filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Note Regarding Forward-Looking Statements
In accordance with the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995, we provide the following cautionary remarks regarding important factors that, among others, could cause future results to differ materially from the forward-looking statements, expectations and assumptions expressed or implied herein. All forward-looking statements made by us are subject to risks and uncertainties and are not guarantees of future performance. These forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance and achievements or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. These statements are identified by the use of such terms as “may,” “could,” “expect,” “intend,” “believe,” “plan,” “estimate,” “forecast,” “project,” “anticipate” or other comparable terms. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Annual Report on Form 10-K, and in particular the risks discussed under the caption “Risk Factors” in Item 1A of this report and those discussed in other documents we file with the Securities and Exchange Commission (SEC).
Risk factors and uncertainties that could cause actual results to differ materially from current and historical results include, but are not limited to: effects of a highly competitive and consolidating market; our dependence on third parties for the manufacture and supply of our products; our dependence upon sales personnel, customers, suppliers and manufacturers; our dependence on our senior management; fluctuations in quarterly earnings; risks from expansion of customer purchasing power and multi-tiered costing structures; increases in shipping costs for our products or other service issues with our third-party shippers; general global macro-economic conditions; risks associated with currency fluctuations; risks associated with political and economic uncertainty; disruptions in financial markets; volatility of the market price of our common stock; changes in the health care industry; implementation of health care laws; failure to comply with regulatory requirements and data privacy laws; risks associated with our global operations; transitional challenges associated with acquisitions and joint ventures, including the failure to achieve anticipated synergies; financial risks associated with acquisitions and joint ventures; litigation risks; new or unanticipated litigation developments; the dependence on our continued product development, technical support and successful marketing in the technology segment; our dependence on third parties for certain technologically advanced components; increased competition by third party online commerce sites; risks from disruption to our information systems; cyberattacks or other privacy or data security breaches; certain provisions in our governing documents that may discourage third-party acquisitions of us; and changes in tax legislation. The order in which these factors appear should not be construed to indicate their relative importance or priority.
We caution that these factors may not be exhaustive and that many of these factors are beyond our ability to control or predict. Accordingly, any forward-looking statements contained herein should not be relied upon as a prediction of actual results. We undertake no duty and have no obligation to update forward-looking statements.
Where You Can Find Important Information
We may disclose important information through one or more of the following channels: SEC filings, public conference calls and webcasts, press releases, the investor relations page of our website (www.henryschein.com) and the social media channels identified on the Newsroom page of our website.
Executive-Level Overview
We believe we are the world’s largest provider of health care products and services primarily to office-based dental, animal health and medical practitioners. We serve more than 1 million customers worldwide including dental practitioners and laboratories, animal health clinics and physician practices, as well as government, institutional health care clinics and other alternate care clinics. We believe that we have a strong brand identity due to our more than 85 years of experience distributing health care products.
We are headquartered in Melville, New York, employ more than 22,000 people (of which more than 11,400 are based outside the United States) and have operations or affiliates in 34 countries, including the United States, Australia, Austria, Belgium, Brazil, Canada, Chile, China, the Czech Republic, Denmark, France, Germany, Hong Kong SAR, Ireland, Israel, Italy, Japan, Liechtenstein, Luxembourg, Malaysia, the Netherlands, New Zealand, Norway, Poland, Portugal, Romania, Slovakia, South Africa, Spain, Sweden, Switzerland, Thailand, United Arab Emirates and the United Kingdom.
We have established strategically located distribution centers to enable us to better serve our customers and increase our operating efficiency. This infrastructure, together with broad product and service offerings at competitive prices, and a strong commitment to customer service, enables us to be a single source of supply for our customers’ needs. Our infrastructure also allows us to provide convenient ordering and rapid, accurate and complete order fulfillment.
We conduct our business through two reportable segments: (i) health care distribution and (ii) technology and value-added services. These segments offer different products and services to the same customer base.
The health care distribution reportable segment aggregates our global dental, animal health and medical operating segments. This segment distributes consumable products, small equipment, laboratory products, large equipment, equipment repair services, branded and generic pharmaceuticals, vaccines, surgical products, diagnostic tests, infection-control products and vitamins. Our global dental group serves office-based dental practitioners, dental laboratories, schools and other institutions. Our global animal health group serves animal health practices and clinics. Our global medical group serves office-based medical practitioners, ambulatory surgery centers, other alternate-care settings and other institutions.
Our global technology and value-added services group provides software, technology and other value-added services to health care practitioners. Our technology group offerings include practice management software systems for dental and medical practitioners and animal health clinics. Our value-added practice solutions include financial services on a non-recourse basis, e-services, practice technology, network and hardware services, as well as continuing education services for practitioners.
Industry Overview
In recent years, the health care industry has increasingly focused on cost containment. This trend has benefited distributors capable of providing a broad array of products and services at low prices. It also has accelerated the growth of HMOs, group practices, other managed care accounts and collective buying groups, which, in addition to their emphasis on obtaining products at competitive prices, tend to favor distributors capable of providing specialized management information support. We believe that the trend towards cost containment has the potential to favorably affect demand for technology solutions, including software, which can enhance the efficiency and facilitation of practice management.
Our operating results in recent years have been significantly affected by strategies and transactions that we undertook to expand our business, domestically and internationally, in part to address significant changes in the health care industry, including consolidation of health care distribution companies, health care reform, trends toward managed care, cuts in Medicare and collective purchasing arrangements.
Our current and future results have been and could be impacted by the current economic environment and uncertainty, particularly impacting overall demand for our products and services.
Industry Consolidation
The health care products distribution industry, as it relates to office-based health care practitioners, is fragmented and diverse. This industry, which encompasses the dental, animal health and medical markets, was estimated to produce revenues of approximately $45 billion in 2017 in the global markets. The industry ranges from sole practitioners working out of relatively small offices to group practices or service organizations ranging in size from a few practitioners to a large number of practitioners who have combined or otherwise associated their practices.
Due in part to the inability of office-based health care practitioners to store and manage large quantities of supplies in their offices, the distribution of health care supplies and small equipment to office-based health care practitioners has been characterized by frequent, small quantity orders, and a need for rapid, reliable and substantially complete order fulfillment. The purchasing decisions within an office-based health care practice are typically made by the practitioner or an administrative assistant. Supplies and small equipment are generally purchased from more than one distributor, with one generally serving as the primary supplier.
The trend of consolidation extends to our customer base. Health care practitioners are increasingly seeking to partner, affiliate or combine with larger entities such as hospitals, health systems, group practices or physician hospital organizations. In many cases, purchasing decisions for consolidated groups are made at a centralized or professional staff level; however, orders are delivered to the practitioners’ offices.
We believe that consolidation within the industry will continue to result in a number of distributors, particularly those with limited financial, operating and marketing resources, seeking to combine with larger companies that can provide growth opportunities. This consolidation also may continue to result in distributors seeking to acquire companies that can enhance their current product and service offerings or provide opportunities to serve a broader customer base.
Our trend with regard to acquisitions and joint ventures has been to expand our role as a provider of products and services to the health care industry. This trend has resulted in our expansion into service areas that complement our existing operations and provide opportunities for us to develop synergies with, and thus strengthen, the acquired businesses.
As industry consolidation continues, we believe that we are positioned to capitalize on this trend, as we believe we have the ability to support increased sales through our existing infrastructure, although there can be no assurances that we will be able to successfully accomplish this. We also have invested in expanding our sales/marketing infrastructure to include a focus on building relationships with decision makers who do not reside in the office-based practitioner setting.
As the health care industry continues to change, we continually evaluate possible candidates for merger and joint venture or acquisition and intend to continue to seek opportunities to expand our role as a provider of products and services to the health care industry. There can be no assurance that we will be able to successfully pursue any such opportunity or consummate any such transaction, if pursued. If additional transactions are entered into or consummated, we would incur merger and/or acquisition-related costs, and there can be no assurance that the integration efforts associated with any such transaction would be successful.
Aging Population and Other Market Influences
The health care products distribution industry continues to experience growth due to the aging population, increased health care awareness, the proliferation of medical technology and testing, new pharmacology treatments and expanded third-party insurance coverage, partially offset by the effects of unemployment on insurance coverage. In addition, the physician market continues to benefit from the shift of procedures and diagnostic testing from acute care settings to alternate-care sites, particularly physicians’ offices.
According to the U.S. Census Bureau’s International Data Base, in 2017 there were more than six million Americans aged 85 years or older, the segment of the population most in need of long-term care and elder-care
services. By the year 2050, that number is projected to nearly triple to approximately 19 million. The population aged 65 to 84 years is projected to increase over 50% during the same time period.
As a result of these market dynamics, annual expenditures for health care services continue to increase in the United States. We believe that demand for our products and services will grow, while continuing to be impacted by current and future operating, economic and industry conditions. The Centers for Medicare and Medicaid Services, or CMS, published “National Health Expenditure Projections 2016-2025” indicating that total national health care spending reached approximately $3.4 trillion in 2016, or 18.1% of the nation’s gross domestic product, the benchmark measure for annual production of goods and services in the United States. Health care spending is projected to reach approximately $5.5 trillion in 2025, approximately 19.9% of the nation’s gross domestic product.
Government
Certain of our businesses involve the distribution of pharmaceuticals and medical devices, and in this regard we are subject to extensive local, state, federal and foreign governmental laws and regulations applicable to the distribution and sale of pharmaceuticals and medical devices. Additionally, government and private insurance programs fund a large portion of the total cost of medical care, and there has been an emphasis on efforts to control medical costs, including laws and regulations lowering reimbursement rates for pharmaceuticals, medical devices, and/or medical treatments or services. Also, many of these laws and regulations are subject to change and may impact our financial performance. In addition, our businesses are generally subject to numerous other laws and regulations that could impact our financial performance, including securities, antitrust, anti-bribery and anti-kickback, customer interaction transparency, data privacy, data security and other laws and regulations. Failure to comply with law or regulations could have a material adverse effect on our business.
Health Care Reform
The United States Patient Protection and Affordable Care Act as amended by the Health Care and Education Reconciliation Act, each enacted in March 2010 (the “Health Care Reform Law”) increased federal oversight of private health insurance plans and included a number of provisions designed to reduce Medicare expenditures and the cost of health care generally, to reduce fraud and abuse, and to provide access to increased health coverage.
The Health Care Reform Law requirements include a 2.3% excise tax on domestic sales of many medical devices by manufacturers and importers that began in 2013 and a fee on branded prescription drugs and biologics that was implemented in 2011, both of which may affect sales. However, with respect to the medical device excise tax, a two-year moratorium was imposed under the Consolidated Appropriations Act, 2016, suspending the imposition of the tax on device sales during the period beginning January 1, 2016 and ending on December 31, 2017, and on January 22, 2018 an additional two-year moratorium was imposed under Public Law No. 115-120, suspending the imposition of the tax on device sales during the period beginning January 1, 2018 and ending on December 31, 2019. The Health Care Reform Law has also materially expanded the number of individuals in the United States with health insurance. The Health Care Reform Law has faced ongoing legal challenges, including litigation seeking to invalidate some of or all of the law or the manner in which it has been implemented. In addition, the President is seeking to repeal and replace the Health Care Reform Law. Repeal and replace legislation has been passed in the House of Representatives, but did not obtain the necessary votes in the Senate. Subsequently, the President has affirmed his intention to repeal and replace the Health Care Reform Law and has taken a number of administrative actions to materially weaken the Health Care Reform Law. On December 22, 2017, the President signed the Tax Cuts and Jobs Act into law, which contains a broad range of tax reform provisions that impact the individual and corporate tax rates, international tax provisions, income tax add-back provisions and deductions. The tax reform law also repealed the individual mandate of the Health Care Reform Law. The uncertain status of the Health Care Reform Law affects our ability to plan.
A Health Care Reform Law provision, generally referred to as the Physician Payment Sunshine Act or Open Payments Program, has imposed new reporting and disclosure requirements for drug and device manufacturers and distributors with regard to payments or other transfers of value made to certain covered recipients (including physicians, dentists and teaching hospitals), and for such manufacturers and distributors and for group purchasing organizations, with regard to certain ownership interests held by physicians in the reporting entity. CMS publishes information from these reports on a publicly available website, including amounts transferred and physician, dentist and teaching hospital identities.
Under the Physician Payment Sunshine Act, we are required to collect and report detailed information regarding certain financial relationships we have with physicians, dentists and teaching hospitals. We believe that we are substantially compliant with applicable Physician Payment Sunshine Act requirements. The Physician Payment Sunshine Act pre-empts similar state reporting laws, although we or our subsidiaries may be required to report under certain state transparency laws that address circumstances not covered by the Physician Payment Sunshine Act, and some of these state laws, as well as the federal law, can be ambiguous. We are also subject to foreign regulations requiring transparency of certain interactions between suppliers and their customers. While we believe we have substantially compliant programs and controls in place to comply with these requirements, our compliance with these rules imposes additional costs on us.
Another notable Medicare health care reform initiative, the Medicare Access and CHIP Reauthorization Act of 2015 (“MACRA”), enacted on April 16, 2015, establishes a new payment framework, called the Quality Payment Program, which modifies certain Medicare payments to “eligible clinicians,” including physicians, dentists and other practitioners. Under MACRA, eligible clinicians will be required to participate in Medicare through the Merit-Based Incentive Payment System (“MIPS”) or Advanced Alternative Payment Models (“APMs”). MIPS generally will consolidate three current programs; the physician quality reporting system, the value-based payment modifier and the Medicare electronic health record (“EHR”) program, into a single program in which Medicare reimbursement to eligible clinicians will include both positive and negative payment adjustments that take into account quality, resource use, clinical practice improvement and meaningful use of certified EHR technology. Advanced APMs generally involve higher levels of financial and technology risk. A final rule was published in the Federal Register on November 4, 2016 and allows eligible Medicare clinicians to pick their pace of participation for the first performance period that began January 1, 2017. The data collected in the first performance year will determine payment adjustments beginning January 1, 2019. A final rule updating certain Quality Payment Program regulations was published on November 16, 2017, which became effective as of January 1, 2018. MACRA represents a fundamental change in physician reimbursement that is expected to provide substantial financial incentives for physicians to participate in risk contracts, and to increase physician information technology and reporting obligations. The implications of the implementation of MACRA are uncertain and will depend on future regulatory activity and physician activity in the marketplace. MACRA may encourage physicians to move from smaller practices to larger physician groups or hospital employment, leading to a consolidation of a portion of our customer base. Although we believe that we are positioned to capitalize on this consolidation trend, there can be no assurances that we will be able to successfully accomplish this.
Health Care Fraud
Certain of our businesses are subject to federal and state (and similar foreign) health care fraud and abuse, referral and reimbursement laws and regulations with respect to their operations. Some of these laws, referred to as “false claims laws,” prohibit the submission or causing the submission of false or fraudulent claims for reimbursement to federal, state and other health care payers and programs. Other laws, referred to as “anti-kickback laws,” prohibit soliciting, offering, receiving or paying remuneration in order to induce the referral of a patient or ordering, purchasing, leasing or arranging for, or recommending ordering, purchasing or leasing of, items or services that are paid for by federal, state and other health care payers and programs.
The fraud and abuse laws and regulations have been subject to varying interpretations, as well as heightened enforcement activity over the past few years, and significant enforcement activity has been the result of “relators,” who serve as whistleblowers by filing complaints in the name of the United States (and if applicable, particular states) under federal and state false claims laws. Under the federal False Claims Act, relators can be entitled to receive up to 30% of total recoveries. Also, violations of the federal False Claims Act can result in treble damages, and, in accordance with a final rule published by the Department of Justice on February 3, 2017, which substantially increased the maximum and minimum civil penalties for False Claims Act violations, the amounts for civil penalties assessed after February 3, 2017, whose associated violations occurred after November 2, 2015, were increased from a minimum per-claim penalty of $10,781 to $10,957, and from a maximum per-claim penalty of $21,563 to $21,916. Most states have adopted similar state false claims laws, and these state laws have their own penalties which may be in addition to federal False Claims Act penalties. The Health Care Reform Law significantly strengthened the federal False Claims Act and the federal Anti-Kickback Law provisions, which could lead to the possibility of increased whistleblower or relator suits, and among other things made clear that a federal Anti-Kickback Law violation can be a basis for federal False Claims Act liability.
The United States government (among others) has expressed concerns about financial relationships between suppliers on the one hand and physicians and dentists on the other. As a result, we regularly review and revise our marketing practices as necessary to facilitate compliance.
We also are subject to certain United States and foreign laws and regulations concerning the conduct of our foreign operations, including the U.S. Foreign Corrupt Practices Act, the U.K. Bribery Act, German anti-corruption laws and other anti-bribery laws and laws pertaining to the accuracy of our internal books and records, which have been the focus of increasing enforcement activity globally in recent years.
Failure to comply with fraud and abuse laws and regulations could result in significant civil and criminal penalties and costs, including the loss of licenses and the ability to participate in federal and state health care programs, and could have a material adverse effect on our business. Also, these measures may be interpreted or applied by a prosecutorial, regulatory or judicial authority in a manner that could require us to make changes in our operations or incur substantial defense and settlement expenses. Even unsuccessful challenges by regulatory authorities or private relators could result in reputational harm and the incurring of substantial costs. In addition, many of these laws are vague or indefinite and have not been interpreted by the courts, and have been subject to frequent modification and varied interpretation by prosecutorial and regulatory authorities, increasing the risk of noncompliance.
While we believe that we are substantially compliant with applicable fraud and abuse laws and regulations, and have adequate compliance programs and controls in place to ensure substantial compliance, we cannot predict whether changes in applicable law, or interpretation of laws, or changes in our services or marketing practices in response to changes in applicable law or interpretation of laws, could have a material adverse effect on our business.
Operating, Security and Licensure Standards
Certain of our businesses involve the distribution of pharmaceuticals and medical devices, and in this regard we are subject to various local, state, federal and foreign governmental laws and regulations applicable to the distribution of pharmaceuticals and medical devices. Among the United States federal laws applicable to us are the Controlled Substances Act, the Federal Food, Drug, and Cosmetic Act, as amended (“FDC Act”), and Section 361 of the Public Health Service Act. We are also subject to comparable foreign regulations.
The FDC Act and similar foreign laws generally regulate the introduction, manufacture, advertising, labeling, packaging, storage, handling, reporting, marketing and distribution of, and record keeping for, pharmaceuticals and medical devices shipped in interstate commerce, and states may similarly regulate such activities within the state. Section 361 of the Public Health Service Act, which provides authority to prevent the spread of communicable diseases, serves as the legal basis for the United States Food and Drug Administration’s (“FDA”) regulation of human cells, tissues and cellular and tissue-based products, also known as “HCT/P products.”
The Federal Drug Quality and Security Act of 2013 brought about significant changes with respect to pharmaceutical supply chain requirements and pre-empts state law. Title II of this measure, known as the Drug Supply Chain Security Act (“DSCSA”), is being phased in over a period of ten years, and is intended to build a national electronic, interoperable system to identify and trace certain prescription drugs as they are distributed in the United States. The law’s track and trace requirements applicable to manufacturers, wholesalers, repackagers and dispensers (e.g., pharmacies) of prescription drugs took effect in January 2015, and will continue to be implemented. The DSCSA product tracing requirements replace the former FDA drug pedigree requirements and pre-empt state requirements that are inconsistent with, more stringent than, or in addition to, the DSCSA requirements.
The DSCSA also establishes certain requirements for the licensing and operation of prescription drug wholesalers and third party logistics providers (“3PLs”), and includes the eventual creation of national wholesaler and 3PL licenses in cases where states do not license such entities. The DSCSA requires that wholesalers and 3PLs distribute drugs in accordance with certain standards regarding the recordkeeping, storage and handling of prescription drugs. According to FDA guidance, states are pre-empted from imposing any licensing requirements that are inconsistent with, less stringent than, directly related to, or covered by the standards established by federal law in this area. Current state licensing requirements will likely remain in effect until the FDA issues new regulations as directed by the DSCSA.
We believe that we are substantially compliant with applicable DSCSA requirements.
The Food and Drug Administration Amendments Act of 2007 and the Food and Drug Administration Safety and Innovation Act of 2012 amended the FDCA to require the FDA to promulgate regulations to implement a unique device identification (“UDI”) system. The FDA is phasing in the implementation of the UDI regulations over seven years, generally beginning with the highest-risk devices (i.e., Class III medical devices) and ending with the lowest-risk devices. The UDI regulations require “labelers” to include unique device identifiers (“UDIs”), with a content and format prescribed by the FDA and issued under a system operated by an FDA-accredited issuing agency, on the labels and packages of medical devices, and to directly mark certain devices with UDIs. The UDI regulations also require labelers to submit certain information concerning UDI-labeled devices to the FDA, much of which information is publicly available on an FDA database, the Global Unique Device Identification Database. The UDI regulations provide for certain exceptions, alternatives and time extensions. For example, the UDI regulations include a general exception for Class I devices exempt from the Quality System Regulation (other than record-keeping requirements and complaint files). Regulated labelers include entities such as device manufacturers, repackagers, reprocessors and relabelers that cause a device’s label to be applied or modified, with the intent that the device will be commercially distributed without any subsequent replacement or modification of the label, and include certain of our businesses.
We believe that we are substantially compliant with applicable UDI requirements.
Under the Controlled Substances Act, as a distributor of controlled substances, we are required to obtain and renew annually registrations for our facilities from the United States Drug Enforcement Administration (“DEA”) permitting us to handle controlled substances. We are also subject to other statutory and regulatory requirements relating to the storage, sale, marketing, handling and distribution of such drugs, in accordance with the Controlled Substances Act and its implementing regulations, and these requirements have been subject to heightened enforcement activity in recent times. We are subject to inspection by the DEA.
Certain of our businesses are also required to register for permits and/or licenses with, and comply with operating and security standards of, the DEA, the FDA, the United States Department of Health and Human Services, and various state boards of pharmacy, state health departments and/or comparable state agencies as well as comparable foreign agencies, and certain accrediting bodies depending on the type of operations and location of product distribution, manufacturing or sale. These businesses include those that distribute, manufacture and/or repackage prescription pharmaceuticals and/or medical devices and/or HCT/P products, or own pharmacy operations, or install, maintain or repair equipment. In addition, Section 301 of the National Organ Transplant Act, and a number of comparable state laws, impose civil and/or criminal penalties for the transfer of certain human tissue (for example, human bone products) for valuable consideration, while generally permitting payments for the reasonable costs incurred in procuring, processing, storing and distributing that tissue. We are also subject to
foreign government regulation of such products. The DEA, the FDA and state regulatory authorities have broad inspection and enforcement powers, including the ability to suspend or limit the distribution of products by our distribution centers, seize or order the recall of products and impose significant criminal, civil and administrative sanctions for violations of these laws and regulations. Foreign regulations subject us to similar foreign enforcement powers. Furthermore, compliance with legal requirements has required and may in the future require us to institute voluntary recalls of products we sell, which could result in financial losses and potential reputational harm. Our customers are also subject to significant federal, state, local and foreign governmental regulation.
Certain of our businesses are subject to various additional federal, state, local and foreign laws and regulations, including with respect to the sale, transportation, storage, handling and disposal of hazardous or potentially hazardous substances, and safe working conditions.
Certain of our businesses also maintain contracts with governmental agencies and are subject to certain regulatory requirements specific to government contractors.
Antitrust
The U.S. federal government, most U.S. states and many foreign countries have antitrust laws that prohibit certain types of conduct deemed to be anti-competitive. Violations of antitrust laws can result in various sanctions, including criminal and civil penalties. Private plaintiffs also could bring civil lawsuits against us in the United States for alleged antitrust law violations, including claims for treble damages.
Regulated Software; Electronic Health Records
The FDA has become increasingly active in addressing the regulation of computer software intended for use in health care settings, and has developed and continues to develop policies on regulating clinical decision support tools and other types of software as medical devices. Certain of our businesses involve the development and sale of software and related products to support physician and dental practice management, and it is possible that the FDA or foreign government authorities could determine that one or more of our products is a medical device, which could subject us or one or more of our businesses to substantial additional requirements with respect to these products.
In addition, the European Parliament and the Council of the European Union have adopted a new pan-European General Data Protection Regulation (“GDPR”), effective from May 25, 2018, which increases privacy rights for individuals in Europe, extends the scope of responsibilities for data controllers and data processors and imposes increased requirements and potential penalties on companies offering goods or services to individuals who are located in Europe (“Data Subjects”) or monitoring the behavior of such individuals (including by companies based outside of Europe). Noncompliance can result in penalties of up to the greater of EUR 20 million, or 4% of global company revenues. Individual member states may impose additional requirements and penalties as they relate to certain things such as employee personal data. Among other things, the GDPR requires with respect to data concerning Data Subjects, company accountability, consents from Data Subjects or other acceptable legal basis needed to process the personal data, prompt breach notifications within 72 hours, fairness and transparency in how the personal data is stored, used or otherwise processed, and data integrity and security, and provides rights to Data Subjects relating to modification, erasure and transporting of the personal data. While we expect to have substantially compliant programs and controls in place to comply with the GDPR requirements, our compliance with the new regulation is likely to impose additional costs on us, and we cannot predict whether the interpretations of the requirements, or changes in our practices in response to new requirements or interpretations of the requirements, could have a material adverse effect on our business.
We also sell products and services that health care providers, such as physicians and dentists, use to store and manage patient medical or dental records. These customers are subject to laws, regulations and industry standards, such as HIPAA and the Payment Card Industry Data Security Standards, which require that they protect the privacy and security of those records, and our products may be used as part of these customers’ comprehensive data security programs, including in connection with their efforts to comply with applicable privacy and security laws. Perceived or actual security vulnerabilities in our products or services, or the perceived or actual failure by us or our customers who use our products to comply with applicable legal or contractual requirements, may not only
cause us significant reputational harm, but may also lead to claims against us by our customers and/or governmental agencies and involve substantial fines, penalties and other liabilities and expenses and costs for remediation.
Federal initiatives provide a program of incentive payments available to certain health care providers involving the adoption and use of certain electronic health care records systems and processes. The initiatives include providing, among others, physicians and dentists, with financial incentives if they meaningfully use certified EHR technology in accordance with applicable and evolving requirements. In addition, Medicare-eligible providers that fail to timely adopt certified EHR systems and meet “meaningful use” requirements for those systems in accordance with regulatory requirements are to be subject to cumulative Medicare reimbursement reductions, which reductions for applicable health professionals (including physicians and dentists) began on January 1, 2015. Qualification for the incentive payments requires the use of EHRs that have certain capabilities for meaningful use pursuant to evolving standards adopted by CMS and by the Office of the National Coordinator for Health Information Technology (“ONC”) of the Department of Health and Human Services (“HHS”).
The use of certified EHR technology will continue as a feature of MACRA’s MIPS program, and in connection with this, Medicare EHR program payment adjustments to eligible professionals will sunset at the end of 2018 and MIPS payment adjustments will begin on January 1, 2019. The first performance period for MIPS began January 1, 2017, and will afford eligible clinicians different reporting options linked to the amount of data reported and the duration of the reporting period, with positive payment adjustments generally linked to more robust reporting.
On October 6, 2015, CMS and ONC released comprehensive final rules with respect to the EHR program that, among other things, established the more challenging “Stage 3” criteria, made certain adjustments to Stage 1 and Stage 2 standards (e.g., reducing the 2015 reporting period from a full year to 90 days), and finalized 2015 edition health information technology (HIT) certification criteria (which is now added to the existing 2014 edition HIT certification criteria, but not required until 2018). Notably, under the new rules, compliance with Stage 3 standards is optional for providers in 2017, and would generally be required for all eligible providers (regardless of prior participation in the EHR incentive program) for 2018 reporting periods and subsequently. Developers and others involved in the manufacture of EHR program technology will have this interim period to develop and certify products, and work with customers to implement products for the 2018 EHR program period. In connection with the release of the October 6 rules, HHS has also stated that it will continue to modify applicable EHR program standards. On November 14, 2016, CMS published a final rule that will impact Medicare and Medicaid EHR incentive programs through revisions to the objectives and measures for eligible hospitals, critical access hospitals and dual-eligible hospitals.
Certain of our businesses involve the manufacture and sale of certified EHR systems and other products linked to incentive programs. CMS and ONC establish criteria for certified EHR systems, and these criteria have been subject to change. In order to maintain certification of our EHR products, we must satisfy these changing governmental criteria. Certain of our businesses involve the manufacture and sale of certified EHR systems and other products linked to incentive programs. CMS and ONC establish criteria for certified EHR systems, and these criteria have been subject to change. In order to maintain certification of our EHR products, we must satisfy these changing governmental criteria. If any of our EHR systems do not meet these standards, yet have been relied upon by health care providers to receive federal incentive payments, as noted above, we are exposed to risk under federal health care fraud and abuse laws, such as the False Claims Act. For example, on May 31, 2017, the U.S. Department of Justice announced a $155 million settlement and 5-year corporate integrity agreement involving a vendor of certified EHR systems, based on allegations that the vendor, by misrepresenting capabilities to the certifying body, caused its health care provider customers to submit false Medicare and Medicaid claims for meaningful use payments in violation of the False Claims Act. While we believe we are substantially in compliance with such certifications and with applicable fraud and abuse laws and regulations, and we have adequate compliance programs and controls in place to ensure substantial compliance, we cannot predict whether changes in applicable law, or interpretation of laws, or changes in our practices in response to changes in applicable law or interpretation of laws, could have a material adverse effect on our business. Moreover, in order to satisfy our customers, our products may need to incorporate increasingly complex reporting functionality. Although we believe we are positioned to accomplish this, the effort may involve increased costs, and our failure to implement product modifications, or otherwise satisfy applicable standards, could have a material adverse effect on our
business.
Other health information standards, such as regulations under HIPAA, establish standards regarding electronic health data transmissions and transaction code set rules for specific electronic transactions, such as transactions involving claims submissions to third party payers. Certain of our businesses provide electronic practice management products that must meet these requirements. Failure to abide by electronic health data transmission standards could expose us to breach of contract claims, substantial fines, penalties, and other liabilities and expenses, costs for remediation and harm to our reputation.
Additionally, as electronic medical devices are increasingly connected to each other and to other technology, the ability of these connected systems safely and effectively to exchange and use exchanged information becomes increasingly important. On September 6, 2017, the FDA issued guidance to assist industry in identifying specific considerations related to the ability of electronic medical devices to safely and effectively exchange and use exchanged information. As a medical device manufacturer, we must manage risks including those associated with an electronic interface that is incorporated into a medical device.
There may be additional legislative initiatives in the future impacting health care.
E-Commerce
Electronic commerce solutions have become an integral part of traditional health care supply and distribution relationships. Our distribution business is characterized by rapid technological developments and intense competition. The continuing advancement of online commerce requires us to cost-effectively adapt to changing technologies, to enhance existing services and to develop and introduce a variety of new services to address the changing demands of consumers and our customers on a timely basis, particularly in response to competitive offerings.
Through our proprietary, technologically based suite of products, we offer customers a variety of competitive alternatives. We believe that our tradition of reliable service, our name recognition and large customer base built on solid customer relationships, position us well to participate in this significant aspect of the distribution business. We continue to explore ways and means to improve and expand our Internet presence and capabilities, including our online commerce offerings and our use of various social media outlets.
Results of Operations
The following tables summarize the significant components of our operating results and cash flows for each of the three years ended December 30, 2017, December 31, 2016 and December 26, 2015 (in thousands):
| Years Ended | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| December 30, | December 31, | December 26, | |||||||||
| 2017 | 2016 | 2015 | |||||||||
| Operating results: | |||||||||||
| Net sales ............................................................................................................................................................................. | $ | 12,461,543 | $ | 11,571,668 | $ | 10,629,719 | |||||
| Cost of sales ........................................................................................................................................................................ | 9,062,440 | 8,345,195 | 7,622,765 | ||||||||
| Gross profit ...................................................................................................................................................................... | 3,399,103 | 3,226,473 | 3,006,954 | ||||||||
| Operating expenses: | |||||||||||
| Selling, general and administrative ........................................................................................................................................ | 2,539,734 | 2,409,008 | 2,238,051 | ||||||||
| Restructuring costs ........................................................................................................................................................... | - | 45,891 | 34,931 | ||||||||
| Operating income .......................................................................................................................................................... | $ | 859,369 | $ | 771,574 | $ | 733,972 | |||||
| Other expense, net ................................................................................................................................................................. | $ | (36,521) | $ | (15,739) | $ | (13,214) | |||||
| Net income ........................................................................................................................................................................... | 459,293 | 556,395 | 523,427 | ||||||||
| Net income attributable to Henry Schein, Inc. .............................................................................................................................. | 406,299 | 506,778 | 479,058 | ||||||||
| Years Ended | |||||||||||
| December 30, | December 31, | December 26, | |||||||||
| 2017 | 2016 | 2015 | |||||||||
| Cash flows: | |||||||||||
| Net cash provided by operating activities ................................................................................................................................... | $ | 545,515 | $ | 642,576 | $ | 615,500 | |||||
| Net cash used in investing activities ......................................................................................................................................... | (342,276) | (316,422) | (260,031) | ||||||||
| Net cash used in financing activities ......................................................................................................................................... | (112,551) | (327,344) | (348,030) |
Plans of Restructuring
On November 6, 2014, we announced a corporate initiative to rationalize our operations and provide expense efficiencies, which was expected to be completed by the end of fiscal 2015. This initiative originally planned for the elimination of approximately 2% to 3% of our workforce and the closing of certain facilities. We subsequently announced our plan to extend these restructuring activities through the end of 2016 to further implement cost-savings initiatives, which ultimately resulted in the elimination of approximately 900 positions, representing slightly more than 4% of our workforce. The total costs associated with the actions for this restructuring included $34.9 million pre-tax, which was recorded in fiscal 2015, and $45.9 million pre-tax, which was recorded in fiscal 2016. The costs associated with this restructuring are included in a separate line item, “Restructuring costs” within our consolidated statements of income.
As of December 31, 2016 our restructuring activities are complete and we did not incur any additional restructuring charges in fiscal 2017.
2017 Compared to 2016
Net Sales
Net sales for 2017 and 2016 were as follows (in thousands):
| % of | % of | Increase | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2017 | Total | 2016 | Total | $ | % | |||||||||||||||
| Health care distribution (1): | ||||||||||||||||||||
| Dental .......................................................................................................................................................................................... | $ | 6,048,813 | 48.5 | % | $ | 5,555,299 | 48.0 | % | $ | 493,514 | 8.9 | % | ||||||||
| Animal health ................................................................................................................................................................................. | 3,476,635 | 27.9 | 3,253,095 | 28.1 | 223,540 | 6.9 | ||||||||||||||
| Medical ........................................................................................................................................................................................ | 2,497,994 | 20.1 | 2,337,661 | 20.2 | 160,333 | 6.9 | ||||||||||||||
| Total health care distribution ............................................................................................................................................................ | 12,023,442 | 96.5 | 11,146,055 | 96.3 | 877,387 | 7.9 | ||||||||||||||
| Technology and value-added services (2)...................................................................................................................................................... | 438,101 | 3.5 | 425,613 | 3.7 | 12,488 | 2.9 | ||||||||||||||
| Total ........................................................................................................................................................................................ | $ | 12,461,543 | 100.0 | % | $ | 11,571,668 | 100.0 | % | $ | 889,875 | 7.7 | |||||||||
| (1) | Consists of consumable products, small equipment, laboratory products, large equipment, equipment repair services, branded | |||||||||||||||||||
| and generic pharmaceuticals, vaccines, surgical products, diagnostic tests, infection-control products and vitamins. | ||||||||||||||||||||
| (2) | Consists of practice management software and other value-added products, which are distributed primarily to health care | |||||||||||||||||||
| providers, and financial services on a non-recourse basis, e-services, continuing education services for practitioners, consulting | ||||||||||||||||||||
| and other services. |
The fiscal year ended December 30, 2017 consisted of 52 weeks as compared to the fiscal year ended December 31, 2016, which consisted of 53 weeks.
The $889.9 million, or 7.7%, increase in net sales for the year ended December 30, 2017 includes an increase of 7.2% local currency growth (5.1% increase in internally generated revenue, 1.5% decrease due to the impact from the extra week in 2016 and 3.6% growth from acquisitions) as well as an increase of 0.5% related to foreign currency exchange.
The $493.5 million, or 8.9%, increase in dental net sales for the year ended December 30, 2017 includes an increase of 7.9% in local currencies (3.0% increase in internally generated revenue, 1.4% decrease due to the impact from the extra week in 2016 and 6.3% growth from acquisitions) as well as an increase of 1.0% related to foreign currency exchange. The 7.9% increase in local currency sales was due to increases in dental equipment sales and service revenues of 4.5% (6.5% increase in internally generated revenue, 2.4% decrease due to the impact from the extra week in 2016 and 0.4% growth from acquisitions) and dental consumable merchandise sales growth of 9.0% (1.9% increase in internally generated revenue, 1.1% decrease due to the impact from the extra week in 2016 and 8.2% growth from acquisitions).
The $223.6 million, or 6.9%, increase in animal health net sales for the year ended December 30, 2017 includes an increase of 6.9% local currency growth (6.3% increase in internally generated revenue, 1.3% decrease due to the impact from the extra week in 2016 and 1.9% growth from acquisitions). The growth in internally generated animal health revenue is affected by the revenue for certain products being recognized on a gross basis in 2017 that had been recognized on an agency basis in the prior year. When excluding the effects of this change, internally generated revenue grew by 6.0%.
The $160.3 million, or 6.9%, increase in medical net sales for the year ended December 30, 2017 includes an increase of 6.8% local currency growth (8.4% increase in internally generated revenue and 1.6% decrease due to the impact from the extra week in 2016) as well as an increase of 0.1% related to foreign currency exchange.
The $12.5 million, or 2.9%, increase in technology and value-added services net sales for the year ended December 30, 2017 includes an increase of 3.2% local currency growth (3.5% increase in internally generated revenue, 0.8% decrease due to the impact from the extra week in 2016 and 0.5% growth from acquisitions) partially offset by a decrease of 0.3% related to foreign currency exchange.
Gross Profit
Gross profit and gross margins for 2017 and 2016 by segment and in total were as follows (in thousands):
| Gross | Gross | Increase | |||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2017 | Margin % | 2016 | Margin % | $ | % | ||||||||||||||
| Health care distribution ....................................................................................................................................................................... | $ | 3,112,436 | 25.9 | % | $ | 2,953,136 | 26.5 | % | $ | 159,300 | 5.4 | % | |||||||
| Technology and value-added services ...................................................................................................................................................... | 286,667 | 65.4 | 273,337 | 64.2 | 13,330 | 4.9 | |||||||||||||
| Total ........................................................................................................................................................................................ | $ | 3,399,103 | 27.3 | $ | 3,226,473 | 27.9 | $ | 172,630 | 5.4 |
Gross profit increased $172.6 million, or 5.4%, for the year ended December 30, 2017 compared to the prior year period. As a result of different practices of categorizing costs associated with distribution networks throughout our industry, our gross margins may not necessarily be comparable to other distribution companies. Additionally, we realize substantially higher gross margin percentages in our technology segment than in our health care distribution segment. These higher gross margins result from being both the developer and seller of software products and services, as well as certain financial services. The software industry typically realizes higher gross margins to recover investments in research and development.
Within our health care distribution segment, gross profit margins may vary from one period to the next. Changes in the mix of products sold as well as changes in our customer mix have been the most significant drivers affecting our gross profit margin. For example, sales of pharmaceutical products are generally at lower gross profit margins than other products. Conversely, sales of our private label products achieve gross profit margins that are higher than average. With respect to customer mix, sales to our large-group customers are typically completed at lower gross margins due to the higher volumes sold as opposed to the gross margin on sales to office-based practitioners who normally purchase lower volumes at greater frequencies.
Health care distribution gross profit increased $159.3 million, or 5.4%, for the year ended December 30, 2017 compared to the prior year period. Health care distribution gross profit margin decreased to 25.9% for the year ended December 30, 2017 from 26.5% for the comparable prior year period. The overall increase in our health care distribution gross profit is attributable to a $104.0 million gross profit increase from growth in internally generated revenue and $125.3 million is attributable to acquisitions. These increases were partially offset by a $70.0 million decline in gross profit due to the decrease in the gross margin rates.
Technology and value-added services gross profit increased $13.3 million, or 4.9%, for the year ended December 30, 2017 compared to the prior year period. Technology and value-added services gross profit margin increased to 65.4% for the year ended December 30, 2017 from 64.2% for the comparable prior year period. Acquisitions accounted for $2.0 million of our gross profit increase within our technology and value-added services segment for the year ended December 30, 2017 compared to the prior year period. The remaining increase of $11.3 million in our technology and value-added services segment gross profit was primarily attributable to growth in internally generated revenue and the increase in gross margin rates.
Selling, General and Administrative
Selling, general and administrative expenses by segment and in total for 2017 and 2016 were as follows (in thousands):
| % of | % of | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Respective | Respective | Increase | |||||||||||||||||
| 2017 | Net Sales | 2016 | Net Sales | $ | % | ||||||||||||||
| Health care distribution ...................................................................................................................................................................... | $ | 2,383,916 | 19.8 | % | $ | 2,256,948 | 20.2 | % | $ | 126,968 | 5.6 | % | |||||||
| Technology and value-added services ...................................................................................................................................................... | 155,818 | 35.6 | 152,060 | 35.7 | 3,758 | 2.5 | |||||||||||||
| Total ....................................................................................................................................................................................... | $ | 2,539,734 | 20.4 | $ | 2,409,008 | 20.8 | $ | 130,726 | 5.4 |
Selling, general and administrative expenses increased $130.7 million, or 5.4%, for the year ended December 30, 2017 from the comparable prior year period. The $127.0 million increase in selling, general and administrative expenses within our health care distribution segment for the year ended December 30, 2017 as compared to the prior year period was attributable to $107.3 million of additional costs from acquired companies, and $19.7 million of additional operating costs. The $3.7 million increase in selling, general and administrative expenses within our
technology and value-added services segment for the year ended December 30, 2017 as compared to the prior year period was attributable to $2.1 million of additional costs from acquired companies and $1.6 million of additional operating costs. As a percentage of net sales, selling, general and administrative expenses decreased to 20.4% from 20.8% for the comparable prior year period.
As a component of total selling, general and administrative expenses, selling expenses increased $82.2 million, or 5.6%, for the year ended December 30, 2017 from the comparable prior year period. As a percentage of net sales, selling expenses decreased to 12.5% from 12.8% for the comparable prior year period.
As a component of total selling, general and administrative expenses, general and administrative expenses increased $48.5 million, or 5.2%, for the year ended December 30, 2017 from the comparable prior year period. As a percentage of net sales, general and administrative expenses decreased to 7.8% from 8.0% for the comparable prior year period.
Other Expense, Net
Other expense, net for the years ended 2017 and 2016 was as follows (in thousands):
| Variance | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2017 | 2016 | $ | % | ||||||||||
| Interest income ....................................................................................................................................................................... | $ | 17,553 | $ | 13,275 | $ | 4,278 | 32.2 | % | |||||
| Interest expense ...................................................................................................................................................................... | (53,654) | (31,893) | (21,761) | (68.2) | |||||||||
| Other, net ............................................................................................................................................................................. | (420) | 2,879 | (3,299) | (114.6) | |||||||||
| Other expense, net ............................................................................................................................................................ | $ | (36,521) | $ | (15,739) | $ | (20,782) | (132.0) |
Other expense, net increased $20.8 million to $36.5 million for the year ended December 30, 2017 from the comparable prior year period. Interest income increased $4.3 million primarily due to increased investment and late fee income. Interest expense increased $21.8 million primarily due to increased borrowings and higher interest rates under our bank credit lines and interest expense related to a financing arrangement entered into during the first quarter of 2017 in Brazil. Other, net decreased by $3.3 million due primarily to investment proceeds received in the first quarter of 2016.
Income Taxes
For the year ended December 30, 2017, our effective tax rate was 44.1% compared to 28.8% for the prior year period. Our effective tax rate in 2017 was primarily higher due to the Tax Cuts and Jobs Act (“the Tax Act”). Our effective tax rate was favorably impacted in 2017 by the adoption of Accounting Standards Update (“ASU”) 2016-09, Accounting for Stock Compensation, as well as savings from implementation of tax planning initiatives and higher income from lower tax jurisdictions. During the second quarter of 2016, the effective tax rate was affected by a federal tax audit settlement, which reduced our income tax expense by approximately $4.5 million. For 2018, we expect our effective tax rate to be in the range of 24%.
On December 22, 2017, the U.S. government passed the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act is comprehensive tax legislation that implements complex changes to the U.S. tax code including, but not limited to, the reduction of the corporate tax rate from 35% to 21%, modification of accelerated depreciation, the repeal of the domestic manufacturing deduction and changes to the limitations of the deductibility of interest. Additionally, the Tax Act moves from a global tax regime to a modified territorial regime, which requires U.S. companies to pay a mandatory one-time transition tax on historical offshore earnings that have not been repatriated to the U.S. The transition tax is payable over eight years.
Due to the complexities of the Tax Act, the SEC staff issued Staff Accounting Bulletin No. 118 (“SAB 118”) that allows the company to record a provisional amount for any income tax effects of the Tax Act in accordance with ASC 740, to the extent that a reasonable estimate can be made. SAB 118 allows for a measurement period of up to one year after the enactment date of the Tax Act to finalize the recording of the related tax impacts.
We have recorded provisional amounts for any items that could be reasonably estimated at this time. This includes the one-time transition tax that we have estimated to be $140.0 million. Within our consolidated balance sheets, $27.4 million is included in “Accrued taxes” and $112.6 million is included in “Other liabilities”. The U.S.
deferred tax assets and liabilities were revalued due to the lower enacted federal income tax rate, of 21%, that was effective January 1, 2018. The Company accrued a net deferred tax expense of $3.0 million attributable to the revaluation. In the aggregate, for the quarter ended December 30, 2017, these Tax Act modifications resulted in a one-time tax expense of approximately $143.0 million. Absent the effects of the transition tax and the revaluation of deferred tax assets and liabilities, our effective tax rate for the year ended December 30, 2017 would have been 26.7% as compared to our actual effective tax rate of 44.1%.
The Tax Act also includes provisions to tax global intangible low-taxed income (“GILTI”) and a base erosion and anti-abuse tax (“BEAT”) that imposes tax on certain foreign related-party payments. The Company is subject to the GILTI and BEAT provisions which are effective January 1, 2018. The Company is in the process of assessing the effects of these provisions for 2018.
The ultimate impacts of the Tax Act may differ from the estimate above, possibly materially, due to additional guidance from the U.S. Department of Treasury, updates or changes in our assumptions, revision of accounting standards for income taxes or related interpretations and future information that may become available. We currently anticipate finalizing and recording any resulting adjustments by the quarter ended September 29, 2018. If the information necessary to finalize and record the related tax impacts are available prior to the quarter ended September 29, 2018, we will book these impacts accordingly.
Net Income
Net income decreased $97.1 million, or 17.5%, for the year ended December 30, 2017, compared to the prior year period due to the factors noted above.
2016 Compared to 2015
Net Sales
Net sales for 2016 and 2015 were as follows (in thousands):
| % of | % of | Increase | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2016 | Total | 2015 | Total | $ | % | |||||||||||||||
| Health care distribution (1): | ||||||||||||||||||||
| Dental .......................................................................................................................................................................................... | $ | 5,555,299 | 48.0 | % | $ | 5,276,407 | 49.6 | % | $ | 278,892 | 5.3 | % | ||||||||
| Animal health ................................................................................................................................................................................. | 3,253,095 | 28.1 | 2,921,624 | 27.5 | 331,471 | 11.3 | ||||||||||||||
| Medical ........................................................................................................................................................................................ | 2,337,661 | 20.2 | 2,072,915 | 19.5 | 264,746 | 12.8 | ||||||||||||||
| Total health care distribution .............................................................................................................................................................. | 11,146,055 | 96.3 | 10,270,946 | 96.6 | 875,109 | 8.5 | ||||||||||||||
| Technology and value-added services (2) ...................................................................................................................................................... | 425,613 | 3.7 | 358,773 | 3.4 | 66,840 | 18.6 | ||||||||||||||
| Total ........................................................................................................................................................................................ | $ | 11,571,668 | 100.0 | % | $ | 10,629,719 | 100.0 | % | $ | 941,949 | 8.9 | |||||||||
| (1) | Consists of consumable products, small equipment, laboratory products, large equipment, equipment repair services, branded and | |||||||||||||||||||
| generic pharmaceuticals, vaccines, surgical products, diagnostic tests, infection-control products and vitamins. | ||||||||||||||||||||
| (2) | Consists of practice management software and other value-added products, which are distributed primarily to health care | |||||||||||||||||||
| providers, and financial services on a non-recourse basis, e-services, continuing education services for practitioners, consulting | ||||||||||||||||||||
| and other services. |
The fiscal year ended December 31, 2016 consisted of 53 weeks as compared to the fiscal year ended December 26, 2015, which consisted of 52 weeks.
The $941.9 million, or 8.9%, increase in net sales for the year ended December 31, 2016 includes an increase of 10.1% local currency growth (6.7% increase in internally generated revenue, 1.5% impact from extra week and 1.9% growth from acquisitions) partially offset by a decrease of 1.2% related to foreign currency exchange.
The $278.9 million, or 5.3%, increase in dental net sales for the year ended December 31, 2016 includes an increase of 6.2% in local currencies (3.2% increase in internally generated revenue, 1.5% impact from extra week and 1.5% growth from acquisitions) offset by a decrease of 0.9% related to foreign currency exchange. The 6.2% increase in local currency sales was due to increases in dental equipment sales and service revenues of 9.0% (5.1% increase in internally generated revenue, 2.5% impact from extra week and 1.4% growth from acquisitions) and dental consumable merchandise sales growth of 5.3% (2.6% increase in internally generated revenue, 1.2% impact from extra week and 1.5% growth from acquisitions).
The $331.5 million, or 11.3%, increase in animal health net sales for the year ended December 31, 2016 includes an increase of 13.9% local currency growth (9.6% increase in internally generated revenue, 1.5% impact from extra week and 2.8% growth from acquisitions) partially offset by a decrease of 2.6% related to foreign currency exchange. The growth in internally generated animal health revenue is affected by the revenue for certain products being recognized on a gross basis in 2016 that had been recognized on an agency basis in the prior year. When excluding the effects of this change, internally generated revenue grew by 7.1%.
The $264.7 million, or 12.8%, increase in medical net sales for the year ended December 31, 2016 includes an increase of 12.8% local currency growth (11.1% increase in internally generated revenue and 1.7% impact from extra week). The growth in internally generated medical revenue is affected by certain sales being recognized on a gross basis in 2016 that had been recognized on an agency basis in the prior year. When excluding the effects of this change, internally generated revenue grew by 7.9%
The $66.8 million, or 18.6%, increase in technology and value-added services net sales for the year ended December 31, 2016 includes an increase of 20.0% local currency growth (7.9% increase in internally generated revenue, 0.9% impact from extra week and 11.2% growth from acquisitions) partially offset by a decrease of 1.4% related to foreign currency exchange.
Gross Profit
Gross profit and gross margins for 2016 and 2015 by segment and in total were as follows (in thousands):
| Gross | Gross | Increase | |||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2016 | Margin % | 2015 | Margin % | $ | % | ||||||||||||||
| Health care distribution ....................................................................................................................................................................... | $ | 2,953,136 | 26.5 | % | $ | 2,768,627 | 27.0 | % | $ | 184,509 | 6.7 | % | |||||||
| Technology and value-added services ...................................................................................................................................................... | 273,337 | 64.2 | 238,327 | 66.4 | 35,010 | 14.7 | |||||||||||||
| Total ........................................................................................................................................................................................ | $ | 3,226,473 | 27.9 | $ | 3,006,954 | 28.3 | $ | 219,519 | 7.3 |
Gross profit increased $219.5 million, or 7.3%, for the year ended December 31, 2016 compared to the prior year period. As a result of different practices of categorizing costs associated with distribution networks throughout our industry, our gross margins may not necessarily be comparable to other distribution companies. Additionally, we realize substantially higher gross margin percentages in our technology segment than in our health care distribution segment. These higher gross margins result from being both the developer and seller of software products and services, as well as certain financial services. The software industry typically realizes higher gross margins to recover investments in research and development.
Within our health care distribution segment, gross profit margins may vary from one period to the next. Changes in the mix of products sold as well as changes in our customer mix have been the most significant drivers affecting our gross profit margin. For example, sales of pharmaceutical products are generally at lower gross profit margins than other products. Conversely, sales of our private label products achieve gross profit margins that are higher than average. With respect to customer mix, sales to our large-group customers are typically completed at lower gross margins due to the higher volumes sold as opposed to the gross margin on sales to office-based practitioners who normally purchase lower volumes at greater frequencies.
Health care distribution gross profit increased $184.5 million, or 6.7%, for the year ended December 31, 2016 compared to the prior year period. Health care distribution gross profit margin decreased to 26.5% for the year ended December 31, 2016 from 27.0% for the comparable prior year period. The overall increase in our health care distribution gross profit is attributable to a $170.8 million gross profit increase from growth in internally generated revenue and $60.9 million is attributable to acquisitions. These increases were partially offset by a $47.2 million decline in gross profit due primarily to the effects of foreign exchange on revenues and the decrease in the gross margin rates.
Technology and value-added services gross profit increased $35.0 million, or 14.7%, for the year ended December 31, 2016 compared to the prior year period. Technology and value-added services gross profit margin decreased to 64.2% for the year ended December 31, 2016 from 66.4% for the comparable prior year period. Acquisitions accounted for $18.5 million of our gross profit increase within our technology and value-added services segment for the year ended December 31, 2016 compared to the prior year period. The remaining increase of $16.5 million in our technology and value-added services segment gross profit was primarily attributable to growth in internally generated revenue.
Selling, General and Administrative
Selling, general and administrative expenses by segment and in total for 2016 and 2015 were as follows (in thousands):
| % of | % of | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Respective | Respective | Increase | |||||||||||||||||
| 2016 | Net Sales | 2015 | Net Sales | $ | % | ||||||||||||||
| Health care distribution ....................................................................................................................................................................... | $ | 2,256,948 | 20.2 | % | $ | 2,108,164 | 20.5 | % | $ | 148,784 | 7.1 | % | |||||||
| Technology and value-added services ...................................................................................................................................................... | 152,060 | 35.7 | 129,887 | 36.2 | 22,173 | 17.1 | |||||||||||||
| Total ........................................................................................................................................................................................ | $ | 2,409,008 | 20.8 | $ | 2,238,051 | 21.1 | $ | 170,957 | 7.6 |
Selling, general and administrative expenses increased $171.0 million, or 7.6%, for the year ended December 31, 2016 from the comparable prior year period. The $148.8 million increase in selling, general and administrative expenses within our health care distribution segment for the year ended December 31, 2016 as compared to the prior year period was attributable to $57.6 million of additional costs from acquired companies, and $91.2 million of additional operating costs. The $22.2 million increase in selling, general and administrative expenses within our technology and value-added services segment for the year ended December 31, 2016 as compared to the prior year period was attributable to $15.3 million of additional costs from acquired companies and $6.9 million of additional operating costs. As a percentage of net sales, selling, general and administrative expenses decreased to 20.8% from 21.1% for the comparable prior year period.
As a component of total selling, general and administrative expenses, selling expenses increased $104.3 million, or 7.6%, for the year ended December 31, 2016 from the comparable prior year period. As a percentage of net sales, selling expenses decreased to 12.8% from 13.0% for the comparable prior year period.
As a component of total selling, general and administrative expenses, general and administrative expenses increased $66.7 million, or 7.7%, for the year ended December 31, 2016 from the comparable prior year period. As a percentage of net sales, general and administrative expenses decreased to 8.0% from 8.1% for the comparable prior year period.
Other Expense, Net
Other expense, net for the years ended 2016 and 2015 was as follows (in thousands):
| Variance | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2016 | 2015 | $ | % | ||||||||||
| Interest income ....................................................................................................................................................................... | $ | 13,275 | $ | 12,935 | $ | 340 | 2.6 | % | |||||
| Interest expense ...................................................................................................................................................................... | (31,893) | (26,008) | (5,885) | (22.6) | |||||||||
| Other, net ............................................................................................................................................................................. | 2,879 | (141) | 3,020 | (2,141.8) | |||||||||
| Other expense, net ............................................................................................................................................................ | $ | (15,739) | $ | (13,214) | $ | (2,525) | (19.1) |
Other expense, net increased $2.5 million to $15.7 million for the year ended December 31, 2016 from the comparable prior year period. Interest expense increased $5.9 million primarily due to increased borrowings under our bank credit lines and our U.S. trade accounts receivable securitization. Higher interest rates also contributed to the increase in interest expense. Other, net increased by $3.0 million due primarily to investment proceeds received in the first quarter of 2016.
Income Taxes
For the year ended December 31, 2016, our effective tax rate was 28.8% compared to 29.3% for the prior year period. During the second quarter of 2016, the effective tax rate was affected by a federal tax audit settlement, which reduced our income tax expense by approximately $4.5 million.
During the third quarter of 2015, we received a favorable response to a tax petition, which allowed us to conclude that it was more likely than not that certain unrecognized tax benefits, which had been previously reserved, would be realized. As a result, our provision for income taxes in 2015 included a $6.3 million income tax benefit.
Absent the effects of this income tax benefit in the third quarter of 2015, our effective tax rate for the year ended December 26, 2015 would have been 30.2% as compared to our actual effective tax rate of 29.3%. The remaining difference between our effective tax rate and the federal statutory tax rate for both periods primarily relates to state and foreign income taxes and interest expense.
Net Income
Net income increased $33.0 million, or 6.3%, for the year ended December 31, 2016, compared to the prior year period due to the factors noted above.
Liquidity and Capital Resources
Our principal capital requirements include funding of acquisitions, purchases of additional noncontrolling interests, repayments of debt principal, the funding of working capital needs, purchases of fixed assets and repurchases of common stock. Working capital requirements generally result from increased sales, special inventory forward buy-in opportunities and payment terms for receivables and payables. Historically, sales have tended to be stronger during the third and fourth quarters and special inventory forward buy-in opportunities have been most prevalent just before the end of the year, and have caused our working capital requirements to be higher from the end of the third quarter to the end of the first quarter of the following year.
We finance our business primarily through cash generated from our operations, revolving credit facilities and debt placements. Our ability to generate sufficient cash flows from operations is dependent on the continued demand of our customers for our products and services, and access to products and services from our suppliers.
Our business requires a substantial investment in working capital, which is susceptible to fluctuations during the year as a result of inventory purchase patterns and seasonal demands. Inventory purchase activity is a function of sales activity, special inventory forward buy-in opportunities and our desired level of inventory. We anticipate future increases in our working capital requirements.
We finance our business to provide adequate funding for at least 12 months. Funding requirements are based on forecasted profitability and working capital needs, which, on occasion, may change. Consequently, we may change our funding structure to reflect any new requirements.
We believe that our cash and cash equivalents, our ability to access private debt markets and public equity markets, and our available funds under existing credit facilities provide us with sufficient liquidity to meet our currently foreseeable short-term and long-term capital needs. We have no off-balance sheet arrangements.
Net cash provided by operating activities was $545.5 million for the year ended December 30, 2017, compared to $642.6 million for the prior year. The net change of $97.1 million was primarily attributable to working capital requirements.
Net cash used in investing activities was $342.3 million for the year ended December 30, 2017, compared to $316.4 million for the prior year. The net change of $25.9 million was primarily due to increased payments for equity investments and business acquisitions, partially offset by proceeds of sales of equity investments.
Net cash used in financing activities was $112.6 million for the year ended December 30, 2017, compared to $327.3 million for the prior year. The net change of $214.7 million was primarily due to increased net borrowings from debt, decreased repurchases of common stock and decreased acquisitions of noncontrolling interests in subsidiaries.
The following table summarizes selected measures of liquidity and capital resources (in thousands):
| December 30, | December 31, | |||||||
|---|---|---|---|---|---|---|---|---|
| 2017 | 2016 | |||||||
| Cash and cash equivalents ............................................................................................................................................................ | $ | 174,658 | $ | 62,381 | ||||
| Working capital .......................................................................................................................................................................... | 1,257,045 | 1,022,134 | ||||||
| Debt: | ||||||||
| Bank credit lines ...................................................................................................................................................................... | $ | 741,653 | $ | 437,476 | ||||
| Current maturities of long-term debt ............................................................................................................................................ | 16,659 | 65,923 | ||||||
| Long-term debt ....................................................................................................................................................................... | 907,756 | 715,457 | ||||||
| Total debt .......................................................................................................................................................................... | $ | 1,666,068 | $ | 1,218,856 |
Our cash and cash equivalents consist of bank balances and investments in money market funds representing overnight investments with a high degree of liquidity.
Accounts receivable days sales outstanding and inventory turns
Our accounts receivable days sales outstanding from operations decreased to 41.2 days as of December 30, 2017 from 41.3 days as of December 31, 2016. During the years ended December 30, 2017 and December 31, 2016, we wrote off approximately $6.7 million and $6.2 million, respectively, of fully reserved accounts receivable against our trade receivable reserve. Our inventory turns from operations were 5.3 as of December 30, 2017 and 5.5 as of December 31, 2016. Our working capital accounts may be impacted by current and future economic conditions.
Contractual obligations
The following table summarizes our contractual obligations related to fixed and variable rate long-term debt, including interest (assuming a weighted average interest rate of 2.7%), as well as inventory purchase commitments and operating and capital lease obligations as of December 30, 2017:
| Payments due by period (in thousands) | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| < 1 year | 2 - 3 years | 4 - 5 years | > 5 years | Total | ||||||||||
| Contractual obligations: | ||||||||||||||
| Long-term debt, including interest ................................................................................................................................................. | $ | 42,750 | $ | 513,207 | $ | 163,687 | $ | 345,618 | $ | 1,065,262 | ||||
| Inventory purchase commitments .................................................................................................................................................. | 232,479 | 507,324 | 242,394 | - | 982,197 | |||||||||
| Operating lease obligations .......................................................................................................................................................... | 94,038 | 131,461 | 68,446 | 64,674 | 358,619 | |||||||||
| Transition tax obligations ............................................................................................................................................................ | 27,400 | 21,400 | 30,900 | 60,300 | 140,000 | |||||||||
| Capital lease obligations, including interest ..................................................................................................................................... | 1,678 | 1,426 | 628 | 1,799 | 5,531 | |||||||||
| Total ....................................................................................................................................................................................... | $ | 398,345 | $ | 1,174,818 | $ | 506,055 | $ | 472,391 | $ | 2,551,609 |
Bank Credit Lines
On April 18, 2017, we entered into a new $750 million revolving credit agreement (the “Credit Agreement”). This facility, which matures in April 2022, replaced our $500 million revolving credit facility, which was scheduled to mature in September 2019. The interest rate is based on the USD LIBOR plus a spread based on our leverage ratio at the end of each financial reporting quarter. The Credit Agreement provides, among other things, that we are required to maintain maximum leverage ratios, and contains customary representations, warranties and affirmative covenants. The Credit Agreement also contains customary negative covenants, subject to negotiated exceptions on liens, indebtedness, significant corporate changes (including mergers), dispositions and certain restrictive agreements. As of December 30, 2017 and December 31, 2016, the borrowings outstanding on this revolving credit facility and the prior credit facility were $320.0 million and $65.0 million, respectively. As of December 30, 2017 and December 31, 2016, there were $11.3 million and $13.0 million of letters of credit, respectively, provided to third parties under this credit facility and the prior credit facility.
As of December 30, 2017 and December 31, 2016, we had various other short-term bank credit lines available, of which $421.7 million and $372.5 million, respectively, were outstanding. At December 30, 2017 and December 31, 2016, borrowings under all of our credit lines had a weighted average interest rate of 2.27% and 1.61%, respectively.
Private Placement Facilities
On September 15, 2017, we increased our available private placement facilities with three insurance companies to a total facility amount of $1 billion, and extended the expiration date to September 15, 2020. These facilities are available on an uncommitted basis at fixed rate economic terms to be agreed upon at the time of issuance, from time to time through September 15, 2020. The facilities allow us to issue senior promissory notes to the lenders at a fixed rate based on an agreed upon spread over applicable treasury notes at the time of issuance. The term of each possible issuance will be selected by us and can range from five to 15 years (with an average life no longer than 12 years). The proceeds of any issuances under the facilities will be used for general corporate purposes, including working capital and capital expenditures, to refinance existing indebtedness and/or to fund potential acquisitions. The agreements provide, among other things, that we maintain certain maximum leverage ratios, and
contain restrictions relating to subsidiary indebtedness, liens, affiliate transactions, disposal of assets and certain changes in ownership. These facilities contain make-whole provisions in the event that we pay off the facilities prior to the applicable due dates.
The components of our private placement facility borrowings as of December 30, 2017 are presented in the following table (in thousands):
| Amount of | ||||||||
| Date of | Borrowing | Borrowing | ||||||
| Borrowing | Outstanding | Rate | Due Date | |||||
| September 2, 2010 | $ | 100,000 | 3.79 | % | September 2, 2020 | |||
| January 20, 2012 | 50,000 | 3.45 | January 20, 2024 | |||||
| January 20, 2012 (1) | 35,714 | 3.09 | January 20, 2022 | |||||
| December 24, 2012 | 50,000 | 3.00 | December 24, 2024 | |||||
| June 2, 2014 | 100,000 | 3.19 | June 2, 2021 | |||||
| June 16, 2017 | 100,000 | 3.42 | June 16, 2027 | |||||
| September 15, 2017 | 100,000 | 3.52 | September 15, 2029 | |||||
| Less: Deferred debt issuance costs | (419) | |||||||
| $ | 535,295 | |||||||
| (1) Annual repayments of approximately $7.1 million for this borrowing commenced on January 20, 2016. |
U.S. Trade Accounts Receivable Securitization
We have a facility agreement with a bank, as agent, based on the securitization of our U.S. trade accounts receivable that is structured as an asset-backed securitization program with pricing committed for up to three years. On June 1, 2016, we extended the expiration date of this facility agreement to April 29, 2019 and increased the purchase limit under the facility from $300 million to $350 million. On July 6, 2017, we extended the expiration date of this facility agreement to April 29, 2020. The borrowings outstanding under this securitization facility were $350.0 million and $350.0 million as of December 30, 2017 and December 31, 2016, respectively. At December 30, 2017, the interest rate on borrowings under this facility was based on the asset-backed commercial paper rate of 153 basis points plus 75 basis points, for a combined rate of 2.28%. At December 31, 2016, the interest rate on borrowings under this facility was based on the asset-backed commercial paper rate of 101 basis points plus 75 basis points, for a combined rate of 1.76%.
We are required to pay a commitment fee of 30 basis points on the daily balance of the unused portion of the facility if our usage is greater than or equal to 50% of the facility limit or a commitment fee of 35 basis points on the daily balance of the unused portion of the facility if our usage is less than 50% of the facility limit.
Borrowings under this facility are presented as a component of Long-term debt within our consolidated balance sheet.
Long-term debt
Long-term debt consisted of the following:
| December 30, | December 31, | ||||||
|---|---|---|---|---|---|---|---|
| 2017 | 2016 | ||||||
| Private placement facilities ........................................................................................................................................................... | $ | 535,295 | $ | 342,857 | |||
| U.S. trade accounts receivable securitization .................................................................................................................................... | 350,000 | 350,000 | |||||
| Note payable to bank at a weighted average interest rate of 21.37% | |||||||
| at December 31, 2016........................................................................................................................................................... | - | 47,957 | |||||
| Various collateralized and uncollateralized loans payable with interest, | |||||||
| in varying installments through 2022 at interest rates | |||||||
| ranging from 2.56% to 12.90% at December 30, 2017 and | |||||||
| ranging from 2.56% to 12.90% at December 31, 2016................................................................................................................... | 34,027 | 35,150 | |||||
| Capital lease obligations (see Note 17) ............................................................................................................................................ | 5,093 | 5,416 | |||||
| Total ....................................................................................................................................................................................... | 924,415 | 781,380 | |||||
| Less current maturities ................................................................................................................................................................ | (16,659) | (65,923) | |||||
| Total long-term debt ........................................................................................................................................................... | $ | 907,756 | $ | 715,457 | |||
Stock repurchases
From June 21, 2004 through December 30, 2017, we repurchased approximately $2.7 billion, or 55,670,990 shares, under our common stock repurchase programs, with $200.0 million available as of December 30, 2017 for future common stock share repurchases.
Redeemable noncontrolling interests
Some minority stockholders in certain of our subsidiaries have the right, at certain times, to require us to acquire their ownership interest in those entities at fair value. Accounting Standards Codification Topic 480-10 is applicable for noncontrolling interests where we are or may be required to purchase all or a portion of the outstanding interest in a consolidated subsidiary from the noncontrolling interest holder under the terms of a put option contained in contractual agreements. The components of the change in the Redeemable noncontrolling interests for the years ended December 30, 2017, December 31, 2016 and December 26, 2015 are presented in the following table:
| December 30, | December 31, | December 26, | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| 2017 | 2016 | 2015 | ||||||||
| Balance, beginning of period ................................................................................................................................................... | $ | 607,636 | $ | 542,194 | $ | 564,527 | ||||
| Decrease in redeemable noncontrolling interests due to | ||||||||||
| redemptions .................................................................................................................................................................... | (48,669) | (72,729) | (82,563) | |||||||
| Increase in redeemable noncontrolling interests due to | ||||||||||
| business acquisitions......................................................................................................................................................... | 78,939 | 58,172 | 18,936 | |||||||
| Net income attributable to redeemable noncontrolling interests ...................................................................................................... | 52,203 | 48,760 | 43,588 | |||||||
| Dividends declared ............................................................................................................................................................... | (28,161) | (32,973) | (32,706) | |||||||
| Effect of foreign currency translation gain (loss) attributable to | ||||||||||
| redeemable noncontrolling interests ..................................................................................................................................... | 7,461 | (2,652) | (4,790) | |||||||
| Change in fair value of redeemable securities ............................................................................................................................. | 162,729 | 66,864 | 35,202 | |||||||
| Balance, end of period ........................................................................................................................................................... | $ | 832,138 | $ | 607,636 | $ | 542,194 |
Changes in the estimated redemption amounts of the noncontrolling interests subject to put options are adjusted at each reporting period with a corresponding adjustment to Additional paid-in capital. Future reductions in the carrying amounts are subject to a floor amount that is equal to the fair value of the redeemable noncontrolling interests at the time they were originally recorded. The recorded value of the redeemable noncontrolling interests cannot go below the floor level. These adjustments do not impact the calculation of earnings per share.
Additionally, some prior owners of such acquired subsidiaries are eligible to receive additional purchase price cash consideration if certain financial targets are met. Any adjustments to these accrual amounts are recorded in our consolidated statement of income.
Unrecognized tax benefits
As more fully disclosed in Note 12 of “Notes to Consolidated Financial Statements,” we cannot reasonably estimate the timing of future cash flows related to the unrecognized tax benefits, including accrued interest, of $105.2 million as of December 30, 2017.
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. We base our estimates on historical data, when available, experience, industry and market trends, and on various other assumptions that are believed to be reasonable under the circumstances, the combined 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. However, by their nature, estimates are subject to various assumptions and uncertainties. Reported results are therefore sensitive to any changes in our assumptions, judgments and estimates, including the possibility of obtaining materially different results if different assumptions were to be applied.
We believe that the following critical accounting policies, which have been discussed with the Audit Committee of the Board of Directors, affect the significant estimates and judgments used in the preparation of our financial statements:
Revenue Recognition
We generate revenue from the sale of dental, animal health and medical consumable products, as well as equipment, software products and services and other sources. Provisions for discounts, rebates to customers, customer returns and other contra-revenue adjustments are recorded based upon historical data and estimates and are provided for in the period in which the related sales are recognized.
Revenue derived from the sale of consumable products is recognized when products are shipped to customers. Such sales typically entail high-volume, low-dollar orders shipped using third-party common carriers. We believe that the shipment date is the most appropriate point in time indicating the completion of the earnings process because we have no post-shipment obligations, the product price is fixed and determinable, collection of the resulting receivable is reasonably assured and product returns are reasonably estimable.
Revenue derived from the sale of equipment is recognized when products are delivered to customers. Such sales typically entail scheduled deliveries of large equipment primarily by equipment service technicians. Some equipment sales require minimal installation, which is typically completed at the time of delivery.
Revenue derived from the sale of software products is recognized when products are shipped to customers. Such software is generally installed by customers and does not require extensive training due to the nature of its design. Revenue derived from post-contract customer support for software, including annual support and/or training, is recognized over the period in which the services are provided.
Revenue derived from multiple element arrangements, and the related deferral of such revenue (which is insignificant to our financial statements), is recognized as follows. When we sell software products together with related services (i.e., training and technical support) we allocate revenue to the delivered elements using the residual method, based upon vendor-specific objective evidence (“VSOE”) of the fair value of the undelivered elements, or defer it until such time as vendor-specific evidence of fair value is obtained. Multiple element arrangements that include elements that are not considered software consist primarily of equipment and the related installation service. We allocate revenue for such arrangements based on the relative selling prices of the elements applying the following hierarchy: first VSOE, then third-party evidence (“TPE”) of selling price if VSOE is not available, and finally our estimate of the selling price if neither VSOE nor TPE is available. VSOE exists when we sell the deliverables separately and represents the actual price charged by us for each deliverable. Estimated selling
price reflects our best estimate of what the selling prices of each deliverable would be if it were sold regularly on a standalone basis taking into consideration the cost structure of our business, technical skill required, customer location and other market conditions. Each element that has standalone value is accounted for as a separate unit of accounting. Revenue allocated to each unit of accounting is recognized when the service is provided or the product is delivered.
Revenue derived from other sources including freight charges, equipment repairs and financial services, is recognized when the related product revenue is recognized or when the services are provided.
Accounts Receivable and Reserves
The carrying amount of accounts receivable is reduced by a valuation allowance that reflects our best estimate of the amounts that will not be collected. The reserve for accounts receivable is comprised of allowance for doubtful accounts and sales returns. In addition to reviewing delinquent accounts receivable, we consider many factors in estimating our reserve, including historical data, experience, customer types, credit worthiness and economic trends. From time to time, we may adjust our assumptions for anticipated changes in any of these or other factors expected to affect collectability. Although we believe our judgments, estimates and/or assumptions related to accounts receivable and reserves are reasonable, making material changes to such judgments, estimates and/or assumptions could materially affect our financial results.
Inventories and Reserves
Inventories consist primarily of finished goods and are valued at the lower of cost or market. Cost is determined by the first-in, first-out method for merchandise or actual cost for large equipment and high tech equipment. In accordance with our policy for inventory valuation, we consider many factors including the condition and salability of the inventory, historical sales, forecasted sales and market and economic trends.
From time to time, we may adjust our assumptions for anticipated changes in any of these or other factors expected to affect the value of inventory. Although we believe our judgments, estimates and/or assumptions related to inventory and reserves are reasonable, making material changes to such judgments, estimates and/or assumptions could materially affect our financial results.
Goodwill and Other Indefinite-Lived Intangible Assets
Goodwill and other indefinite-lived intangible assets (primarily trademarks) are not amortized, but are subject to impairment analysis at least once annually. Such impairment analyses for goodwill require a comparison of the fair value to the carrying value of reporting units. We regard our reporting units to be our operating segments: health care distribution (global dental, animal health and medical) and technology and value-added services. Goodwill was allocated to such reporting units, for the purposes of preparing our impairment analyses, based on a specific identification basis.
For the years ended December 30, 2017 and December 31, 2016, and December 26, 2015 we tested goodwill for impairment using a quantitative analysis consisting of a two-step approach. The first step of our quantitative analysis consists of a comparison of the carrying value of our reporting units, including goodwill, to the estimated fair value of our reporting units using a discounted cash flow methodology. If step one results in the carrying value of the reporting unit exceeding the fair value of such reporting unit, we would then proceed to step two which would require us to calculate the amount of impairment loss, if any, that we would record for such reporting unit. The calculation of the impairment loss in step two would be equivalent to the reporting unit’s carrying value of goodwill less the implied fair value of such goodwill.
Our use of a discounted cash flow methodology includes estimates of future revenue based upon budget projections and growth rates which take into account estimated inflation rates. We also develop estimates for future levels of gross and operating profits and projected capital expenditures. Our methodology also includes the use of estimated discount rates based upon industry and competitor analysis as well as other factors. The estimates that we use in our discounted cash flow methodology involve many assumptions by management that are based upon future growth projections.
Our impairment analysis for indefinite-lived intangibles consists of a comparison of the fair value to the carrying value of the assets. This comparison is made based on a review of historical, current and forecasted sales and gross profit levels, as well as a review of any factors that may indicate potential impairment. For indefinite-lived intangible assets, a present value technique, such as estimates of future cash flows, is utilized. We assessed the potential impairment of goodwill and other indefinite-lived intangible assets annually (at the beginning of our fourth quarter) and on an interim basis whenever events or changes in circumstances indicate that the carrying value may not be recoverable.
Some factors we consider important that could trigger an interim impairment review include:
-
significant underperformance relative to expected historical or projected future operating results;
-
significant changes in the manner of our use of acquired assets or the strategy for our overall business (e.g., decision to divest a business); or
-
significant negative industry or economic trends.
If we determine through the impairment review process that goodwill or other indefinite-lived intangible assets are impaired, we record an impairment charge in our consolidated statements of income.
For the years ended December 30, 2017, December 31, 2016 and December 26, 2015, the results of our goodwill and intangible impairment analysis did not result in any impairments.
Supplier Rebates
Supplier rebates are included as a reduction of cost of sales and are recognized over the period they are earned. The factors we consider in estimating supplier rebate accruals include forecasted inventory purchases and sales in conjunction with supplier rebate contract terms which generally provide for increasing rebates based on either increased purchase or sales volume. Although we believe our judgments, estimates and/or assumptions related to supplier rebates are reasonable, making material changes to such judgments, estimates and/or assumptions could materially affect our financial results.
Long-Lived Assets
Long-lived assets, other than goodwill and other indefinite-lived intangibles, are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable through the estimated undiscounted future cash flows to be derived from such assets.
Definite-lived intangible assets primarily consist of non-compete agreements, trademarks, trade names, customer lists, customer relationships and intellectual property. For long-lived assets used in operations, impairment losses are only recorded if the asset’s carrying amount is not recoverable through its undiscounted, probability-weighted future cash flows. We measure the impairment loss based on the difference between the carrying amount and the estimated fair value. When an impairment exists, the related assets are written down to fair value. Although we believe our judgments, estimates and/or assumptions used in estimating cash flows and determining fair value are reasonable, making material changes to such judgments, estimates and/or assumptions could materially affect such impairment analyses and our financial results.
Stock-Based Compensation
Stock-based compensation represents the cost related to stock-based awards granted to employees and non-employee directors. We measure stock-based compensation at the grant date, based on the estimated fair value of the award, and recognize the cost (net of estimated forfeitures) as compensation expense on a straight-line basis over the requisite service period. Our stock-based compensation expense is reflected in selling, general and administrative expenses in our consolidated statements of income.
Stock-based awards are provided to certain employees and non-employee directors under the terms of our 2013 Stock Incentive Plan, as amended, and our 2015 Non-Employee Director Stock Incentive Plan (together, the “Plans”). The Plans are administered by the Compensation Committee of the Board of Directors. Prior to March 2009, awards under the Plans principally included a combination of at-the-money stock options and restricted stock/units. Since March 2009, equity-based awards have been granted solely in the form of restricted stock/units, with the exception of providing stock options to employees pursuant to certain pre-existing contractual obligations.
Grants of restricted stock/units are stock-based awards granted to recipients with specified vesting provisions. In the case of restricted stock, common stock is delivered on the date of grant, subject to vesting conditions. In the case of restricted stock units, common stock is generally delivered on or following satisfaction of vesting conditions. We issue restricted stock/units that vest solely based on the recipient’s continued service over time (primarily four-year cliff vesting, except for grants made under the 2015 Non-Employee Director Stock Incentive Plan, which are primarily 12-month cliff vesting) and restricted stock/units that vest based on our achieving specified performance measurements and the recipient’s continued service over time (primarily three-year cliff vesting).
With respect to time-based restricted stock/units, we estimate the fair value on the date of grant based on our closing stock price. With respect to performance-based restricted stock/units, the number of shares that ultimately vest and are received by the recipient is based upon our performance as measured against specified targets over a specified period, as determined by the Compensation Committee of the Board of Directors. Although there is no guarantee that performance targets will be achieved, we estimate the fair value of performance-based restricted stock/units based on our closing stock price at time of grant.
The Plans provide for adjustments to the performance-based restricted stock/units targets for significant events, including, without limitation, acquisitions, divestitures, new business ventures, certain capital transactions (including share repurchases), restructuring costs, if any, changes in accounting principles or in applicable laws or regulations, foreign exchange fluctuations, certain litigation related costs, and material changes in income tax rates. Over the performance period, the number of shares of common stock that will ultimately vest and be issued and the related compensation expense is adjusted upward or downward based upon our estimation of achieving such performance targets. The ultimate number of shares delivered to recipients and the related compensation cost recognized as an expense will be based on our actual performance metrics as defined under the Plans.
Although we believe our judgments, estimates and/or assumptions related to stock-based compensation are reasonable, making material changes to such judgments, estimates and/or assumptions could materially affect our financial results.
Accounting Pronouncements Adopted
In March 2016, the Financial Accounting Standard Board (“FASB”) issued ASU No. 2016-09, “Stock Compensation” (Topic 718) (“ASU 2016-09”). ASU 2016-09 contains amended guidance for share-based payment accounting. We adopted the provisions of this standard during the first quarter of 2017.
Under ASU 2016-09, all excess tax benefits and tax deficiencies resulting from the difference between the deduction for tax purposes and the stock-based compensation cost recognized for financial reporting purposes are included as a component of income tax expense as of January 1, 2017. Prior to the implementation of ASU 2016-09, excess tax benefits were recorded as a component of Additional paid-in capital and tax deficiencies were recognized either as an offset to accumulated excess tax benefits or in the income statement if there were no accumulated excess tax benefits. The adoption of ASU 2016-09 reduced income tax expense by approximately $19.6 million for the year ended December 30, 2017.
The ASU clarifies the classification of certain share based payment activities within the statements of cash flows. We have elected to prospectively present the amount of excess tax benefits related to stock compensation as a component of cash flows from operating activities. Additionally, all cash payments made to taxing authorities on an employees’ behalf when directly withholding shares for tax-withholding purposes, which were previously included as cash flows from operating activities, are now presented retrospectively as cash flows from financing activities within the statement of cash flows.
Recently Issued Accounting Standards
In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”), which supersedes nearly all existing revenue recognition guidance under accounting principles generally accepted in United States (“U.S. GAAP”). The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP.
In August 2015, the FASB issued ASU No. 2015-14, “Revenue from Contracts with Customers”, which deferred the effective date by one year to December 15, 2017 for interim and annual reporting periods beginning after that date.
When effective, ASU 2014-09 will require us to use either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients; or (ii) a modified retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures to describe the nature, amount, timing and uncertainty of revenue, certain costs and cash flows arising from our contracts with customers).
We have finalized our review of our various revenue streams within our two reportable segments: (i) health care distribution and (ii) technology and value-added services. We have gathered data and quantified the amount of sales by type of revenue stream and categorized the types of sales for our business units for the purpose of comparing how we currently recognize revenue to the new standard in order to quantify the impact of this ASU. We generally anticipate having substantially similar performance obligations under the new guidance as compared with deliverables and units of account currently being recognized.
We do not anticipate any material changes to the timing or amount of revenues recognized for our health care distribution or our technology and value-added services reportable segments.
Due to the variety of our product offerings in our technology and value-added segment, the actual revenue recognition treatment required under the new standard will depend on contract-specific terms. There will be some impact on timing of revenue recognition, which will include the following:
· We currently defer license revenue in cases where we do not have VSOE of the fair value of an element in the arrangement that has not been delivered yet such as customer support. Under Accounting Standards Codification (“ASC”) 606, the concept of VSOE is eliminated and there are no cases where revenue is deferred due to a lack of standalone selling price. As such, we will recognize certain revenue related to the software license earlier than current practice.
· Certain upfront fees related to service arrangements are currently deferred and recognized over the estimated customer life. Under ASC 606, the period over which we will recognize these fees will be reduced.
· Revenue related to term licenses is currently recognized over the license term. Under ASC 606, the license will be recognized upon delivery or license renewal.
· We currently expense contract acquisition costs. The new requirement to defer incremental contract acquisition costs and recognize them over the term of the initial contract and anticipated renewal contracts to which the costs relate will require us to capitalize additional costs. We will utilize the practical expedient permitting expensing of costs to obtain a contract when the expected amortization period is one year or less which will typically result in expensing commissions on all products or services except our software support contracts.
In these cases, we generally will recognize revenue related to technology and value-added contracts earlier than current practice, while certain contract acquisition costs will be recognized later than current practice. However, we do not believe the impact will be material to each of our segments or to our consolidated financial statements.
As of December 31, 2017, we expect to adopt the standard on a modified retrospective basis and recognize an immaterial adjustment to retained earnings reflecting the cumulative impact for the above described accounting changes.
In February 2016, the FASB issued ASU No. 2016-02, “Leases” (Topic 842) (“ASU 2016-02”). ASU 2016-02 contains guidance on accounting for leases and requires that most lease assets and liabilities and the associated rights and obligations be recognized on the Company’s balance sheet. ASU 2016-02 focuses on lease assets and lease liabilities by lessees classified as operating leases under previous generally accepted accounting principles. For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities. ASU 2016-02 will require disclosures regarding the amount, timing and uncertainty of cash flows arising from leases. The standard, which requires the use of a modified retrospective approach, will be effective for interim and annual periods beginning after December 15, 2018. Early adoption is permitted. We are currently exploring the methods we can use to gather and process our operating lease data at a worldwide consolidated level.
In January 2017, the FASB issued ASU No. 2017-04, “Intangibles-Goodwill and Other” (Topic 350) (“ASU 2017-04”). ASU 2017-04 eliminates step two from the goodwill impairment test, thereby eliminating the requirement to calculate the implied fair value of a reporting unit. ASU 2017-04 will require us to perform our annual goodwill impairment test by comparing the fair value of our reporting units to the carrying value of those units. If the carrying value exceeds the fair value, we will be required to recognize an impairment charge; however, the impairment charge should not exceed the amount of goodwill allocated to such reporting unit. ASU 2017-04 is required to be implemented on a prospective basis for fiscal years beginning after December 15, 2019. We do not expect that the requirements of ASU 2017-04 will have a material impact on our consolidated financial statements.
In May 2017, the FASB issued ASU No. 2017-09, “Compensation-Stock Compensation (Topic 718), Scope of Modification Accounting” (“ASU 2017-09”). ASU 2017-09 clarifies guidance on determining which changes to the terms and conditions of share-based payment awards require an entity to apply modification accounting. ASU 2017-09 requires modification accounting if the fair value, vesting conditions, or equity or liability classification of the award is not the same immediately before and after a change to the terms and conditions of the award. ASU 2017-09 is required to be implemented on a prospective basis for fiscal years beginning after December 15, 2017.
We do not expect that the requirements of ASU 2017-09 will have a material impact on our consolidated financial statements.
In August 2017, the FASB issued ASU No. 2017-12, “Derivatives and Hedging” (Topic 815) (“ASU 2017-12”), which simplifies the requirements for hedge accounting, more closely aligns hedge accounting with risk management activities and increases transparency of the scope and results of hedging activities. This ASU amends the presentation and disclosure requirements and changes how we can assess the effectiveness of our hedging relationships. This ASU will make more financial and nonfinancial hedging strategies eligible for hedge accounting. ASU 2017-12 is required to be implemented for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption of ASU 2017-12 is permitted in any interim period after the issuance of this ASU. We do not expect that the requirements of ASU 2017-12 will have a material impact on our consolidated financial statements.
In June 2016, the FASB issued ASU No. 2016-13, "Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments" which requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. This ASU is effective for interim and annual reporting periods beginning after December 15, 2019, with early adoption permitted for interim and annual reporting periods beginning after December 15, 2018. This ASU is required to be adopted using the modified retrospective basis, with a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance of this ASU is effective. Based upon the level and makeup of our financial asset portfolio, past loan loss activity and current known activity regarding our outstanding loans, we do not expect that this ASU will have a material impact on the results of our consolidated financial statements.
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