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PDCO > SEC Filings for PDCO > Form 10-K on 25-Jun-2014All Recent SEC Filings

Show all filings for PATTERSON COMPANIES, INC.

Form 10-K for PATTERSON COMPANIES, INC.


25-Jun-2014

Annual Report


Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Our fiscal 2014 financial information is summarized in this Management's Discussion and Analysis, the Consolidated Financial Statements, and related Notes. The following background is provided to readers to more fully understand our Company's financial information.

Patterson operates a distribution business in three complementary markets:
dental supply, veterinary supply and rehabilitation supply. Historically, our strategy for growth focused on internal growth and the acquisition of smaller distributors and businesses offering related products and services to the dental market. In fiscal 2002, we expanded our strategy to take advantage of a parallel growth opportunity in the veterinary supply market by acquiring the assets of J.
A. Webster, Inc. July 9, 2001, which we operated as Webster Veterinary Supply (Webster) until January 1, 2013. Webster is now known as Patterson Veterinary. Patterson added a third component to our business platform in fiscal 2004 when we entered the rehabilitation supply market with the acquisition of AbilityOne Products Corp. ("AbilityOne") on September 12, 2003. AbilityOne is now known as Patterson Medical.

Operating margins of the veterinary business are considerably lower than the dental and rehabilitation supply businesses. While operating expenses run at a lower rate in the veterinary business, their gross margin is substantially lower due generally to the low margins on the pharmaceutical products that are distributed.

We operate with a 52-53 week accounting convention with our fiscal year ending on the last Saturday in April. Fiscal years 2012, 2013 and 2014 ending April 28, 2012, April 27, 2013 and April 26, 2014, respectively included 52 weeks.

There are several important aspects of Patterson's business that are useful in analyzing it, including: (1) market growth in the various markets in which we operate; (2) internal growth; (3) growth through acquisition; and (4) continued focus on controlling costs and enhancing efficiency. Management defines "internal growth" as the increase in net sales from period to period, excluding the impact of changes in currency exchange rates, and excluding the net sales, for a period of twelve months following the transaction date, of businesses we have acquired.

NVS Acquisition. On August 16, 2013 Patterson Companies, Inc. completed the acquisition of all the outstanding stock of National Veterinary Services Limited ("NVS") from Dechra Pharmaceuticals, PLC ("NVS Acquisition"). NVS is the largest veterinary products distributor in the United Kingdom. Total cash consideration paid for NVS was 91.2 million (approximately $142.7 million). The acquisition was accretive to earnings by $0.04 per diluted share for the fiscal year ended April 26, 2014. The NVS business has lower gross margins and operating expenses than our historical businesses.

Medical Restructuring. On August 22, 2013 Patterson Companies, Inc. announced a plan to divest certain non-core product lines in its medical segment ("Medical Restructuring"). As a result of the plan to dispose of these product lines, we incurred a pre-tax restructuring charge of $15 million or approximately $0.13 per diluted share. $14 million of the restructuring charge were non-cash losses on disposal of assets. We estimate that disposing of these product lines will generate operational savings of approximately $2 million beginning in fiscal year 2015.

Information Technology Initiative. We estimate that we will invest $45 million to $55 million over the next four years to transform our information systems ("Information Technology Initiative"). We estimate that approximately half of this amount will be capitalized over the project life. An incremental $10 million was expensed in fiscal 2014.


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Results of Operations

The following table summarizes our consolidated results of operations over the past three fiscal years as a percent of sales:

                                        2014         2013         2012
                 Net sales               100.0 %      100.0 %      100.0 %
                 Cost of sales            70.5 %       67.3 %       67.1 %

                 Gross margin             29.5 %       32.7 %       32.9 %
                 Operating expenses       21.0 %       23.0 %       22.8 %

                 Operating income          8.5 %        9.7 %       10.1 %
                 Other income, net         0.1 %        0.1 %        0.1 %
                 Interest expense          0.9 %        1.0 %        0.9 %

                 Income before taxes       7.7 %        8.8 %        9.3 %
                 Income taxes              2.8 %        3.0 %        3.3 %

                 Net income                4.9 %        5.8 %        6.0 %

Fiscal 2014 Compared to Fiscal 2013

Net Sales. Consolidated net sales in fiscal 2014 were $4,063.7 million, an increase of 11.7%, from $3,637.2 million in fiscal 2013. The growth in sales includes an 11.3% contribution from acquisitions and a 0.4% unfavorable impact of changes in foreign currency translation rates.

Dental segment sales in fiscal 2014 rose 0.1% to $2,382.1 million from $2,380.0 million in fiscal 2013. The growth included a 0.1% contribution from acquisitions and a 0.5% unfavorable impact from changes in foreign currency translation rates. Consumable sales increased 1.3%. Dental equipment and software sales decreased 1.8% in fiscal 2014 to $828.9 million due to strong CEREC sales in the prior year following a successful trade-up program, as well as a decrease in revenues from digital radiography products although unit volumes increased. The average selling price per unit in the latter category decline in fiscal 2014 as the focus shifted from higher capacity product to more mid-line product in the extraoral categories. Other dental sales, consisting primarily of technical service parts and labor, software support services and artificial teeth, increased 0.3% in fiscal 2014.

Veterinary segment sales grew 59.3% to $1,203.0 million. Acquisitions added 55.8% to sales in fiscal 2014. Excluding the NVS acquisition, consumables increased 2.5%, equipment and software sales increased 20.3% and other increased 15.5%. We believe that our equipment and technology strategy, which includes enhancing our infrastructure and becoming a national technical service provider, is driving the increases in equipment, software and services.

Medical segment sales of $478.6 million decreased 4.7% from fiscal 2013, primarily as a result of reduced sales from the non-core product lines that were divested in the current year. Fiscal 2014 sales were also impacted by continuing challenges in our international business due to austerity measures implemented over healthcare costs by foreign governments. Foreign exchange rate changes had an unfavorable impact to current year sales growth of 0.2%.

Gross Margin. Consolidated gross margin decreased 320 basis points from the prior year to 29.5%. The NVS Acquisition accounts for 250 basis points of the decrease and the Medical Restructuring accounts for 10 basis points resulting in a comparable decrease of 60 basis points from prior year of 32.7%. Veterinary gross margin decreased 430 basis points mainly due to the acquisition of NVS.

Operating Expenses. The consolidated operating expense ratio of 21.0% decreased 200 basis points from prior year at 23.0%. The NVS Acquisition accounts for 190 basis points of the decrease. The incremental


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expenses from the Information Technology Initiative increased operating expense by 30 basis points and the Medical Restructuring increased operating expenses by 30 basis points resulting in a comparable decrease of 70 basis points from Prior Period of 23.0%.

Operating Income. Current year operating income was $345.8 million, or 8.5% of net sales. In the prior year, operating income was $354.5 million, or 9.7% of net sales. The decrease in the operating margin is due primarily to the NVS Acquisition, the Medical Restructuring and the incremental expenses from the Information Technology Initiative, which combined reduced the operating margin by 140 basis points, resulting in a comparable operating margin rate of 9.9%.

Other (Expense) Income, Net. Net other expense was $32.8 million in the current year, a decrease of $0.5 million from the prior year. Net other expense is comprised primarily of interest expense, partly offset by interest income. Foreign currency had a negative impact of $2.1 million compared to $1.5 million in the prior year. Interest income of $5.0 million was up from $4.5 million in the prior year.

Income Taxes. The effective income tax rate was 35.9% in fiscal 2014 as compared to 34.5% in fiscal 2013. The effective tax rate increased in fiscal 2014 as compared to fiscal 2013 due to certain onetime benefits that were included in the prior year rate in addition to the unfavorable impact of the Medical Restructuring in the current year.

Net Income and Earnings Per Share. Net income decreased 4.6% to $200.6 million, compared to $210.3 million in the prior year. The decline is the result of the restructuring undertaken in the Medical segment and the incremental expenses incurred in the information technology transformation mitigated by the earnings contribution from NVS. Earnings per diluted share were $1.97 in the current year compared to $2.03 in the prior year. Excluding the restructuring costs, earnings per diluted share were $2.10. The impact on earnings per share from the incremental information technology expenditures was $0.07 Diluted shares outstanding in the current year were 101,643,000 compared to 103,807,000 in the prior year. The decrease in the share count is due to share repurchase activity. The current year's cash dividend was $0.68 per common share compared to $0.58 in the prior year.

Fiscal 2013 Compared to Fiscal 2012

Net Sales. Consolidated net sales in fiscal 2013 were $3,637.2 million, an increase of 2.9%, from $3,535.7 million in fiscal 2012. The growth in sales includes a 0.6% contribution from acquisitions and a 0.2% unfavorable impact of changes in foreign currency translation rates.

Dental segment sales in fiscal 2013 rose 4.0% to $2,380.0 million from $2,287.9 million in fiscal 2012. The growth included a 0.2% contribution from acquisitions and a 0.1% unfavorable impact form changes in foreign currency translation rates. Consumable sales increased 1.3%. Dental equipment and software sales increased 9.8% in fiscal 2013 to $843.9 million due to strong CEREC sales, as well as an increase in sales of digital radiography products. Other dental sales, consisting primarily of technical service parts and labor, software support services and artificial teeth, increased 2.8% in fiscal 2013.

Veterinary segment sales grew 2.8% to $755.2 million despite the change in a nutritional distribution arrangement that reduced sales by 5.8%. Sales of consumables were 3.4% higher in fiscal 2013, or over 9% after adjusting for the impact of the change in the nutritional agreement. Acquisitions added 0.9% to sales in fiscal 2013. We have been investing in the Veterinary segment's equipment and technical service offering to expand this unit's full-service platform.

Medical segment sales of $502.0 million decreased 2.2% from fiscal 2012. Acquisitions, contributed 1.6% of sales growth. The negative impact from foreign currency translation rates was 0.6% in fiscal 2013. We believe that continued uncertainty surrounding the U.S. health care system and the overall economy as well as continued austerity efforts in the United Kingdom are adversely affecting this segment.


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Gross Margin. Consolidated gross margin was 32.7% in fiscal 2013 and 32.9% in fiscal 2012. The Dental segment's gross margin decreased 30 basis points to 35.9% in fiscal 2013. This decrease is mainly due to sales mix as equipment growth outpaced consumable growth during the year and as the segment effectuated the change in the CEREC product line, which negatively impacted margins. Gross margin of the Veterinary segment increased 60 basis points to 18.9% in fiscal 2013 due primarily to the change in the nutritional distribution arrangement, which carried a lower than average margin. The Medical segment's gross margin declined 30 basis points to 38.7%, as a result of product mix.

Operating Expenses. The consolidated operating expense ratio in fiscal 2013 was 23.0%, or 20 basis points higher than fiscal 2012. The Dental segment's operating expense ratio increased 10 basis points. The Medical segment's operating expenses as a percent of sales were 80 basis points higher in the current fiscal year, due to the integration expense in the Australian operations of the Surgical Synergies acquisition. The Veterinary segment's operating expense ratio increased 40 basis points, mainly due to the reduced revenue from the nutritional agreement change and the addition of service technicians during the period.

Operating Income. Operating income totaled $354.5 million, or 9.7% of sales, compared to fiscal 2012 operating income of $358.0 million, or 10.1% of net sales for the reasons discussed above.

Interest Expense. Interest expense was $36.4 million in fiscal 2013 compared to $30.3 million in fiscal 2012. This increase is due to the issuance of $325 million of debt in the third quarter of the fiscal 2012 offset slightly by the repayment of $125 million of debt that matured late in fiscal 2013.

Other Income, net. Other income, net of other expenses, was $3.1 million in fiscal 2013 compared to $2.1 million in fiscal 2012. Interest income totaled $4.5 million in fiscal 2013, compared to $4.9 million in fiscal 2012.

Income Taxes. The effective income tax rate was 34.5% in fiscal 2013 as compared to 35.5% in fiscal 2012. The effective tax rate decreased in fiscal 2013 primarily due to an increase in the deductible dividends paid on shares held by our Employee Stock Ownership Plan and deductions claimed for domestic manufacturing activities.

Net Income and Earnings Per Share. Net income decreased 1.2% to $210.3 million in fiscal 2013. Earnings per diluted share and dilutive shares outstanding were $2.03 and 103.8 million, respectively, in fiscal 2013 and $1.92 and 110.8 million, respectively, in fiscal 2012.

Liquidity and Capital Resources

Patterson's operating cash flow has been our principal source of liquidity in the last three fiscal years. During fiscal 2014 and 2012, we used our revolving credit facility periodically as a source of liquidity in addition to operating cash flow. Operating activities generated cash of $195.8 million in fiscal 2014, compared to $299.2 million in fiscal 2013 and $321.2 million in fiscal 2012. Our operating activities are primarily driven by net income.

Capital expenditures were $40.3, $22.0 and $29.7 million in fiscal years 2014, 2013 and 2012, respectively. Significant expenditures in these years included the Information Technology Initiative, purchase and expansion of distribution facilities to accommodate multiple business units and the construction of a new facility for the Patterson Technology Center. In fiscal 2012, a project to build-out a purchased building in Indiana that serves as a distribution facility used by all three business units was completed. This facility replaced several smaller distribution facilities. In addition, the Patterson Technology Center in Illinois was completed in fiscal 2012. This 100,000 square foot state-of-the-art facility replaced a nearby-leased location and opened in the second quarter of fiscal 2012.


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We expect to invest approximately $45 million in capital expenditures during fiscal 2015, our main investment is in information systems. We estimate that we will invest $45 million to $55 million over the next four years to transform our information systems. We estimate that approximately half of this amount with be capitalized over the project life.

Cash used for acquisitions and equity investments totaled $145.8 million in fiscal 2014, $14.6 million in fiscal 2013 and $22.6 million in fiscal 2012. The majority of the cash used for acquisitions in fiscal 2014 related to the acquisitions of National Veterinary Supply and Mercer Mastery. In fiscal 2013, the majority of the cash used for acquisitions related to the acquisitions of Iowa Dental Supply and Universal Vaporizer Support. The majority of the cash used for acquisitions in fiscal 2012 related to the acquisitions of American Veterinary Supply Corporation and Surgical Synergies.

In fiscal 2014, we invested in three time deposits with total principal of $110,000 Canadian dollars. Our time deposit securities are classified as "held-to-maturity" securities and are carried at cost, adjusted for accrued interest and amortization.

In fiscal 2013, we retired $125 million of debt. In fiscal 2012, we entered into a new debt agreement for $325 million; see Note 7 of the Consolidated Financial Statements, "Long-term Debt" for further information.

Total dividends paid in fiscal 2014, fiscal 2013 and fiscal 2012 were $85.7 million, $43.7 million and $54.7 million, respectively. We expect to continue to pay a quarterly cash dividend for the foreseeable future. In addition, during fiscal 2014, we repurchased approximately 2.4 million shares of common stock for approximately $96 million. In fiscal 2013, we repurchased approximately 5.2 million shares of common stock for approximately $180 million. In fiscal 2012, we repurchased approximately 12.0 million shares of common stock for approximately $362 million. Under a share repurchase plan authorized by the Board of Directors, as of March 19, 2013, Patterson may repurchase up to 25 million shares of its common stock. This authorization remains in effect through March 19, 2018.

Management expects funds generated from operations and existing cash to be sufficient to meet our working capital needs for the next fiscal year. We have $265 million in cash and cash equivalents of which $190 million is in foreign bank accounts. None of our cash balances are subject to any withdrawal restrictions. See Note 11, "Income Taxes" for further information regarding our intention to permanently reinvest these funds. We have a $250 million note due in the fourth quarter of fiscal year 2015. We have both the intent and ability to refinance at that time, therefore we have classified this balance as long term debt on the balance sheet as of April 26, 2014. We expect to continue to obtain liquidity from the sale of equipment finance contracts. Patterson's existing debt facilities are believed to be adequate as a supplement to internally generated cash flows to fund anticipated expansion plans and strategic initiatives, including acquisitions. In addition, we have a $300 million revolving credit facility which expires in fiscal 2017.

Patterson sells a significant portion of our finance contracts (see below) to a commercial paper funded conduit managed by a third party bank, and as a result, commercial paper is indirectly an important source of liquidity for Patterson. Patterson is allowed to participate in the conduit due to the quality of our finance contracts and our financial strength. Cash flows could be impaired if our financial strength diminishes to a level that precluded us from taking part in this facility or other similar facilities. Also, market conditions outside of our control could adversely affect the ability for us to sell the contracts.

Customer Financing Arrangements

Patterson is a party to two arrangements under which we have sold finance contracts received from our customers to outside financial institutions. These arrangements provide sources of liquidity for us that would have to be replaced should any of the current financial institutions be unable or unwilling to continue under them.


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In December 2010, the Receivables Purchase Agreement was amended to make The Bank of Tokyo-Mitsubishi UFJ, Ltd. ("BTMU") the managing agent. As of April 26, 2014, the total capacity under this agreement is $500 million, which includes $300 million with BTMU and the remainder with Royal Bank of Canada (RBC). In August 2011, Fifth Third Bank (FTB) replaced U.S. Bank National Association as the agent under the Contract Purchase Agreement, which has a capacity of $100 million as of April 26, 2014. Our financing business is described in further detail in Note 6, "Customer Financing." of the Notes to the Consolidated Financial Statements in Item 8 of this Form 10-K. Note 6, discusses the nature and business purpose of the arrangements and the activity under each arrangement during fiscal 2014, including the amount of finance contracts sold and the holdback receivable owed to us.

Contractual Obligations

A summary of Patterson's contractual obligations as of April 26, 2014 follows
(in thousands):



                                                                  Payment due by year
                                                       Less than                                     More than
Contractual Obligations                    Total         1 year        1-3 years      3-5 years       5 years
Long-Term Debt                           $ 725,000     $  250,000     $        -         210,000        265,000
Interest on Long-Term Debt                 141,063         32,984          40,117         31,492         36,470
Operating Leases                            77,531         18,981          29,304         18,285         10,961

Patterson is unable to determine its contractual obligations by year related to the provisions of ASC Topic 740, "Income Taxes", as the ultimate amount or timing of settlement of its reserves for income taxes cannot be reasonably estimated. The total liability for unrecognized tax benefits including interest and penalties at April 26, 2014, is $21.8 million.

For a more complete description of Patterson's contractual obligations, see Notes 7 and 11 to the Consolidated Financial Statements in Item 8 of this Form 10-K.

Outlook

Over the last ten years, we have been able to grow revenue and earnings through our strategy of emphasizing value-added, full-service capabilities, using technology to enhance customer service, continuing to improve operating efficiencies, and growing through internal expansion and acquisitions. While the weakness in the general economy that has existed during the last several years is expected to continue to affect our performance for at least the near term, Patterson's strategy will continue to focus on these key elements. With strong operating cash flow and available credit capacity, we are confident that we will be able to financially support our future growth. We believe that the strategic initiatives that we have implemented in the past several years, as well as those that will be implemented in fiscal 2015 and beyond, will strengthen our operational platform and contribute to future growth. Given these factors, we consider ourselves well positioned to capitalize upon the growth opportunities in the dental, companion animal veterinary and the worldwide rehabilitation supply markets.

Asset Management

The following table summarizes Patterson's days sales outstanding ("DSO") and
inventory turnover the past three fiscal years:



                                               2014      2013      2012
                  Days sales outstanding (1)      46        42        45
                  Inventory turnover (2)         7.2       7.1       6.7

(1) Receivables as of April 26, 2014, April 27, 2013 and April 28, 2012 include approximately $7 million, $9 million and $20 million, respectively, of finance contracts received from customers related to certain


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financing promotions in fiscal 2014, 2013 and 2012. Patterson has sold contracts in fiscal 2014 and expects to sell the contracts held as of April 26, 2014 to outside institutions under an existing agreement during fiscal 2015. If these finance contracts are excluded from the calculation of DSO, the pro forma DSO would be 45, 42 and 43 as of April 26, 2014, April 27, 2013 and April 28, 2012, respectively.

(2) The inventory values used in this calculation are the LIFO inventory values for all inventories except for manufactured inventories and foreign inventories, which are valued using FIFO inventory methods.

Foreign Operations

Foreign sales derive primarily from Patterson Dental and Patterson Medical operations in Canada, from Patterson Veterinary's operations in the U.K. and from Patterson Medical operations in the U.K., France, Australia and Thailand. Fluctuations in currency exchange rates have not significantly impacted earnings. However, changes in exchange rates adversely affected net sales in fiscal 2014 and 2013, and enhanced net sales in fiscal 2012. Without foreign currency effects, net sales would have been $13.9 million higher, $5.6 million higher, and $6.1 million lower in fiscal years 2014, 2013 and 2012, respectively. Changes in currency exchange rates are a risk accompanying foreign operations, but this risk is not considered material with respect to our consolidated operations.

Critical Accounting Policies and Estimates

Patterson has adopted various accounting policies to prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States. Management believes that our policies are conservative and our philosophy is to adopt accounting policies that minimize the risk of adverse events having a material impact on recorded assets and liabilities. However, the preparation of financial statements requires the use of estimates and judgments regarding the realization of assets and the settlement of liabilities based on the information available to management at the time. Changes subsequent to the preparation of the financial statements in economic, technological and competitive conditions may materially impact the recorded values of Patterson's assets and liabilities. Therefore, the users of the financial statements should read all the notes to the Consolidated Financial Statements and be aware that conditions currently unknown to management may develop in the future. This may require a material adjustment to a recorded asset or liability to consistently apply to our significant accounting principles and policies that are discussed in Note 1 to the Consolidated Financial Statements. The financial performance and condition of Patterson may also be materially impacted by transactions and events that we have not previously experienced and for which we have not been required to establish an accounting policy or adopt a generally accepted accounting principle.

Revenue Recognition - Revenues are generated from the sale of consumable products, equipment, software products and services, technical service parts and labor, freight and delivery charges, and other sources. Revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable, and there is reasonable assurance of collection of the sale. Estimates for returns, damaged goods, rebates, loyalty programs and other revenue allowances are made at the time the revenue is recognized based on the historical experience for such items. In addition to revenues generated from the distribution of consumable . . .

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