify and hold Kimberly-

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Clark harmless for such matters (“Indemnification Obligation”). We have incurred expenses of $3.7 million and $6.6 million related to these matters in the three and nine months ended September 30, 2018, respectively, compared to $3.6 million and $17.3 million in the three and nine months ended September 30, 2017, respectively.

Surgical Gown Litigation and Related Matters

Bahamas Surgery Center

We have an Indemnification Obligation for the matter styled Bahamas Surgery Center, LLC v. Kimberly-Clark Corporation and Halyard Health, Inc., No. 2:14-cv-08390-DMG-SH (C.D. Cal.) (“Bahamas”), filed on October 29, 2014. In that case, the plaintiff brought a putative class action asserting claims for common law fraud (affirmative misrepresentation and fraudulent concealment) and violation of California’s Unfair Competition Law (“UCL”) in connection with our marketing and sale of MicroCool surgical gowns.

On April 7, 2017, a jury returned a verdict for the plaintiff, finding that Kimberly-Clark was liable for $4 million in compensatory damages (not including prejudgment interest) and $350 million in punitive damages, and that Avanos was liable for $0.3 million in compensatory damages (not including prejudgment interest) and $100 million in punitive damages. Subsequently, the court also ruled on the plaintiff’s UCL claim and request for injunctive relief. The court found in favor of the plaintiff on the UCL claim but denied the plaintiff’s request for restitution. The court also denied the plaintiff’s request for injunctive relief.

On May 25, 2017, we filed three post-trial motions: a renewed motion for judgment as a matter of law; a motion to decertify the class; and a motion for new trial, remittitur, or amendment of the judgment. On March 30, 2018, the court ruled on the post-trial motions. The court denied all three, except it granted in part the motion to reduce the award of punitive damages to a 5 to 1 ratio with compensatory damages.

On April 11, 2018, the court issued an Amended Judgment in favor of the plaintiff and against us and Kimberly-Clark. The judgment against us is $0.3 million in compensatory damages and pre-judgment interest and $1.3 million in punitive damages. The judgment against Kimberly-Clark is $3.9 million in compensatory damages, $1.3 million in pre-judgment interest and $19.4 million in punitive damages.

On April 12, 2018, we filed a notice of appeal to the Ninth Circuit Court of Appeals. We intend to continue our vigorous defense of the Bahamas matter.

Kimberly-Clark Corporation

We have notified Kimberly-Clark that we have reserved our rights to challenge any purported obligation to indemnify Kimberly-Clark for the punitive damages awarded against them. In connection with our reservation of rights, on May 1, 2017, we filed a complaint in the matter styled Halyard Health, Inc. v. Kimberly-Clark Corporation, Case No. BC659662 (County of Los Angeles, Superior Court of California). In that case, we seek a declaratory judgment that we have no obligation, under the Distribution Agreement or otherwise, to indemnify, pay, reimburse, assume, or otherwise cover punitive damages assessed against Kimberly-Clark in the Bahamas matter, or any Expenses or Losses (as defined in the distribution agreement) associated with an award of punitive damages. On May 2, 2017, Kimberly-Clark filed a complaint in the matter styled Kimberly-Clark Corporation v. Halyard Health, Inc., Case No. 2017-0332-AGB (Court of Chancery of the State of Delaware). In that case, Kimberly-Clark seeks a declaratory judgment that (1) we must indemnify them for all damages, including punitive damages, assessed against them in the Bahamas matter, (2) we have anticipatorily and materially breached the Distribution Agreement by our failure to indemnify them, and (3) we are estopped from asserting, or have otherwise waived, any claim that we are not required to indemnify them for all damages, including punitive damages, that may be awarded in the Bahamas matter. On May 26, 2017, we moved to dismiss or stay Kimberly-Clark’s Delaware complaint, and on June 16, 2017, Kimberly-Clark moved for summary judgment. On September 12, 2017, the Delaware court granted our motion to stay Kimberly-Clark’s complaint and therefore did not take any action on Kimberly-Clark’s motion for summary judgment. We intend to vigorously pursue our case against Kimberly-Clark in California and to vigorously defend against their case against us in Delaware.

Government Investigation

In June 2015, we were served with a subpoena from the Department of Veterans Affairs Office of the Inspector General (“VA OIG”) seeking information related to the design, manufacture, testing, sale and promotion of MicroCool and other Company surgical gowns, and, in July 2015, we also became aware that the subpoena and an earlier VA OIG subpoena served on Kimberly-Clark requesting information about gown sales to the federal government are related to a United States Department of Justice (“DOJ”) investigation. In May 2016, April 2017 and September 2018, we received additional subpoenas from the DOJ seeking further information related to Company gowns. The Company is cooperating with the DOJ investigation.

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Shahinian

On October 12, 2016, after the DOJ and various States declined to intervene, a qui tam matter was unsealed and a complaint subsequently served on us in a matter styled U.S. ex rel. Shahinian, et al. v. Kimberly-Clark Corporation, No. 2:14-cv-08313-JAK-JPR (C. D. Cal.) (“Shahinian”), filed on October 27, 2014. The case alleges, among other things, violations of the federal and various state False Claims Acts in connection with the marketing and sale of certain surgical gowns. On March 8, 2017, Kimberly-Clark moved to dismiss the Shahinian complaint, and on July 14, 2017, the court granted Kimberly-Clark’s motion. The plaintiff then filed a second amended complaint, and on August 11, 2017, Kimberly-Clark moved to dismiss that one as well. On November 30, 2017, the court again granted Kimberly-Clark’s motion. The plaintiff then filed a third amended complaint. On January 18, 2018, Kimberly-Clark moved to dismiss that one too. On September 30, 2018, the court granted Kimberly-Clark’s motion with prejudice.

We may have an Indemnification Obligation for the Shahinian matter under the distribution agreement with Kimberly-Clark and have notified Kimberly-Clark that we reserve our rights to challenge the obligation to indemnify Kimberly-Clark for any damages or penalties which are not indemnifiable under applicable law or public policy. We intend to vigorously defend the remaining claims.

Kromenaker

On March 17, 2017, the DOJ submitted a filing declining to intervene in another qui tam matter, and the complaint was unsealed and subsequently served on Kimberly-Clark and Avanos. That matter is styled U.S. ex rel. Kromenaker v. Kimberly-Clark Corporation and Halyard Health, Inc., No. 1:15-cv-04413-SCJ (N. D. Ga.) (“Kromenaker”), filed on December 21, 2015. In that case, the plaintiff alleges, among other things, violations of the federal False Claims Act in connection with the marketing and sale of certain products, including feminine hygiene products, surgical gowns and endotracheal tubes. On June 12, 2017, Kimberly-Clark and Avanos moved to dismiss the complaint. On August 21, 2017, Kromenaker filed an amended complaint, and on September 20, 2017, Kimberly-Clark and Avanos filed motions to dismiss it.

We may have an Indemnification Obligation for certain parts of this matter under the distribution agreement with Kimberly-Clark and have notified Kimberly-Clark that we reserve our rights to challenge the obligation to indemnify Kimberly-Clark for any damages or penalties which are not indemnifiable under applicable law or public policy. We intend to vigorously defend this matter.

Jackson

We were served with a complaint in a matter styled Jackson v. Halyard Health, Inc., Robert E. Abernathy, Steven E. Voskuil, et al., No. 1:16-cv-05093-LTS (S.D.N.Y.), filed on June 28, 2016. In that case, the plaintiff brings a putative class action against the Company, our former Chief Executive Officer, our Chief Financial Officer and other defendants, asserting claims for violations of the Securities Exchange Act, Sections 10(b) and 20(a). The plaintiff alleges that the defendants made misrepresentations and failed to disclose certain information about the safety and effectiveness of our MicroCool gowns and thereby artificially inflated the Company’s stock prices during the respective class periods. The alleged class period for purchasers of Kimberly-Clark securities who subsequently received Avanos securities is February 25, 2013 to October 21, 2014, and the alleged class period for purchasers of Avanos securities is October 21, 2014 to April 29, 2016. On February 16, 2017, we moved to dismiss the case. On March 30, 2018, the court granted our motion to dismiss and entered judgment in our favor. On April 27, 2018, the plaintiff filed a Motion for Relief from the Judgment and for Leave to Amend. We intend to continue our vigorous defense of this matter.

Richardson, Chiu and Pick

We were also served with a complaint in a matter styled Margaret C. Richardson Trustee of the Survivors Trust Dated 6/12/84 for the Benefit of the H&M Richardson Revocable Trust v. Robert E. Abernathy, Steven E. Voskuil, et al., No. 1:16-cv-06296 (S. D. N. Y.) (“Richardson”), filed on August 9, 2016. In that case, the plaintiff sues derivatively on behalf of Avanos Medical, Inc., and alleges that the defendants breached their fiduciary duty, were unjustly enriched, and violated Section 14(A) of the Securities and Exchange Act in connection with our marketing and sale of MicroCool gowns. We were also served with a complaint in a matter styled Kai Chiu v. Robert E. Abernathy, Steven E. Voskuil, et al, No. 2:16-cv-08768 (C.D. Cal.), filed on November 23, 2016. In that case, the plaintiff sues derivatively on behalf of Avanos Medical, Inc., and makes allegations and brings causes of action similar to those in Richardson, but the plaintiff also adds causes of action for abuse of control, gross mismanagement, and waste of corporate assets. We were also served with a complaint in a matter styled Lukas Pick v. Robert E. Abernathy, Steven E. Voskuil, et al. No. e:18-cv-00295 (D. Del.) filed on February 21, 2018. In that case, the plaintiff sues derivatively on behalf of Avanos Medical, Inc. and makes allegations and brings causes of action similar to those in Richardson and Chiu. We intend to vigorously defend these matters.

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Medline Industries

We were also served with a complaint in the matter styled Medline Industries, Inc. v. Kimberly-Clark Corporation, Halyard Health, Inc., et al., No. 2:16-cv-08571 (C. D. Cal.), filed on November 17, 2016. In that case, the plaintiff makes allegations similar to those in Bahamas and Shahinian and brings causes of action under federal and state false advertising laws and state unfair competition laws. On March 31, 2017 we moved to dismiss certain of Medline’s claims and to transfer any surviving claims from California to Georgia. On June 2, 2017 the court granted our motion to transfer the case to Georgia and denied without prejudice our motion to dismiss. On June 30, 2017 now before the court in Georgia and with the case re-styled as Medline Industries, Inc. v. Kimberly-Clark Corporation, Halyard Health, Inc., et al., No. 1:17-cv-02032 (N. D. Ga.), Kimberly-Clark and Avanos filed renewed motions to dismiss certain of Medline’s claims. On February 28, 2018, the court granted our motion to dismiss. On March 14, 2018, Medline filed a second amended complaint. On March 28, 2018, we filed our answer and counterclaims. The counterclaims allege violations of false advertising law and state unfair competition laws. On May 9, 2018, Medline filed its answer to our counterclaims.

We may have an Indemnification Obligation for this matter under the distribution agreement with Kimberly-Clark and have notified Kimberly-Clark that we reserve our rights to challenge the obligation to indemnify Kimberly-Clark for any damages or penalties which are not indemnifiable under applicable law or public policy. We intend to vigorously defend this matter.

Naeyaert

On April 13, 2017, Kimberly-Clark was served with a complaint in the matter styled Christopher Naeyaert v. Kimberly-Clark Corporation, et al., No. PSC 1603503 (County of Riverside, Superior Court of California), filed on July 21, 2016. In that case, the plaintiff makes allegations similar to those in Bahamas and brings causes of action similar to those in Bahamas, except the allegations and causes of action relate to the Ultra surgical gown. On June 5, 2017, Kimberly-Clark moved to dismiss the complaint. On August 21, 2017, Naeyaert filed an amended complaint and on September 18, 2017, Kimberly-Clark filed a motion to dismiss the amended complaint. On September 28, 2018, the court granted in part Kimberly-Clark’s motion but allowed Naeyaert leave to amend his complaint. On October 12, 2018, Naeyaert filed a Third Amended Complaint.

We may have an Indemnification Obligation for this matter under the distribution agreement with Kimberly-Clark and have notified Kimberly-Clark that we reserve our rights to challenge the obligation to indemnify Kimberly-Clark for any damages or penalties which are not indemnifiable under applicable law or public policy. We intend to vigorously defend this matter.

Patent Litigation

We operate in an industry characterized by extensive patent litigation and competitors may claim that our products infringe upon their intellectual property. Resolution of patent litigation or other intellectual property claims is typically time consuming and costly and can result in significant damage awards and injunctions that could prevent the manufacture and sale of the affected products or require us to make significant royalty payments in order to continue selling the affected products. At any given time we may be involved as either a plaintiff or a defendant in a number of patent infringement actions, the outcomes of which may not be known for prolonged periods of time.

General

While we maintain general and professional liability, product liability and other insurance, our insurance policies may not cover all of these matters and may not fully cover liabilities arising out of these matters. In addition, we may be obligated to indemnify our directors and officers against these matters.

Although the results of litigation and claims cannot be predicted with certainty, we believe that the ultimate resolution of these matters will not materially impact our liquidity, access to capital markets or ability to conduct our daily operations.

As of September 30, 2018, we have an accrued liability for the matters described herein. The accrued liability is included in “Accrued Expenses” in the accompanying condensed consolidated balance sheet. Our estimate of these liabilities is based on facts and circumstances existing at this time, along with other variables. Factors that may affect our estimate include, but are not limited to: (i) changes in the number of lawsuits filed against us, including the potential for similar, duplicate or “copycat” lawsuits filed in multiple jurisdictions, including lawsuits that bring causes or action or allege violations of law with regard to additional products; (ii) changes in the legal costs of defending such claims; (iii) changes in the nature of the lawsuits filed against us, (iv) changes in the applicable law governing any legal claims against us; (v) a determination that our assumptions used in estimating the liability are no longer reasonable; and (vi) the uncertainties associated with the judicial process, including adverse judgments rendered by courts or juries. Thus, the actual amount of these liabilities for existing and future claims could be different than the accrued amount. Additionally, the above matters, regardless of the outcome, could disrupt our business and result in substantial costs and diversion of management attention.

Environmental Compliance

We are subject to federal, state and local environmental protection laws and regulations with respect to our business operations and are operating in compliance with, or taking action aimed at ensuring compliance with, these laws and regulations. None of

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our compliance obligations with environmental protection laws and regulations, individually or in the aggregate, is expected to have a material adverse effect on our business, financial condition, results of operations or liquidity.

Basic EPS is calculated by dividing net income by the weighted average number of common shares outstanding during each period. Diluted earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding and the effect of all dilutive common stock equivalents outstanding during each period, as determined using the treasury stock method.

The calculation of basic and diluted earnings per share for the three and nine months ended September 30, 2018 and 2017 is set forth in the following table (in millions, except per share amounts):

Restricted share units (“RSUs”) contain provisions allowing for the equivalent of any dividends paid on common stock during the restricted period to be reinvested into additional RSUs at the then fair market value of the common stock on the date the dividends are paid. Such awards are to be included in the EPS calculation under the two-class method. Currently, we do not anticipate any cash dividends for the foreseeable future and our outstanding RSU awards are not material in comparison to our weighted average shares outstanding. Accordingly, all EPS amounts reflect shares as if they were fully vested and the disclosures associated with the two-class method are not presented herein.

In the nine months ended September 30, 2018, 1.2 million of potentially dilutive stock options and restricted shares units were excluded from the computation of earnings per share as their effect would have been anti-dilutive. In the three and nine months ended September 30, 2017, 0.8 million and 0.7 million, respectively, of potentially dilutive stock options and restricted share units were excluded from the computation of earnings per share computation due to losses from continuing operations, which would cause the shares to become anti-dilutive.

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Information concerning unaudited consolidated operations by business segment is presented in the following table (in millions):

Disaggregated Revenue

Our management evaluates the product category sales within our reportable business segment. Net sales by product category is presented in the following table (in millions):

Due to the nature of our business, we receive purchase orders for products under supply agreements which are normally fulfilled within three to four weeks. Our performance obligations under purchase orders are satisfied and revenue is recognized at a point in time, which is upon shipment or upon delivery of our products to unaffiliated customers, depending on shipping terms. Accordingly, we normally do not have transactions that give rise to material unfulfilled performance obligations.