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, dispositions and joint ventures, including the failure to achieve anticipated synergies/benefits; financial and tax risks associated with acquisitions, dispositions 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 and medical practitioners. We serve more than 1 million customers worldwide including dental practitioners and laboratories 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 86 years of experience distributing health care products.
We are headquartered in Melville, New York, employ more than 18,000 people (of which more than 8,800 are based outside the United States) and have operations or affiliates in 31 countries, including the United States, Australia, Austria, Belgium, Brazil, Canada, Chile, China, the Czech Republic, France, Germany, Hong Kong SAR,
Ireland, Israel, Italy, Japan, Liechtenstein, Luxembourg, Malaysia, the Netherlands, New Zealand, Poland, Portugal, Singapore, Slovakia, South Africa, Spain, 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 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. 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.
Spin-Off of Henry Schein Animal Health Business
On February 7, 2019 (the “Distribution Date”), we completed the previously announced separation (the “Separation”) and subsequent merger of our animal health business (the “Henry Schein Animal Health Business”) with Direct Vet Marketing, Inc. (d/b/a Vets First Choice, “Vets First Choice”) (the “Merger”). This was accomplished by a series of transactions among us, Vets First Choice, Covetrus, Inc. (f/k/a HS Spinco, Inc. “Covetrus”), a wholly owned subsidiary of ours prior to the Distribution Date, and HS Merger Sub, Inc., a wholly owned subsidiary of Covetrus (“Merger Sub”). In connection with the Separation, we contributed, assigned and transferred to Covetrus certain applicable assets, liabilities and capital stock or other ownership interests relating to the Henry Schein Animal Health Business. On the Distribution Date, we received a tax-free distribution of $1,120.0 million from Covetrus pursuant to certain debt financing incurred by Covetrus. On the Distribution Date and prior to the Distribution, Covetrus issued shares of Covetrus common stock to certain institutional accredited investors (the “Share Sale Investors”) for $361.1 million (the “Share Sale”). The proceeds of the Share Sale were paid to Covetrus and distributed to us. Subsequent to the Share Sale, we distributed, on a pro rata basis, all of the shares of the common stock of Covetrus held by us to our stockholders of record as of the close of business on January 17, 2019 (the “Animal Health Spin-off”). After the Share Sale and Animal Health Spin-off, Merger Sub consummated the Merger whereby it merged with and into Vets First Choice, with Vets First Choice surviving the Merger as a wholly owned subsidiary of Covetrus. Immediately following the consummation of the Merger, on a fully diluted basis, (i) approximately 63% of the shares of Covetrus common stock were (a) owned by our stockholders and the Share Sale Investors, and (b) in respect of certain equity awards held by certain employees of the Henry Schein Animal Health Business, and (ii) approximately 37% of the shares of Covetrus common stock were (a) owned by stockholders of Vets First Choice immediately prior to the Merger, and (b) in respect of certain equity awards held by certain employees of Vets First Choice. After the Separation and the Merger, we no longer beneficially owned any shares of Covetrus common stock and, following the Distribution Date, will not consolidate the financial results of Covetrus for the purpose of our financial reporting. Following the Separation and the Merger, Covetrus was an independent, publicly traded company on the Nasdaq Global Select Market.
Effective first quarter 2019, we will report the historical earnings of the Henry Schein Animal Health Business as a discontinued operation. The Company estimates that on a continuing operations basis, its 2018 revenues were $9.4 billion and its 2018 net income was $430.7 million.
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. 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 2018 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 2017-2026” indicating that total national health care spending reached approximately $3.7 trillion in 2018, or 18.2% 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 $5.7 trillion in 2026, approximately 19.7% 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 it, including, without limitation, by permitting the use of less robust plans with lower coverage and eliminating “premium support” for insurers providing policies under the Health Care Reform Law. On December 22, 2017, the President signed into law the Tax Cuts and Jobs Act (the “Tax Act”), 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, and which also repealed the individual mandate of the Health Care Reform Law. Further, in December 2018, a Texas federal court struck down the entire Health Care Reform Law, a ruling which is being appealed, and if upheld, could have a significant impact on the U.S. healthcare industry. 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, imposes annual 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. Effective January 1, 2022, transfers of value to physician assistants, nurse practitioners or clinical nurse specialists, certified registered nurse anesthetists, and certified nurse-midwives must also be reported.
Under the Physician Payment Sunshine Act, we are required to collect and report detailed information regarding certain financial relationships we have with covered recipients such as 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, established 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, certain eligible clinicians are required to participate in Medicare through the Merit-Based Incentive Payment System (“MIPS”) or Advanced Alternative Payment Models (“APMs”). MIPS generally consolidated three 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 includes both positive and negative payment adjustments that take into account quality, promoting interoperability, resource use, clinical practice improvement and improving patient access to health information. Advanced APMs generally involve higher levels of financial and technology risk. The first MIPS performance year was 2017, and the data collected in the first performance year determines payment adjustments beginning January 1, 2019. 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, and who may receive up to 30% of total government recoveries. Penalties under fraud and abuse laws may be severe. For example, under the federal False Claims Act, violations may result in treble damages, plus civil penalties of up to $22,363 per claim, as well as exclusion from federal health care programs and criminal penalties. 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. With respect to “anti-kickback laws,” violations of, for example, the federal Anti-Kickback Law may result in civil penalties of up to $100,000 for each violation, plus up to three times the total amount of remuneration offered, paid, solicited or received, as well as exclusion from federal health care programs and criminal penalties. Notably, effective October 24, 2018, a new federal anti-kickback law (the “Eliminating Kickbacks in Recovery Act of 2018”) enacted in connection with broader addiction services legislation, may impose criminal penalties for kickbacks involving clinical laboratory services, regardless of whether the services at issue involved addition services, and regardless of whether the services were reimbursed by a federal health care program or by a commercial health insurer. Furthermore, the Health Care Reform Law significantly strengthened the federal False Claims Act and the federal Anti-Kickback Law provisions, clarifying that a federal Anti-Kickback Law violation can be a basis for federal False Claims Act liability.
With respect to measures of this type, 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 continues 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 FDC Act 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. Most compliance dates were reached as of September 24, 2018, with a final set of requirements for low risk devices being reach on September 24, 2022, which will complete the phase in. 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. The 21st Century Cures Act (“Cures Act”), signed into law on December 13, 2016, amended the device definition to exclude certain software, including clinical decision support software that meet certain criteria. In December 2017, the FCA issued draft guidance documents describing its proposed interpretation of the statutory language regarding which types of clinical decision support tools and other software are exempt from regulation 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 increased privacy rights for individuals in Europe, extended 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 we 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.
Various federal initiatives involve the adoption and use by health care providers of certain electronic health care records systems and processes. The initiatives include, among others, programs that incentivize physicians and dentists, through Medicare’s MIPS, to use certified EHR technology in accordance with certain evolving requirements. Including regarding quality, promoting interoperability, resource use, clinical practice improvement and improving patient access to health information. Qualification for the MIPS incentive payments requires the use of EHRs that are certified as having certain capabilities designated in 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”). These standards have been subject to change.
Certain of our businesses involve the manufacture and sale of certified EHR systems and other products linked to MIPS and other incentive programs. In order to maintain certification of our EHR products, we must satisfy the changing governmental standards. 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 we are exposed to risk, such as under federal health care fraud and abuse laws, including 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 incentive 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 29, 2018, December 30, 2017 and December 31, 2016 (in thousands):
| Years Ended | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| December 29, | December 30, | December 31, | |||||||||
| 2018 | 2017 | 2016 | |||||||||
| Operating results: | |||||||||||
| Net sales .............................................................................................................................................................................. | $ | 13,201,995 | $ | 12,461,543 | $ | 11,571,668 | |||||
| Cost of sales ......................................................................................................................................................................... | 9,606,911 | 9,062,440 | 8,345,195 | ||||||||
| Gross profit ...................................................................................................................................................................... | 3,595,084 | 3,399,103 | 3,226,473 | ||||||||
| Operating expenses: | |||||||||||
| Selling, general and administrative ........................................................................................................................................ | 2,701,876 | 2,534,409 | 2,409,008 | ||||||||
| Litigation settlements.......................................................................................................................................................... | 38,488 | 5,325 | - | ||||||||
| Transaction costs related to Animal Health spin-off................................................................................................................. | 38,756 | - | - | ||||||||
| Restructuring costs ............................................................................................................................................................ | 62,912 | - | 45,891 | ||||||||
| Operating income .......................................................................................................................................................... | $ | 753,052 | $ | 859,369 | $ | 771,574 | |||||
| Other expense, net ................................................................................................................................................................. | $ | (57,704) | $ | (36,521) | $ | (15,739) | |||||
| Net income .......................................................................................................................................................................... | 562,126 | 459,293 | 556,395 | ||||||||
| Net income attributable to Henry Schein, Inc. ............................................................................................................................. | 535,881 | 406,299 | 506,778 | ||||||||
| Years Ended | |||||||||||
| December 29, | December 30, | December 31, | |||||||||
| 2018 | 2017 | 2016 | |||||||||
| Cash flows: | |||||||||||
| Net cash provided by operating activities ................................................................................................................................... | $ | 684,706 | $ | 545,515 | $ | 642,576 | |||||
| Net cash used in investing activities .......................................................................................................................................... | (192,954) | (342,276) | (316,422) | ||||||||
| Net cash used in financing activities .......................................................................................................................................... | (603,776) | (112,551) | (327,344) |
Plans of Restructuring
On July 9, 2018, we committed to an initiative to rationalize our operations and provide expense efficiencies. These actions will allow us to execute on our plan to reduce our cost structure and fund new initiatives that are expected to drive future growth under our 2018 to 2020 strategic plan. This initiative is expected to include the elimination of approximately 2% to 3% of our workforce and the closing of certain facilities. The total 2018 costs associated with the actions to complete this restructuring were initially expected to be in the range of $45 million to $55 million. However, additional cost savings opportunities were identified in the fourth quarter of 2018 resulting in a charge of $35.4 million in the quarter, which increased our full year 2018 restructuring charges to $62.9 million, consisting primarily of severance costs.
We plan to continue restructuring activities in the first half of 2019 and expect to incur additional restructuring costs related to these activities during the first half of 2019. At this time we are identifying specific opportunities and cannot reasonably estimate the amount of additional restructuring costs in 2019.
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 these restructurings are included in a separate line item, “Restructuring costs” within our consolidated statements of income.
2018 Compared to 2017
Net Sales
Net sales for 2018 and 2017 were as follows (in thousands):
| % of | % of | Increase | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2018 | Total | 2017 | Total | $ | % | |||||||||||||||
| Health care distribution (1): | ||||||||||||||||||||
| Dental ........................................................................................................................................................................................... | $ | 6,348,945 | 48.1 | % | $ | 6,048,813 | 48.5 | % | $ | 300,132 | 5.0 | % | ||||||||
| Animal health .................................................................................................................................................................................. | 3,682,639 | 27.9 | 3,476,635 | 27.9 | 206,004 | 5.9 | ||||||||||||||
| Medical ......................................................................................................................................................................................... | 2,661,166 | 20.1 | 2,497,994 | 20.1 | 163,172 | 6.5 | ||||||||||||||
| Total health care distribution .............................................................................................................................................................. | 12,692,750 | 96.1 | 12,023,442 | 96.5 | 669,308 | 5.6 | ||||||||||||||
| Technology and value-added services (2)....................................................................................................................................................... | 509,245 | 3.9 | 438,101 | 3.5 | 71,144 | 16.2 | ||||||||||||||
| Total .......................................................................................................................................................................................... | $ | 13,201,995 | 100.0 | % | $ | 12,461,543 | 100.0 | % | $ | 740,452 | 5.9 | |||||||||
| (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 $740.5 million, or 5.9%, increase in net sales for the year ended December 29, 2018 includes an increase of 5.2% local currency growth (3.4% increase in internally generated revenue and 1.8% growth from acquisitions) as well as an increase of 0.7% related to foreign currency exchange.
The $300.1 million, or 5.0%, increase in dental net sales for the year ended December 29, 2018 includes an increase of 4.2% in local currencies (3.0% increase in internally generated revenue and 1.2% growth from acquisitions) as well as an increase of 0.8% related to foreign currency exchange. The 4.2% increase in local currency sales was due to increases in dental equipment sales and service revenues of 2.6% (2.5% increase in internally generated revenue and 0.1% growth from acquisitions) and dental consumable merchandise sales growth of 4.8% (3.2% increase in internally generated revenue and 1.6% growth from acquisitions).
The $206.0 million, or 5.9%, increase in animal health net sales for the year ended December 29, 2018 includes an increase of 4.6% local currency growth (2.1% increase in internally generated revenue and 2.5% growth from acquisitions) as well as an increase of 1.3% related to foreign currency exchange. The growth in internally generated animal health revenue is affected by year-over-year changes to certain supplier agreements where we acted as an agent in 2018 versus acting as a principal in the prior year. When excluding the effects of this change, internally generated revenue grew by 5.4%. As indicated above, we completed the Animal Health Spin-off on February 7, 2019.
The $163.2 million, or 6.5%, increase in medical net sales for the year ended December 29, 2018 includes an increase of 6.4% local currency growth (6.3% increase in internally generated revenue and 0.1% growth from acquisitions) as well as an increase of 0.1% related to foreign currency exchange.
The $71.1 million, or 16.2%, increase in technology and value-added services net sales for the year ended December 29, 2018 includes an increase of 15.8% local currency growth (3.5% increase in internally generated revenue and 12.3% growth from acquisitions) as well as an increase of 0.4% related to foreign currency exchange.
Gross Profit
Gross profit and gross margins for 2018 and 2017 by segment and in total were as follows (in thousands):
| Gross | Gross | Increase | |||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2018 | Margin % | 2017 | Margin % | $ | % | ||||||||||||||
| Health care distribution ........................................................................................................................................................................ | $ | 3,253,452 | 25.6 | % | $ | 3,112,436 | 25.9 | % | $ | 141,016 | 4.5 | % | |||||||
| Technology and value-added services ....................................................................................................................................................... | 341,632 | 67.1 | 286,667 | 65.4 | 54,965 | 19.2 | |||||||||||||
| Total .......................................................................................................................................................................................... | $ | 3,595,084 | 27.2 | $ | 3,399,103 | 27.3 | $ | 195,981 | 5.8 |
Gross profit increased $196.0 million, or 5.8%, for the year ended December 29, 2018 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 $141.0 million, or 4.5%, for the year ended December 29, 2018 compared to the prior year period. Health care distribution gross profit margin decreased to 25.6% for the year ended December 29, 2018 from 25.9% for the comparable prior year period. The overall increase in our health care distribution gross profit is attributable to a $128.9 million gross profit increase from growth in internally generated revenue and $49.4 million is attributable to acquisitions. These increases were partially offset by a $37.3 million decline in gross profit due to the decrease in the gross margin rates.
Technology and value-added services gross profit increased $55.0 million, or 19.2%, for the year ended December 29, 2018 compared to the prior year period. Technology and value-added services gross profit margin increased to 67.1% for the year ended December 29, 2018 from 65.4% for the comparable prior year period. Acquisitions accounted for $45.2 million of our gross profit increase within our technology and value-added services segment for the year ended December 29, 2018 compared to the prior year period. The remaining increase of $9.8 million in our technology and value-added services segment gross profit was primarily attributable to $11.4 million growth in internally generated revenue, partially offset by $1.6 million related to gross margin rates.
Selling, General and Administrative
Selling, general and administrative expenses by segment and in total for 2018 and 2017 were as follows (in thousands):
| % of | % of | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Respective | Respective | Increase | |||||||||||||||||
| 2018 | Net Sales | 2017 | Net Sales | $ | % | ||||||||||||||
| Health care distribution ....................................................................................................................................................................... | $ | 2,634,664 | 20.8 | % | $ | 2,383,916 | 19.8 | % | $ | 250,748 | 10.5 | % | |||||||
| Technology and value-added services ....................................................................................................................................................... | 207,368 | 40.7 | 155,818 | 35.6 | 51,550 | 33.1 | |||||||||||||
| Total ........................................................................................................................................................................................ | $ | 2,842,032 | 21.5 | $ | 2,539,734 | 20.4 | $ | 302,298 | 11.9 |
Selling, general and administrative expenses (together with litigation settlements, transaction costs related to the Animal Health spin-off and restructuring costs) increased $302.3 million, or 11.9%, to $2,842.0 million for the year ended December 29, 2018 from the comparable prior year period. The $250.7 million increase in selling, general and administrative expenses within our health care distribution segment for the year ended December 29,
2018 as compared to the prior year period was attributable to $209.3 million of additional operating costs (including an increase of $33.2 million for litigation settlements, $38.8 million of transaction costs related to the Animal Health spin-off and $59.1 million of restructuring costs) and $41.4 million of additional costs from acquired companies. The $51.6 million increase in selling, general and administrative expenses within our technology and value-added services segment for the year ended December 29, 2018 as compared to the prior year period was attributable to $45.6 million of additional costs from acquired companies and $6.0 million of additional operating costs. As a percentage of net sales, selling, general and administrative expenses increased to 21.5% from 20.4% for the comparable prior year period.
As a component of total selling, general and administrative expenses, selling expenses increased $90.3 million, or 5.8%, to $1,653.7 million for the year ended December 29, 2018 from the comparable prior year period. As a percentage of net sales, selling expenses remained consistent at 12.5%.
As a component of total selling, general and administrative expenses, general and administrative expenses increased $212.0 million, or 21.7%, to $1,188.3 million for the year ended December 29, 2018 from the comparable prior year period primarily due to an increase of $33.2 million for litigation settlements, $38.8 million of transaction costs related to the Animal Health spin-off and $59.1 million of restructuring costs. As a percentage of net sales, general and administrative expenses increased to 9.0% from 7.8% for the comparable prior year period.
Other Expense, Net
Other expense, net for the years ended 2018 and 2017 was as follows (in thousands):
| Variance | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2018 | 2017 | $ | % | ||||||||||
| Interest income ........................................................................................................................................................................ | $ | 21,236 | $ | 17,553 | $ | 3,683 | 21.0 | % | |||||
| Interest expense ....................................................................................................................................................................... | (78,786) | (53,654) | (25,132) | (46.8) | |||||||||
| Other, net .............................................................................................................................................................................. | (154) | (420) | 266 | 63.3 | |||||||||
| Other expense, net ............................................................................................................................................................. | $ | (57,704) | $ | (36,521) | $ | (21,183) | (58.0) |
Other expense, net increased $21.2 million to $57.7 million for the year ended December 29, 2018 from the comparable prior year period. Interest income increased $3.7 million primarily due to increased investment and late fee income. Interest expense increased $25.1 million primarily due to increased borrowings under our bank credit lines and our private placement facilities primarily to fund acquisitions of noncontrolling interests in subsidiaries, as well as higher interest rates.
Income Taxes
For the year ended December 29, 2018, our effective tax rate was 22.4% compared to 44.1% for the prior year period. In 2018, our effective tax rate was primarily impacted by a reduction in the estimate of our transition tax associated with the Tax Act, tax charges and credits associated with legal entity reorganizations outside the U.S., and state and foreign income taxes and interest expense. In 2017, our effective tax rate was primarily impacted by the Tax Act, the adoption of Accounting Standards Update (“ASU”) No. 2016-09, “Stock Compensation” (Topic 718) (“ASU 2016-09”), as well as state and foreign income taxes and interest expense.
On December 22, 2017, the U.S. government passed the Tax Act. The Tax Act is comprehensive tax legislation that implemented 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 moved 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. The Tax Act also included provisions to tax global intangible low-taxed income (“GILTI”), a beneficial tax rate foreign Derived Intangible Income (“FDII”), a base erosion and anti-abuse tax (“BEAT”) that imposes tax on certain foreign related-party payments, and IRC Section 163(j) interest limitation (Interest Limitation). We became subject to the GILTI, FDII, BEAT and Interest Limitation provisions effective January 1, 2018.
The Financial Accounting Standards Board (“FASB”) Staff Q&A, Topic 740 No. 5, Accounting for Global Intangible Low-Taxed Income, states that an entity can make an accounting policy election to either recognize deferred taxes for temporary differences expected to reverse as GILTI in future years or provide for the tax expense related to GILTI in the year the tax is incurred. We elected to recognize the tax on GILTI as a period expense in the period the tax is incurred. Under Topic 740, we estimated the impact of each provision of the Tax Act on our effective tax and recorded a current tax expense for the GILTI provision of $7.5 million in our effective tax rate for the year ended December 29, 2018. For the BEAT, FDII and Interest Limitation computations, we have not recorded an estimate in our effective tax rate for the year ended December 29, 2018 because we have concluded that these provisions of the Tax Act will not apply to us or will have an immaterial impact in 2018.
Due to the complexities of the Tax Act, the SEC staff issued Staff Accounting Bulletin No. 118 (“SAB 118”) that allowed the company to record a provisional amount for any income tax effects of the Tax Act in accordance with Accounting Standards Codification (“ASC”) 740, to the extent that a reasonable estimate can be made, in its 2017 financial statements. SAB 118 allowed 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. In the fourth quarter of 2017, we recorded provisional amounts related to the Tax Act for any items that could be reasonably estimated at the time. This included the one-time transition tax that we estimated to be $140.0 million and a net deferred tax expense of $3.0 million attributable to the revaluation of deferred tax assets and liabilities due to the lower enacted federal income tax rate of 21%. Within our consolidated balance sheets, $27.4 million was included in “Accrued taxes” and $112.6 million was included in “Other liabilities”. In the aggregate, for the quarter ended December 30, 2017, these Tax Act modifications resulted in a one-time tax expense of approximately $143.0million. 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%.
For the year ended December 29, 2018 we have recorded a net $10.0 million reduction to the one-time transition tax and an additional $1.7 million net deferred tax benefit from the revaluation of deferred tax assets and liabilities to reflect the new tax rate. Within our consolidated balance sheets, $9.9 million is included in “Accrued taxes” and $104.2 million is included in “Other liabilities” for the transition tax. The changes were a result of additional analysis, changes in interpretation and assumptions, as well as additional regulatory guidance that was issued. As of December 29, 2018, the Company has completed its analysis of the impact of the Tax Act in accordance with SAB 118 and the amounts are now considered final.
Net Income
Net income increased $102.8 million, or 22.4%, for the year ended December 29, 2018, compared to the prior year period due to the factors noted above.
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%. As indicated above, we completed the Animal Health Spin-off on February 7, 2019.
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 Act. Our effective tax rate was favorably impacted in 2017 by the adoption of 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.
On December 22, 2017, the U.S. government passed 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 moved from a global tax regime to a modified territorial regime, which required 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 SAB 118 that allowed 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 allowed 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 that time. This included the one-time transition tax that we 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%.
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.
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 $684.7 million for the year ended December 29, 2018, compared to $545.5 million for the prior year. The net change of $139.2 million was primarily attributable to working capital requirements.
Net cash used in investing activities was $193.0 million for the year ended December 29, 2018, compared to $342.3 million for the prior year. The net change of $149.3 million was primarily due to reduced payments for equity investments and business acquisitions, partially offset by reduced proceeds of sales of equity investments.
Net cash used in financing activities was $603.8 million for the year ended December 29, 2018, compared to $112.6 million for the prior year. The net change of $491.2 million was primarily due to increased acquisitions of noncontrolling interests in subsidiaries and reduced net borrowings from debt, partially offset by decreased repurchases of common stock.
The following table summarizes selected measures of liquidity and capital resources (in thousands):
| December 29, | December 30, | |||||||
|---|---|---|---|---|---|---|---|---|
| 2018 | 2017 | |||||||
| Cash and cash equivalents ........................................................................................................................................................... | $ | 80,209 | $ | 174,658 | ||||
| Working capital (1)...................................................................................................................................................................... | 956,393 | 1,257,045 | ||||||
| Debt: | ||||||||
| Bank credit lines ..................................................................................................................................................................... | $ | 951,458 | $ | 741,653 | ||||
| Current maturities of long-term debt ........................................................................................................................................... | 8,955 | 16,659 | ||||||
| Long-term debt ....................................................................................................................................................................... | 1,003,873 | 907,756 | ||||||
| Total debt .......................................................................................................................................................................... | $ | 1,964,286 | $ | 1,666,068 | ||||
| (1) Includes $422 million of accounts receivable which serve as security for U.S. trade accounts receivable securitization at December 29, 2018 and December 30, 2017. |
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 increased to 43.6 days as of December 29, 2018 from 42.7 days as of December 30, 2017. During the years ended December 29, 2018 and December 30, 2017, we wrote off approximately $7.7 million and $6.7 million, respectively, of fully reserved accounts receivable against our trade receivable reserve. Our inventory turns from operations were 4.9 as of December 29, 2018 and 5.3 as of December 30, 2017. 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 3.4%), as well as inventory purchase commitments and operating and capital lease obligations as of December 29, 2018:
| Payments due by period (in thousands) | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| < 1 year | 2 - 3 years | 4 - 5 years | > 5 years | Total | ||||||||||
| Contractual obligations: | ||||||||||||||
| Long-term debt, including interest ................................................................................................................................................. | $ | 43,450 | $ | 609,428 | $ | 61,905 | $ | 453,678 | $ | 1,168,461 | ||||
| Inventory purchase commitments ................................................................................................................................................ | 499,346 | 446,412 | 124,911 | - | 1,070,669 | |||||||||
| Operating lease obligations .......................................................................................................................................................... | 78,940 | 106,179 | 54,866 | 68,373 | 308,358 | |||||||||
| Transition tax obligations ............................................................................................................................................................ | 9,923 | 19,845 | 43,411 | 31,008 | 104,187 | |||||||||
| Capital lease obligations, including interest ..................................................................................................................................... | 1,695 | 1,844 | 604 | 1,430 | 5,573 | |||||||||
| Total ....................................................................................................................................................................................... | $ | 633,354 | $ | 1,183,708 | $ | 285,697 | $ | 554,489 | $ | 2,657,248 |
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. On June 29, 2018, we amended the Credit Agreement to, among other things, (i) permit the consummation of the Animal Health Spin-off (See Note 21), (ii) provide for swing-line commitments in the amount of $75 million, and (iii) provide for the designation of subsidiary borrowers under the facility. 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 29, 2018 and December 30, 2017, the borrowings outstanding on this revolving credit facility and the prior credit facility were $175.0 million and $320.0 million, respectively. As of December 29, 2018 and December 30, 2017, there were $11.2 million and $11.3 million of letters of credit, respectively, provided to third parties under this credit facility.
As of December 29, 2018 and December 30, 2017, we had various other short-term bank credit lines available, of which $376.5 million and $421.7 million, respectively, were outstanding. At December 29, 2018 and December 30, 2017, borrowings under all of our credit lines had a weighted average interest rate of 3.30% and 2.27%, respectively.
Committed Loan Associated with Animal Health Spin-off
On May 21, 2018, we obtained a $400 million committed loan which matured on the earlier of (i) March 31, 2019 and (ii) the consummation of the Animal Health Spin-off. The proceeds of this loan were used, among other things, to fund our purchase of all of the equity interests in Butler Animal Health Holding Company, LLC (“BAHHC”) directly or indirectly owned by Darby Group Companies, Inc. (“Darby”) and certain other sellers pursuant to the terms of that certain Amendment to Put Rights Agreements, dated as of April 20, 2018, by and among us, Darby, BAHHC and the individual sellers party thereto for an aggregate purchase price of $365 million. As of December 29, 2018, the balance outstanding on this loan was $400 million and is included within the “Bank credit lines” caption within our consolidated balance sheet. At December 29, 2018, the interest rate on this loan was 3.38%. Concurrent with the completion of the Animal Health Spin-off on February 7, 2019, we re-paid the balance of this loan.
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. On June 29, 2018, we amended and restated the above private placement facilities to, among other things, (i) permit the consummation of the Animal Health Spin-off and (ii) provide for the issuance of notes in Euros, British Pounds and Australian Dollars, in addition to U.S. Dollars. 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 29, 2018 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) | 28,571 | 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 | |||||
| January 2, 2018 | 100,000 | 3.32 | January 2, 2028 | |||||
| Less: Deferred debt issuance costs | (382) | |||||||
| $ | 628,189 | |||||||
| (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 29, 2018 and December 30, 2017, respectively. At December 29, 2018, the interest rate on borrowings under this facility was based on the asset-backed commercial paper rate of 2.66% plus 0.75%, for a combined rate of 3.41%. At December 30, 2017, the interest rate on borrowings under this facility was based on the asset-backed commercial paper rate of 1.53% plus 0.75%, for a combined rate of 2.28%.
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 29, | December 30, | ||||||
|---|---|---|---|---|---|---|---|
| 2018 | 2017 | ||||||
| Private placement facilities .......................................................................................................................................................... | $ | 628,189 | $ | 535,295 | |||
| U.S. trade accounts receivable securitization ................................................................................................................................... | 350,000 | 350,000 | |||||
| Various collateralized and uncollateralized loans payable with interest, | |||||||
| in varying installments through 2023 at interest rates | |||||||
| ranging from 2.61% to 5.01% at December 29, 2018 and | |||||||
| ranging from 2.56% to 12.90% at December 30, 2017.............................................................................................................. | 29,491 | 34,027 | |||||
| Capital lease obligations (see Note 18) ........................................................................................................................................... | 5,148 | 5,093 | |||||
| Total ....................................................................................................................................................................................... | 1,012,828 | 924,415 | |||||
| Less current maturities ................................................................................................................................................................ | (8,955) | (16,659) | |||||
| Total long-term debt .......................................................................................................................................................... | $ | 1,003,873 | $ | 907,756 | |||
Stock repurchases
From June 21, 2004 through December 29, 2018, we repurchased approximately $2.9 billion, or 58,189,377 shares, under our common stock repurchase programs, with $400.0 million available as of December 29, 2018 for future common stock share repurchases.
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. ASC 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 29, 2018, December 30, 2017 and December 31, 2016 are presented in the following table:
| December 29, | December 30, | December 31, | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| 2018 | 2017 | 2016 | ||||||||
| Balance, beginning of period .................................................................................................................................................. | $ | 832,138 | $ | 607,636 | $ | 542,194 | ||||
| Decrease in redeemable noncontrolling interests due to | ||||||||||
| redemptions .................................................................................................................................................................... | (669,947) | (48,669) | (72,729) | |||||||
| Increase in redeemable noncontrolling interests due to | ||||||||||
| business acquisitions.......................................................................................................................................................... | 10,294 | 78,939 | 58,172 | |||||||
| Net income attributable to redeemable noncontrolling interests ..................................................................................................... | 21,848 | 52,203 | 48,760 | |||||||
| Dividends declared ............................................................................................................................................................... | (18,065) | (28,161) | (32,973) | |||||||
| Effect of foreign currency translation gain (loss) attributable to | ||||||||||
| redeemable noncontrolling interests ..................................................................................................................................... | (13,031) | 7,461 | (2,652) | |||||||
| Change in fair value of redeemable securities ........................................................................................................................... | 148,919 | 162,729 | 66,864 | |||||||
| Balance, end of period .......................................................................................................................................................... | $ | 312,156 | $ | 832,138 | $ | 607,636 |
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.
During 2018, we entered into a joint venture with Internet Brands to create a newly formed entity, Henry Schein One, LLC. The joint venture includes Henry Schein Practice Solutions products and services, as well as Henry Schein’s international dental practice management systems and the dental businesses of Internet Brands. Internet Brands holds a 26% noncontrolling interest in Henry Schein One, LLC that is accounted for within stockholders’ equity, as well as a freestanding and separately exercisable right to put its noncontrolling interest to Henry Schein, Inc. for fair value following the fifth anniversary of the effective date of the formation of the joint venture. Beginning with the second anniversary of the effective date of the formation of the joint venture, Henry Schein One will issue a fixed number of additional interests to Internet Brands through the fifth anniversary, thereby increasing Internet Brands’ ownership by approximately 7.6%. Internet Brands will also be entitled to receive a fixed number of additional interests, in the aggregate up to approximately 1.6% of the joint venture’s ownership, if certain operating targets are met by the joint venture in its fourth, fifth and sixth operating years. These additional shares are considered contingent consideration that are accounted for within stockholders’ equity; however, these shares will not be allocated any net income of Henry Schein One until the shares vest or are earned by Internet Brands. As a result of this transaction with Internet Brands, we recorded $567.6 million of noncontrolling interest within stockholders’ equity reflecting certain fair value methodology.
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 $100.0 million as of December 29, 2018.
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
On December 31, 2017, we adopted ASC 606 (“Topic 606”) using the modified retrospective method applied to those contracts which were not completed as of the adoption date. Results for reporting periods beginning after December 30, 2017 are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported under the accounting standards in effect for those periods. Our revenue recognition accounting policies applied prior to adoption of Topic 606 are outlined in the financial statements in our Annual Report on Form 10-K for the year ended December 30, 2017. The disclosures included herein reflect our accounting policies under Topic 606.
We generate revenue from the sale of dental, medical, and prior to the completion of the Animal Health Spin-off, animal health 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 included in the transaction price at contract inception by estimating the most likely amount 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 at a point in time when control transfers to the customer. 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 control has transferred to the customer because we have no post-shipment obligations and this is when legal title and risks and rewards of ownership transfer to the customer and the point at which we have an enforceable right to payment.
Revenue derived from the sale of equipment is recognized when control transfers to the customer. This occurs when the equipment is delivered. 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. Our product generally carries standard warranty terms provided by the manufacturer, however, in instances where we provide warranty labor services, the warranty costs are accrued in accordance with ASC 460 “Guarantees”.
Revenue derived from the sale of software products is recognized when products are shipped to customers or made available electronically. 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 generally recognized over time using time elapsed as the input method that best depicts the transfer of control to the customer.
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. We apply the practical expedient to treat shipping and handling activities performed after the customer obtains control as fulfillment activities, rather than a separate performance obligation in the contract.
Sales, value-add and other taxes we collect concurrent with revenue-producing activities are excluded from revenue.
Certain of our revenue is derived from bundled arrangements that include multiple distinct performance obligations which are accounted for separately. When we sell software products together with related services (i.e., training and technical support), we allocate revenue to software using the residual method, using an estimate of the standalone selling price to estimate the fair value of the undelivered elements. There are no cases where revenue is deferred due to a lack of a standalone selling price. Bundled 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 goods or services. If an observable selling price is not available (i.e., we do not sell the goods or services separately), we use one of the following techniques to estimate the standalone selling price: adjusted market approach; cost-plus approach; or the residual method. There is no specific hierarchy for the use of these methods, but the 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.
Accounts Receivable
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. 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 adjust our assumptions for anticipated changes in any of these or other factors expected to affect collectability.
Contract Assets
Contract assets include amounts related to any conditional right to consideration for work completed but not billed as of the reporting date and generally represent amounts owed to us by customers, but not yet billed. Contract assets are transferred to accounts receivable when the right becomes unconditional. Current contract assets are included in Prepaid expenses and other and the non-current contract assets are included in Investments and other within our consolidated balance sheet.
Contract Liabilities
Contract liabilities are comprised of advance payments and deferred revenue amounts. Contract liabilities are transferred to revenue once the performance obligation has been satisfied. Current contract liabilities are included in Accrued expenses: Other and the non-current contract liabilities are included in Other liabilities within our consolidated balance sheet.
Deferred Commissions
Sales commissions earned by our sales force that relate to long term arrangements are capitalized as costs to obtain a contract when the costs incurred are incremental and are expected to be recovered. Deferred sales commissions are amortized over the estimated customer relationship period. We apply the practical expedient related to the capitalization of incremental costs of obtaining a contract, and recognize such costs as an expense when incurred if the amortization period of the assets that we would have recognized is one year or less.
Sales Returns
Sales returns are recognized as a reduction of revenue by the amount of expected returns and are recorded as refund liability within current liabilities. We estimate the amount of revenue expected to be reversed to calculate the sales return liability based on historical data for specific products, adjusted as necessary for new products. The allowance for returns is presented gross as a refund liability and we record an inventory asset (and a corresponding adjustment to cost of sales) for any goods or services that we expect to be returned.
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, medical, and prior to the completion of the Animal Health Spin-off, animal health) 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 29, 2018 and December 30, 2017, and December 31, 2016 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 29, 2018, December 30, 2017 and December 31, 2016, 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 Standards Update
For a discussion of accounting standards updates that have been adopted or will be adopted in the future, please refer to Note 1 of the Notes to Consolidated Financial Statements included under Item 8.
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