IDEXX LABORATORIES INC /DE - Quarter Report: 2017 September (Form 10-Q)

 

UNITED STATES 

SECURITIES AND EXCHANGE COMMISSION 

WASHINGTON, D.C. 20549 

FORM 10-Q 

 

(Mark One) 

[X]        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 

For the quarterly period ended September 30, 2017

OR 

[   ]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 

For the transition period from _______________ to _______________. 

  

COMMISSION FILE NUMBER: 000-19271 



  

IDEXX LABORATORIES, INC. 

(Exact name of registrant as specified in its charter) 



 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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐  

  Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth 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 ☒  



Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. The number of shares outstanding of the registrant’s Common Stock, $0.10 par value per share,  was 87,218,713 on October  24, 2017.

  

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GLOSSARY OF TERMS AND SELECTED ABBREVIATIONS



In order to aid the reader, we have included certain terms and abbreviations used throughout this Quarterly Report on Form 10-Q below:





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IDEXX LABORATORIES, INC. 

Quarterly Report on Form 10-Q 

Table of Contents 





  

 

 

 

 

 

 

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PART I— FINANCIAL INFORMATION 

Item 1.  Financial Statements. 

 

IDEXX LABORATORIES, INC. AND SUBSIDIARIES 

 

CONDENSED CONSOLIDATED BALANCE SHEETS 

(in thousands, except per share amounts) 

(Unaudited)





  

 

 

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IDEXX LABORATORIES, INC. AND SUBSIDIARIES 

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS 

(in thousands, except per share amounts) 

(Unaudited) 

 







  

 

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IDEXX LABORATORIES, INC. AND SUBSIDIARIES 

 

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME 

(in thousands) 

(Unaudited) 

 





  

 

 

 

 

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IDEXX LABORATORIES, INC. AND SUBSIDIARIES 

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands) 

(Unaudited) 

2

  

 

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IDEXX LABORATORIES, INC. AND SUBSIDIARIES 

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 

(Unaudited)

  

 

NOTE 1.      BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION 

 

The accompanying condensed consolidated financial statements of IDEXX Laboratories, Inc. and its subsidiaries have been prepared in accordance with U.S. GAAP for interim financial information and with the requirements of Regulation S-X, Rule 10-01 for financial statements required to be filed as a part of this Quarterly Report on Form 10-Q. Unless the context requires otherwise, references in this Quarterly Report on Form 10-Q to "IDEXX," the "Company," "we," "our" or "us" refer to IDEXX Laboratories, Inc. and its subsidiaries.

 

The accompanying condensed consolidated financial statements include the accounts of IDEXX Laboratories, Inc. and our wholly-owned and majority-owned subsidiaries. We do not have any variable interest entities for which we are the primary beneficiary. All intercompany transactions and balances have been eliminated in consolidation. 



The accompanying condensed consolidated financial statements reflect, in the opinion of our management, all adjustments necessary for a fair statement of our financial position and results of operations. All such adjustments are of a recurring nature. The consolidated balance sheet data at December 31, 2016, was derived from audited financial statements, but does not include all disclosures required by U.S. GAAP. The results of operations for the three and nine months ended September 30, 2017, are not necessarily indicative of the results to be expected for the full year or any future period. These condensed consolidated financial statements should be read in conjunction with this Quarterly Report on Form 10-Q for the quarter ended September 30, 2017, and our Annual Report on Form 10-K for the year ended December 31, 2016, (the “2016 Annual Report”) filed with the SEC.



For the nine months ended September 30, 2017, changes in stockholders’ equity included (i) changes in other comprehensive income reflected in the condensed consolidated statements of comprehensive income; (ii) changes in common stock and additional paid-in capital reflected in the condensed consolidated statements of cash flows (including share-based compensation expense, proceeds from exercise of stock options and employee stock purchase plans and repurchases of common stock); (iii) changes in noncontrolling interest; and (iv) changes in net income.



NOTE 2.      ACCOUNTING POLICIES  



Significant Accounting Policies



The significant accounting policies used in preparation of these condensed consolidated financial statements for the three and nine months ended September 30, 2017 are consistent with those discussed in Note 2 to the consolidated financial statements in our 2016 Annual Report, except as noted below.



New Accounting Pronouncements Adopted



Effective January 1, 2017, we adopted the FASB Accounting Standard Update (“ASU”) 2016-09, “Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting” which simplifies several aspects of the accounting for share-based payment transactions, including income tax consequences, recognition of stock compensation award forfeitures, classification of awards as either equity or liabilities, the calculation of diluted shares outstanding and classification on the statement of cash flows.



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The following table summarizes the most significant impacts of the new accounting guidance for the three and nine months ended September 30, 2017 and 2016, as applicable:





Effective July 1, 2017, we adopted ASU 2017-01, “Business Combinations (Topic 805): Clarify the Definition of a Business” which amended the definition of a business to be an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members or participants. In order to be considered a business, the three elements of inputs, processes and outputs must be present. In a business acquisition, if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets, the integrated set of assets and activities acquired is not considered a business. We began using this guidance in analyzing acquisitions and disposals in the third quarter of 2017. This amendment may impact the allocation of purchase price in future acquisitions that are determined to be asset acquisitions as opposed to business combinations, however during the third quarter of 2017 there was no material impact on our consolidated financial statements.



New Accounting Pronouncements Not Yet Adopted



In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (the “New Revenue Standard”), which will replace most of the existing revenue recognition guidance within U.S. GAAP. The FASB has also issued several updates to ASU 2014-09. The core principle of ASU 2014-09 is that an entity should recognize revenue for the transfer of goods or services to customers in an amount that it expects to be entitled to receive for those goods or services. In doing so, companies will be required to make certain judgments and estimates, including identifying contract performance obligations, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price among separate performance obligations. Additionally, disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, significant judgments reached in the application of the guidance and assets recognized from the costs to obtain or fulfill a contract will be required. In July 2015, the FASB approved a one-year deferral of the effective date to all annual and interim periods beginning after December 15, 2017. The new guidance permits two methods of adoption: a full retrospective method to each prior reporting period presented or a modified retrospective approach with the cumulative effect of initially applying the guidance recognized at the date of initial application. We plan to adopt ASU 2014-09, as amended, in the first quarter of 2018 on a modified-retrospective basis.



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Since the issuance of ASU 2014-09, we have been preparing for the adoption of the New Revenue Standard. We have been monitoring the activity of the FASB and the Transition Resource Group as it relates to specific industry interpretive guidance and overall interpretations and clarifications. We developed a three-phase adoption plan and have completed Phase I, which included activities such as establishing a transition team and assessing significant revenue streams and representative contracts to determine potential changes to existing accounting policies.  We are in Phase II of our adoption plan, during which we will further determine the impact of adoption. Phase II includes activities such as validating and concluding on changes to existing accounting policies, quantifying the effects on our consolidated financial statements, evaluating expanded disclosure requirements and addressing the impact on business processes, systems and internal controls.  Phase III of our adoption plan will complete our adoption and implementation of the New Revenue Standard during the first quarter of 2018 and will include activities such as running parallel reporting for impacted areas under the New Revenue Standard and the current standard, recording the accounting adjustments that were identified in Phase II, evaluating and testing modified and newly implemented internal controls over the New Revenue Standard, and revising our financial statements disclosures.



While ASU 2014-09 will not impact the overall economics of our products and services sold under customer marketing and incentive programs, we expect the New Revenue Standard will require us to accelerate revenue recognition related to certain of our customer programs and to delay revenue recognition for certain other customer programs.  We expect to accelerate revenue recognition on instruments and systems placed through programs where customers are committed to purchase future goods and services, including our up-front customer loyalty programs.  This change is the result of the New Revenue Standard no longer limiting revenue recognition to the amount of customer consideration received upon placement.  Conversely, we expect to defer an increased portion of revenue related to instrument placements under programs that provide rebate incentives on future purchases, including certain of our instrument marketing programs. Under the New Revenue Standard, future purchases that are optional and not subject to a customer commitment, are not considered part of the customer arrangement, resulting in the instrument absorbing a higher relative allocation of rebate incentives.  We expect this change to result in lower instrument revenue upon placement and higher recurring revenues over the term of the rebate incentive program.  Based on our progress to date, we believe these will be the most significant impacts related to our adoption of the New Revenue Standard, however the overall impact on our 2018 revenues is not expected to be material, as we estimate the net impact of the modified-retrospective cumulative adjustments and the change in timing of revenue recognition on 2018 activity to be relatively neutral.  This assessment is based on the anticipated volume, mix and design of our customer marketing and incentive programs, which may change in response to future customer and competitive demands.  Furthermore, the New Revenue Standard requires the deferral of incremental costs to obtain a customer contract over the term of the customer arrangement, such as sales commissions.  Based on the current design of our sales commission plans, the impact of implementing this element of the New Revenue Standard is also not expected to be material.  



In February 2017, the FASB issued ASU 2017-05, “Other Income-Gains and Losses from the Derecognition of Nonfinancial Assets (Subtopic 610-20): Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets.” ASU 2017-05 clarifies the scope and accounting of a financial asset that meets the definition of an “in-substance nonfinancial asset” and defines the term, “in-substance nonfinancial asset.” It also adds guidance for partial sales of nonfinancial assets. The new guidance is effective for fiscal years beginning after December 15, 2017 and interim periods within those years. Early adoption is permitted for interim or annual reporting periods beginning after December 15, 2016. The guidance may be applied retrospectively for all periods presented or retrospectively with a cumulative-effect adjustment at the date of adoption. The adoption of this guidance is not expected to have an impact on our consolidated financial statements.



In May 2017, the FASB issued ASU 2017-09, Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting, which provides clarification on accounting for modifications in share-based payment awards. ASU 2017-09 is effective for fiscal years beginning after December 15, 2017, with early adoption permitted. The adoption of this guidance is not expected to have an impact on our consolidated financial statements or related disclosures unless there are modifications to our share-based payment awards.



In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815). The new standard amends the hedge accounting recognition and presentation requirements. The ASU also simplifies the application of the hedge accounting guidance. This ASU is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. We are currently evaluating the timing of adopting the new guidance as well as the impact it may have on our consolidated financial statements.



For a discussion of other accounting standards that have been issued by the FASB but are not yet effective, refer to the New Accounting Pronouncements Not Yet Adopted section in our 2016 Annual Report.







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NOTE 3.      ACQUISITIONS



We believe that our acquisitions of businesses and other assets enhance our existing businesses by either expanding our geographic range and customer base or expanding our existing product lines.



On July 1, 2017, we adopted ASU 2017-01, which amended the definition of a business. During the third quarter of 2017, we acquired three reference laboratory customer lists in the United States for approximately $1.3 million and recorded these transactions as asset acquisitions. The results of operations for these reference laboratories have been included in our CAG segment since the acquisition dates.



During the second quarter of 2017, we acquired the assets of two software companies that expand our suite of technology applications for the veterinary profession, specifically related to patient referral management and other connectivity needs between practices and other parties. The combined purchase price of $15 million consists of $12 million paid at closing and a $3 million contingent payment to be paid within 36 months if certain commercial goals are achieved. We finalized the valuation of the acquired assets in the third quarter of 2017.  The fair value estimate of the assets acquired consists of $13.3 million of goodwill, representing synergies within our broader CAG portfolio, $1.0 million of customer relationship intangibles and $0.6 million of technology intangible assets. Goodwill related to these acquisitions is expected to be deductible for income tax purposes. The amount of net tangible assets acquired was immaterial. Pro forma information has not been presented for these acquisitions because such information is not material to our financial statements. The results of operations have been included in our CAG segment since the acquisition date.



During the first quarter of 2017, we acquired a reference laboratory in Austria for approximately $1.3 million, with the majority of the acquisition price valued as an intangible asset. The results of operations of this reference laboratory have been included in our CAG segment since the acquisition date.



NOTE 4.      SHARE-BASED COMPENSATION 

 

The fair value of options, restricted stock units, deferred stock units and employee stock purchase rights awarded during the three and nine months ended September 30, 2017, totaled $1.5 million and $31.0 million, respectively, as compared to $0.4 million and $26.1 million for the three and nine months ended September 30, 2016, respectively.  The total unrecognized compensation expense, net of estimated forfeitures, for unvested share-based compensation awards outstanding at September 30, 2017, was $50.6 million, which will be recognized over a weighted average period of approximately 1.9 years. During the three and nine months ended September 30, 2017, we recognized expense of $6.1 million and $17.8 million, respectively, related to share-based compensation.

 

           We determine the assumptions used in the valuation of option awards as of the date of grant. Differences in the expected stock price volatility, expected term or risk-free interest rate may necessitate distinct valuation assumptions at each grant date. As such, we may use different assumptions for options granted throughout the year. Option awards are granted with an exercise price equal to the closing market price of our common stock at the date of grant. We have never paid any cash dividends on our common stock, and we have no intention to pay such a dividend at this time; therefore, we assume that no dividends will be paid over the expected terms of option awards.



The weighted averages of the valuation assumptions used to determine the fair value of each option award on the date of grant and the weighted average estimated fair values were as follows: 

 









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Note 5.      marketable securities



The amortized cost and fair value of marketable securities were as follows (in thousands):





As of September 30, 2017, unrealized losses on marketable securities that have been in a continuous loss position for more than twelve months were not material. Our portfolio of marketable securities had an average AA- credit rating as of September 30, 2017. There were no marketable securities that we consider to be other-than-temporarily impaired as of September 30, 2017.





Remaining effective maturities of marketable securities were as follows (in thousands):







 

         Our investment strategy is to buy short-duration marketable securities with a high credit rating. Some of our marketable securities have call features that can effectively shorten the lifespan from the contractual maturity date. We use the effective maturity date to measure the duration of the marketable securities.



Note 6.      Inventories  

 

Inventories, which are stated at the lower of cost (first-in, first-out) or market, include material, conversion costs and inbound freight charges. The components of inventories were as follows (in thousands): 





  





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NOTE  7.       GOODWILL AND INTANGIBLE ASSETS, NET

 

We believe that our acquisitions of businesses and intangible assets enhance our existing businesses by either expanding our geographic range and customer base or expanding our existing product lines. See “Note 3. Acquisitions,” for further information regarding goodwill and intangible assets.



During the first half of 2016, management reviewed our OPTI Medical product offering, which resulted in the discontinuance of our product development activities in the human point-of-care medical diagnostics market and a decision to focus our commercial efforts to support our latest generation OPTI CCA-TS2 Blood Gas and Electrolyte Analyzer.  During the first half of 2016, management identified unfavorable trends in our OPTI Medical business resulting from this change in strategy. We revised our forecasts downward, causing us to assess the realizability of the related tangible and intangible assets and determined the expected future cash flows were less than the carrying value of the OPTI Medical asset group. Non-cash intangible asset impairments of $2.2 million were recorded within our condensed consolidated statement of operations for the six months ended June 30, 2016.



NOTE 8.      Other current and long-term ASSETS 



Other current assets consisted of the following (in thousands):

 





Other long-term assets consisted of the following (in thousands):  







Note 9.      Accrued liabilities 

 

Accrued liabilities consisted of the following (in thousands):











  

  



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Note 10.      Repurchases of common STOCK 





We primarily acquire shares by repurchases in the open market. However, we also acquire shares that are surrendered by employees in payment for the minimum required statutory withholding taxes due on the vesting of restricted stock units and the settlement of deferred stock units, otherwise referred to herein as employee surrenders.



We issue shares of treasury stock upon the vesting of certain restricted stock units and upon the exercise of certain stock options. The number of shares of treasury stock issued during the three and nine months ended September 30, 2017 and 2016 was not material.



The following is a summary of our open market common stock repurchases, reported on a trade date basis, and shares acquired through employee surrender for the three and nine months ended September 30, 2017 and 2016 (in thousands, except per share amounts): 







 



Note 11.      Income Taxes 

 

 Our effective income tax rate was 23.4 percent for the three months ended September 30, 2017, as compared to 30.8 percent for the three months ended September 30, 2016, and 22.8 percent for the nine months ended September 30, 2017, as compared to 30.7 percent for the nine months ended September 30, 2016.



The decrease in our effective tax rate for the three months ended September 30, 2017, as compared to the same period in the prior year, was primarily related to the adoption of ASU 2016-09 related to share-based compensation, which reduced our effective tax rate by approximately 4 percent, and the expected utilization of foreign tax credits, which reduced our effective tax rate by approximately 3 percent.



 The decrease in our effective tax rate for the nine months ended September 30, 2017, as compared to the same period in the prior year, was primarily related to the adoption of ASU 2016-09 related to share-based compensation, which reduced our effective tax rate by approximately 8 percent, and the expected utilization of foreign tax credits, which reduced our effective tax rate by approximately 1 percent. See “Note 2. Accounting Policies”, for more information regarding the adoption of ASU 2016-09.

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Note 12.    ACCUMULATED OTHER Comprehensive Income  

 

The changes in AOCI, net of tax, for the nine months ended September 30, 2017 consisted of the following (in thousands): 



















The following is a summary of reclassifications out of AOCI for the three and nine months ended September 30, 2017 and 2016 (in thousands):











Note 13.    Earnings per Share  

 

Basic earnings per share is computed by dividing net income attributable to our stockholders by the weighted average number of shares of common stock and vested deferred stock units outstanding during the year. The computation of diluted earnings per share is similar to the computation of basic earnings per share, except that the denominator is increased for the assumed exercise of dilutive options and assumed issuance of unvested restricted stock units and unvested deferred stock units using the treasury stock method unless the effect is anti-dilutive. The treasury stock method assumes that proceeds, including cash received from the exercise of employee stock options, the total unrecognized compensation expense for unvested share-based compensation awards and, prior to the adoption of new accounting guidance related to share-based compensation on January 1, 2017, the tax benefits resulting from share-based compensation tax deductions in excess of the related expense recognized for financial reporting purposes, would be used to purchase our common stock at the average market price during the period. For further discussion regarding the impact of the new accounting guidance related to share-based compensation, see “Note 2. Accounting Policies.” Vested deferred stock units outstanding are included in shares outstanding for basic and diluted earnings per share because the associated shares of our common stock are issuable for no cash consideration, the number of shares of our common stock to be issued is fixed and issuance is not contingent. See Note 4 to the consolidated financial statements in our 2016 Annual Report for additional information regarding deferred stock units.  



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The following is a reconciliation of weighted average shares outstanding for basic and diluted earnings per share for the three and nine months ended September 30, 2017 and 2016 (in thousands):   

 

 







Certain options to acquire shares and restricted stock units have been excluded from the calculation of shares outstanding for diluted earnings per share because they were anti-dilutive. The following table presents information concerning those anti-dilutive options and restricted stock units for the three and nine months ended September 30, 2017 and 2016 (in thousands): 

 



  

Note 14.    Commitments, Contingencies and Guarantees 

 

Significant commitments, contingencies and guarantees at September 30, 2017, are consistent with those discussed in Note 14 to the consolidated financial statements in our 2016 Annual Report.

 

Note 15.     Segment Reporting 

  

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision-maker (“CODM”), or decision-making group, in deciding how to allocate resources and in assessing performance. Our CODM is our Chief Executive Officer. Our reportable segments include diagnostic and information technology-based products and services for the veterinary market, which we refer to as the Companion Animal Group (“CAG”), water quality products (“Water”) and diagnostic products and services for livestock and poultry health and to ensure the quality and safety of milk and improve dairy efficiency, which we refer to as Livestock, Poultry and Dairy (“LPD”). Our Other operating segment combines and presents products for the human point-of-care medical diagnostics market with our pharmaceutical product line and our out-licensing arrangements because they do not meet the quantitative or qualitative thresholds for reportable segments.



Certain costs are not allocated to our operating segments and are instead reported under the caption “Unallocated Amounts.” These costs include costs that do not align with one of our existing operating segments or are cost prohibitive to allocate, which primarily consist of our R&D function, regional or country expenses, certain foreign currency revaluation gains and losses on monetary balances in currencies other than our subsidiaries’ functional currency and unusual items. Corporate support function costs (such as information technology, facilities, human resources, finance and legal), health benefits and incentive compensation are charged to our business segments at pre-determined budgeted amounts or rates. Differences from these pre-determined budgeted amounts or rates are captured within Unallocated Amounts.



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The following is a summary of segment performance for the three and nine months ended September 30, 2017 and 2016 (in thousands):







 















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The following is a summary of revenue by product and service category for the three and nine months ended September 30, 2017 and 2016 (in thousands): 





During the fourth quarter of 2016, we modified our management reporting and reclassified the location of SNAP Pro service plans previously located in CAG Diagnostics capital - instruments to CAG Diagnostics service and accessories. The amount of revenue reclassified was $0.4 million during the three months ended September 30, 2016 and $1.1 million for the nine months ended September 30, 2016.



Note 16.     FAIR VALUE MEASUREMENTS 

 

U.S. GAAP defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. U.S. GAAP requires an entity to maximize the use of observable inputs, where available, and minimize the use of unobservable inputs when measuring fair value.  



We have certain financial assets and liabilities that are measured at fair value on a recurring basis, certain nonfinancial assets and liabilities that may be measured at fair value on a nonrecurring basis and certain financial assets and liabilities that are not measured at fair value in our condensed consolidated balance sheets but for which we disclose the fair value. The fair value disclosures of these assets and liabilities are based on a three-level hierarchy, which is defined as follows: 

 

 

Assets and liabilities measured at fair value are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability. We did not have any transfers between Level 1 and Level 2 or transfers in or out of Level 3 of the fair value hierarchy during the three and nine months ended September 30, 2017. 



Our marketable debt securities are initially valued at the transaction price and are subsequently remeasured to fair value as of the balance sheet date utilizing third-party pricing services. The pricing services utilize industry standard valuation models, including both income and market-based approaches and observable market inputs to determine value. Observable market inputs include reportable trades, benchmark yields, credit spreads, broker/dealer quotes, bids, offers and other industry and economic events. We validate the prices provided by our third-party pricing services by obtaining independent market values from other pricing sources and analyzing pricing data in certain instances.



            

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          Our foreign currency exchange contracts are measured at fair value on a recurring basis in our accompanying condensed consolidated balance sheets. We measure the fair value of our foreign currency exchange contracts classified as derivative instruments using an income approach, based on prevailing market forward rates less the contract rate multiplied by the notional amount. The product of this calculation is then adjusted for counterparty risk.



The amounts outstanding under our unsecured revolving credit facility (“Credit Facility” or “line of credit”) and senior notes (“long-term debt”) are measured at carrying value in our condensed consolidated balance sheets though we disclose the fair value of these financial instruments. We determine the fair value of the amount outstanding under our Credit Facility and long-term debt using an income approach, utilizing a discounted cash flow analysis based on current market interest rates for debt issues with similar remaining years to maturity, adjusted for applicable credit risk. Our Credit Facility and long-term debt are valued using Level 2 inputs. The estimated fair value of our Credit Facility approximates its carrying value. The estimated fair value and carrying value of our long-term debt were $631.0 million and $604.7 million, respectively, as of September 30, 2017, and $609.5 million and $593.7 million, respectively, as of December 31, 2016. 



The following tables set forth our assets and liabilities that were measured at fair value on a recurring basis at September 30, 2017, and at December 31, 2016, by level within the fair value hierarchy (in thousands):







 

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The estimated fair value of certain financial instruments, including cash and cash equivalents, accounts receivable and accounts payable, approximate carrying value due to their short maturity.





Note 17.    HEDGING Instruments

 

Disclosure within this note is presented to provide transparency about how and why we use derivative and non-derivative instruments (collectively “hedging instruments”), how the instruments and related hedged items are accounted for, and how the instruments and related hedged items affect our financial position, results of operations and cash flows.  

 

We are exposed to certain risks related to our ongoing business operations. The primary risks that we manage by using hedging instruments are foreign currency exchange risk and interest rate risk. Our subsidiaries enter into foreign currency exchange contracts to manage the exchange risk associated with their forecasted intercompany inventory purchases and sales for the next year. From time to time, we may also enter into other foreign currency exchange contracts or foreign-denominated debt issuances to minimize the impact of foreign currency fluctuations associated with specific balance sheet exposures, including net investments in certain foreign subsidiaries. We may also enter into interest rate swaps to minimize the impact of interest rate fluctuations associated with borrowings under our variable-rate Credit Facility. 

 

The primary purpose of our foreign currency hedging activities is to protect against the volatility associated with foreign currency transactions, including transactions denominated in the euro, British pound, Japanese yen, Canadian dollar, Australian dollar and Swiss franc. We also utilize natural hedges to mitigate our transaction and commitment exposures. Our corporate policy prescribes the range of allowable hedging activity. We enter into foreign currency exchange contracts with well-capitalized multinational financial institutions, and we do not hold or engage in transactions involving derivative instruments for purposes other than risk management. Our accounting policies for these contracts are based on the designation of such instruments as hedging transactions.   



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We recognize all hedging instruments on the balance sheet at fair value at the balance sheet date. Instruments that do not qualify for hedge accounting treatment must be recorded at fair value through earnings. To qualify for hedge accounting treatment, cash flow and net investment hedges must be highly effective in offsetting changes to expected future cash flows or fair value on hedged transactions. If the instrument qualifies for hedge accounting, changes in the fair value of the hedging instrument from the effective portion of the hedge are deferred in AOCI, net of tax, and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. We immediately record in earnings the extent to which a hedging instrument is not effective in achieving offsetting changes in fair value. We de-designate hedging instruments from hedge accounting when the likelihood of the hedged transaction occurring becomes less than probable. For de-designated instruments, the gain or loss from the time of de-designation through maturity of the instrument is recognized in earnings. Any gain or loss in AOCI at the time of de-designation is reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. See “Note 12. Accumulated Other Comprehensive Income” for further information regarding the effect of hedging instruments on the condensed consolidated statements of operations for the three and nine months ended September 30, 2017 and 2016.



We enter into master netting arrangements with the counterparties to our derivative transactions which permit certain outstanding receivables and payables to be offset in the event of default. Our derivative contracts do not require either party to post cash collateral. We elect to present our derivative assets and liabilities in the condensed consolidated balance sheets on a gross basis. All cash flows related to our foreign currency exchange contracts and interest rate swaps are classified as operating cash flows, which is consistent with the cash flow treatment of the underlying items being hedged. 

 

Cash Flow Hedges 

 

We have designated our foreign currency exchange contracts and variable-to-fixed interest rate swaps as cash flow hedges as these derivative instruments mitigate the exposure to variability in the cash flows of forecasted transactions attributable to foreign currency exchange and interest rates. Unless noted otherwise, we have also designated our derivative instruments as qualifying for hedge accounting treatment.  

 

We did not de-designate any instruments from hedge accounting treatment during the three and nine months ended September 30, 2017 or 2016. Gains or losses related to hedge ineffectiveness recognized in earnings during the three and nine months ended September 30, 2017 and 2016 were not material.  At September 30, 2017, the estimated amount of net losses, net of income tax benefit, which are expected to be reclassified out of AOCI and into earnings within the next 12 months, is $3.2 million if exchange rates do not fluctuate from the levels at September 30, 2017. 

 

We hedge approximately 85 percent of the estimated exposure from intercompany product purchases and sales denominated in the euro, British pound, Canadian dollar, Japanese yen, Australian dollar and Swiss franc. We have additional unhedged foreign currency exposures related to foreign services and emerging markets where it is not practical to hedge. We primarily utilize foreign currency exchange contracts with durations of less than 24 months. Quarterly, we enter into contracts to hedge incremental portions of anticipated foreign currency transactions for the current and following year. As a result, our risk with respect to foreign currency exchange rate fluctuations and the notional value of foreign currency exchange contracts may vary throughout the year. The U.S. dollar is the currency purchased or sold in all of our foreign currency exchange contracts. The notional amount of foreign currency exchange contracts to hedge forecasted intercompany inventory purchases and sales totaled $184.5 million and $175.9 million at September 30, 2017 and December 31, 2016, respectively.

 

We previously entered into forward fixed interest rate swap agreements to manage the economic effect of variable interest obligations on amounts borrowed under the terms of our Credit Facility. Beginning on March 30, 2012, the variable interest rate associated with $40 million of borrowings outstanding under the Credit Facility was effectively fixed at 1.36 percent plus the range of applicable interest rate fixed credit spreads (“Credit Spread”) through June 30, 2016. Beginning on March 28, 2013, the variable interest rate associated with an additional $40 million of borrowings outstanding under the Credit Facility was effectively fixed at 1.64 percent plus the Credit Spread through June 30, 2016. From July 1, 2016, to September 30, 2017, we had no outstanding interest rate swap agreements.



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Net Investment Hedge



In June 2015, we issued and sold through a private placement an aggregate principal amount of €88.9 million in euro-denominated 1.785 percent Series C Senior Notes due June 18, 2025. We have designated these euro-denominated notes as a hedge of our euro net investment in certain foreign subsidiaries to reduce the volatility in stockholders’ equity caused by changes in foreign currency exchange rates in the euro relative to the U.S. dollar. As a result of this designation, gains and losses from the change in translated U.S. dollar value of these euro-denominated notes are recorded in AOCI rather than to earnings. We recorded losses of $2.0 million and $6.9 million, net of income tax, within AOCI as a result of this net investment hedge for the three and nine months ended September 30, 2017, respectively. The related cumulative unrealized loss recorded at September 30, 2017 will not be reclassified in earnings until the complete or substantially complete liquidation of the net investment in the hedged foreign operations or a portion of the hedge no longer qualifies for hedge accounting treatment. See Note 11 to the consolidated financial statements included in our 2016 Annual Report for further information regarding the issuance of these euro-denominated notes.



Fair Values of Hedging Instruments Designated as Hedges in Consolidated Balance Sheets



 

The fair values of hedging instruments and their respective classification on the condensed consolidated balance sheets and amounts subject to offset under master netting arrangements consisted of the following (in thousands):

 







The effect of derivative instruments designated as cash flow hedges on the condensed consolidated balance sheets consisted of the following (in thousands):









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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations. 

 

This Quarterly Report on Form 10-Q contains statements which, to the extent they are not statements of historical fact, constitute “forward-looking statements.” Such forward-looking statements about our business and expectations within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), include statements relating to future revenue growth rates, future tax benefits; business trends, earnings and other measures of financial performance;  the effect of economic downturns on our business performance; projected impact of foreign currency exchange rates; demand for our products; realizability of assets; future cash flow and uses of cash; future repurchases of common stock; future levels of indebtedness and capital spending; interest expense; warranty expense; share-based compensation expense; the adoption and projected impact of new accounting standards; future commercial efforts; and competition. Forward-looking statements can be identified by the use of words such as “expects,” “may,” “anticipates,” “intends,” “would,” “will,” “plans,” “believes,” “estimates,” “should,” “project,” and similar words and expressions. These forward-looking statements are intended to provide our current expectations or forecasts of future events; are based on current estimates, projections, beliefs, and assumptions; and are not guarantees of future performance. Actual events or results may differ materially from those described in the forward-looking statements. These forward-looking statements involve a number of risks and uncertainties, including the matters discussed in Item 1A, “Risk Factors” described in our Annual Report on Form 10-K for the year ended December 31, 2016, (the “2016 Annual Report”) and this Quarterly Report on Form 10-Q, as well as those described from time to time in our other periodic reports filed with the U.S. Securities and Exchange Commission (the “SEC”).



Any forward-looking statements represent our estimates only as of the day this Quarterly Report on Form 10-Q was filed with the SEC and should not be relied upon as representing our estimates as of any subsequent date. From time to time, oral or written forward-looking statements may also be included in other materials released to the public. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates or expectations change.  



You should read the following discussion and analysis in conjunction with our 2016 Annual Report that includes additional information about us, our results of operations, our financial position, and our cash flows, and with our unaudited condensed consolidated financial statements and related notes included in Part I, Item 1 of this Quarterly Report on Form 10-Q.



During the fourth quarter of 2016, we modified our management reporting and reclassified the location of SNAP Pro service plans previously located in CAG Diagnostics capital - instruments to CAG Diagnostics service and accessories. The amount of revenue reclassified was $0.4 million during the three months ended September 30, 2016 and $1.1 million for the nine months ended September 30, 2016.

 

       Business Overview 

 

We develop, manufacture, and distribute products and provide services primarily for the companion animal veterinary, livestock, poultry and dairy and water testing markets. We also sell a line of portable electrolytes and blood gas analyzers for the human point-of-care medical diagnostics market. Our primary products and services are:



 

Operating Segments. We operate primarily through three business segments: diagnostic and information technology-based products and services for the veterinary market, which we refer to as the Companion Animal Group (“CAG”), water quality products (“Water”) and diagnostic products and services for livestock and poultry health and to ensure the quality and safety of milk and improve dairy reproductive efficiency, which we refer to as Livestock, Poultry and Dairy (“LPD”). Our Other operating segment combines and presents products for the human point-of-care medical diagnostics market (“OPTI Medical”) with our pharmaceutical product line and our out-licensing arrangements because they do not meet the quantitative or qualitative thresholds for reportable segments. 



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CAG develops, designs, manufactures and distributes products and performs services for veterinarians and the bioresearch market, primarily related to diagnostics and information management. Water develops, designs, manufactures and distributes a range of products used in the detection of various microbiological parameters in water. LPD develops, designs, manufactures and distributes diagnostic tests and related software and performs services that are used to manage the health status of livestock and poultry, to improve bovine reproductive efficiency, and to ensure the quality and safety of milk and food. OPTI Medical manufactures and distributes point-of-care electrolyte and blood gas analyzers and related consumable products for the human medical diagnostics market.



Certain costs are not allocated to our operating segments and are instead reported under the caption “Unallocated Amounts.” These costs include costs that do not align with one of our existing operating segments or are cost prohibitive to allocate, which primarily consist of our R&D function, regional or country expenses, certain foreign currency revaluation gains and losses on monetary balances in currencies other than our subsidiaries’ functional currency and unusual items. Corporate support function costs (such as information technology, facilities, human resources, finance and legal), health benefits and incentive compensation are charged to our business segments at pre-determined budgeted amounts or rates. Differences from these pre-determined budgeted amounts or rates are captured within Unallocated Amounts.



Effects of Certain Factors and Trends on Results of Operations 

  

Currency Impact. See “Part I. Item 3. Quantitative and Qualitative Disclosures about Market Risk” included in this Quarterly Report on Form 10-Q for additional information regarding the impact of foreign currency exchange rates.



Other Items. See “Part I. Item 1. Business - Patents and Licenses” and “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our 2016 Annual Report for additional information regarding distributor purchasing and inventories, economic conditions and patent expiration.



Critical Accounting Policies and Estimates 

 

The discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates on an ongoing basis. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. The critical accounting policies and the significant judgments and estimates used in the preparation of our condensed consolidated financial statements for the three and nine months ended September 30, 2017, are consistent with those discussed in our 2016 Annual Report in the section under the heading “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates.”  

 

Recent Accounting Pronouncements 

 

Share-Based Compensation. We estimate that tax benefits related to share-based payments will reduce income tax expense by approximately $27 million for the full year 2017, primarily through a reduction in our effective income tax rate.  We do not estimate that the level of share-based payment activity expected in 2017 will continue in future periods. We believe that the historical range of $13 million to $16 million of annual tax benefits reflects a reasonable estimate for 2018, based on current settlement trends, stock price levels and assuming no change in U.S. corporate tax policy. These impacts may vary significantly by quarter based on the timing of actual settlement activity. For more information regarding the adoption of the new share-based compensation guidance, ASU 2016-09, see Note 2 to the unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q.



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Revenue Recognition. In May 2014, the FASB issued ASU 2014-09, which will replace most of the existing revenue recognition guidance within U.S. GAAP.  We plan to adopt ASU 2014-09, as amended, in the first quarter of 2018 on a modified-retrospective basis. While ASU 2014-09 will not impact the overall economics of our products and services sold under customer marketing and incentive programs, we expect the New Revenue Standard will require us to accelerate revenue recognition related to certain of our customer programs and to delay revenue recognition for certain other customer programs.  We expect to accelerate revenue recognition on instruments and systems placed through programs where customers are committed to purchase future goods and services, including our up-front customer loyalty programs.  This change is the result of the New Revenue Standard no longer limiting revenue recognition to the amount of customer consideration received upon placement.  Conversely, we expect to defer an increased portion of revenue related to instrument placements under programs that provide rebate incentives on future purchases, including certain of our instrument marketing programs. Under the New Revenue Standard, future purchases that are optional and not subject to a customer commitment, are not considered part of the customer arrangement, resulting in the instrument absorbing a higher relative allocation of rebate incentives.  We expect this change to result in lower instrument revenue upon placement and higher recurring revenues over the term of the rebate incentive program.  Based on our progress to date, we believe these will be the most significant impacts related to our adoption of the New Revenue Standard, however the overall impact on our 2018 revenues is not expected to be material, as we estimate the net impact of the modified-retrospective cumulative adjustments and the change in timing of revenue recognition on 2018 activity to be relatively neutral.  This assessment is based on the anticipated volume, mix and design of our customer marketing and incentive programs, which may change in response to future customer and competitive demands.  Furthermore, the New Revenue Standard requires the deferral of incremental costs to obtain a customer contract over the term of the customer arrangement, such as sales commissions.  Based on the current design of our sales commission plans, the impact of implementing this element of the New Revenue Standard is also not expected to be material. For more information regarding the adoption of the revenue recognition guidance, ASU 2014-09, see Note 2 to the unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q.



Other Pronouncements. We are evaluating the impact that other recent accounting standards and amendments will have on our consolidated financial statements as described in Note 2 to the unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q.

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Non-GAAP Financial Measures



The following revenue analysis and discussion focuses on organic revenue growth, and references in this analysis and discussion to “revenue,” “revenues” or “revenue growth” are references to “organic revenue growth.” Organic revenue growth is a non-GAAP financial measure and represents the percentage change in revenue during the three and nine months ended September 30, 2017, as compared to the same periods for the prior year, net of the effect of changes in foreign currency exchange rates, acquisitions, and divestitures. Organic revenue growth should be considered in addition to, and not as a replacement for, or as a superior measure to, revenues reported in accordance with U.S. GAAP, and may not be comparable to similarly titled measures reported by other companies. Management believes that reporting organic revenue growth provides useful information to investors by facilitating easier comparisons of our revenue performance with prior and future periods and to the performance of our peers. We exclude the effect of changes in foreign currency exchange rates because changes in foreign currency exchange rates are not under management’s control, are subject to volatility and can obscure underlying business trends. We exclude the effect of acquisitions and divestitures because the nature, size and number of these transactions can vary dramatically from period to period, require or generate cash as an inherent consequence of the transaction, and therefore can also obscure underlying business and operating trends.



Organic revenue growth and the percentage changes in revenue from foreign currency exchange rates and acquisitions are non-GAAP financial measures. We calculate the impact on revenue resulting from changes in foreign currency exchange rates by applying the difference between the weighted average exchange rates during the current year period and the comparable previous year period to foreign currency denominated revenues for the prior year period. The percentage change in revenue resulting from acquisitions represents incremental revenues attributable to acquisitions that have occurred since the beginning of the prior year period.



We also use Adjusted EBITDA, gross debt, net debt, gross debt to Adjusted EBITDA ratio and net debt to Adjusted EBITDA ratio, in this Quarterly Report on Form 10-Q, all of which are non-GAAP financial measures that should be considered in addition to, and not as a  replacement for, financial measures presented according to U.S. GAAP.  Management believes that reporting these non-GAAP financial measures provides supplemental analysis to help investors further evaluate our business performance and available borrowing capacity under our Credit Facility. 

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Results of Operations

Three Months Ended September 30, 2017, Compared to Three Months Ended September 30, 2016



Total Company. The following table presents total Company revenue by operating segment: 









The increase in both U.S. and international organic revenues, for the three months ended September 30, 2017, as compared to the same period in the prior year, was driven by strong volume gains in CAG Diagnostics recurring revenue, supported by our differentiated diagnostic technologies that are driving increased volumes from new and existing customers in our reference laboratory business and the continued expansion of our CAG Diagnostics instrument installed base. International organic growth was strong in Europe and Asia Pacific, reflecting the aforementioned CAG Diagnostics recurring volume driven growth. Our Water business also contributed to our international growth, including benefits from our go-direct initiatives. The decline in LPD revenue was primarily the result of lower global milk prices which drove lower dairy producer demand for diagnostic testing, particularly in China and Brazil, including lower herd health screening.

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Total Company gross profit increased during the three months ended September 30, 2017, as compared to the same period in the prior year, due to higher sales volumes and a 70 basis point increase in the gross profit percentage. The increase in the gross profit percentage was supported by the net benefit of price increases in our CAG Diagnostics recurring revenue portfolio, the favorable impact of lower product and manufacturing costs, and favorable mix benefits from high growth CAG Diagnostic recurring revenues. These favorable impacts were slightly offset by a reduction of approximately 20 basis points from currency movements, including the combined impact of comparisons to hedge gains in the prior year and hedge losses in the current year.



The increase in total Company sales and marketing expense during the three months ended September 30, 2017, as compared to the same period in the prior year, was due primarily to increased personnel-related costs as we continue to invest in and grow our global commercial infrastructure. The increase in general and administrative expense resulted primarily from information technology investments, including ongoing depreciation and maintenance associated with prior year projects, and higher personnel-related costs. Research and development expense increased primarily due to higher personnel-related and consultant costs.

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Companion Animal Group





The following table presents revenue by product and service category for CAG: 





CAG Diagnostics Recurring Revenue. The increase in CAG Diagnostics recurring revenue was due primarily to increased volumes in reference laboratory diagnostic services and IDEXX VetLab consumables and, to a lesser extent, higher realized prices, offset by the impact of fewer equivalent business days during the third quarter of 2017, as compared to the third quarter of 2016, changes in distributor inventory levels in select international markets and the impact of natural disasters in North America and the Caribbean, which are collectively estimated to have reduced overall growth by approximately 2 percent.



IDEXX VetLab consumables revenue growth was primarily due to higher sales volumes in the U.S., Europe, and the Asia-Pacific region for our Catalyst consumables and, to a lesser extent, ProCyte Dx® consumables and Sedivue Dx® analyzer pay-per-run sales, resulting from growth in testing by existing customers and an expanded menu of available tests, as well as benefits from higher average unit sales prices. 



The increase in rapid assay revenue resulted from higher sales volume of canine SNAP® 4Dx Plus tests and higher sales volumes of single analyte SNAP products.

   

The increase in reference laboratory diagnostic and consulting services revenue was primarily due to the impact of higher testing volumes throughout our worldwide network of laboratories, most prominently in the U.S., resulting from increased testing from existing customers, supported by our differentiated diagnostic technologies, such as IDEXX SDMA™ and fecal antigen testing. Additionally, the increase in revenue was the result of higher average unit sales prices. 



CAG Diagnostics services and accessories revenue growth was primarily a result of the increase in our active installed base of instruments.



CAG Diagnostics Capital – Instruments Revenue. The decrease in CAG Diagnostics capital instruments revenue reflects comparison to strong prior year placement levels, including fulfillment of SediVue Dx backlog orders and our shift to focus sales incentives on the long-term economic value of instrument placements. Our focus on long-term economic value continues to drive new and competitive Catalyst placements, which are the highest economic value placements due to the incremental CAG Diagnostic recurring revenue. As part of this focus, we saw declines in the lower relative economic value second Catalyst placements, as well as growth of our long-term customer commitment programs, including up-front customer loyalty programs in the U.S. and reagent rental programs internationally. These customer commitment programs result in lower upfront instrument revenue recognized at the time of placement and instead the recognition of revenues for these programs occurs over the term of the customer agreement.



Veterinary Software, Services and Diagnostic Imaging Systems Revenue. The increase in customer information management and diagnostic imaging systems revenue was primarily due to increasing diagnostic imaging system placements, veterinary subscription service revenue and higher support revenue resulting from an increase in our installed base. These favorable factors were partially offset by fewer licensed-based Cornerstone  ® placements as we evolve to a subscription-based model for new practice management customer acquisitions and lower relative diagnostic imaging system prices. 

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The following table presents the CAG segment results of operations:





CAG Gross Profit. Gross profit for CAG increased during the three months ended September 30, 2017, as compared to the same period in the prior year, primarily due to higher sales volume and a 100 basis point increase in the gross profit percentage for the three months ended September 30, 2017, as compared to the same period in the prior year. The gross profit percentage was supported by the net benefit of price increases in our CAG Diagnostics recurring revenue portfolio, the favorable impact of lower product and manufacturing costs and favorable mix benefits from high growth in IDEXX VetLab consumables revenue. These favorable impacts were slightly offset by a reduction of approximately 20 basis points from currency movements, including the combined impact of comparisons to hedge gains in the prior year and hedge losses in the current year.



CAG Operating Expense. The increase in sales and marketing expense during the three months ended September 30, 2017, as compared to the same period in the prior year, was due primarily to increased personnel-related costs as we continue to invest in  our global commercial infrastructure. The increase in general and administrative expense resulted primarily from higher personnel-related costs and, to a lesser extent, incremental information technology investments. The increase in research and development expense was due primarily to increased personnel-related costs. 



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Water



The following table presents the Water segment results of operations:



 



Revenue. The increase in Water revenue during the three months ended September 30, 2017, as compared to the same period in the prior year, was attributable to the benefits of price increases, partially driven by our go-direct initiative in Brazil and, to a lesser extent, higher sales volumes of our Colilert test products and related accessories, used in coliform and E. coli testing in North America, the Asia-Pacific region and Europe. These overall favorable impacts also benefited by approximately 110 basis points from currency movements. 



Gross Profit. Gross profit for Water increased during the three months ended September 30, 2017, as compared to the same period in the prior year, due to higher sales volumes as well as a 70 basis point increase in the gross profit percentage. The increase in the gross profit percentage was primarily due to the net benefit of price increases, partially driven by our go-direct initiatives as well as decreases in manufacturing costs. The overall change in currency exchange rates resulted in a decrease in the gross profit percentage of approximately 90 basis points during the three months ended September 30, 2017, as compared to the same period of the prior year, including the combined impact of comparisons to hedge gains in the prior year and hedge losses in the current year.



Operating Expenses. The increase in Water operating expense during the three months ended September 30, 2017, as compared to the same period in the prior year, was primarily due to higher personnel-related costs in sales and marketing expense and general administrative expenses. The increase in research and development expense for the three months ended September 30, 2017, as compared to the same period in the prior year, was primarily due to lower product development costs in the third quarter of 2016.

 

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Livestock, Poultry and Dairy 



The following table presents the LPD segment results of operations:







Revenue. The decrease in LPD revenue for the three months ended September 30, 2017, as compared to the same period in the prior year, primarily resulted from lower global milk prices which drove lower dairy producer demand for diagnostic testing particularly in China and Brazil, including lower herd health screening. These decreases were partially offset by an increase in swine testing, primarily in China.  The overall change in exchange rates increased revenue growth by approximately 180 basis points.



Gross Profit. The decrease in LPD gross profit for the three months ended September 30, 2017, as compared to the same period in the prior year, was due to lower sales volume as well as a 4.9 percent reduction in the gross profit percentage reflecting higher product costs and lower realized prices due primarily to unfavorable regional mix. These unfavorable factors were offset by approximately 10 basis points of a favorable currency impact, as compared to the same period in the prior year.



Operating Expenses. The overall decrease in LPD operating expenses for the three months ended September 30, 2017, as compared to the same period in the prior year, was primarily due to lower LPD allocation of overall overhead costs reflecting the higher relative growth in our CAG business as compared to LPD. This decrease was offset by higher personnel-related costs related to increased headcount in sales and marketing. Research and development expense for the three months ended September 30, 2017, as compared to the same period in the prior year, was lower primarily due to lower personnel-related costs and consultant costs, slightly offset by higher regulatory costs.

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Other



The following table presents the Other results of operations:







Revenue. The increase in Other revenue during the three months ended September 30, 2017, as compared to the same period in the prior year, was primarily due to higher realized prices, partially offset by product availability constraints. The overall change in exchange rates increased revenue growth by approximately 40 basis points.

 

Gross Profit. Gross profit for Other increased due to higher sales volumes and a 9.6 percent increase in the gross profit percentage related to higher realized prices and, to a lesser extent, lower overall OPTI Medical product costs. The overall change in currency exchange rates had no impact on the gross profit percentage.



Operating Expenses. The decrease in operating expense for the three months ended September 30, 2017, as compared to the same period in the prior year, was due primarily to lower personnel cost in sales and marketing, due to targeted cost reductions, and research and development, due to discontinuing our product development activities in the human point-of-care medical diagnostics market. These decreases were partially offset by increases in general and administrative costs, primarily related to personnel related expense.

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Unallocated Amounts



The following table presents the Unallocated Amounts results of operations:



 



We estimate certain personnel-related costs and allocate these budgeted expenses to the operating segments. This allocation differs from actual expense and consequently yields a difference that is reported under the caption “Unallocated Amounts.”



Gross Profit. Costs of revenues that were not allocated to segments during the three months ended September 30, 2017, as compared to the same period in the prior year, were relatively consistent.



Operating Expenses. The increase in operating expenses during the three months ended September 30, 2017, as compared to the same period in the prior year, was primarily due to corporate function spending in research and development and information technology, as well as employee incentives. The decrease in sales and marketing expense was primarily due to lower consulting costs. The overall increase in operating expenses was partially offset by favorable foreign exchange gains on monetary assets, as compared to losses in the prior year period.



Non-Operating Items



Interest Income. Interest income was $1.4 million for the three months ended September 30, 2017, as compared to $0.9 million for the three months ended September 30, 2016. The increase in interest income was due primarily to a relatively larger portfolio of marketable securities during the three months ended September 30, 2017, as compared to the same period of the prior year.



Interest Expense. Interest expense was $9.8 million for the three months ended September 30, 2017, as compared to $7.8 million for the same period in the prior year. The increase in interest expense was due to higher outstanding balances and higher floating interest rates on our Credit Facility.



Provision for Income Taxes. Our effective income tax rate was 23.4 percent for the three months ended September 30, 2017, and 30.8 percent for the three months ended September 30, 2016. The decrease in our effective tax rate for the three months ended September 30, 2017, as compared to the same period in the prior year, was primarily related to the adoption of ASU 2016-09 related to share-based compensation, which reduced our effective tax rate by approximately 4 percent and the expected utilization of foreign tax credits, which reduced our effective tax rate by approximately 3 percent. See Note 2 to the unaudited condensed consolidated financial statements in Part I, Item I of this Quarterly Report on Form 10-Q for more information on the adoption of ASU 2016-09.    



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Nine Months Ended September 30, 2017, Compared to Nine Months Ended September 30, 2016



Total Company. The following table presents total Company revenue by operating segment: 











The increase in both U.S. and international organic revenues, for the nine months ended September 30, 2017, as compared to the same period in the prior year, was driven by strong volume gains in CAG Diagnostics recurring revenue, supported by our differentiated diagnostic technologies that are driving increased volumes from new and existing customers in our reference laboratory business and continued expansion of our CAG Diagnostics instrument installed base, as well as growth in our Sedivue analyzer. International organic growth was strong in Europe and the Asia Pacific region, reflecting the aforementioned CAG Diagnostics recurring volume driven growth, and growth in our Water business primarily due to our Colilert  ® test products, offset by declines in LPD, primarily the result of lower global milk prices which drove lower dairy producer demand for diagnostic testing, including herd health screening revenues.

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Total Company gross profit increased during the nine months ended September 30, 2017, as compared to the same period in the prior year, due to higher sales volumes and a 130 basis point increase in the gross profit percentage. The increase in the gross profit percentage was primarily supported by the net benefit of price increases in our CAG Diagnostic recurring portfolio, the favorable impact of lower product and manufacturing costs and favorable mix benefits from high growth in CAG Diagnostics recurring revenues. The gross profit percentage was unfavorably impacted by approximately 20 basis points of currency impact during the nine months ended September 30, 2017, as compared to the same period in the prior year.



The increase in total Company sales and marketing expense during the nine months ended September 30, 2017, as compared to the same period in the prior year, was due primarily to increased personnel-related costs as we continue to invest in and grow  our global commercial infrastructure. The increase in general and administrative expense resulted primarily from information technology investments, including ongoing depreciation and maintenance associated with prior year projects, and higher personnel-related costs, offset by a prior year non-cash intangible asset impairment within our OPTI Medical business. Research and development expense increased primarily due to higher personnel-related and consultant costs. 

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Companion Animal Group





The following table presents revenue by product and service category for CAG: 











CAG Diagnostics Recurring Revenue. The increase in CAG Diagnostics recurring revenue was due primarily to increased volumes in reference laboratory diagnostic services and IDEXX VetLab consumables and, to a lesser extent, higher realized prices.



IDEXX VetLab consumables revenue growth was primarily due to higher sales volumes in the U.S., Europe, and the Asia-Pacific region for our Catalyst consumables and, to a lesser extent, ProCyte Dx® consumables and SediVue Dx analyzer pay-per-run sales, resulting from growth in testing by existing customers and an expanded menu of available tests, as well as benefits from higher average unit sales prices. 



The increase in rapid assay revenue resulted from higher sales volume and average unit price of canine SNAP 4Dx Plus tests and higher sales volumes of single analyte SNAP products.

   

The increase in reference laboratory diagnostic and consulting services revenue was primarily due to the impact of higher testing volumes throughout our worldwide network of laboratories, most prominently in the U.S., resulting from increased testing from existing customers, supported by our differentiated diagnostic technologies, such as IDEXX SDMA and fecal antigen testing. Additionally, the increase in revenue was the result of higher average unit sales prices.



CAG Diagnostics services and accessories revenue growth was primarily a result of the increase in our active installed base of instruments.



CAG Diagnostics Capital – Instruments Revenue. The decrease in CAG Diagnostics capital instruments revenue reflects comparison to strong prior year placement levels, including the introduction of SediVue Dx in the second quarter of 2016 and our shift to focus sales incentives on the long-term economic value of instrument placements during 2017. Our focus on long-term economic value continues to drive new and competitive Catalyst placements, which are the highest economic value placements due to the incremental CAG Diagnostic recurring revenue. As part of this focus, we continue to see declines in the lower relative long-term economic value second Catalyst placements, as well as growth of our customer commitment programs, including up-front customer loyalty programs in the U.S. and reagent rental programs internationally. These customer commitment programs result in lower upfront instrument revenue recognized at the time of placement, and instead the recognition of revenue for these programs occurs over the term of the customer agreement.



Veterinary Software, Services and Diagnostic Imaging Systems Revenue. The increase in customer information management and diagnostic imaging systems revenue was primarily due to increasing veterinary subscription service revenue and higher support revenue resulting from an increase in our installed base. These favorable factors were partially offset by fewer licensed-based Cornerstone  ® placements as we evolve to a subscription-based model for new practice management customer acquisitions and lower relative diagnostic imaging system prices.

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The following table presents the CAG segment results of operations:







CAG Gross Profit. Gross profit for CAG increased during the nine months ended September 30, 2017, as compared to the same period in the prior year, primarily due to higher sales volume and a 150 basis point increase in the gross profit percentage for the nine months ended September 30, 2017, as compared to the same period in the prior year. The gross profit percentage was primarily supported by the net benefit of price increases in our CAG Diagnostic recurring portfolio, the favorable impact of lower product and manufacturing costs, and favorable mix benefits from high growth in IDEXX VetLab consumables and rapid assay revenues. These favorable impacts were slightly offset by a reduction of approximately 20 basis points from currency movements.



CAG Operating Expense. The increase in sales and marketing expense during the nine months ended September 30, 2017, as compared to the same period in the prior year, was due primarily to increased personnel-related costs as we continue to invest in and grow our global commercial infrastructure. The increase in general and administrative expense resulted primarily from higher personnel-related costs to support overall growth. The increase in research and development expense was also due primarily to increased personnel-related costs.



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Water



The following table presents the Water segment results of operations:













Revenue. The increase in Water revenue during the nine months ended September 30, 2017, as compared to the same period in the prior year, was attributable to the benefits of price increases, partially driven by our go-direct initiative in Brazil and, to a lesser extent, higher sales volumes of our Colilert test products and related accessories, used in coliform and E. coli testing in North America, the Asia-Pacific region. These overall favorable impacts were offset by a reduction of approximately 40 basis points from currency movements, in the current period.



Gross Profit. Gross profit for Water increased during the nine months ended September 30, 2017, as compared to the same period in the prior year, due to higher sales volumes as well as a 90 basis point increase in the gross profit percentage. The increase in the gross profit percentage was primarily due to the net benefit of price increases, partially driven by our go-direct initiatives. The overall change in currency exchange rates resulted in a decrease in the gross profit percentage of approximately 40 basis points during the nine months ended September 30, 2017, as compared to the same period of the prior year, primarily due to lower relative hedge gains in the current year, compared to the prior year.



Operating Expenses. The increase in Water operating expense during the nine months ended September 30, 2017, as compared to the same period in the prior year, was primarily due to higher personnel-related costs related to increased head count in sales and marketing expense and general administrative expenses. Research and development expense for the nine months ended September 30, 2017, as compared to the same period in the prior year, was lower primarily due to certain project costs that were incurred in the first half of 2016.



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Livestock, Poultry and Dairy 



The following table presents the LPD segment results of operations:







Revenue. The decrease in LPD revenue for the nine months ended September 30, 2017, as compared to the same period in the prior year, resulted from lower global milk prices which drove lower dairy producer demand for diagnostic testing particularly in China and Brazil, including lower herd health screening. These decreases were partially offset by an increase in swine testing, primarily in China, as well as expanded pregnancy testing primarily in North America and Europe. The overall change in exchange rates had no impact to overall revenue growth for the nine months ended September 30, 2017, as compared to the same period in the prior year.



Gross Profit. The decrease in LPD gross profit for the nine months ended September 30, 2017, as compared to the same period in the prior year, was due to lower sales volume as well as a 160 basis point reduction in the gross profit percentage reflecting higher product costs. These unfavorable factors were offset by approximately 20 basis points of currency impact during the nine months ended September 30, 2017, primarily due to lower relative hedge losses in the current year compared to the prior year.



Operating Expenses. Overall LPD operating expenses for the nine months ended September 30, 2017, as compared to the same period in the prior year, was relatively unchanged. Sales and marketing expenses increased during the nine months ended September 30, 2017, as compared to the same period in the prior year, due to increases in commercial infrastructure investments in emerging markets. General and administration expenses were lower due to a lower LPD allocation of overall overhead costs reflecting the higher relative growth in our CAG business as compared to LPD. Research and development expense for the nine months ended September 30, 2017, was lower due to lower consultant and personnel-related costs, slightly offset by increases in regulatory costs, as compared to the same period in the prior year.

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Other



The following table presents the Other results of operations:











Revenue. The decrease in Other revenue during the nine months ended September 30, 2017, as compared to the same period in the prior year, was primarily due to lower sales volumes of our OPTI Medical blood gas analyzers and related consumables as a result of temporary product availability constraints, partially offset by price increases.

 

Gross Profit. Gross profit for Other increased due to a 210 basis points increase in the gross profit percentage due to lower manufacturing costs and, to a lesser extent, higher realized pricing on overall OPTI Medical product and services. The overall change in currency exchange rates resulted in a decrease in the gross profit percentage of less than 10 basis points.



Operating Expenses. The decrease in operating expense for the nine months ended September 30, 2017, as compared to the same period in the prior year, was due primarily to an intangible asset impairment within our OPTI Medical business during the first half of 2016 and lower personnel cost in research and development as a result of discontinuing our product development activities in the human point-of-care medical diagnostics market.



 During the first quarter of 2016, management reviewed our OPTI Medical product offering, which resulted in the discontinuance of our instrument development activities in the human point-of-care medical diagnostics market and a decision to focus our commercial and development efforts to support our latest generation OPTI CCA-TS2 Blood Gas and Electrolyte Analyzer. During the second quarter of 2016, management identified unfavorable trends in our OPTI Medical business resulting from this change in strategy. We revised our forecasts downward, causing us to assess the realizability of the related tangible and intangible assets and determined the expected future cash flows were less than the carrying value of the OPTI Medical asset group. Non-cash intangible asset impairments of $2.2 million were recognized during the six months ended June 30, 2016.

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Unallocated Amounts



The following table presents the Unallocated Amounts results of operations:









We estimate certain personnel-related costs and allocate these budgeted expenses to the operating segments. This allocation differs from actual expense and consequently yields a difference that is reported under the caption “Unallocated Amounts.”



Gross Profit. The cost of revenue that was not allocated to segments was relatively consistent during the nine months ended September 30, 2017, as compared to the same period in the prior year.



Operating Expenses. The increase in operating expenses during the nine months ended September 30, 2017, as compared to the same period in the prior year, was primarily due to higher than budgeted employee incentive costs, as well as corporate function spending in research and development, information technology and human resources. The overall increase in operating expenses was partially offset by favorable foreign exchange gains on monetary assets, as compared to losses in the prior year, as well as customer interest payments on overdue accounts. 



Non-Operating Items



Interest Income. Interest income was $3.7 million for the nine months ended September 30, 2017, as compared to $2.6 million for the nine months ended September 30, 2016. The increase in interest income was due primarily to a relatively larger portfolio of marketable securities during the nine months ended September 30, 2017, as compared to the same period in the prior year.



Interest Expense. Interest expense was $27.5 million for the nine months ended September 30, 2017, as compared to $24.3 million for the same period of the prior year. The increase in interest expense was due to higher outstanding balances and higher floating interest rates on our Credit Facility.



Provision for Income Taxes. Our effective income tax rate was 22.8 percent for the nine months ended September 30, 2017, and 30.7 percent for the nine months ended September 30, 2016. The decrease in our effective tax rate for the nine months ended September 30, 2017, as compared to the same period in the prior year, was primarily related to the adoption of ASU 2016-09 related to share-based compensation, which reduced our effective tax rate by approximately 8 percent and the expected utilization of foreign tax credits, which reduced our effective tax rate by approximately 1 percent.

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Liquidity and Capital Resources  

 

Liquidity 

 

We fund the capital needs of our business through cash on hand, funds generated from operations, proceeds from long-term senior note financings and amounts available on our $850 million five-year unsecured revolving credit facility under an amended and restated credit agreement that we executed in December 2015 (the “Credit Facility”). At September 30, 2017, we had $454.1 million of cash, cash equivalents and marketable securities, as compared to $391.8 million on December 31, 2016. Working capital, including our Credit Facility, totaled negative $53.8 million at September 30, 2017, as compared to negative $89.0 million at December 31, 2016. Additionally, at September 30, 2017, we had remaining borrowing availability of $162.8 million under our $850 million Credit Facility. We believe that, if necessary, we could obtain additional borrowings at similar rates to our existing borrowings to fund our growth objectives. We further believe that current cash and cash equivalents, our portfolio of short-duration marketable securities, funds generated from operations, and committed borrowing availability will be sufficient to fund our operations, capital purchase requirements, and anticipated growth needs for the next twelve months. We believe that these resources, coupled with our ability, as needed, to obtain additional financing on favorable terms will also be sufficient for the foreseeable future to fund our business as currently conducted. We may enter into new financing arrangements or refinance or retire existing debt in the future depending on market conditions.



We consider the majority of the operating earnings of certain of our non-U.S. subsidiaries to be indefinitely invested outside the U.S. No provision has been made for the payment of U.S. federal and state or international taxes that may result from future remittances of these undistributed earnings of our non-U.S. subsidiaries. Changes to this position could have adverse tax consequences. A determination of the related tax liability that would be paid on these undistributed earnings if repatriated, is not practicable for several reasons including the complexity of laws and regulations in the various jurisdictions where we operate, the varying tax treatment of potential repatriation scenarios, and the timing of any future repatriation. We manage our worldwide cash requirements considering available funds among all of our subsidiaries. Our foreign cash and marketable securities are generally available without restrictions to fund ordinary business operations outside the U.S.



The following table presents cash, cash equivalents and marketable securities held domestically and by our foreign subsidiaries at September 30, 2017, and December 31, 2016:









 The following table presents marketable securities at fair value as of September 30, 2017, and December 31, 2016:





Of the $169 million of cash and cash equivalents held as of September 30, 2017, 84 percent was held as bank deposits, 12 percent was invested in money market funds restricted to U.S. government and agency securities, and the remainder consisted of commercial paper and other securities with original maturities of less than ninety days.



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Should we require more capital in the U.S. than is generated by our operations domestically, for example to fund significant discretionary activities, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in higher effective tax rates or increased interest expense and other dilution of our earnings. We have borrowed funds domestically and believe we will continue to have the ability to borrow funds domestically at reasonable interest rates. 

 

The following table presents additional key information concerning working capital: 







(1) Days sales outstanding represents the average of the accounts receivable balances at the beginning and end of each quarter divided by revenue for that quarter, the result of which is then multiplied by 91.25 days.

(2) Inventory turns represent inventory-related cost of product revenue for the 12 months preceding each quarter-end divided by the inventory balance at the end of the quarter.



Sources and Uses of Cash 



The following table presents cash provided (used):







Operating Activities. The increase in cash provided by operating activities of $14.0 million was driven primarily by the increase in net income, including the impact of adopting the new accounting guidance to share-based compensation, offset by the changes in operating assets and liabilities. The following table presents cash flows from changes in operating assets and liabilities and the tax benefit from share-based compensation arrangements: 



 

Cash used by accounts receivable during the nine months ended September 30, 2017, as compared to cash used during the same period in the prior year, increased approximately $2.1 million as a result of higher revenues, period over period. Cash used by inventory during the nine months ended September 30, 2017, as compared to cash used during the same period in the prior year, increased by $20.5 million, driven by operational initiatives to optimize inventory levels that were implemented in the first half of 2016, which followed a period of inventory growth to support new products and increasing demand, as well as timing impacts of inventory shipments between the fourth quarter of 2016 and the first quarter of 2017.  Cash used by other assets and liabilities during the nine months ended September 30, 2017 increased $23.1 million primarily as a result of higher relative employee incentive compensation payments, compared to the same period in the prior year.



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We have historically experienced proportionally lower net cash flows from operating activities during the first quarter and proportionally higher cash flows from operating activities for the remainder of the year and for the annual period driven primarily by payments related to annual employee incentive programs in the first quarter following the year for which the bonuses were earned and the seasonality of vector-borne disease testing, which has historically resulted in significant increases in accounts receivable balances during the first quarter of the year.



Investing Activities. Cash used by investing activities was $114.2 million for the nine months ended September 30, 2017, as compared to $76.5 million for the same period in the prior year. The increase in cash used by investing activities was primarily due to net purchases of marketable securities and acquisitions of businesses during the first nine months of 2017.

 

Financing Activities. Cash used by financing activities was $130.0 million for the nine months ended September 30, 2017, as compared to cash used by financing activities of $144.9 million for the same period in the prior year. The decrease in cash used by financing activities was due to an increase in borrowings on our revolving Credit Facility partially offset by an increase in repurchases of our common stock and the impacts of adopting the new accounting guidance related to share-based compensation, which resulted in reclassification to operating activities.

 

Cash used to repurchase shares of our common stock increased $137.1 million during the nine months ended September 30, 2017, as compared to the same period in the prior year. We believe that the repurchase of our common stock is a favorable means of returning value to our shareholders and we also repurchase our stock to offset the dilutive effect of our share-based compensation programs. Repurchases of our common stock may vary depending upon the level of other investing activities and the share price. See Note 10 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for additional information about our share repurchases.



Net borrowing and repayment activity under the Credit Facility resulted in incremental cash provided of $160.3 million during the nine months ended September 30, 2017, as compared to the same period of the prior year. At September 30, 2017, we had $686.3 million outstanding under the Credit Facility. The general availability of funds under the Credit Facility was further reduced by $1.0 million for a letter of credit that was issued in connection with claims under our workers’ compensation policy. The Credit Facility contains affirmative, negative, and financial covenants customary for financings of this type. The negative covenants include restrictions on liens, indebtedness of subsidiaries of the Company, fundamental changes, investments, transactions with affiliates, certain restrictive agreements and violations of laws and regulations. The obligations under the Credit Facility may be accelerated upon the occurrence of an event of default under the Credit Facility, which includes customary events of default including payment defaults, defaults in the performance of the affirmative, negative and financial covenants, the inaccuracy of representations or warranties, bankruptcy and insolvency related defaults, defaults relating to judgments, certain events related to employee pension benefit plans under the Employee Retirement Income Security Act of 1974, the failure to pay specified indebtedness, cross-acceleration to specified indebtedness and a change of control default.



Since December 2013, we have issued and sold through private placements senior notes having an aggregate principal amount of approximately $600 million pursuant to certain note purchase agreements (collectively, the “Senior Note Agreements”). The Senior Note Agreements contain affirmative, negative, and financial covenants customary for agreements of this type. The negative covenants include restrictions on liens, indebtedness of our subsidiaries, priority indebtedness, fundamental changes, investments, transactions with affiliates, certain restrictive agreements and violations of laws and regulations. See Note 11 to the consolidated financial statements in our 2016 Annual Report for additional information regarding our senior notes.



Should we elect to prepay the senior notes, such aggregate prepayment will include the applicable make-whole amount(s), as defined within the applicable Senior Note Agreements. Additionally, in the event of a change in control of the Company or upon the disposition of certain assets of the Company the proceeds of which are not reinvested (as defined in the Senior Note Agreements), we may be required to prepay all or a portion of the Senior Notes. The obligations under the Senior Notes may be accelerated upon the occurrence of an event of default under the applicable Senior Note Agreement, each of which includes customary events of default including payment defaults, defaults in the performance of the affirmative, negative and financial covenants, the inaccuracy of representations or warranties, bankruptcy and insolvency related defaults, defaults relating to judgments, certain events related to employee pension benefit plans under the Employee Retirement Income Security Act of 1974, the failure to pay specified indebtedness and cross-acceleration to specified indebtedness.



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The sole financial covenant of our Credit Facility and Senior Note Agreements is a consolidated leverage ratio test that requires our ratio of debt to earnings before interest, taxes, depreciation and amortization and certain other non-cash charges (“Adjusted EBITDA”) not to exceed 3.5-to-1. At September 30, 2017, we were in compliance with the covenants of the Credit Facility and Senior Note Agreements. The following details our consolidated leverage ratio calculation as of September 30, 2017:







Adjusted EBITDA, gross debt, net debt, gross debt to Adjusted EBITDA ratio and net debt to Adjusted EBITDA ratio are non-GAAP financial measures which should be considered in addition to, and not as a  replacement for, financial measures presented according to U.S. GAAP.  Management believes that reporting these non-GAAP financial measures provides supplemental analysis to help investors further evaluate our business performance and available borrowing capacity under our Credit Facility. 



Other Commitments, Contingencies and Guarantees 

 

Significant commitments, contingencies and guarantees at September 30, 2017, are consistent with those discussed in the section under the heading “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources,” and in Note 14 to the consolidated financial statements contained in our 2016 Annual Report.  

 

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Item 3.  Quantitative and Qualitative Disclosures About Market Risk 

 

For quantitative and qualitative disclosures about market risk affecting us, see the section under the heading “Part II, Item 7A. Quantitative and Qualitative Disclosures About Market Risk” of our 2016 Annual Report. As of the date of this Quarterly Report on Form 10-Q, there have been no material changes to the market risks described in our 2016 Annual Report, except for the impact of foreign exchange rates, as discussed below. 



Foreign Currency Exchange Impacts. For both the three and nine months ended September 30, 2017, approximately 21 percent of our consolidated revenue was derived from products manufactured in the U.S. and sold internationally in local currencies, as compared to 21 percent for the three months ended September 31, 2016, and 20 percent for the nine months ended September 30, 2016. Strengthening of the U.S. dollar exchange rate relative to other currencies has a negative impact on our revenues derived in currencies other than the U.S. dollar and on profits of products manufactured in the U.S. and sold internationally, and a weakening of the U.S. dollar has the opposite effect. Similarly, to the extent that the U.S. dollar is stronger in current or future periods relative to the exchange rates in effect in the corresponding prior periods, our growth rate will be negatively affected. The impact of foreign currency denominated operating expenses and foreign currency denominated supply contracts partly offsets this exposure. Additionally, our designated hedges of intercompany inventory purchases and sales help delay the impact of certain exchange rate fluctuations on non-U.S. denominated revenues.



Our foreign currency exchange impacts are comprised of three components: 1) local currency revenues and expenses; 2) the impact of hedge contracts; and 3) intercompany and trade receivables and payables balances, and monetary balances for our subsidiaries that are denominated in a currency that is different from the functional currency used by each subsidiary. Based on projected revenues and expenses for the remainder of 2017, excluding the impact of intercompany and trade balances denominated in currencies other than the functional subsidiary currencies, we project a 1 percent strengthening of the U.S. dollar would reduce revenue by approximately $2 million and operating income by approximately $1 million. Additionally, we project our foreign currency hedge contracts in place as of September 30, 2017, would result in incremental offsetting gains of less than $0.5 million. The impact of the intercompany and trade balances, and monetary balances referred to in the third component above have been excluded, as they are transacted at multiple times during the year and we are not able to reliably forecast the impact that changes in exchange rates would have on such balances.



The following table presents the foreign currency exchange impact on our revenues, operating profit and diluted earnings per share for the three and nine months ended September 30, 2017 and 2016, as compared to the respective prior periods:







At our current foreign currency exchange rate assumptions, we anticipate the impact of a weaker U.S. dollar in the second half of 2017 will more than offset the impact of a stronger dollar in the first half of 2017 on our revenues, resulting in a year-over-year increase of approximately $5 million. We anticipate the movement in the exchange rates will decrease our operating profit and diluted earnings per share in the year ending December 31, 2017, by approximately $1 million, and $0.01 per share, respectively. This unfavorable impact is net of projected 2017 benefits from previously established foreign currency hedging contracts, which is expected to decrease total company operating profit by approximately $3 million and diluted earnings per share by approximately $0.02 in the year ending December 31, 2017. The actual impact of changes in the value of the U.S. dollar against foreign currencies in which we transact may materially differ from our expectations described above. The above estimate assumes that the value of the U.S. dollar relative to other currencies will reflect the euro at $1.16, the British pound at $1.30, the Canadian dollar at $0.78, the Australian dollar at $0.77, the Japanese yen at ¥114, Chinese renminbi at RMB 6.71 and Brazilian real at R$3.20 to the U.S. dollar for the remainder of 2017. 

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Item 4.  Controls and Procedures 

 

Disclosure Controls and Procedures 

 

Our management is responsible for establishing and maintaining disclosure controls and procedures, as defined by the SEC in its Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 as amended (the “Exchange Act”). The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures at September 30, 2017, our Chief Executive Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.  

 

Changes in Internal Control Over Financial Reporting 

 

There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the three months ended September 30, 2017, that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 

 

PART II — OTHER INFORMATION 

 

Item 1. Legal Proceedings



Due to the nature of our activities, we are at times subject to pending and threatened legal actions that arise out of the ordinary course of business. In the opinion of management, based in part upon advice of legal counsel, the disposition of any such currently pending matters is not expected to have a material effect on our results of operations, financial condition, or cash flows. However, the results of legal actions cannot be predicted with certainty. Therefore, it is possible that our results of operations, financial condition or cash flows could be materially adversely affected in any particular period by the unfavorable resolution of one or more legal actions.



Item 1A. Risk Factors 

 

In addition to the other information set forth in this Quarterly Report on Form 10-Q, you should carefully consider the factors discussed in “Part I, Item 1A. Risk Factors" in our 2016 Annual Report, which could materially affect our business, financial condition, or future results. There have been no material changes from the risk factors previously disclosed in the 2016 Annual Report. The risks described in our 2016 Annual Report are not the only risks facing our Company and additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition, or future results.



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Item 2.Unregistered Sales of Equity Securities and Use of Proceeds 

 

During the three months ended September 30, 2017, we repurchased shares of common stock as described below:  



The total shares repurchased include shares purchased in the open market and shares surrendered for employee statutory tax withholding. See Part 1, Item 1, “Note 10. Repurchases of Common Stock” for discussion on shares repurchased.



 



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Item 6.Exhibits 





 

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SIGNATURES 

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. 



 



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