BIO-TECHNE Corp - Quarter Report: 2018 December (Form 10-Q)

 

---

 

---

 

		Quarter Ended								Six Months Ended
		December 31,								December 31,
		2018				2017				2018				2017
Net sales		$	174,510			$	154,153			$	337,480			$	298,766
Cost of sales			61,492				52,319				116,859				99,064
Gross margin			113,018				101,834				220,621				199,702
Operating expenses:
Selling, general and administrative			63,603				63,775				130,655				122,064
Research and development			15,812				13,911				30,602				27,459
Total operating expenses			79,415				77,686				161,257				149,523
Operating income			33,603				24,148				59,364				50,179
Other income (expense)			(11,836	)			(2,417	)			(20,012	)			(5,480	)
Earnings before income taxes			21,767				21,731				39,352				44,699
Income tax expense (benefit)			4,211				(27,116	)			4,394				(20,011	)
Net earnings		$	17,556			$	48,847			$	34,958			$	64,710
Other comprehensive income:
Foreign currency translation adjustments			(8,464	)			1,524				(9,600	)			8,492
Unrealized gain (loss) on derivative instruments - cash flow hedges			(3,915	)			-				(3,915	)			-
Unrealized gain (loss) on available-for-sale investments			-				(8,582	)			-				(16,374	)
Other comprehensive (loss) income			(12,379	)			(7,058	)			(13,515	)			(7,882	)
Comprehensive income		$	5,177			$	41,789				21,443			$	56,828
Earnings per share:
Basic		$	0.46			$	1.30			$	0.93			$	1.73
Diluted		$	0.45			$	1.29			$	0.90			$	1.71
Cash dividends per common share:		$	0.32			$	0.32			$	0.64			$	0.64
Weighted average common shares outstanding:
Basic			37,766				37,449				37,732				37,412
Diluted			38,748				37,926				38,782				37,816

---

 

		December 31, 2018				June 30, 2018
ASSETS
Current assets:
Cash and cash equivalents		$	85,886			$	121,990
Short-term available-for-sale investments			70,647				59,764
Accounts receivable, less allowance for doubtful accounts of $1,012 and $839, respectively			113,283				120,296
Inventories			90,905				85,648
Other current assets			19,213				10,668
Total current assets			379,934				398,366
Property and equipment, net			145,262				145,348
Goodwill			706,355				597,890
Intangible assets, net			608,273				446,332
Other assets			5,008				5,266
Total assets		$	1,844,832			$	1,593,202
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Trade accounts payable		$	16,013			$	18,452
Salaries, wages and related accruals			19,677				23,710
Accrued expenses			25,862				20,361
Contract liabilities			8,396				8,109
Income taxes payable			4,984				8,878
Contingent portion of long-term debt obligations			12,500				-
Total current liabilities			87,432				79,510
Deferred income taxes			104,113				86,293
Long-term debt obligations, net of deferred financing costs of $388 and $0 respectively			532,869				339,000
Long-term contingent consideration payable			6,000				-
Other long-term liabilities			17,993				9,338
Shareholders' equity:
Common stock, par value $.01 per share; authorized 100,000,000; issued and outstanding 37,734,646 and 37,607,500, respectively			377				376
Additional paid-in capital			283,854				246,568
Retained earnings			895,205				876,931
Accumulated other comprehensive loss			(83,011	)			(44,814	)
Total shareholders' equity			1,096,425				1,079,061
Total liabilities and shareholders’ equity		$	1,844,832			$	1,593,202

---

 

		Six Months Ended
		December 31,
		2018				2017
CASH FLOWS FROM OPERATING ACTIVITIES:
Net earnings		$	34,958			$	64,710
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization			38,930				31,038
Costs recognized on sale of acquired inventory			1,869				582
Deferred income taxes			(9,106	)			(43,537	)
Stock-based compensation expense			18,426				8,839
Fair value adjustment to contingent consideration payable			(700	)			19,900
Fair value adjustment on available for sale investments			9,366				-
Other operating activity			2,340				1,556
Change in operating assets and operating liabilities, net of acquisition:
Accounts receivable			7,848				18,636
Inventories			(8,212	)			(7,513	)
Prepaid expenses			(2,258	)			1,321
Trade accounts payable and accrued expenses			5,385				(4,736	)
Salaries, wages and related accruals			(3,937	)			454
Income taxes payable			(8,898	)			(7,372	)
Net cash provided by operating activities			86,011				83,878
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions, net of cash acquired			(272,287	)			(10,644	)
Proceeds from maturities of available-for-sale investments			5,334				6,563
Purchases of available-for-sale investments			(26,000	)			(3,061	)
Purchases of property and equipment			(8,794	)			(11,608	)
Net cash used in investing activities			(301,747	)			(18,750	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Cash dividends			(24,151	)			(23,946	)
Proceeds from stock option exercises			18,860				6,699
Re-purchases of common stock			(15,404	)			-
Borrowings under credit agreement			580,000				25,000
Payments on credit agreement			(373,250	)			(6,000	)
Payments of contingent consideration			-				(35,000	)
Other financing			(4,731	)			(2,157	)
Net cash provided by (used in) financing activities			181,324				(35,404	)
Effect of exchange rate changes on cash and cash equivalents			(1,692	)			122
Net increase (decrease) in cash and cash equivalents			(36,104	)			29,846
Cash and cash equivalents at beginning of period			121,990				91,612
Cash and cash equivalents at end of period		$	85,886			$	121,458
Supplemental disclosure of cash flow information:
Cash paid for interest		$	10,812			$	3,630
Cash paid for income taxes		$	19,135			$	27,873

---

 

Note 1. Basis of Presentation and Summary of Significant Accounting Policies:

 

The interim consolidated financial statements of Bio-Techne Corporation and subsidiaries, (the Company) presented here have been prepared by the Company and are unaudited. They have been prepared in accordance with accounting principles generally accepted in the United States of America and with instructions to Form 10-Q and Article 10 of Regulation S-X. They reflect all adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods presented. All such adjustments are of a normal recurring nature.

 

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These interim unaudited condensed consolidated financial statements should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto for the fiscal year ended June 30, 2018, included in the Company's Annual Report on Form 10-K for fiscal year 2018. A summary of significant accounting policies followed by the Company is detailed in the Company's Annual Report on Form 10-K for fiscal year 2018. The Company follows these policies in preparation of the interim unaudited condensed consolidated financial statements.

 

Effective in the first quarter of fiscal year 2019, the Company changed its reportable segments due to changes in its underlying organizational model designed to better support the business following recent acquisitions and to facilitate global growth. The Company did not operate under the realigned reportable segment structure prior to fiscal year 2019. As a result, the Company’s new segment structure will focus on synergies between our existing businesses including sharing certain functions such as sales resources, with its five existing operating segments aggregated into two reportable segments as follows:

 

	●	“Diagnostics and Genomics” will consist of the ACD operating segment, the Diagnostics operating segment, and the ExosomeDx operating segment. As part of the realignment, ACD will now be referred to as the Genomics operating segment.
	●	“Protein Sciences” will consist of the Core Biotechnology operating segment and the Protein Platforms operating segment. As part of the realignment, Protein Platforms will now be referred to as the Analytical Solutions Division (ASD) operating segment and Core Biotechnology will now be referred to as the Reagent Solutions Division (RSD) operating segment.

 

Recently Adopted Accounting Pronouncements

 

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. The standard provides revenue recognition guidance for any entity that enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of non-financial assets, unless those contracts are within the scope of other accounting standards. The core principle of ASC 606 is that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

 

On  July 1, 2018, the Company adopted ASC 606 using the modified retrospective method for all contracts. Results for reporting periods beginning  July 1, 2018 are presented under ASC 606, while prior period amounts were not adjusted and continue to be reported in accordance with the Company’s historic accounting under Topic 605, Revenue Recognition.

 

The Company recorded a net increase to beginning retained earnings of $98,000 as of  July 1, 2018 due to the cumulative impact of adopting ASC 606. The impact to beginning retained earnings was primarily driven by the transition to over-time revenue recognition on custom development projects, partially offset by the deferral of revenue for unfulfilled performance obligations. The adoption of ASC 606 did not have a material impact on the Company’s consolidated financial statements as of and for the quarter and six month period ended  December 31, 2018 and, as a result, comparisons of revenues and operating profit performance between periods are not affected by the adoption of this ASU. Refer to Note 2 for additional disclosures required by ASC 606.

 

In January 2016, the FASB issued ASU No. 2016-01 Recognition and Measurement of Financial Assets and Financial Liabilities. The standard is intended to improve the recognition, measurement, presentation and disclosure of financial instruments. Among other changes, there will no longer be an available-for-sale classification for which changes in fair value are currently reported in other comprehensive income for equity securities with readily determinable fair values. Equity investments with readily determinable fair values will be measured at fair value with changes in fair value recognized in net income. ASU 2016-01 was effective for us on July 1, 2018 which required a cumulative effect adjustment to opening retained earnings to be recorded for equity investments with readily determinable fair values. As of the adoption date, we held publicly traded equity investments with a fair value of $54.3 million in a net unrealized gain position of $35.4 million, and having an associated deferred tax liability of $8.3 million. We recorded a cumulative-effect adjustment of $27.1 million to decrease Accumulated Other Comprehensive Income (AOCI) with a corresponding increase to retained earnings for the amount of unrealized gains, net of tax as of the beginning of fiscal year 2019. As a result of the implementation of ASU 2016-01, effective on July 1, 2018 unrealized gains and losses in equity investments with readily determinable fair values are recorded on the Consolidated Statement of Income within other (expense)income. We recorded a loss in other (expense)income of $7.2 million and $9.4 million for the quarter and six month period ended December 31, 2018 as a result of adopting this standard. The implementation of ASU 2016-01 is expected to increase volatility in our net income as the volatility previously recorded in Other Comprehensive Income (OCI) related to changes in the fair market value of available-for-sale equity investments will now be reflected in net income effective with the adoption date.

 

 

In February 2018, the FASB issued ASU No. 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. The standard allows companies to make an election to reclassify from Accumulated Other Comprehensive Income (AOCI) to retained earnings the stranded tax effects resulting from the Tax Cuts and Jobs Act of 2017. This ASU is effective for annual and interim periods beginning after December 15, 2018, which for us is July 1, 2019. Early adoption is permitted. We elected to early adopt ASU 2018-02 on July 1, 2018. We use a specific identification approach to release the income tax effects in AOCI. As a result of adopting this standard, we recorded a cumulative effect adjustment to increase AOCI by $2.4 million with a corresponding decrease to retained earnings. We recorded the impacts of adopting ASU 2018-02 prior to recording the impacts of adopting ASU 2016-01 and included state income tax related effects in the amounts reclassified to retained earnings.

 

The following table presents a summary of cumulative effect adjustments to retained earnings due to the adoption of new accounting standards on July 1, 2018 as noted above:

 

 

In January 2017, the FASB issued ASU No. 2017-01, Clarifying the Definition of a Business. The standard revises the definition of a business, which affects many areas of accounting such as business combinations and disposals and goodwill impairment. The revised definition of a business will likely result in more acquisitions being accounted for as asset acquisitions, as opposed to business combinations. We adopted this standard on July 1, 2018, applying the guidance to transactions occurring on or after this date.

 

In August 2017, the FASB issued ASU No. 2017-12, Targeted Improvements to Accounting for Hedging Activities. The standard changes the designation and measurement guidance for qualifying hedging relationships to better align financial reporting to risk management activities.  As part of the guidance, the entire change in fair value of a qualifying hedging instrument will be recorded within other comprehensive income which is then reclassified into earnings in the same period or periods during which the hedged item impacts earnings. Additionally, the gain or loss resulting from the hedging activity will be presented in the same income statement line item as the hedged item. The standard is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2018, which for us is July 1, 2019. Early adoption is permitted. We elected to early adopt ASU 2017-12 on October 1, 2018, prior to the Company entering into cash flow hedges as described in Note 5. The adoption of this standard did not have a material impact on our consolidated financial statements.

 

Pronouncements Issued But Not Yet Adopted

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which amends the existing guidance to require lessees to recognize lease assets and lease liabilities from operating leases on the balance sheet. This ASU is effective using the modified retrospective approach for annual periods and interim periods within those annual periods beginning after December 15, 2018, which for us is July 1, 2019. Early adoption is permitted. In July 2018, the FASB issued ASU No. 2018-10, Codification Improvements to Topic 842, Leases, which amends narrow aspects of the guidance in ASU No. 2016-02. We have established an implementation team to evaluate and identify the impact of the standard on our financial position, results of operations and cash flows. We are currently assessing our leasing arrangements and evaluating the impact of practical expedients. We are not able to quantify the impact of the standard at this time.

 

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments. The amendment in this update replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses on instruments within its scope, including trade and loan receivables and available-for-sale debt securities. This update is intended to provide financial statement users with more decision-useful information about the expected credit losses. This ASU is effective for annual periods and interim periods for those annual periods beginning after December 15, 2019, which for us is July 1, 2020. Entities may early adopt beginning after December 15, 2018. We are currently evaluating the impact of the adoption of ASU 2016-13 on our consolidated financial statements.

 

In August 2018, the FASB issued ASU No. 2018-15, Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. The standard aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. The accounting for the service element of a hosting arrangement that is a service contract is not affected by the new standard.  This ASU is effective for annual periods and interim periods for those annual periods beginning after December 15, 2019, which for us is July 1, 2020 and may be adopted retrospectively or prospectively to eligible costs incurred on or after the date the guidance is first applied. We are currently evaluating the impact of the adoption of ASU 2018-15 on our consolidated financial statements and anticipate that we will adopt the standard prospectively.

 

 

 

Note 2. Revenue Recognition:

 

Consumables revenues consist of single-use products and are recognized at a point in time following the transfer of control of such products to the customer, which generally occurs upon shipment. Instruments revenues typically consist of longer-lived assets that, for the substantial majority of sales, are recognized at a point in time in a manner similar to consumables. The vast majority of service revenues consist of extended warranty contracts, post contract support (“PCS”), and custom development projects that are recognized over time as either the customers receive and consume the benefits of such services simultaneously or the underlying asset being developed has no alternative use for the Company at contract inception and the Company has an enforceable right to payment for the portion of the performance completed. The remaining service revenues were not material to the period and consist of laboratory services recognized at point in time. Given the Company does not have significant historical experience collecting payments from Medicare or insurance providers, the Company considered the variable consideration for such services to be constrained as it would not be probable that a significant amount of revenue would not need to be reversed in future periods for the services provided. Accordingly, the Company did not record revenue upon completion of the performance obligation, but rather upon cash receipt, which was subsequent to the performance obligation being satisfied. Royalty revenues are based on net sales of the Company’s licensed products by a third party. We recognize royalty revenues in the period the sales occur using third party evidence. The Company has also elected the "right to invoice" practical expedient based on the Company's right to invoice a customer at an amount that approximates the value to the customer and the performance completed to date. 

 

The Company has elected the exemption to not disclose the unfulfilled performance obligations for contracts with an original length of one year or less and the exemption to exclude future performance obligations that are accounted under the sales-based or usage-based royalty guidance.  The Company's unfulfilled performance obligations were not material as of December 31, 2018. 

 

Contracts with customers that contain instruments may include multiple performance obligations. For these contracts, the Company allocates the contract’s transaction price to each performance obligation on a relative standalone selling price basis. Allocation of the transaction price is determined at the contracts’ inception.

 

Payment terms for shipments to end-users are generally net 30 days. Payment terms for distributor shipments may range from 30 to 90 days. Service arrangements commonly call for payments in advance of performing the work (e.g. extended warranty and service contracts), upon completion of the service (e.g. custom development manufacturing) or a mix of both.

 

Contract assets include revenues recognized in advance of billings. Contract assets are included within other current assets in the accompanying balance sheet as the amount of time expected to lapse until the company's right to consideration becomes unconditional is less than one year. We elected the practical expedient allowing us to expense costs of obtaining contracts less than one year that would otherwise be capitalized and amortized over the contract period. Contract assets as of December 31, 2018 are not material.

 

Contract liabilities include billings in excess of revenues recognized, such as those resulting from customer advances and deposits and unearned revenue on warranty contracts. Contract liabilities as of December 31, 2018 and June 30, 2018 were approximately $9.7 million and $9.3 million, respectively. Contract liabilities as of June 30, 2018 subsequently recognized as revenue during the quarter and six month period ended December 31, 2018 were approximately $2.0 million and $5.6 million, respectively. Contract liabilities in excess of one year are included in Other long-term liabilities on the balance sheet. 

 

Any claims for credit or return of goods must be made within 10 days of receipt. Revenues are reduced to reflect estimated credits and returns. Although the amounts recorded for these revenue deductions are dependent on estimates and assumptions, historically our adjustments to actual results have not been material.

 

Taxes collected from customers relating to product sales and remitted to governmental authorities are excluded from revenue. Amounts billed to customers for shipping and handling are included in revenue, while the related shipping and handling costs are reflected in cost of products. We have elected the practical expedient that allows us to account for shipping and handling activities that occur after the customer has obtained control of a good as a fulfillment cost, and we accrue costs of shipping and handling when the related revenue is recognized.

 

The following tables present our disaggregated revenue for the periods presented.

 

Revenue by type is as follows:

 

 

Revenue by geography is as follows:

 

 

 

 

Note 3. Selected Balance Sheet Data:

 

Inventories:

 

Inventories consist of (in thousands):

 

 

 

Property and Equipment:

 

Property and equipment consist of (in thousands): 

 

 

Intangible Assets:

 

Intangible assets consist of (in thousands): 

 

 

 

Changes to the carrying amount of net intangible assets for the six months ended December 31, 2018 consist of (in thousands):

 

 

The estimated future amortization expense for intangible assets as of December 31, 2018 is as follows (in thousands):

 

 

 

Goodwill:

 

Changes to the carrying amount of goodwill for the six months ended December 31, 2018 consist of (in thousands):

 

 

We evaluate the carrying value of goodwill in the fourth quarter of each fiscal year and between annual evaluations if events occur or circumstances change that would indicate a possible impairment. The Company performed a quantitative assessment for all of its reporting units during the fourth quarter of fiscal 2018. The quantitative assessment indicated that all of the reporting units had substantial headroom as of June 30, 2018.

 

No triggering events were identified during the six months ended December 31, 2018. There has been no impairment of goodwill since the adoption of Financial Accounting Standards Board (“FASB”) ASC 350 guidance for goodwill and other intangibles on July 1, 2002.

 

 

 

Note 4. Acquisitions:

 

We periodically complete business combinations that align with our business strategy. Acquisitions are accounted for using the acquisition method of accounting, which requires, among other things, that assets acquired and liabilities assumed be recognized at fair value as of the acquisition date and the results of operations of each acquired business are included in our Condensed Consolidated Statement of Earnings and Comprehensive Income from their respective dates of acquisition. Acquisition costs are recorded in selling, general and administrative expenses as incurred.

 

 

Quad Technologies

 

On July 2, 2018, the Company acquired QT Holdings Corporation (Quad) for approximately $20.5 million, net of cash acquired, plus contingent consideration of up to $51.0 million, subject to certain product development milestones and revenue thresholds. The goodwill recorded as a result of the acquisition represents the strategic benefits of growing the Company’s product portfolio and the expected revenue growth from increased market penetration. The goodwill is not deductible for income tax purposes. The business became part of the Protein Sciences reportable segment in the first quarter of fiscal year 2019.

 

Certain estimated fair values are not yet finalized and are subject to change, which could be significant. The Company expects to finalize by the end of the fourth quarter of fiscal year 2019 when we have completed our valuation models for acquired intangible assets, including the determination of related estimated useful lives, and finalized our income tax assessment of acquired net operating losses (NOLs). Amounts for intangible assets and related deferred tax liabilities, acquired NOLs, and goodwill also remain subject to change. The preliminary estimated fair values of the assets acquired and liabilities assumed are as follows (in thousands):

 

 

As summarized in the table, there were adjustments totaling $3.8 million to goodwill during the measurement period. These adjustments primarily relate to refinements made to acquired intangible asset cash flow models, an update in the discount rate used in the contingent consideration calculation based on refinements made in the acquired intangible asset cash flow models, and adjustments to preliminary deferred tax amounts based on updated assessments of the applicability of certain NOLs. 

 

Tangible assets and liabilities acquired were recorded at fair value on the date of close based on management's assessment. The purchase price allocated to developed technology was estimated based on management's forecasted cash inflows and outflows using a multi-period excess earnings method to calculate the fair value of assets purchased. The preliminary amount recorded for developed technology is being amortized with the expense reflected in cost of goods sold in the Condensed Consolidated Statement of Earnings and Comprehensive Income. The preliminary amortization periods for intangible assets acquired in fiscal 2019 are estimated to be 15 years for developed technology. The net deferred income tax liability represents the net amount of the estimated future impact of adjustments for costs to be recognized as intangible asset amortization, which is not deductible for income tax purposes offset by the deferred tax asset for the preliminary calculation of acquired NOLs.

 

Exosome Diagnostics

 

On August 1, 2018, the Company acquired Exosome Diagnostics, Inc. (ExosomeDx) for approximately $251.8 million, net of cash acquired, plus contingent consideration of up to $325.0 million as follows:

 

●	Up to $250 million if calendar year 2020 EBITA is between $45 million and $58 million or greater.
●	Up to $45 million if calendar year 2022 EBITA for a new instrument product is between $54 million and $70 million or greater.
●	Up to $30 million if calendar year 2022 EBITA for the remaining business is between $150 million and $190 million or greater.

 

The goodwill recorded as a result of the acquisition represents the strategic benefits of growing the Company’s product portfolio and the expected revenue growth from increased market penetration. The goodwill is not deductible for income tax purposes. The business became part of the Diagnostics and Genomics reportable segment in the first quarter of fiscal year 2019.

 

Certain estimated fair values are not yet finalized and are subject to change, which could be significant. The Company expects to finalize these by the end of fourth quarter of fiscal year 2019 when we have completed our assessment of the working capital adjustment, completed our identification and valuation models for acquired intangible assets, including our assessment of the ExosomeDx trade name and the determination of related estimated useful lives, and finalized our income tax assessment of acquired NOLs. Amounts for acquired current assets and liabilities, intangible assets, related deferred tax liabilities, and goodwill also remain subject to change. The preliminary estimated fair values of the assets acquired and liabilities assumed are as follows (in thousands):

 

 

As summarized in the table, there were adjustments totaling $2.4 million to goodwill during the measurement period. These adjustments relate to refinements within working capital, primarily for updates to the net realizable value of certain acquired receivables based on factors existing on the acquisition date. 

 

Tangible assets and liabilities acquired were recorded at fair value on the date of close based on management's assessment. The purchase price allocated to developed technology was estimated based on management's forecasted cash inflows and outflows and using a multi-period excess earnings method to calculate the fair value of assets purchased. The preliminary amount recorded for developed technology is being amortized with the expense reflected in cost of goods sold in the Condensed Consolidated Statement of Earnings and Comprehensive Income. The preliminary amortization periods for intangible assets acquired in fiscal 2019 are estimated to be 15 years for developed technology. The net deferred income tax liability represents the net amount of the estimated future impact of adjustments for costs to be recognized as intangible asset amortization, which is not deductible for income tax purposes offset by the deferred tax asset for the preliminary calculation of acquired NOLs.

 

 

 

Note 5. Fair Value Measurements:

 

The Company’s financial instruments include cash and cash equivalents, available for sale investments, accounts receivable, accounts payable, contingent consideration obligations, derivative instruments, and long-term debt.

 

Fair value is defined as the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. This standard also establishes a hierarchy for inputs used in measuring fair value. This standard maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs market participants would use in valuing the asset or liability based on market data obtained from independent sources. Unobservable inputs are inputs that reflect our assumptions about the factors market participants would use in valuing the asset or liability based upon the best information available in the circumstances.

 

The categorization of financial assets and liabilities within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The hierarchy is broken down into three levels. Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs (other than quoted prices) that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable for the asset or liability and their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 may also include certain investment securities for which there is limited market activity or a decrease in the observability of market pricing for the investments, such that the determination of fair value requires significant judgment or estimation.

 

The following tables provide information by level for financial assets and liabilities that are measured at fair value on a recurring basis (in thousands):

 

 

 

	(1)	Included in available-for-sale investments on the balance sheet.   The cost basis in the Company's investment in CCXI at December 31, 2018 and June 30, 2018 was $18.8 million
	(2)	Included in available-for-sale investments on the balance sheet.  The certificate of deposits have contractual maturity dates within one year.

 

 

 

Fair value measurements of available for sale securities

Our available for sale securities are measured at fair value using quoted market prices in active markets for identical assets and are therefore classified as Level 1 assets.

 

Fair value measurements of derivative instruments

In October 2018, the Company entered into forward starting swaps designated as cash flow hedges on outstanding debt. The forward starting swaps reduce the variability of cash flow payments for the Company by converting the variable interest rate on the Company’s long-term debt described in Note 6 to that of a fixed interest rate. Accordingly, as part of the forward starting swaps, the Company will exchange, at specified intervals, the difference between floating and fixed interest amounts based on $380 million of notional principal amount. The change in the fair value of the instrument is reported as a component of other comprehensive income and reclassified into interest expense over the corresponding term of the cash flow hedge. The Company did not reclassify any amounts out of other comprehensive income into interest expense during the quarter and six month period ended December 31, 2018. The liability related to the derivative instrument was recorded within Other long-term liabilities on the Consolidated Balance Sheet. The instrument was valued using observable market inputs in active markets and therefore classified as a Level 2 liability.

 

Fair value measurements of contingent consideration

In connection with the ExosomeDx and Quad acquisitions the Company is required to make contingent consideration payments of up to $325.0 million and $51.0 million, respectively. The contingent consideration payments are subject to ExosomeDx achieving certain EBITA thresholds and Quad meeting certain product development milestones and revenue thresholds. The preliminary fair value of the liabilities for the contingent payments recognized upon the acquisition as part of the purchase accounting opening balance sheet totaled $6.7 million ($1.8 million for ExosomeDx and $4.9 million for Quad) as discussed in Note 4.  The preliminary fair value of the development milestone payments was estimated by discounting to present value the probability-weighted contingent payments expected to be made. Assumptions used in these calculations were probability of success, duration of the earn-out, and discount rate.   The preliminary fair value for the EBITA and revenue milestone payments was determined using a Monte Carlo simulation-based model discounted to present value.  Assumptions used in these calculations are units sold, expected revenue, expected expenses, discount rate and various probability factors. The ultimate settlement of contingent consideration could deviate from current estimates based on the actual results of these financial measures. This liability is considered to be a Level 3 financial liability that is re-measured each reporting period. The change in fair value of contingent consideration for these acquisitions is included in general and administrative expense.

 

The following table presents a reconciliation of the liability measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the six months ended December 31, 2018 (in thousands):

 

 

The use of different assumptions, applying different judgment to matters that inherently are subjective and changes in future market conditions could result in different estimates of fair value of our securities or contingent consideration, currently and in the future. If market conditions deteriorate, we may incur impairment charges for securities in our investment portfolio. We may also incur changes to our contingent consideration liability as discussed below.

 

Fair value measurements of other financial instruments – The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it is practicable to estimate fair value.

 

Cash and cash equivalents, certificates of deposit, accounts receivable, and accounts payable – The carrying amounts reported in the Condensed Consolidated Balance Sheet approximate fair value because of the short-term nature of these items.

 

Long-term debt – The carrying amounts reported in the Condensed Consolidated Balance Sheet for the amount drawn on our line-of-credit facility and borrowed under our term loan approximate fair value because our interest rate is variable and reflects current market rates.

 

 

Note 6. Debt and Other Financing Arrangements:

 

On August 1, 2018, the Company entered into a new revolving line-of-credit and term loan governed by a Credit Agreement (the Credit Agreement). The Credit Agreement provides for a revolving credit facility of $600.0 million, which can be increased by an additional $200.0 million subject to certain conditions, and a term loan of $250.0 million. Borrowings under the Credit Agreement may be used for working capital and expenditures of the Company and its subsidiaries, including financing permitted acquisitions. Borrowings under the Credit Agreement bear interest at a variable rate. The current outstanding debt is based on the Eurodollar Loans term for which the interest rate is calculated as the sum of LIBOR plus an applicable margin. The applicable margin is determined from the total leverage ratio of the Company and updated on a quarterly basis. The annualized fee for any unused portion of the credit facility is currently 20 basis points.

 

The Credit Agreement matures on August 1, 2023 and contains customary restrictive and financial covenants and customary events of default. At the closing on August 1, 2018, the Company borrowed $250.0 million under the term loan and $330.0 million under the revolving credit facility. As of December 31, 2018, the outstanding balance under the Credit Agreement was $545.8 million.

 

 

 

Note 7. Supplemental Equity and Accumulated Other Comprehensive Income (loss):

 

Consolidated Changes in Equity (amounts in thousands)

  

 

 

 

Accumulated Other Comprehensive Income

 

The components of other comprehensive income (loss) consist of changes in net unrealized gains (losses) on available for sale investments with readily determinable fair values in fiscal 2018, changes in foreign currency translation adjustments, and changes in net unrealized gains (losses) on derivative instruments designated as cash flow hedges entered into in fiscal 2019. There were no reclassifications of gains (losses) from accumulated other comprehensive income (loss) to earnings during the six months ended December 31, 2018 and 2017.

 

The accumulated balances related to each component of other comprehensive income (loss), net of tax, are summarized as follows (in thousands):

 

 

⁽¹⁾See Note 1 for further information related to the adoption of ASU 2016-01 and 2018-02.

⁽²⁾ The gain (loss) on the forward starting interest rate swap will be reclassified into earnings beginning October 31, 2019. Approximately ($250) of the ($3,915) will be reclassified into earnings in the 12 months subsequent to  December 31, 2018.

 

 

 

 

Note 8. Earnings Per Share:

 

The following table reflects the calculation of basic and diluted earnings per share (in thousands, except per share amounts):

 

 

The dilutive effect of stock options and restricted stock units in the above table excludes all options for which the aggregate exercise proceeds exceeded the average market price for the period. The number of potentially dilutive option shares excluded from the calculation was 1.3 million and 1.6 million for the quarter ended December 31, 2018 and 2017, respectively and 1.3 million and 1.7 million for the six months ended December 31, 2018 and 2017, respectively.

 

 

 

Note 9. Share-based Compensation:

 

During the six months ended December 31, 2018 and 2017, the Company granted 0.9 million and 1.0 million stock options at weighted average grant prices of $174.10 and $118.97 and weighted average fair values of $34.69 and $21.58, respectively. During the six months ended December 31, 2018 and 2017, the Company granted 53,903 and 35,674 restricted stock units at a weighted average fair value of $170.74 and $125.02, respectively. During the six months ended December 31, 2018 and 2017, the Company granted 14,887 and 20,106 shares of restricted common stock shares at a grant date fair value of $177.93 and $125.05, respectively.

 

Stock options for 189,627 and 70,069 shares of common stock with total intrinsic values of $16.3 million and $2.8 million were exercised during the six months ended December 31, 2018 and 2017, respectively.

 

Stock-based compensation expense of $6.9 million and $5.0 million was included in selling, general and administrative expenses for the quarter ended December 31, 2018 and 2017, respectively. Stock-based compensation expense of $18.4 million and $8.8 million was included in selling, general, and administrative expenses for the six months ended December 31, 2018 and 2017, respectively. As of December 31, 2018, there was $37.8 million of unrecognized compensation cost related to non-vested stock options, non-vested restricted stock units and non-vested restricted stock. The weighted average period over which the compensation cost is expected to be recognized is 2.2 years.

 

 

 

Note 10. Other Income / (Expense):

 

The components of other income (expense) in the accompanying Statement of Earnings and Comprehensive Income are as follows: 

 

 

 

 

Note 11. Income Taxes:

 

The Company’s effective income tax rate for the second quarter of fiscal 2019 and 2018 was 19.3% and (124.8)% of consolidated earnings before income taxes, and (11.2)% and (44.8)% for the first six months of fiscal 2019 and 2018, respectively. The change in the Company’s tax rate for the second quarter and first six months of fiscal 2019 compared to second quarter and first six months of fiscal 2018 was driven by discrete tax items.

 

The Company recognized total net benefits related to discrete tax items of $1.1 million during the second quarter and $5.3 million during the first six months of fiscal 2019.  U.S. tax reform (as described further below) resulted in $0.6 million tax benefit for the second quarter and first six months of fiscal 2019.  Share-based compensation excess tax benefit contributed $0.3 million and $3.7 million in the second quarter and first six months of 2019, respectively.

 

The Company recognized total net benefits related to discrete tax items of $31.0 million during the second quarter and $31.5 million during the first six months of fiscal 2018.  U.S. tax reform (as described further below) resulted in $33.5 million tax benefit for the second quarter and first six months of fiscal 2018.  This tax benefit was partially offset by a net discrete tax expense of $2.9 million and $3.8 million for the second quarter and first six months of fiscal 2018 related to the revaluation of contingent consideration, which is not tax deductible.

 

On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Act”) was enacted, which reduced the U.S. federal corporate tax rate from 35% to 21%, required companies to pay a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred and created new taxes on certain foreign sourced earnings. The Tax Act added many new provisions including changes the deduction for executive compensation, a tax on global intangible low taxed income (“GILTI”), the base erosion anti abuse tax (“BEAT”) and a deduction for foreign derived intangible income (“FDII”). The SEC staff issued Staff Accounting Bulletin (“SAB 118”) later codified as ASU 2018-05 Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin (SAB) No. 118, which provides a measurement period of up to one year from the Tax Act’s enactment date to complete the accounting for the effects of the Tax Act.

 

During the quarter, the Company recorded a net discrete benefit of $0.6 million related to the mandatory deemed repatriation tax calculation which is inclusive of a benefit for a dividends received deduction for certain foreign tax credits offset by an increased expense due to the Company’s refinement of the calculation as the tax return is being prepared as well as increased expense due to interpretation of guidance issued within the quarter.  The additional dividends received deduction is based on our assessment of the treatment under the applicable provisions of the Tax Act as currently written and enacted. If, in the future, Congress or the Department of the Treasury provides legislative or regulatory updates, this could change our assessment of the benefit associated with the dividends received deduction, and we may be required to recognize additional tax expense up to the full amount of the $4.3 million in the period such updates are issued.

 

Measurement period adjustments recorded during the second quarter and first six months of fiscal 2019 related to the mandatory repatriation inclusion and were approximately $2.1 million, all of which had an impact on the effective rate. The Company is at the end of the measurement period allowed under ASU 2018-05, but anticipates additional interpretations and clarifications to be issued by the U.S. Treasury Department, which may affect future period tax estimates. The Company made the accounting policy election to treat taxes due on U.S. inclusions in taxable income related to GILTI as a current period expense when incurred.