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
Description of Segments. Prior to January 1, 2013, we operated primarily through three business segments: diagnostic and information technology-based products and services for the veterinary market, which we continue to refer to as the Companion Animal Group (“CAG”); water quality products (“Water”); and diagnostic products for livestock and poultry health, which we referred to as Livestock and Poultry Diagnostics. We also operated two smaller operating segments that comprised products for milk quality and safety (“Dairy”) and products for the human point-of-care medical diagnostics market (“OPTI Medical”). Financial information about our Dairy and OPTI Medical operating segments was combined and presented with our remaining pharmaceutical product line and our out-licensing arrangements in an “Other” category because they did not meet the quantitative or qualitative thresholds for reportable segments.
In 2013, we combined the management of our Livestock and Poultry Diagnostics, and Dairy lines of business to more effectively realize the market synergies between the product lines and to achieve operational efficiencies. We refer to this segment as Livestock, Poultry and Dairy (“LPD”). Our OPTI Medical operating segment remains combined and presented with our remaining pharmaceutical product line and our out-licensing arrangements in an “Other” category because they do not meet the quantitative or qualitative thresholds for reportable segments. The segment income (loss) from operations discussed within this report for the year ended December 31, 2012 has been retrospectively revised to reflect this change in the composition of our reportable segments. See Note 14 to the consolidated financial statements for the year ended December 31, 2014 included in this Annual Report on Form 10-K for financial information about our segments, including our product and service categories, and our geographic areas.
Items that are not allocated to our operating segments are as follows: a portion of corporate support function and personnel-related expenses; certain manufacturing costs; corporate research and development expenses that do not align with one of our existing business or service categories; the difference between estimated and actual share-based compensation expense; certain foreign currency exchange gains and losses; and variances from standard cost for products sold resulting from changes in certain currency exchange rates. In our segment disclosure, these amounts are shown under the caption “Unallocated Amounts.”
The following is a discussion of the strategic and operating factors that we believe have the most significant effect on the performance of our business.
Companion Animal Group
Our strategy is to provide veterinarians with both the highest quality diagnostic information to support more advanced medical care and information management solutions that help demonstrate the value of diagnostics to pet owners and enable efficient practice management. By doing so, we are able to build a mutually successful partnership with our veterinarian customers based on healthy pets, loyal customers and expanding practice revenues.
CAG Diagnostics. We refer to the extensiveness and integration of our diagnostic and information management offerings as the IDEXX Diagnostic Advantage. We provide diagnostic capabilities that meet veterinarian’s diverse needs through a variety of modalities including in-clinic diagnostic solutions and outside reference laboratories. Veterinarians that utilize our full line of diagnostic modalities obtain a single view of a patient’s diagnostic results, which allows them to spot trends and achieve greater medical insight.
The breadth and complementary nature of our diagnostic solutions also provides us scale in sales and distribution. During 2013, we reorganized our companion animal diagnostic sales organization in North America, transitioning our specialty sales force that represented either in-clinic or outside reference laboratory diagnostics to account representatives who represent all CAG diagnostic modalities. In addition to this reorganization, we increased the size of our sales force resulting in smaller geographically sized sales territories. These changes allowed for more frequent customer contact by a consistent sales professional. We have experienced accelerated revenue growth subsequently to implementing this change.
To further increase our customer reach, effective January 1, 2015 we transitioned to an all-direct sales strategy in the U.S. and did not renew our current annual contracts with our U.S. distribution partners. Under this approach, we take orders, ship product, invoice and receive payment for all rapid assay test kits and instrument consumables in the U.S., aligning with our direct model for instruments, reference laboratory services, and other CAG products and services. We believe these changes will continue to strengthen customer loyalty and help support growth of our diagnostic revenues in North America.
Our diagnostic capabilities generate both recurring and non-recurring revenues. Revenues related to capital placements of our in-clinic VetLab suite of instruments and our SNAP Pro Mobile Device are non-recurring in nature, while revenues from the associated proprietary VetLab consumables, SNAP rapid assay test kits, outside reference laboratory and consulting services, and extended maintenance agreements and accessories related to our VetLab instruments are recurring in nature. Instrument sales have significantly lower gross margins than those provided by our recurring revenues, especially in the case of VetLab consumables and rapid assay test kits. Therefore, the mix of nonrecurring and recurring revenues in a particular period will impact our gross margins.
Diagnostic Capital Revenue. Revenues related to the placement of the VetLab suite of instruments are non-recurring in nature, in that the customer will buy an instrument once over its respective product life cycle, but will purchase consumables for that instrument on a recurring basis as they use that instrument for testing purposes. During the early stage of an instrument’s life cycle, we derive relatively greater revenues from instrument placements, while consumable sales become relatively more significant in later stages as the installed base of instruments increases and instrument placement revenues begin to decline. In the early stage of an instrument’s life cycle, placements are made primarily through sales transactions. As the market for the product matures, an increasing percentage of placements are made in transactions, sometimes referred to as “reagent rentals,” in which instruments are placed at customer sites at little or no cost in exchange for a long-term customer commitment to purchase instrument consumables.
Prior to the Catalyst One instrument launch during November 2014, we pre-sold the instrument under a customer marketing program through which customers preordering a Catalyst One were initially provided with the right to use a Catalyst Dx instrument. Under this marketing program, we deferred $7 million of instrument revenue in 2014, which will not be recognized until delivery of the Catalyst One instrument occurs in 2015.
We place our Catalyst chemistry analyzers through sales, leases, rental and other programs. In addition, we continue to place VetTest instruments through sales, lease, rental and other programs, with substantially all of our revenues from that product line currently derived from consumable sales. As of December 31, 2014, these three chemistry analyzers provided for a combined active installed base of approximately 38,000 units. Approximately half of 2014 Catalyst analyzer placements were to customers that are new to IDEXX, including customers who had been using instruments from one of our competitors, sometimes referred to as competitive accounts. Generally, placement of an instrument with a competitive account is more attractive as the entire consumable stream associated with that placement represents incremental revenue, whereas the consumable stream associated with a Catalyst placement at a VetTest customer substitutes a Catalyst consumable stream for a VetTest consumable stream. We have found that the consumables revenues increase by approximately 25% when a customer upgrades from a VetTest analyzer to a Catalyst analyzer due to the superior capability, flexibility and ease of use of the Catalyst, which leads to additional testing by the customer.
As we continue to experience growth in placements of Catalyst analyzers and in sales of related consumables, we expect this growth to be partly offset by a decline in placements of VetTest analyzers and in sales of related consumables.
The ProCyte Dx analyzer is our latest generation hematology analyzer, which we launched in 2010. In addition we sell the LaserCyte Dx and LaserCyte analyzers and VetAutoread analyzers. As of December 31, 2014, these four hematology analyzers provided for a combined active installed base of approximately 27,000 units. A substantial portion of ProCyte Dx analyzer placements continue to be made at veterinary clinics that elect to upgrade from their LaserCyte analyzer to a ProCyte Dx analyzer. In 2014, slightly less than half of ProCyte placements were made at competitive accounts. We also continue to place a substantial number of LaserCyte Dx and LaserCyte instruments, both new and recertified, as trade-ups from the VetAutoread analyzer and at new and competitive accounts. In 2014, a significant number of LaserCyte instruments that were placed were recertified instruments that had been received in trade in the sale of a ProCyte Dx analyzer. As we continue to experience growth in placements of ProCyte Dx analyzers and in sales of related consumables, we expect this growth to be partly offset by a decline in placements of LaserCyte and VetAutoread analyzers and in sales of related consumables.
We seek to enhance the attractiveness of our SNAP rapid assay tests by providing the SNAP Pro Mobile Device, which activates SNAP tests, properly times the run, captures and saves images of the results and, in conjunction with IVLS, records invoice charges in the patient record. This promotes practice efficiency by eliminating manual entry of test results in patient records and also helps ensure that the services are recorded and accurately invoiced. In addition, SNAP Pro Mobile Device results can be shared with pet owners on the SNAP Pro screen or, in conjunction with IVLS, via VetConnect PLUS. We also sell the SNAPshot Dx, which automatically reads certain SNAP test results and, in conjunction with IVLS, records those results in the electronic medical record. We continue to work on enhancing the functionality of our analyzers to read the results of additional tests from our canine and feline family of rapid assay products.
Prior to 2014, the SNAPshot Dx was our primary in-clinic solution which screened for thyroid disease. With the recent launch of the total thyroxine (“T4”) slide for use with the Catalyst One analyzer, we anticipate a decline in placements of the SNAPshot Dx, although we will continue to service the existing install base.
Our long-term success in this area of our business is dependent upon new customer acquisition, customer loyalty and retention and customer utilization of existing and new assays introduced for use on our analyzers. We continuously seek opportunities to enhance the care that veterinary professionals give to their patients and clients through supporting the implementation of real-time care testing work flows, which is performing tests and sharing test results with the client at the time of the patient visit. Our latest generation of chemistry and hematology instruments demonstrates this commitment by offering enhanced ease of use, faster time to results, greater sample throughput, broader test menu and connectivity to various information technology platforms that enhance the value of the diagnostic information generated by the instruments. In addition, we provide marketing tools and consultative services that help drive efficiencies in veterinary practice processes and allow practices to increase the number of clients they see on a daily basis.
With all of our instrument product lines, we seek to differentiate our products from our competitors’ products based on time-to-result, ease-of-use, throughput, breadth of diagnostic menu, flexibility of menu selection, accuracy, reliability, ability to handle compromised samples, analytical capability of software, integration with the IDEXX VetLab Station and VetConnect PLUS, client communications capabilities, education and training, and superior sales and customer service. Our success depends, in part, on our ability to differentiate our products in a way that justifies a premium price.
Recurring Diagnostic Revenue. Revenues from our proprietary VetLab consumable products, our SNAP rapid assay test kits, outside reference laboratory and consulting services, and extended maintenance agreements and accessories related to our VetLab instruments are considered recurring in nature. Recurring diagnostic revenue accounts for approximately 71% of our consolidated revenue and is both highly durable and profitable.
Our in-clinic diagnostic solutions, consisting of our VetLab consumable products and SNAP rapid assay test kits, provide real-time reference lab quality diagnostic results for a variety of companion animal diseases and health conditions. Our outside reference laboratories provide veterinarians with the benefits of a more comprehensive list of diagnostic tests and access to consultations with board-certified veterinary specialists and pathologists, combined with the benefit of same-day or next-day turnaround times.
We derive substantial revenues and margins from the sale of consumables that are used in VetLab instruments and the multi-year consumable revenue stream is significantly more valuable than the placement of the instrument. Our strategy is to increase diagnostic testing within veterinary practices by placing VetLab instruments and increasing instrument utilization of consumables. Utilization can increase due to a greater number of patient samples being run or to an increase in the number of tests being run per patient sample. Our strategy is to increase both drivers. To increase utilization, we seek to educate veterinarians about best medical practices that emphasize the importance of chemistry and hematology testing for a variety of diagnostic purposes, as well as by introducing new testing capabilities that were previously not available to veterinarians. Additionally, we have found that veterinarian adoption of VetConnect PLUS drives utilization by spurring testing across all IDEXX diagnostic modalities. In connection with the purchase of instruments, we also offer protocol-based rebate incentives when customers utilize the broad testing functionality of our analyzers.
Our in-clinic diagnostic solutions also include SNAP rapid assay tests that address important medical needs for particular diseases prevalent in the companion animal population. We seek to differentiate these tests from those of other in-clinic test providers and reference laboratory diagnostic service providers through ease-of-use, superior performance, sensitivity, specificity and by providing our customers with combination tests that test a single sample for up to six diseases at once. We further augment our product development and customer service efforts with sales and marketing programs that enhance medical awareness and understanding regarding certain diseases and the importance of diagnostic testing.
We believe that more than half of all diagnostic testing by U.S. veterinarians is provided by outside reference laboratories such as our IDEXX Reference Laboratories. In several markets outside the U.S., in-clinic testing is less prevalent and an even greater percentage of diagnostic testing is done in reference laboratories. We attempt to differentiate our reference laboratory testing services from those of competitive reference laboratories and competitive in-clinic offerings primarily on the basis of test menu, technology employed, quality, turnaround time, customer service and tools such as VetConnect PLUS that demonstrate the complementary manner in which our laboratory services work with our in-clinic offerings.
Profitability from our reference laboratory diagnostic and consulting services is largely the result of our ability to achieve efficiencies from both volume and operational improvements. When possible, we utilize core reference laboratories to service samples from other countries, expanding our customer reach without an associated expansion in our reference laboratory footprint. Start-up laboratories that we open typically will operate at a loss until testing volumes achieve sufficient scale. Acquired laboratories frequently operate less profitably than our existing laboratories and acquired laboratories may not achieve the profitability of our existing laboratory network for several years until we complete the implementation of operating improvements and efficiencies. Therefore, in the short term, new and acquired reference laboratories generally will have a negative effect on our operating margin. Recurring revenue growth is achieved both through increased sales to existing customers and through the acquisition of new customers. We believe the increased number of customer visits resulting from our all-direct sales strategy in the U.S. will lead to increased reference laboratory opportunities with customers who already use one of our in-clinic diagnostic modalities. In recent years, recurring reference laboratory diagnostic and consulting revenues have also been increased through reference laboratory acquisitions, customer list acquisitions, the opening of new reference laboratories, including laboratories that are co-located with large practice customers, and as a result of our up-front customer loyalty programs. Under these arrangements, we provide incentives to customers in the form of cash payments or IDEXX Points upon entering multi-year agreements to purchase annual minimum amounts of products or services in the future.
Health Monitoring and Biological Materials Testing. We believe the acquisition of the research and diagnostic laboratory business of the College of Veterinary Medicine from the University of Missouri allows us to leverage our expertise in veterinary diagnostics and expand our integrated offering of reference laboratory diagnostic and consulting services and in-clinic testing solutions in the adjacent bioresearch market.
Customer Information Management and Digital Imaging Systems. Our Cornerstone practice management system provides a superior integrated information solution, backed by exceptional customer support and education, to allow the veterinarian to practice better medicine and achieve the practice’s business objectives, including a quality client experience, staff efficiency and practice profitability. We differentiate our practice management systems through enhanced functionality, ease of use and connectivity with in-clinic VetLab instruments and outside reference laboratory test results. Our client communication services create more meaningful pet owner experiences through personalized communication. Pet Health Network Pro online client communication and education service complements the entire IDEXX product offering by educating pet owners and building loyalty through engaging the pet owner before, during and after the visit, thereby building client loyalty and driving more patient visits.
Our digital imaging systems offer a convenient system that provides superior image quality and software capability that enables sharing of these images with clients virtually anywhere and enhanced diagnostic features and customer workflow, backed by the same customer support provided for our other products and services in CAG.
Water
Our strategy in the water testing business is to develop, manufacture, market and sell proprietary products with superior performance, supported by exceptional customer service. Our customers primarily consist of water utilities, government laboratories and private certified laboratories that highly value strong relationships and customer support. Sales of water testing products outside of the U.S. represented 52% of total water product sales in 2014, and we expect that future growth in this business will be significantly dependent on our ability to increase international sales. Growth also will be dependent on our ability to enhance and broaden our product line. Most water microbiological testing is driven by regulation, and, in many countries, a test may not be used for compliance testing unless it has been approved by the applicable regulatory body. As a result, we maintain an active regulatory program that involves applying for regulatory approvals in a number of countries, primarily in Europe. Further, we seek to receive regulatory approvals from governing agencies as a means to differentiate our products from the competition.
Livestock, Poultry and Dairy
We develop, manufacture, market and sell a broad range of tests for various cattle, swine and poultry diseases and conditions, and have active research and development and in-licensing programs in this area. Our strategy is to offer proprietary tests with superior performance characteristics for use in government programs to control or eradicate disease and disease outbreaks and in livestock and poultry producers’ disease and reproductive management programs. Disease outbreaks are episodic and unpredictable, and certain diseases that are prevalent at one time may be substantially contained or eradicated at a later time. In response to outbreaks, testing initiatives may lead to exceptional demand for certain products in certain periods. Conversely, successful eradication programs may result in significantly decreased demand for certain products. In addition, increases in government funding may lead to increased demand for certain products and budgetary constraints may lead to decreased demand for certain products. As result, the performance of this business can fluctuate.
Our strategy in the dairy testing business is to develop, manufacture and sell antibiotic residue and contaminant testing products that satisfy applicable regulatory requirements or dairy processor standards for testing of milk and provide reliable field performance. The manufacture of these testing products leverages the SNAP platform as well as the manufacturing equipment of our rapid assay business, incorporating customized reagents for antibiotic and contaminant detection. To successfully increase sales of dairy testing products, we believe that we need to increase penetration in dairy processors and develop product line enhancements and extensions.
We also distribute food safety products, including Randox Food Diagnostics, a wide range of cost effective ELISAs, sensitive and reproducible diagnostic assays, for the detection of multiple compounds in one test based on a multi-analyte quantitative screening drug residue analyzer called the Evidence Investigator. Our technology for food safety screening reduces the number of samples sent to confirmation laboratories, lowering costs on expensive confirmation tests. We believe distributing food safety products provides us opportunities at a later stage in the food value chain.
In 2014, approximately 90% of our sales in this business were from markets outside of the U.S., most notably Europe and China. The performance of the business is particularly subject to the various risks that are associated with doing business internationally. See “Part I, Item 1A. Risk Factors.”
Other
OPTI Medical Systems. Our strategy in the OPTI Medical Systems business for the human market is to develop, manufacture, and sell electrolyte and blood gas analyzers and related consumable products for the medical point-of-care diagnostics market worldwide, with a focus on small to mid-sized hospitals. We seek to differentiate our products based on ease of use, convenience, international distribution and service and instrument reliability. Similar to our veterinary instruments and consumables strategy, a substantial portion of the revenues from this product line is derived from the sale of consumables for use on the installed base of electrolyte and blood gas analyzers. During the early stage of an instrument’s life cycle, relatively greater revenues are derived from instrument placements, while consumable sales become relatively more significant in later stages as the installed base of instruments increases and instrument placement revenues begin to decline. Our long-term success in this area of our business is dependent upon new customer acquisition, customer retention and increased customer utilization of existing and new assays introduced on these instruments.
Our strategy in the OPTI Medical Systems business for the veterinary market is to utilize this unit’s know-how, intellectual property and manufacturing capability to continue to expand the menu and instrument capability of the VetStat and Catalyst Dx platforms for veterinary applications while reducing our cost of consumables by leveraging experience and economies of scale.
In 2014, approximately 83% of our sales in the OPTI Medical Systems business were from markets outside of the U.S., most notably Asia and Europe. The performance of the business is particularly subject to the various risks that are associated with doing business internationally. See “Part I, Item 1A. Risk Factors.”
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates on an ongoing basis. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. Note 2 to the consolidated financial statements included in this Annual Report on Form 10-K describes the significant accounting policies used in preparation of these consolidated financial statements.
We believe the following critical accounting estimates and assumptions may have a material impact on reported financial condition and operating performance and involve significant levels of judgment to account for highly uncertain matters or are susceptible to significant change.
Revenue Recognition
We recognize revenue when four criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred or services have been rendered; (iii) the sales price is fixed or determinable; and (iv) collectability is reasonably assured. See Note 2(i) to the consolidated financial statements for the year ended December 31, 2014 included in this Annual Report on Form 10-K for additional information about our revenue recognition policy and criteria for recognizing revenue.
Multiple Element Arrangements (“MEAs”). Arrangements to sell products to customers frequently include multiple deliverables. Our most significant MEAs include the sale of one or more of the instruments from the IDEXX VetLab suite of analyzers, digital imaging systems or practice management software, combined with one or more of the following products: extended maintenance agreements (“EMAs”), consumables and reference laboratory diagnostic and consulting services. Practice management software is frequently sold with post-contract customer support and implementation services. Delivery of the various products or performance of services within the arrangement may or may not coincide. Delivery of our IDEXX VetLab instruments, digital imaging systems and practice management software generally occurs at the onset of the arrangement. EMAs, consumables, and reference laboratory diagnostic and consulting services typically are delivered over future periods, generally one to six years. In certain arrangements, revenue recognized is limited to the amount invoiced or received that is not contingent on the delivery of products and services in the future.
We allocate revenue to each element based on the relative selling price and recognize revenue when the elements have standalone value and the four criteria for revenue recognition, as discussed above, have been met for each element. If available, we establish the selling price of each element based on vendor-specific objective evidence (“VSOE”), which represents the price charged for a deliverable when it is sold separately. We use third-party evidence (“TPE”) if VSOE is not available, or best estimate of selling price if neither VSOE nor TPE is available. When these arrangements include a separately-priced EMA, we recognize revenue related to the EMA at the stated contractual price on a straight-line basis over the life of the agreement to the extent the separately stated price is substantive. If there is no stated contractual price for an EMA, or the separately stated price is not substantive, we allocate revenue to each element based on the relative selling price and recognize revenue when the elements have standalone value and the four criteria for revenue recognition, as discussed above, have been met for each element.
When arrangements within the scope of software revenue recognition guidance include multiple elements, we allocate revenue to each element based on relative fair value, when VSOE exists for all elements, or by using the residual method when there is VSOE for the undelivered elements but no such evidence for the delivered elements. Under the residual method, the fair value of the undelivered elements is deferred and the residual revenue is allocated to the delivered elements. Revenue is recognized on any delivered elements when the four criteria for revenue recognition have been met for each element. If VSOE does not exist for the undelivered element, all revenue from the arrangement is deferred until the earlier of the point at which such sufficient VSOE does exist or all elements of the arrangement have been delivered. We determine fair value based on amounts charged separately for the delivered and undelivered elements to similar customers in standalone sales of the specific elements.
Certain arrangements with customers include discounts on future sales of products and services. We apply judgment in determining whether future discounts are significant and incremental. When the future discount offered is not considered significant and incremental, we do not account for the discount as an element of the original arrangement. If the future discount is significant and incremental, we recognize that discount as an element of the original arrangement and allocate the discount to the other elements of the arrangement based on relative selling price. To determine whether a discount is significant and incremental, we look to the discount provided in comparison to standalone sales of the same product or service to similar customers, the level of discount provided on other elements in the arrangement and the significance of the discount to the overall arrangement. If the discount in the MEA approximates the discount typically provided in standalone sales, that discount is not considered incremental.
Customer Programs. We record reductions to revenue related to customer marketing and incentive programs, which include end-user rebates and other volume-based incentives. Incentives may be provided in the form of IDEXX Points, credits or cash and are earned by end users upon achieving defined volume purchases or utilization levels or upon entering an agreement to purchase products or services in future periods. The summary of revenue reductions presented below reflects all revenue reductions recorded for the year for each particular program. These amounts are presented on a net basis when applicable, which accounts for any differences between estimates and actual incentives earned for the relevant customer marketing or incentive program. These differences have been insignificant in all quarterly or annual periods. Our most significant customer programs are categorized as follows:
Customer Loyalty Programs. Our customer loyalty programs offer customers the opportunity to earn incentives on a variety of IDEXX products and services as those products and services are purchased and utilized. Revenue reductions related to customer loyalty programs are recorded based on the actual issuance of incentives, incentives earned but not yet issued and estimates of incentives to be earned in the future.
Up-Front Customer Loyalty Programs. Our up-front loyalty programs provide incentives to customers in the form of cash payments or IDEXX Points upon entering multi-year agreements to purchase annual minimum amounts of future products or services. If a customer breaches its agreement, it is required to refund a prorated portion of the up-front cash or IDEXX Points, among other things. These incentives are considered to be customer acquisition costs and are capitalized and recognized as a reduction to revenue over the term of the customer agreement. If these up-front incentives are subsequently utilized to purchase IDEXX VetLab instruments, digital imaging systems or Cornerstone practice management systems, product revenue and cost is deferred and recognized over the term of the customer agreement as products and services are provided to the customer. We monitor customer purchases over the term of their agreement to assess the realizability of our capitalized customer acquisition costs. For the years ended December 31, 2014, 2013 and 2012, impairments of customer acquisition costs were immaterial.
IDEXX Instrument Marketing Programs. Our instrument marketing programs require the customer to enroll at the time of instrument purchase and offer customers the opportunity to earn incentives in future periods based on the volume of the products they purchase and utilize over the term of the program. These arrangements are considered MEAs in accordance with our revenue recognition policy stated above. Revenue reductions related to instrument marketing programs are recorded based on an estimate of customer purchase and utilization levels and the incentive the customer will earn over the term of the program. Our estimates are based on historical experience and the specific terms and conditions of the marketing program and require us to apply judgment to approximate future product purchases and utilization. Differences between our estimates and actual incentives earned are accounted for as a change in estimate. These differences were not material for the years ended December 31, 2014, 2013 and 2012. At December 31, 2014, a 5% change in our estimate of future customer utilization would increase or reduce revenue by approximately $0.4 million.
Reagent Rental Programs. Our reagent rental programs provide our customers the right to use our instruments in consideration for multi-year agreements to purchase annual minimum amounts of consumables. No instrument revenue is recognized at the time of instrument installation. We recognize a portion of the revenue allocated to the instrument concurrent with the future sale of consumables. We determine the amount of revenue allocated from the consumable to the instrument based on relative selling prices and determine the rate of instrument revenue recognition in proportion to the customer’s minimum volume commitment. The cost of the instrument is charged to cost of product revenue on a straight-line basis over the term of the minimum purchase agreement.
IDEXX Points may be applied against the purchase price of IDEXX products and services purchased in the future or applied to trade receivables due to us. IDEXX Points that have not yet been used by customers are classified as a liability until use or expiration occurs. We estimate the amount of IDEXX Points expected to expire, or breakage, based on historical expirations and we recognize the estimated benefit of breakage in proportion to actual redemptions of IDEXX Points by customers. On November 30 of each year, unused IDEXX Points earned before January 1 of the prior year generally expire and any variance from the breakage estimate is accounted for as a change in estimate. This variance was not material for the years ended December 31, 2014, 2013 and 2012.
Future market conditions and changes in product offerings may cause us to change marketing strategies to increase or decrease customer incentive offerings, possibly resulting in incremental reductions of revenue in future periods as compared to reductions in the current or prior periods. Additionally, certain customer programs require us to estimate, based on historical experience, and apply judgment to approximate the number of customers who will actually redeem the incentive. In determining estimated revenue reductions we utilize data supplied from distributors and collected directly from end users, which includes the volume of qualifying products purchased and the number of qualifying tests run as reported to us by end users via IDEXX SmartService. Differences between estimated and actual customer participation in programs may impact the amount and timing of revenue recognition.
Following is a summary of revenue reductions, net recorded in connection with our customer programs for the years ended December 31, 2014, 2013 and 2012 (in thousands):
| For the Years Ended December 31, | ||||||||||
| 2014 | 2013 | 2012 | ||||||||
| Revenue Reductions Recorded, Net | ||||||||||
| Customer Loyalty Programs, net (1) | $ | 14,800 | $ | 16,193 | $ | 17,332 | ||||
| Up-Front Customer Loyalty Programs | 13,089 | 9,937 | 8,704 | |||||||
| IDEXX Instrument Marketing Programs, net (1) | 24,158 | 17,885 | 15,686 | |||||||
| Other Customer Programs, net (1) | 2,796 | 2,733 | 578 | |||||||
| Total revenue reductions, net | $ | 54,843 | $ | 46,748 | $ | 42,300 |
| (1) | Revenue reduction is provided on a net basis, which accounts for any differences between estimates and actual incentives earned. |
|---|
Accrued customer programs are included within accrued liabilities and other long-term liabilities, depending on the anticipated settlement date, in the consolidated balance sheets included in this Annual Report on Form 10-K. Following is a summary of changes in the accrual for estimated revenue reductions attributable to customer programs and the ending accrued customer programs balance for the years ended December 31, 2014, 2013 and 2012 (in thousands):
| For the Years Ended December 31, | ||||||||||
| 2014 | 2013 | 2012 | ||||||||
| Accrued Customer Programs: | ||||||||||
| Balance, beginning of the year | $ | 39,345 | $ | 36,625 | $ | 37,767 | ||||
| Revenue reductions for Customer Loyalty Programs, net (1) | 14,800 | 16,193 | 17,332 | |||||||
| Up-Front Customer Loyalty Program Awards issued as IDEXX Points | 20,315 | 8,019 | 8,215 | |||||||
| Revenue reductions for IDEXX Instrument Marketing Programs, net (1) | 24,158 | 17,885 | 15,686 | |||||||
| Revenue reductions for Other Customer Programs, net (1) | 2,796 | 2,733 | 578 | |||||||
| IDEXX Points redeemed and credits issued | (52,035 | ) | (40,783 | ) | (41,832 | ) | ||||
| Breakage | (421 | ) | (1,044 | ) | (1,135 | ) | ||||
| Exchange impact on balances denominated in foreign currency | (805 | ) | (283 | ) | 14 | |||||
| Balance, end of year | $ | 48,153 | $ | 39,345 | $ | 36,625 | ||||
| (1) | Revenue reduction is provided on a net basis, which accounts for any differences between estimates and actual incentives earned. |
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Inventory Valuation
We write down the carrying value of inventory for estimated obsolescence by an amount equal to the difference between the cost of inventory and the estimated market value when warranted based on assumptions of future demand, market conditions, remaining shelf life or product functionality. If actual market conditions or results of estimated functionality are less favorable than those we estimated, additional inventory write-downs may be required, which would have a negative effect on results of operations.
Valuation of Goodwill and Other Intangible Assets
A significant portion of the purchase price for acquired businesses is generally assigned to intangible assets. Intangible assets other than goodwill are initially valued at fair value. If a quoted price in an active market for the identical asset is not readily available at the measurement date, the fair value of the intangible asset is estimated based on discounted cash flows using market participant assumptions, which are assumptions that are not specific to IDEXX. The selection of appropriate valuation methodologies and the estimation of discounted cash flows require significant assumptions about the timing and amounts of future cash flows, risks, appropriate discount rates, and the useful lives of intangible assets. When material, we utilize independent valuation experts to advise and assist us in determining the fair values of the identified intangible assets acquired in connection with a business acquisition and in determining appropriate amortization methods and periods for those intangible assets. Goodwill is initially valued based on the excess of the purchase price of a business combination over the fair value of acquired net assets recognized and represents the future economic benefits arising from other assets acquired that could not be individually identified and separately recognized. We assess contingent consideration to determine if it is part of the
business combination or if it should be accounted for separately from the business combination in the postcombination period. Contingent consideration is recognized at its fair value on the acquisition date. A liability resulting from contingent consideration is remeasured to fair value at each reporting date until the contingency is resolved. Changes in fair value of contingent consideration are recognized in earnings.
We assess goodwill for impairment annually, at the reporting unit level, in the fourth quarter and whenever events or circumstances indicate impairment may exist. An impairment charge is recorded for the amount, if any, by which the carrying amount of goodwill exceeds its implied fair value. Our reporting units are the individual product and service categories that comprise our CAG operating segment, our Water and LPD operating segments and goodwill remaining from the restructuring of our pharmaceutical business in the fourth quarter of 2008, referred to herein as the Technology reporting unit. A substantial portion of the goodwill remaining from the pharmaceutical business, included in our “Other Segment”, is associated with products that have been, or that we expect to be, licensed to third parties. Realization of this goodwill is dependent upon the success of those third parties in developing and commercializing products, which will result in our receipt of royalties and other payments.
In evaluating goodwill for impairment, we have the option to first assess the qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. If, after assessing the totality of events or circumstances, we determine that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we would then perform step one of the two-step impairment test; otherwise, no further impairment test would be required. In contrast, we can opt to bypass the qualitative assessment for any reporting unit in any period and proceed directly to step one of the two-step impairment test. Doing so does not preclude us from performing the qualitative assessment in any subsequent period.
As part of our goodwill testing process, we evaluate factors specific to a reporting unit as well as industry and macroeconomic factors that are reasonably likely to have a material impact on the fair value of a reporting unit. Examples of the factors considered in assessing the fair value of a reporting unit include: the results of the most recent impairment test, the competitive environment, anticipated changes in product or labor costs, revenue growth trends, the consistency of operating margins and cash flows and current and long-range financial forecasts. The long-range financial forecasts of the reporting units, which are based upon management’s long-term view of our markets, are used by senior management and the Board of Directors to evaluate operating performance.
In the fourth quarter of 2014, we elected to bypass the qualitative approach and instead proceeded directly to step one of the two-step impairment test to assess the fair value of all of our reporting units.
As part of step one of the two-step impairment test, we estimate the fair values of applicable reporting units using an income approach based on discounted forecasted cash flows. We make significant assumptions about the extent and timing of future cash flows, growth rates and discount rates. Model assumptions are based on our projections and best estimates, using appropriate and customary market participant assumptions. In addition, we make certain assumptions in allocating shared assets and liabilities to individual reporting units in determining the carrying value of each reporting unit. As of September 30, 2014, the date that we performed our assessment of goodwill for impairment, the total aggregate fair value of the reporting units approximated the Company’s market capitalization. Valuation assumptions reflect our projections and best estimates, based on significant assumptions about the extent and timing of future cash flows, growth rates and discount rates. The results of our goodwill impairment test indicate an excess of estimated fair value over the carrying amount for each of our reporting units by a range of approximately $12.0 million to $2.1 billion and 125% to 1063% of the reporting unit’s carrying value.
While we believe that the assumptions used to determine the estimated fair values of each of our reporting units are reasonable, a change in assumptions underlying these estimates could result in a material negative effect on the estimated fair value of the reporting units. Our fair value estimate assumes the achievement of future financial results contemplated in our forecasted cash flows, and there can be no assurance that we will realize that value. We use forecasts to estimate future cash flows and include an estimate of long-term future growth rates based on our most recent views of the long-term outlooks for our reporting units. Actual results may differ from those assumed in our forecasts. The discount rate is based on a weighted average cost of capital derived from industry peers. Changes in market conditions, interest rates, growth rates, tax rates, costs, pricing or the discount rate would affect the estimated fair values of our reporting units and could result in a goodwill impairment charge in a future period. No goodwill impairments were identified during the years ended December 31, 2014, 2013 or 2012.
A prolonged economic downturn in the U.S. or internationally resulting in lower long-term growth rates and reduced long-term profitability may reduce the fair value of our reporting units. Industry specific events or circumstances could have a negative impact on our reporting units and may also reduce the fair value of our reporting units. Should such events occur and it becomes more likely than not that a reporting unit’s fair value has fallen below its carrying value, we will perform an interim goodwill impairment test, in addition to the annual impairment test. Future impairment tests may result in an impairment of goodwill, depending on the outcome of future impairment tests. An impairment of goodwill would be reported as a non-cash charge to earnings.
We assess the realizability of intangible assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If an impairment review is triggered, we evaluate the carrying value of intangible assets based on estimated undiscounted future cash flows over the remaining useful life of the primary asset of the asset group and compare that value to the carrying value of the asset group. The cash flows that are used contain our best estimates, using appropriate and customary assumptions and projections at the time. If the net carrying value of an intangible asset exceeds the related estimated undiscounted future cash flows, an impairment to write the intangible asset to its fair value would be reported as a non-cash charge to earnings. If necessary, we would calculate the fair value of an intangible asset using the present value of the estimated future cash flows to be generated by the intangible asset and applying a risk-adjusted discount rate. No material impairments of intangible assets were identified during the years ended December 31, 2014, 2013 and 2012.
Share-Based Compensation
Our share-based compensation programs provide for grants of stock options, restricted stock units and deferred stock units, along with the issuance of employee stock purchase rights. The total fair value of future awards may vary significantly from past awards based on a number of factors, including our share-based award practices. Therefore, share-based compensation expense is likely to fluctuate, possibly significantly, from year to year.
We use the Black-Scholes-Merton option-pricing model to determine the fair value of options granted. Option-pricing models require the input of highly subjective assumptions, particularly for the expected stock price volatility and the expected term of options. The risk-free interest rate is based on the U.S. Treasury yield for a duration similar to the expected term at the date of grant. We have never paid any cash dividends on our common stock and we have no intention to pay a dividend at this time; therefore, we assume that no dividends will be paid over the expected terms of option awards. We determine the assumptions to be used in the valuation of option grants as of the date of grant. As such, we use different assumptions during the year if we grant options at different dates. Substantially all of our options granted during the years ended December 31, 2014, 2013 and 2012 were granted in the first quarter of each year. The weighted average of each of the valuation assumptions used to determine the fair value of each option grant during each of the previous three years is as follows:
| For the Years Ended December 31, | |||||||||
| 2014 | 2013 | 2012 | |||||||
| Expected stock price volatility | 28 | % | 32 | % | 34 | % | |||
| Expected term, in years (1) | 5.7 | 4.9 | 4.6 | ||||||
| Risk-free interest rate | 1.5 | % | 1.0 | % | 0.8 | % |
| (1) | Options granted after May 8, 2013 have a contractual term of ten years. Options granted between January 1, 2006 and May 8, 2013 have contractual terms of seven years. |
|---|
Changes in the subjective input assumptions, particularly for the expected stock price volatility and the expected term of options, can materially affect the fair value estimate. Our expected stock price volatility assumption is based on the historical volatility of our stock over a period similar to the expected term and other relevant factors. Lower estimated volatility reduces the fair value of a stock option, while higher estimated volatility has the opposite effect. The total fair value of stock options granted during the year ended December 31, 2014 was $10.7 million. If the weighted average of the stock price volatility assumption was increased or decreased by 1%, the total fair value of stock options awarded during the year ended December 31, 2014 would have increased or decreased by approximately $0.3 million and the total expense recognized for the year ended December 31, 2014 for options awarded during the same period would have increased or decreased by less than $0.1 million.
We derive the expected term assumption for stock options based on historical experience and other relevant factors concerning expected behavior with regard to option exercises. The expected term is determined using a consistent method at each grant date. A longer expected term assumption increases the fair value of stock option awards, while a shorter expected term assumption has the opposite effect. If the weighted average of the expected term was increased or decreased by one year, the total fair value of stock options awarded during the year ended December 31, 2014 would have increased or decreased by approximately $1.0 million and the total expense recognized for the year ended December 31, 2014 for options awarded during 2014 would have increased or decreased by $0.2 million.
Share-based compensation expense is recognized on a straight-line basis over the requisite service period, which ranges from one to five years, depending on the award. Share-based compensation expense is based on the number of awards ultimately expected to vest and is, therefore, reduced for an estimate of the number of awards that are expected to be forfeited. The forfeiture estimates are based on historical data and other factors; share-based compensation expense is adjusted annually for actual results. Total share-based compensation expense for the year ended December 31, 2014 was $18.1 million, which is net of a reduction of $3.2 million for actual and estimated forfeitures. Fluctuations in our overall employee turnover rate may result in changes in estimated forfeiture rates and differences between estimated forfeiture rates and actual experience and, therefore could have a significant unanticipated impact on share-based compensation expense.
Modifications of the terms of outstanding awards may result in significant increases or decreases in share-based compensation. There were no material modifications to the terms of outstanding options, restricted stock units or deferred stock units during 2014, 2013 or 2012.
The fair value of stock options, restricted stock units, deferred stock units and employee stock purchase rights issued during the years ended December 31, 2014, 2013 and 2012 totaled $24.0 million, $22.2 million and $18.2 million, respectively. The total unrecognized compensation expense, net of estimated forfeitures, for unvested share-based compensation awards outstanding at December 31, 2014 was $35.9 million, which will be recognized over a weighted average period of approximately 1.6 years.
Income Taxes
The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the estimated future tax effects of temporary differences between book and tax treatment of assets and liabilities and carryforwards to the extent they are realizable.
On a quarterly basis, we assess our current and projected earnings by jurisdiction to determine whether or not our earnings during the periods when the temporary differences become deductible will be sufficient to realize the related future tax benefits. Should we determine that we would not be able to realize all or part of our net deferred tax asset in a particular jurisdiction in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. A reduction of net income before taxes in each subsidiary equal to 5% of revenue, compared to the corresponding reported amounts for the year ended December 31, 2014, would not result in the recognition of material incremental valuation allowances.
For those jurisdictions where tax carryforwards are likely to expire unused or the projected operating results indicate that realization is not more likely than not, a valuation allowance is recorded to offset the deferred tax asset within that jurisdiction. In assessing the need for a valuation allowance, we consider future taxable income and ongoing prudent and feasible tax planning strategies. Alternatively, in the event that we were to determine that we would be able to realize our deferred tax assets in the future in excess of the net recorded amount, a reduction of the valuation allowance would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, a reduction to the deferred tax asset would be charged to income in the period such determination was made.
Our net taxable temporary differences and tax carryforwards are recorded using the enacted tax rates expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized. Should the expected applicable tax rates change in the future, an adjustment to the net deferred tax liability would be credited or charged, as appropriate, to income in the period such determination was made. For example, an increase of one percentage point in our anticipated U.S. state income tax rate would cause us to decrease our net deferred tax liability balance by $0.2 million. This decrease in the net deferred liability would increase net income in the period that our rate was adjusted. Likewise, a decrease of one percentage point to our anticipated U.S. state income tax rate would have the opposite effect.
We periodically assess our exposures related to our worldwide provision for income taxes and believe that we have appropriately accrued taxes for contingencies. Any reduction of these contingent liabilities or additional assessment would increase or decrease income, respectively, in the period such determination was made.
We consider the majority of the operating earnings of non-U.S. subsidiaries to be indefinitely invested outside the U.S. The cumulative earnings of these subsidiaries were $431.7 million at December 31, 2014, of which approximately $321.5 million was held in cash and cash equivalents as of December 31, 2014. No provision has been made for the payment of U.S. federal and state or international taxes that may result from future remittances of these undistributed earnings of non-U.S. subsidiaries. Should we repatriate these earnings in the future, we would have to adjust the income tax provision in the period in which the decision to repatriate earnings is made. A determination of the related tax liability that would be paid on these undistributed earnings if repatriated is not practicable. For the operating earnings not considered to be indefinitely invested outside the U.S. we have accounted for the tax impact on a current basis.
We record a liability for uncertain tax positions that do not meet the more likely than not standard as prescribed by the authoritative guidance for income tax accounting. We record tax benefits for only those positions that we believe will more likely than not be sustained. For positions that we believe that it is more likely than not that we will prevail, we record a benefit considering the amounts and probabilities that could be realized upon ultimate settlement. If our judgment as to the likely resolution of the uncertainty changes, if the uncertainty is ultimately settled or if the statute of limitation related to the uncertainty expires, the effects of the change would be recognized in the period in which the change, resolution or expiration occurs. Our net liability for uncertain tax positions was $6.1 million and $6.6 million as of December 31, 2014 and 2013, respectively, which includes estimated interest expense and penalties.
RESULTS OF OPERATIONS AND TRENDS
Effects of Certain Factors on Results of Operations
Distributor Purchasing and Inventories. The instrument consumables and rapid assay products in our CAG segment were sold in the U.S. and continue to be sold in certain other geographies by third party distributors, who purchase products from us and sell them to veterinary practices, which are the end users. As a result, distributor purchasing dynamics have an impact on our reported sales of these products. Distributor purchasing dynamics may be affected by many factors and in a given period may not be directly related to underlying end-user demand for our products. Consequently, reported results may reflect fluctuations in inventory levels held at distributors and not necessarily reflect changes in underlying end-user demand. Therefore, we believe it is important to track distributor sales to end users and to distinguish between the impact of end-user demand and the impact of distributor purchasing dynamics on reported revenue.
Where growth rates are affected by changes in end-user demand, we refer to this as the impact of practice-level sales on growth. Where growth rates are affected by distributor purchasing dynamics, we refer to this as the impact of changes in distributors’ inventories on growth. If during the current year, distributors’ inventories grew by less than those inventories grew in the comparable period of the prior year, then changes in distributors’ inventories have an unfavorable impact on our reported sales growth in the current period. Conversely, if during the current year, distributors’ inventories grew by more than those inventories grew in the comparable period of the prior year, then changes in distributors’ inventories have a favorable impact on our reported sales growth in the current period.
Effective January 1, 2015, we fully transitioned to an all-direct sales strategy in the U.S. and did not renew our existing contracts with our former key U.S. distribution partners after their expiration at the end of 2014. Under this approach, we take orders, ship product, invoice and receive payment for all rapid assay test kits and instrument consumables in the U.S., aligning with our direct model for instruments, reference laboratory services, and other CAG products and services.
We incurred transition costs to implement this all-direct sales strategy in the U.S., including approximately $5 million in incremental expense during the year ended December 31, 2014 resulting from the ramp up of sales and operating resources. We also incurred $9.5 million in non-recurring expenses during the year ended December 31, 2014 associated with project management and other one-time costs required to implement this new strategy. Further, we incurred one-time transitional impacts related to the drawdown of distributor inventory in the fourth quarter of 2014, resulting in a reduction in revenue and operating profit of $25 million and $21 million, respectively.
During the three months ended December 31, 2014, we began recognizing revenue on rapid assay kits and instrument consumables upon delivery to end users in the U.S., instead of at distribution. We continue to expect to capture an additional $50 million to $55 million in annual revenue on these direct sales. We estimate that annual operating profit associated with this incremental revenue stream will increase approximately $5 million to $8 million in 2015 and will continue to provide accretive benefits that will scale over time based on our expected future growth rates. Also as a result of the transition to an all-direct sales strategy in the U.S., we anticipate increased working capital demands of approximately $15 million to $20 million, including inventory costs previously held by our distributors and incremental accounts receivable resulting from a potentially longer elapsed time to collect our receivables.
Currency Impact. Approximately 28% of our consolidated revenue for the year ended December 31, 2014 and 26% of our consolidated revenue for each of the years ended December 31, 2013 and 2012 was derived from products manufactured in the U.S. and sold internationally in local currencies. Strengthening of the rate of exchange for the U.S. dollar relative to other currencies has a negative impact on our revenues derived in currencies other than the U.S. dollar and on profits of products manufactured in the U.S. and sold internationally, and a weakening of the U.S. dollar has the opposite effect. Similarly, to the extent that the U.S. dollar is stronger in current or future periods relative to the exchange rates in effect in the corresponding prior periods, our growth rate will be negatively affected. The impact of foreign currency denominated operating expenses and foreign currency denominated supply contracts partly offsets this exposure. Additionally, our designated hedges of intercompany inventory purchases and sales help delay the impact of certain exchange rate fluctuations on non-U.S. denominated revenues. See Item 7A. “Quantitative and Qualitative Disclosure About Market Risks” included in this Annual Report on Form 10-K for additional information regarding currency impact.
The impact on revenue resulting from changes in foreign currency exchange rates is not a measure defined by accounting principles generally accepted in the United States of America (“U.S. GAAP”), otherwise referred to herein as a non-GAAP financial measure. As exchange rates are an important factor in understanding period-to-period comparisons, we believe the presentation of results normalized for changes in currency in addition to reported results helps improve investors’ ability to understand our operating results and evaluate our performance in comparison to prior periods.
Effective January 1, 2014, we calculate the impact on revenue resulting from changes in foreign currency exchange rates by applying the difference between the weighted average exchange rates during the current year period and the comparable previous year period to foreign currency denominated revenues for the prior year period. Prior to January 1, 2014, we calculated this impact by applying the difference between the weighted average exchange rates during the current year period and the comparable previous year period to foreign currency denominated revenues for the current year period. This change in methodology, which was implemented to achieve operational efficiencies, has not had a material impact on organic revenue growth. See the subsection below titled “Results of Operations” for the definition of and other information regarding organic revenue growth.
During the twelve months ended December 31, 2014, compared to the twelve months ended December 31, 2013, changes in foreign currency exchange rates decreased total company revenue by approximately $8.3 million, due primarily to the strengthening of the U.S. dollar against the Canadian dollar, Australian dollar and Japanese yen, partly offset by a weakening of the U.S. dollar against the British pound.
During the twelve months ended December 31, 2013, compared to the twelve months ended December 31, 2012, changes in foreign currency exchange rates decreased total company revenue by approximately $9.5 million, due primarily to the strengthening of the U.S. dollar against the Japanese yen and the Australian dollar.
Effects of Economic Conditions. Demand for our products and services is vulnerable to changes in the economic environment, including slow economic growth, high unemployment and credit availability. Negative or cautious consumer sentiment can lead to reduced or delayed consumer spending, resulting in a decreased number of patient visits to veterinary clinics. Unfavorable economic conditions can impact sales of instruments, digital radiography and practice management systems, which are larger capital purchases for veterinarians. Additionally, economic turmoil can cause our customers to remain sensitive to the pricing of our products and services. We monitor patient visits and clinic revenue data provided by a subset of our CAG customers. Although limited and susceptible to short-term impacts such as weather, we believe that this data provides a fair and meaningful long-term representation of the trend in patient visit activity in the U.S., providing us insight regarding demand for our products and services. We believe the overall trends in patient visits and capital investments since the beginning of the economic downturn in 2008 have had a slightly negative impact on our CAG segment revenue growth rates. Although the rate of growth has not been steady, we have seen an improvement in growth of patient visits since the beginning of 2012.
Economic conditions can also affect the purchasing decisions of our Water and LPD business customers. In the past, water testing volumes have been susceptible to declines in discretionary testing and in mandated testing as a result of decreases in home and commercial construction. Fiscal difficulties can also reduce government funding for water and livestock testing programs.
We believe that the diversity of our products and services and the geographic diversity of our markets partially mitigate the effects of the economic environment and negative consumer sentiment on our revenue growth rates.
Effects of Patent Expiration. Although the Company had and will have several patents and licenses of patents and technologies from third parties expire during 2014 and 2015, the expiration of these patents or licenses, individually or in the aggregate, is not expected to have a material effect on the Company’s financial position or future operations due to a range of factors including our brand strength and reputation in the marketplace; the breadth, quality and integration of our product offerings; our existing customer relationships and our customer support; our sales force; the applicable regulatory approval status for certain products; our continued investments in innovative product improvements that often result in new technologies and/or additional patents; and our significant know-how, scale and investments related to manufacturing processes of associated product offerings.
Twelve Months Ended December 31, 2014 Compared to Twelve Months Ended December 31, 2013
Revenue
The following revenue analysis and discussion focuses on organic revenue growth. Organic revenue growth is a non-GAAP financial measure and represents the percentage change in revenue during the twelve months ended December 31, 2014, as compared to the same period for the prior year, net of the effect of changes in foreign currency exchange rates and acquisitions. Organic revenue growth should be considered in addition to, and not as a replacement for or as a superior measure to, revenues reported in accordance with U.S. GAAP, and may not be comparable to similarly titled measures reported by other companies. Management believes that reporting organic revenue growth provides useful information to investors by facilitating easier comparisons of our revenue performance with prior and future periods and to the performance of our peers. We exclude the effect of changes in foreign currency exchange rates because changes in foreign currency exchange rates are not under management’s control, are subject to volatility and can obscure underlying business trends. We exclude the effect of acquisitions because the nature, size and number of acquisitions can vary dramatically from period to period and therefore can also obscure underlying business trends.
The percentage changes in revenue from foreign currency exchange rates and acquisitions are non-GAAP financial measures. See the subsection above titled “Effects of Certain Factors on Results of Operations – Currency Impact” for a description of the calculation of the percentage change in revenue resulting from changes in foreign currency exchange rates. The percentage change in revenue resulting from acquisitions represents incremental revenues attributable to acquisitions that have occurred since the beginning of the prior year period.
Total Company. The following table presents revenue by operating segment:
| For the Year | For the Year | ||||||||||||||||||||
| Ended | Ended | Percentage | Percentage | Organic | |||||||||||||||||
| Net Revenue | December 31, | December 31, | Dollar | Percentage | Change from | Change from | Revenue | ||||||||||||||
| (dollars in thousands) | 2014 | 2013 | Change | Change | Currency | Acquisitions | Growth | ||||||||||||||
| CAG | $ | 1,236,855 | $ | 1,150,169 | $ | 86,686 | 7.5% | (0.8%) | 0.3% | 8.0% | |||||||||||
| Water | 94,725 | 87,959 | 6,766 | 7.7% | (0.4%) | 1.0% | 7.1% | ||||||||||||||
| LPD | 127,388 | 113,811 | 13,577 | 11.9% | (0.7%) | 4.0% | 8.6% | ||||||||||||||
| Other | 26,839 | 25,119 | 1,720 | 6.8% | - | - | 6.8% | ||||||||||||||
| Total | $ | 1,485,807 | $ | 1,377,058 | $ | 108,749 | 7.9% | (0.7%) | 0.6% | 8.0% |
We transitioned to an all-direct sales strategy in the U.S. during the fourth quarter of 2014, resulting in a drawdown of distributors’ inventory levels which reduced both reported CAG and Total Company revenue growth by 2%.
U.S. and International Revenue. The following table provides further analysis of total company revenue by U.S. markets and non-U.S., or international, markets:
| For the Year | For the Year | ||||||||||||||||||||
| Ended | Ended | Percentage | Percentage | Organic | |||||||||||||||||
| Net Revenue | December 31, | December 31, | Dollar | Percentage | Change from | Change from | Revenue | ||||||||||||||
| (dollars in thousands) | 2014 | 2013 | Change | Change | Currency | Acquisitions | Growth | ||||||||||||||
| United States | $ | 848,925 | $ | 802,346 | $ | 46,579 | 5.8% | - | 0.1% | 5.7% | |||||||||||
| International | 636,882 | 574,712 | 62,170 | 10.8% | (1.7%) | 1.3% | 11.2% | ||||||||||||||
| Total | $ | 1,485,807 | $ | 1,377,058 | $ | 108,749 | 7.9% | (0.7%) | 0.6% | 8.0% |
The increase in both U.S. and international revenues was primarily driven by CAG Diagnostics recurring revenue. The increase in international revenues was driven by strong growth in Europe and Asia-Pacific markets, most significantly from the United Kingdom, Germany, China, Australia and France. We transitioned to an all-direct sales strategy in the U.S. during the fourth quarter of 2014, resulting in a drawdown of distributors’ inventory levels which reduced reported U.S. revenue growth by 3%. The impact of changes in distributors’ inventory levels did not have a significant impact on reported international revenue growth.
Companion Animal Group. The following table presents revenue by product and service category for CAG:
| For the Year | For the Year | ||||||||||||||||||||
| Ended | Ended | Percentage | Percentage | Organic | |||||||||||||||||
| Net Revenue | December 31, | December 31, | Dollar | Percentage | Change from | Change from | Revenue | ||||||||||||||
| (dollars in thousands) | 2014 | 2013 | Change | Change | Currency | Acquisitions | Growth | ||||||||||||||
| CAG Diagnostics recurring revenue: | $ | 1,053,410 | $ | 973,886 | $ | 79,524 | 8.2% | (0.7%) | 0.3% | 8.6% | |||||||||||
| VetLab consumables | 341,397 | 312,457 | 28,940 | 9.3% | (0.6%) | - | 9.9% | ||||||||||||||
| VetLab service and accessories | 53,383 | 50,675 | 2,708 | 5.3% | (0.8%) | - | 6.1% | ||||||||||||||
| Rapid assay products | 165,647 | 169,547 | (3,900) | (2.3%) | (0.4%) | - | (1.9%) | ||||||||||||||
| Reference laboratory diagnostic and consulting services | 492,983 | 441,207 | 51,776 | 11.7% | (0.9%) | 0.5% | 12.1% | ||||||||||||||
| CAG Diagnostics capital instruments | 79,626 | 83,492 | (3,866) | (4.6%) | (1.2%) | - | (3.4%) | ||||||||||||||
| Customer information management and digital imaging systems | 103,819 | 92,791 | 11,028 | 11.9% | (0.5%) | 0.5% | 11.9% | ||||||||||||||
| Net CAG revenue | $ | 1,236,855 | $ | 1,150,169 | $ | 86,686 | 7.5% | (0.8%) | 0.3% | 8.0% |
The increase in CAG Diagnostics recurring revenue was due primarily to increased volumes and higher realized prices in both our reference laboratory diagnostic services and our VetLab consumables. The drawdown of inventory held by distributors, as a result of our transition to an all-direct sales strategy in the U.S. during the fourth quarter of 2014, reduced reported CAG Diagnostics recurring revenue by 3%.
VetLab consumables revenue growth was due primarily to higher unit volumes. The increase in unit volumes resulted primarily from growth of our installed base of Catalyst and ProCyte Dx instruments as a result of new customer acquisitions, as well as an increase in testing from existing customers, including those who upgraded to these instruments. Additionally, VetLab consumables revenue benefited from higher average unit sales prices resulting from price increases. These favorable impacts were partly offset by lower consumables volumes from our VetTest chemistry instrument as customers continue to upgrade from our VetTest instrument to our Catalyst instruments. The drawdown of inventory held by distributors, resulting from our transition to an all-direct sales strategy in the U.S. during the fourth quarter of 2014, reduced reported consumables revenue growth by 5%.
VetLab service and accessories revenue growth was primarily a result of the increase in our installed base of instruments.
The decrease in rapid assay revenue was due primarily to the drawdown of inventory held by distributors as we transitioned to an all-direct sales strategy in the U.S. during the fourth quarter of 2014, which reduced reported rapid assay revenue growth by 7%. This unfavorable factor was partly offset by higher sales of both our canine and feline testing products, resulting from both an increase in U.S. practice-level sales volumes and higher average unit sales prices.
The increase in reference laboratory diagnostic and consulting services revenue was due primarily to the impact of higher volumes throughout our worldwide network of laboratories resulting from increased testing from existing customers, the acquisition of new customers and improved customer retention. Additionally, the increase in revenue was favorably impacted by higher average unit sales prices due to price increases.
The decrease in CAG Diagnostics capital instruments revenue was due primarily to the unfavorable impact of deferred revenue associated with preorders for our Catalyst One analyzer, which we launched during the fourth quarter of 2014 and the impact of lower realized prices. Under our Catalyst One introductory offer, customers are provided with the right to use a Catalyst Dx instrument through the Catalyst One delivery date. As a result, we do not recognize instrument revenue for preorders relating to the Catalyst One introductory offer until the Catalyst One is delivered. These unfavorable impacts were partly offset by higher placements of our Catalyst Dx and ProCyte Dx instruments, primarily in Europe and the Asia-Pacific region, and placements of our SNAP Pro Mobile Device in North America. For the year ended December 31, 2014, the majority of SNAP Pro Mobile Device placements were made under a reagent rental program for which instrument revenue will be recognized with the future sale of consumables.
The increase in customer information management and digital imaging systems revenue was due primarily to a growing Pet Health Network Pro subscriber base, higher support revenue resulting from an increase in our installed base of digital imaging and practice management systems and higher revenue from hardware upgrades as a result of Microsoft ending support for Windows XP.
Water. The increase in Water revenue resulted from higher revenue from our Colilert products and related accessories, due primarily to increased sales volumes worldwide resulting from the acquisition of new customers.
Livestock, Poultry and Dairy. The increase in LPD organic revenue was due primarily to higher sales of certain bovine test products in the Asia-Pacific region, higher volumes in Europe of our milk-based bovine pregnancy test and higher sales of poultry tests in Europe and Latin America. Lower European bovine volumes are expected to reduce revenue by less than $5 million for the year ending December 31, 2015. The acquisition of a Brazilian distributor of our LPD products in the third quarter of 2013 added 4% to reported revenue growth for the year ended December 31, 2014 as compared to the prior year.
Other. The increase in Other revenue was due primarily to higher milestone revenue from our pharmaceutical out-licensing arrangements earned during the year ended December 31, 2014 and higher sales volumes associated with our OPTI Medical consumables and pharmaceutical product line. These favorable impacts were partly offset by lower sales of our OPTI Medical instruments in Latin America.
Gross Profit
Total Company. The following table presents gross profit and gross profit percentages by operating segment:
| For the Year | For the Year | ||||||||||||||||||
| Ended | Ended | ||||||||||||||||||
| Gross Profit | December 31, | Percent of | December 31, | Percent of | Dollar | Percentage | |||||||||||||
| (dollars in thousands) | 2014 | Revenue | 2013 | Revenue | Change | Change | |||||||||||||
| CAG | $ | 665,477 | 53.8% | $ | 616,335 | 53.6% | $ | 49,142 | 8.0% | ||||||||||
| Water | 62,924 | 66.4% | 58,218 | 66.2% | 4,706 | 8.1% | |||||||||||||
| LPD | 79,239 | 62.2% | 62,534 | 54.9% | 16,705 | 26.7% | |||||||||||||
| Other | 14,236 | 53.0% | 12,650 | 50.4% | 1,586 | 12.5% | |||||||||||||
| Unallocated amounts (1) | (5,760) | N/A | 6,381 | N/A | (12,141) | (190.3%) | |||||||||||||
| Total Company | $ | 816,116 | 54.9% | $ | 756,118 | 54.9% | $ | 59,998 | 7.9% |
| (1) | “Unallocated amounts” refers to items not allocated to our operating segments, including a portion of corporate support function and personnel-related expenses, certain manufacturing costs, corporate research and development expenses that do not align with one of our existing business or service categories, the difference between estimated and actual share-based compensation expense and certain foreign currency exchange gains and losses. |
|---|
Companion Animal Group. Gross profit for CAG increased due to higher sales and a slight increase in the gross profit percentage. The increase in gross profit percentage was due primarily to lower overall VetLab product costs and price increases across our CAG Diagnostics recurring revenue portfolio. These favorable factors were partly offset by impacts related to our transition to an all-direct sales strategy in the U.S. during the fourth quarter of 2014, including an unfavorable product mix resulting from the inventory drawdown of higher margin rapid assay test kits and VetLab consumables from our U.S. distributors and higher freight and distribution costs.
Water. Gross profit for Water increased due primarily to higher sales. The slight increase in the gross profit percentage was due primarily to a more favorable product mix resulting from higher relative sales of our Colilert products which yield higher margins, lower overall manufacturing costs resulting from a decrease in materials costs and higher average unit sales prices due to price increases. These favorable factors were partly offset by the unfavorable impact of currency due primarily to lower relative hedging gains during the year ended December 31, 2014 as compared to the prior year.
Livestock, Poultry and Dairy. Gross profit for LPD increased due to an improvement in the gross profit percentage to 62% from 55% and higher sales. The increase in the gross profit percentage resulted from lower overall manufacturing costs, driven by higher production volumes, a decrease in royalty expense and higher average unit sales prices. The decrease in royalty expense was due primarily to an agreement executed in the first quarter of 2014 with a licensor of patents related to the sale of certain swine tests.
Other. Gross profit for Other increased due to higher sales and an improvement in the gross profit percentage to 53% from 50%. The increase in the gross profit percentage was due primarily to lower overall manufacturing costs in our OPTI Medical business, resulting from a reduction in material costs and higher production volumes, and an increase in milestone revenue related to our pharmaceutical out-licensing arrangements, for which there is no associated costs of revenue. These favorable factors were partly offset by higher cost of service associated with OPTI Medical instruments and a decrease in average unit sales prices on related consumables.
Unallocated Amounts. Gross profit for Unallocated Amounts decreased due primarily to an increase in certain manufacturing costs and changes in certain currency exchange rates.
The manufacturing costs reported in our operating segments include our standard cost for products sold and any variances from standard cost for products purchased or manufactured within the period. We capitalize these variances for inventory on hand at the end of the period to record inventory in accordance with U.S. GAAP. We then record these variances as cost of product revenue as that inventory is sold. The impact to cost of product revenue resulting from this variance capitalization and subsequent recognition is reported within the caption “Unallocated Amounts.” The net unfavorable impact to gross profit as a result of increased manufacturing costs was due to the capitalization of favorable manufacturing variances, primarily within our LPD business, during the year ended December 31, 2014.
In certain geographies where we maintain inventories in currencies other than the U.S. dollar, the product costs reported in our operating segments include our standard cost for products sold, which is stated at the budgeted currency exchange rate from the beginning of the fiscal year. In these geographies, the variances from standard cost for products sold related to changes in currency exchange rates are reported within the caption “Unallocated Amounts.” The U.S. dollar strengthened significantly against the Japanese yen during the year ended December 31, 2013. The strengthening in the value of the U.S. dollar relative to the Japanese yen during the year ended December 31, 2014 was less significant, as compared to the prior year, resulting in a lower favorable variance within Unallocated Amounts relating to the cost of products sold in Japanese yen.
Operating Expenses and Operating Income
Total Company. The following tables present operating expenses and operating income by operating segment:
| For the Year | For the Year | ||||||||||||||||||
| Ended | Ended | ||||||||||||||||||
| Operating Expenses | December 31, | Percent of | December 31, | Percent of | Dollar | Percentage | |||||||||||||
| (dollars in thousands) | 2014 | Revenue | 2013 | Revenue | Change | Change | |||||||||||||
| CAG | $ | 452,368 | 36.6% | $ | 397,690 | 34.6% | $ | 54,678 | 13.7% | ||||||||||
| Water | 23,662 | 25.0% | 20,897 | 23.8% | 2,765 | 13.2% | |||||||||||||
| LPD | 55,024 | 43.2% | 48,375 | 42.5% | 6,649 | 13.7% | |||||||||||||
| Other | 11,757 | 43.8% | 10,245 | 40.8% | 1,512 | 14.8% | |||||||||||||
| Unallocated amounts | 13,050 | N/A | 12,149 | N/A | 901 | 7.4% | |||||||||||||
| Total Company | $ | 555,861 | 37.4% | $ | 489,356 | 35.5% | $ | 66,505 | 13.6% |
| For the Year | For the Year | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Ended | Ended | ||||||||||||||||||
| Operating Income | December 31, | Percent of | December 31, | Percent of | Dollar | Percentage | |||||||||||||
| (dollars in thousands) | 2014 | Revenue | 2013 | Revenue | Change | Change | |||||||||||||
| CAG | $ | 213,109 | 17.2% | $ | 218,645 | 19.0% | $ | (5,536) | (2.5%) | ||||||||||
| Water | 39,262 | 41.4% | 37,321 | 42.4% | 1,941 | 5.2% | |||||||||||||
| LPD | 24,215 | 19.0% | 14,159 | 12.4% | 10,056 | 71.0% | |||||||||||||
| Other | 2,479 | 9.2% | 2,405 | 9.6% | 74 | 3.1% | |||||||||||||
| Unallocated amounts | (18,810) | N/A | (5,768) | N/A | (13,042) | (226.1%) | |||||||||||||
| Total Company | $ | 260,255 | 17.5% | $ | 266,762 | 19.4% | $ | (6,507) | (2.4%) |
The transition to an all-direct sales strategy in the U.S. within our CAG segment reduced operating profit by $35.3 million during the year ended December 31, 2014. These impacts consisted of a one-time reduction in operating profit related to the drawdown of inventory held by our U.S. distributors, which reduced operating income by $20.8 million, $5.0 million in incremental expenses related to the ramp up of sales and operating resources and approximately $9.5 million of non-recurring expenses during the year ended December 31, 2014. For the year ended December 31, 2014, adjusted operating income, which is total Company operating income adjusted for the aforementioned transition impacts was approximately $295.6 million and 19.6% of revenue, which represents an increase in adjusted operating income of $24.7 million and 9.1%, as compared to the year ended December 31, 2013, which is adjusted for the 2013 bankruptcy of a third-party service provider of approximately $4.1 million. Adjusted operating income is a non-GAAP financial measure and should be considered in addition to, and not as a replacement for or as a superior measure to, operating income reported in accordance with U.S. GAAP. Management believes that reporting adjusted operating income provides useful information to investors by facilitating easier comparisons of our operating income performance with prior and future periods and to the performance of our peers.
See the subsection above titled “Effects of Certain Factors on Results of Operations – Distributor Purchasing and Inventories” for details regarding anticipated transitional costs related to moving to an all-direct sales strategy for VetLab consumables and rapid assay products and services within our CAG segment in the U.S.
Companion Animal Group. The following table presents CAG operating expenses by functional area:
| For the Year | For the Year | ||||||||||||||||||
| Ended | Ended | ||||||||||||||||||
| Operating Expenses | December 31, | Percent of | December 31, | Percent of | Dollar | Percentage | |||||||||||||
| (dollars in thousands) | 2014 | Revenue | 2013 | Revenue | Change | Change | |||||||||||||
| Sales and marketing | $ | 244,414 | 19.8% | $ | 208,991 | 18.2% | $ | 35,423 | 16.9% | ||||||||||
| General and administrative | 137,675 | 11.1% | 125,877 | 10.9% | 11,798 | 9.4% | |||||||||||||
| Research and development | 70,279 | 5.7% | 62,822 | 5.5% | 7,457 | 11.9% | |||||||||||||
| Total operating expenses | $ | 452,368 | 36.6% | $ | 397,690 | 34.6% | $ | 54,678 | 13.7% |
The increase in sales and marketing expense resulted from higher personnel-related costs across all major regions, including our North American sales force transformation started in the second half of 2013 and increased commissions resulting from improved sales performance; and non-recurring consulting costs related to the aforementioned implementation of an all-direct sales strategy in the U.S. The increase in general and administrative expense resulted primarily from higher personnel-related costs and, to a lesser extent, depreciation of internal-use software, partly offset by the favorable impact of changes in foreign currency exchange rates. The increase in research and development expense resulted primarily from higher personnel-related costs and increased materials costs, partly offset by lower external consulting and development costs.
Water. The following table presents Water operating expenses by functional area:
| For the Year | For the Year | ||||||||||||||||||
| Ended | Ended | ||||||||||||||||||
| Operating Expenses | December 31, | Percent of | December 31, | Percent of | Dollar | Percentage | |||||||||||||
| (dollars in thousands) | 2014 | Revenue | 2013 | Revenue | Change | Change | |||||||||||||
| Sales and marketing | $ | 11,494 | 12.1% | $ | 9,942 | 11.3% | $ | 1,552 | 15.6% | ||||||||||
| General and administrative | 9,226 | 9.7% | 8,398 | 9.5% | 828 | 9.9% | |||||||||||||
| Research and development | 2,942 | 3.1% | 2,557 | 2.9% | 385 | 15.1% | |||||||||||||
| Total operating expenses | $ | 23,662 | 25.0% | $ | 20,897 | 23.8% | $ | 2,765 | 13.2% |
The increase in sales and marketing expense was due primarily to higher personnel-related costs and incremental spending on promotional activities. Personnel-related costs included commissions related to improved sales performance, and incremental costs associated with the acquisition of our distributor in South Africa in the fourth quarter of 2013. The increase in general and administrative expense resulted primarily from higher personnel-related costs. The increase in research and development expense was due primarily to higher materials costs.
Livestock, Poultry and Dairy. The following table presents LPD operating expenses by functional area:
| For the Year | For the Year | ||||||||||||||||||
| Ended | Ended | ||||||||||||||||||
| Operating Expenses | December 31, | Percent of | December 31, | Percent of | Dollar | Percentage | |||||||||||||
| (dollars in thousands) | 2014 | Revenue | 2013 | Revenue | Change | Change | |||||||||||||
| Sales and marketing | $ | 25,144 | 19.7% | $ | 20,972 | 18.4% | $ | 4,172 | 19.9% | ||||||||||
| General and administrative | 16,870 | 13.2% | 14,855 | 13.1% | 2,015 | 13.6% | |||||||||||||
| Research and development | 13,010 | 10.2% | 12,548 | 11.0% | 462 | 3.7% | |||||||||||||
| Total operating expenses | $ | 55,024 | 43.2% | $ | 48,375 | 42.5% | $ | 6,649 | 13.7% |
The increase in sales and marketing expense resulted from higher personnel-related costs, including incremental costs associated with the acquisition of a Brazilian distributor in the third quarter of 2013 and commercial team investments worldwide, most significantly in the Asia-Pacific region. The increase in general and administrative expense resulted from incremental costs associated with the acquisition of the Brazilian distributor, primarily personnel-related costs and higher amortization of the acquired intangible assets. The increase in research and development expense was due primarily to higher personnel-related costs.
Other. Operating expenses for Other increased $1.5 million to $11.8 million for the year ended December 31, 2014, as compared to the prior year due primarily to higher personnel-related costs and an increase in external development and consulting costs in our OPTI Medical line of business.
Unallocated Amounts. Operating expenses that are not allocated to our operating segments increased by $0.9 million to $13.1 million for the year ended December 31, 2014, as compared to the prior year, due primarily to certain foreign exchange losses and an increase in certain personnel-related costs. These unfavorable factors were partly offset by the absence of a $4.1 million loss incurred during the year ended December 31, 2013 resulting from the bankruptcy of a freight payment and audit service provider.
Over the second half of 2014, the U.S. dollar experienced a continued and persistent strengthening relative to all major foreign currencies in which we transact, resulting in realized and unrealized losses on monetary assets, partly offset by gains on liabilities denominated in a currency other than the U.S. dollar.
We estimate certain personnel-related costs and allocate the estimated expenses to the operating segments. This allocation differs from actual expense and consequently yields a difference that is reported under the caption “Unallocated Amounts.”
Interest Income and Interest Expense
Interest income was $1.7 million for the year ended December 31, 2014 as compared to $1.9 million for the prior year. The decrease in interest income resulted from our June 2014 disposition of a debt investment and repayment of the related notes receivable, partly offset by increased interest income earned on higher average cash balances. See Note 3 to the consolidated financial statements included in this Annual Report on Form 10-K for additional information regarding the disposition of this strategic investment.
Interest expense was $15.4 million for the year ended December 31, 2014, as compared to $5.4 million for the prior year. The increase in interest expense was due primarily to senior notes that we issued and sold through three private placements between December 2013 and September 2014 in an aggregate principal amount of $350 million. Fixed interest rates on the senior notes range from 3.32% to 4.04%. See Note 10 to the consolidated financial statements included in this Annual Report on Form 10-K for additional information regarding our senior notes.
Provision for Income Taxes
Our effective income tax rate was 26.2% for the year ended December 31, 2014 and 28.7% for the year ended December 31, 2013. The decrease in our effective income tax rate for the year ended December 31, 2014, as compared to the year ended December 31, 2013, was related to higher relative earnings subject to international tax rates that are lower than domestic tax rates, a non-recurring benefit related to the deferral of intercompany profits that were included in prior year tax provisions in error, which is not material to current or prior interim or annual periods, and the resolution of domestic and international tax audits, which resulted in a net reduction in our provision for uncertain tax positions. These favorable factors were partly offset by a reduction in the benefit from the U.S. research and development (“R&D”) tax credit. During the three months ended March 31, 2013, legislation in the U.S. retroactively allowed the R&D tax credit for all of 2012 and extended the R&D tax credit through the year ending December 31, 2013. As a result, in the year ending December 31, 2013 we recorded the benefit of two years of R&D tax credit as compared to the year ending December 31, 2014 in which we have recorded only the benefit related to that year’s activities.
In 2015, it is reasonably possible that we could recognize up to $0.4 million of income tax benefits that have not been recognized at December 31, 2014. The income tax benefits are primarily due to the lapse in the statutes of limitations for various tax jurisdictions.
Twelve Months Ended December 31, 2013 Compared to Twelve Months Ended December 31, 2012
Revenue
The following revenue analysis and discussion focuses on organic revenue growth. Organic revenue growth is a non-GAAP financial measure and represents the percentage change in revenue during the twelve months ended December 31, 2013, as compared to the same period for the prior year, net of the effect of changes in foreign currency exchange rates and acquisitions. Organic revenue growth should be considered in addition to, and not as a replacement for or as a superior measure to, revenues reported in accordance with U.S. GAAP, and may not be comparable to similarly titled measures reported by other companies. Management believes that reporting organic revenue growth provides useful information to investors by facilitating easier comparisons of our revenue performance with prior and future periods and to the performance of our peers. We exclude the effect of changes in foreign currency exchange rates because changes in foreign currency exchange rates are not under management’s control, are subject to volatility and can obscure underlying business trends. We exclude the effect of acquisitions because the nature, size and number of acquisitions can vary dramatically from period to period and therefore can also obscure underlying business trends.
The percentage changes in revenue from foreign currency exchange rates and acquisitions are non-GAAP financial measures. See the subsection above titled “Effects of Certain Factors on Results of Operations – Currency Impact” for a description of the calculation of the percentage change in revenue resulting from changes in foreign currency exchange rates. The percentage change in revenue resulting from acquisitions represents incremental revenues attributable to acquisitions that have occurred since the beginning of the prior year period.
Total Company. The following table presents revenue by operating segment:
| For the Year | For the Year | ||||||||||||||||||||
| Ended | Ended | Percentage | Percentage | Organic | |||||||||||||||||
| Net Revenue | December 31, | December 31, | Dollar | Percentage | Change from | Change from | Revenue | ||||||||||||||
| (dollars in thousands) | 2013 | 2012 | Change | Change | Currency | Acquisitions | Growth | ||||||||||||||
| CAG | $ | 1,150,169 | $ | 1,072,211 | $ | 77,958 | 7.3% | (0.8%) | 0.3% | 7.8% | |||||||||||
| Water | 87,959 | 84,680 | 3,279 | 3.9% | (0.6%) | 0.3% | 4.2% | ||||||||||||||
| LPD | 113,811 | 111,308 | 2,503 | 2.2% | 0.2% | 2.6% | (0.6%) | ||||||||||||||
| Other | 25,119 | 25,139 | (20) | (0.1%) | 0.1% | - | (0.2%) | ||||||||||||||
| Total | $ | 1,377,058 | $ | 1,293,338 | $ | 83,720 | 6.5% | (0.7%) | 0.5% | 6.7% |
U.S. and International Revenue. The following table provides further analysis of total company revenue by U.S. markets and non-U.S., or international, markets:
| For the Year | For the Year | ||||||||||||||||||||
| Ended | Ended | Percentage | Percentage | Organic | |||||||||||||||||
| Net Revenue | December 31, | December 31, | Dollar | Percentage | Change from | Change from | Revenue | ||||||||||||||
| (dollars in thousands) | 2013 | 2012 | Change | Change | Currency | Acquisitions | Growth | ||||||||||||||
| United States | $ | 802,346 | $ | 759,419 | $ | 42,927 | 5.7% | - | 0.5% | 5.2% | |||||||||||
| International | 574,712 | 533,919 | 40,793 | 7.6% | (1.8%) | 0.7% | 8.7% | ||||||||||||||
| Total | $ | 1,377,058 | $ | 1,293,338 | $ | 83,720 | 6.5% | (0.7%) | 0.5% | 6.7% |
The increase in both U.S. and international revenues was primarily driven by CAG Diagnostics recurring revenue. The increase in international revenues was driven by strong growth in Europe and Asia-Pacific markets, most significantly within the Nordic countries as a result of our move to a direct sales model in this region during the first quarter of 2013, Germany and China. The impact of changes in distributors’ inventory levels reduced U.S. revenue growth by approximately 1% and did not have a significant impact on reported international revenue growth.
Companion Animal Group. The following table presents revenue by product and service category for CAG:
| For the Year | For the Year | ||||||||||||||||||||
| Ended | Ended | Percentage | Percentage | Organic | |||||||||||||||||
| Net Revenue | December 31, | December 31, | Dollar | Percentage | Change from | Change from | Revenue | ||||||||||||||
| (dollars in thousands) | 2013 | 2012 | Change | Change | Currency | Acquisitions | Growth | ||||||||||||||
| CAG Diagnostics recurring revenue: | $ | 973,886 | $ | 896,449 | $ | 77,437 | 8.6% | (0.8%) | 0.1% | 9.3% | |||||||||||
| VetLab consumables | 312,457 | 278,818 | 33,639 | 12.1% | (0.7%) | - | 12.8% | ||||||||||||||
| VetLab service and accessories | 50,675 | 48,056 | 2,619 | 5.4% | (2.5%) | - | 7.9% | ||||||||||||||
| Rapid assay products | 169,547 | 162,232 | 7,315 | 4.5% | (0.7%) | - | 5.2% | ||||||||||||||
| Reference laboratory diagnostic and consulting services | 441,207 | 407,343 | 33,864 | 8.3% | (0.8%) | 0.3% | 8.8% | ||||||||||||||
| CAG Diagnostics capital instruments | 83,492 | 90,177 | (6,685) | (7.4%) | (1.5%) | - | (5.9%) | ||||||||||||||
| Customer information management and digital imaging systems | 92,791 | 85,585 | 7,206 | 8.4% | (0.3%) | 3.1% | 5.6% | ||||||||||||||
| Net CAG revenue | $ | 1,150,169 | $ | 1,072,211 | $ | 77,958 | 7.3% | (0.8%) | 0.3% | 7.8% |
The increase in CAG Diagnostics recurring revenue is due primarily to increased volumes and higher realized prices in both our reference laboratory diagnostic services and our VetLab consumables.
VetLab consumables revenue growth was due to higher unit volumes and higher realized prices. The increase in unit volumes resulted primarily from growth of our installed base for our Catalyst Dx and ProCyte Dx instruments as a result of customer acquisitions, as well as an increase in testing from existing customers who upgraded to these instruments, partially offset by lower sales of consumables used with our VetTest chemistry instrument. Higher realized prices were the result of changes in certain distributor arrangements and list price increases. The impact of changes in distributors’ inventory levels reduced reported consumables revenue growth by approximately 1%.
VetLab service and accessories revenue growth was primarily a result of the increase in our active installed base of instruments.
The increase in rapid assay product revenue was due primarily to both higher unit volumes and higher realized prices resulting from price increases and a change in a distributor arrangement. Higher sales volumes were driven by an increase in U.S. canine practice-level sales volumes and increased volumes of our canine pancreatitis products. The impact of changes in distributors’ inventory levels did not have a significant impact on revenue growth.
The increase in reference laboratory diagnostic and consulting services revenue resulted from the impact of both increased testing volumes and price increases. Higher testing volumes were driven by the acquisition of new customers, increased testing volumes from existing customers and improved customer retention.
The decrease in CAG Diagnostics capital instruments revenue was due primarily to the impact of customer programs. The impact from customer programs includes a reagent rental program that we launched in North America during the fourth quarter of 2012. Under the reagent rental program, VetLab instrument revenue is recognized over the term of the minimum purchase agreement instead of at the time we place the instrument.
The increase in customer information management and digital imaging systems revenue resulted primarily from higher support revenue due to an increase in our active installed base and revenue from Pet Health Network Pro, which launched commercially in the first quarter of 2013. These favorable factors were partly offset by a decrease in digital radiography system placements.
Water. The increase in Water revenue was due primarily to higher sales volumes of our Colilert products and related accessories in Europe and North America, driven by new account acquisitions and higher average unit sales prices.
Livestock, Poultry and Dairy. The decrease in LPD revenue resulted primarily from lower sales volumes of BSE tests resulting from changes in European testing requirements and a reduction in sales volumes of our Dairy SNAP tests used for the detection of the contaminant Aflatoxin M1 and antibiotic residues in milk. In early 2012, Dairy SNAP sales volumes were favorably impacted by testing as a result of an Aflatoxin M1 outbreak in China; testing volumes in China subsided over the remainder of 2012. These unfavorable factors were partly offset by higher sales of certain bovine tests resulting from increased testing levels from government programs and higher sales volumes of certain poultry and swine tests.
Other. Other revenue for the year ended December 31, 2013 was generally consistent with the prior year as lower sales volumes associated with our pharmaceutical product line were almost entirely offset by higher sales volumes of consumables and accessories used with our OPTI Medical instruments.
Gross Profit
Total Company. The following table presents gross profit and gross profit percentages by operating segment:
| For the Year | For the Year | ||||||||||||||||||
| Ended | Ended | ||||||||||||||||||
| Gross Profit | December 31, | Percent of | December 31, | Percent of | Dollar | Percentage | |||||||||||||
| (dollars in thousands) | 2013 | Revenue | 2012 | Revenue | Change | Change | |||||||||||||
| CAG | $ | 616,335 | 53.6% | $ | 561,043 | 52.3% | $ | 55,292 | 9.9% | ||||||||||
| Water | 58,218 | 66.2% | 56,133 | 66.3% | 2,085 | 3.7% | |||||||||||||
| LPD | 62,534 | 54.9% | 66,166 | 59.4% | (3,632) | (5.5%) | |||||||||||||
| Other | 12,650 | 50.4% | 10,645 | 42.3% | 2,005 | 18.8% | |||||||||||||
| Unallocated amounts | 6,381 | N/A | 5,161 | N/A | 1,220 | 23.6% | |||||||||||||
| Total Company | $ | 756,118 | 54.9% | $ | 699,148 | 54.1% | $ | 56,970 | 8.1% |
Companion Animal Group. Gross profit for CAG increased due to higher sales and an increase in the gross profit percentage to 54% from 52%. The increase in the gross profit percentage was due primarily to price increases for our reference laboratory diagnostic and consulting services, VetLab consumables and, to a lesser extent, rapid assay products and volume-related efficiencies realized throughout our reference laboratory operations.
Water. Gross profit for Water increased due primarily to higher sales. The gross profit percentage for the year ended December 31, 2013 was generally consistent with the prior year, as the unfavorable impact of currency was mostly offset by higher average unit sales prices. The unfavorable impact of currency was due primarily to hedging losses during the year ended December 31, 2013 compared to hedging gains during the prior year.
Livestock, Poultry and Dairy. Gross profit for LPD decreased due to a decrease in the gross profit percentage to 55% from 59%, partly offset by higher sales. The decrease in the gross profit percentage was due primarily to higher overall manufacturing costs and the unfavorable impact of currency. Higher manufacturing costs were due primarily to an increase in materials costs and lower production volumes in certain product lines. The unfavorable impact of currency was due primarily to hedging losses during the year ended December 31, 2013 compared to hedging gains during the prior year.
Other. Gross profit for Other increased due to an increase in the gross profit percentage to 50% from 42%, due primarily to lower overall OPTI Medical manufacturing costs resulting from a reduction in materials costs and higher relative sales of consumables used with our OPTI Medical instruments and milestone and royalty revenue earned from our remaining pharmaceutical out-licensing arrangements, both of which yield higher relative margins.
Unallocated Amounts. Gross profit for Unallocated Amounts increased due primarily to changes in certain currency exchange rates and a decrease in certain manufacturing costs, partly offset by an increase in personnel-related costs.
In certain geographies where we maintain inventories in currencies other than the U.S. dollar, the product costs reported in our operating segments include our standard cost for products sold, which is stated at the budgeted currency exchange rate from the beginning of the fiscal year. In these geographies, the variances from standard cost for products sold related to changes in currency exchange rates are reported within the caption “Unallocated Amounts.” For the year ended December 31, 2013, these variances were due primarily to the cost of products sold in Japanese yen.
The manufacturing costs reported in our operating segments include our standard cost for products sold and any variances from standard cost for products purchased or manufactured within the period. We capitalize these variances for inventory on hand at the end of the period to record inventory in accordance with U.S. GAAP. We then record these variances as cost of product revenue as that inventory is sold. The impact to cost of product revenue resulting from this variance capitalization and subsequent recognition is reported within the caption “Unallocated Amounts.” The decrease in certain manufacturing costs is due primarily to the recognition of previously favorable capitalized variances.
We estimate certain personnel-related costs and allocate the estimated expenses to the operating segments. This allocation differs from actual expense and consequently yields a difference that is reported under the caption “Unallocated Amounts.” The increase in personnel-related costs for Unallocated Amounts is due primarily to higher self-insured healthcare costs during the year ended December 31, 2013 compared to the prior year.
Operating Expenses and Operating Income
Total Company. The following tables present operating expenses and operating income by operating segment:
| For the Year | For the Year | ||||||||||||||||||
| Ended | Ended | ||||||||||||||||||
| Operating Expenses | December 31, | Percent of | December 31, | Percent of | Dollar | Percentage | |||||||||||||
| (dollars in thousands) | 2013 | Revenue | 2012 | Revenue | Change | Change | |||||||||||||
| CAG | $ | 397,690 | 34.6% | $ | 357,807 | 33.4% | $ | 39,883 | 11.1% | ||||||||||
| Water | 20,897 | 23.8% | 18,446 | 21.8% | 2,451 | 13.3% | |||||||||||||
| LPD | 48,375 | 42.5% | 45,358 | 40.7% | 3,017 | 6.7% | |||||||||||||
| Other | 10,245 | 40.8% | 7,743 | 30.8% | 2,502 | 32.3% | |||||||||||||
| Unallocated amounts | 12,149 | N/A | 7,231 | N/A | 4,918 | 68.0% | |||||||||||||
| Total Company | $ | 489,356 | 35.5% | $ | 436,585 | 33.8% | $ | 52,771 | 12.1% |
| For the Year | For the Year | ||||||||||||||||||
| Ended | Ended | ||||||||||||||||||
| Operating Income | December 31, | Percent of | December 31, | Percent of | Dollar | Percentage | |||||||||||||
| (dollars in thousands) | 2013 | Revenue | 2012 | Revenue | Change | Change | |||||||||||||
| CAG | $ | 218,645 | 19.0% | $ | 203,236 | 19.0% | $ | 15,409 | 7.6% | ||||||||||
| Water | 37,321 | 42.4% | 37,687 | 44.5% | (366) | (1.0%) | |||||||||||||
| LPD | 14,159 | 12.4% | 20,808 | 18.7% | (6,649) | (32.0%) | |||||||||||||
| Other | 2,405 | 9.6% | 2,902 | 11.5% | (497) | (17.1%) | |||||||||||||
| Unallocated amounts | (5,768) | N/A | (2,070) | N/A | (3,698) | (178.6%) | |||||||||||||
| Total Company | $ | 266,762 | 19.4% | $ | 262,563 | 20.3% | $ | 4,199 | 1.6% |
Companion Animal Group. The following table presents CAG operating expenses by functional area:
| For the Year | For the Year | ||||||||||||||||||
| Ended | Ended | ||||||||||||||||||
| Operating Expenses | December 31, | Percent of | December 31, | Percent of | Dollar | Percentage | |||||||||||||
| (dollars in thousands) | 2013 | Revenue | 2012 | Revenue | Change | Change | |||||||||||||
| Sales and marketing | $ | 208,991 | 18.2% | $ | 186,287 | 17.4% | $ | 22,704 | 12.2% | ||||||||||
| General and administrative | 125,877 | 10.9% | 115,266 | 10.8% | 10,611 | 9.2% | |||||||||||||
| Research and development | 62,822 | 5.5% | 56,254 | 5.2% | 6,568 | 11.7% | |||||||||||||
| Total operating expenses | $ | 397,690 | 34.6% | $ | 357,807 | 33.4% | $ | 39,883 | 11.1% |
The increase in sales and marketing expense was due primarily to increased personnel-related costs from investment in our commercial organizations in all major regions, including the completion of our North American sales force expansion and associated marketing and consulting costs related to this transformation. The increase in general and administrative expense resulted primarily from increased personnel-related costs and an increase in costs attributable to investments in information technology. The increase in research and development expense resulted primarily from higher personnel-related costs and an increase in consulting and external development costs.
Water. The following table presents Water operating expenses by functional area:
| For the Year | For the Year | ||||||||||||||||||
| Ended | Ended | ||||||||||||||||||
| Operating Expenses | December 31, | Percent of | December 31, | Percent of | Dollar | Percentage | |||||||||||||
| (dollars in thousands) | 2013 | Revenue | 2012 | Revenue | Change | Change | |||||||||||||
| Sales and marketing | $ | 9,942 | 11.3% | $ | 9,398 | 11.1% | $ | 544 | 5.8% | ||||||||||
| General and administrative | 8,398 | 9.5% | 6,546 | 7.7% | 1,852 | 28.3% | |||||||||||||
| Research and development | 2,557 | 2.9% | 2,502 | 3.0% | 55 | 2.2% | |||||||||||||
| Total operating expenses | $ | 20,897 | 23.8% | $ | 18,446 | 21.8% | $ | 2,451 | 13.3% |
The increase in sales and marketing and general and administrative expense resulted primarily from higher personnel-related costs. Research and development expense for the year ended December 31, 2013 was generally consistent with the prior year.
Livestock, Poultry and Dairy. The following table presents LPD operating expenses by functional area:
| For the Year | For the Year | ||||||||||||||||||
| Ended | Ended | ||||||||||||||||||
| Operating Expenses | December 31, | Percent of | December 31, | Percent of | Dollar | Percentage | |||||||||||||
| (dollars in thousands) | 2013 | Revenue | 2012 | Revenue | Change | Change | |||||||||||||
| Sales and marketing | $ | 20,972 | 18.4% | $ | 18,517 | 16.6% | $ | 2,455 | 13.3% | ||||||||||
| General and administrative | 14,855 | 13.1% | 14,388 | 12.9% | 467 | 3.2% | |||||||||||||
| Research and development | 12,548 | 11.0% | 12,453 | 11.2% | 95 | 0.8% | |||||||||||||
| Total operating expenses | $ | 48,375 | 42.5% | $ | 45,358 | 40.7% | $ | 3,017 | 6.7% |
The increase in sales and marketing expense resulted primarily from higher personnel-related costs, including costs associated with the acquisition of a Brazilian distributor, and increased spending on promotional activities in the Asia-Pacific region. The increase in general and administrative expense was due primarily to costs associated with the acquisition and integration of the Brazilian distributor, a portion of which will not recur, partly offset by lower personnel-related costs and a decrease in intangible asset amortization. Research and development expense during the year ended December 31, 2013 was generally consistent with the prior year.
Other. Operating expenses for Other increased $2.5 million to $10.2 million for the year ended December 31, 2013, due primarily to a $3.5 million milestone payment earned during the year ended December 31, 2012 related to the 2008 sale of product rights previously included in our pharmaceutical product line, partly offset by lower personnel-related costs in our OPTI Medical line of business. The pharmaceutical milestone payment was not classified as revenue because the transaction was accounted for as the sale of a business; rather it was reflected as a reduction to general and administrative expenses as earned.
Unallocated Amounts. Operating expenses that are not allocated to our operating segments increased $4.9 million to $12.1 million for the year ended December 31, 2013 as compared to the prior year due primarily to losses incurred resulting from the bankruptcy of a freight payment and audit service provider (“freight service company”), partly offset by lower legal and other professional fees incurred as a result of the resolution of the FTC investigation in February 2013 and proceeds received during 2013 in connection with the demutualization of an insurance provider. In March 2013, the freight service company provided notice to us that all freight payment services would cease immediately and that certain amounts paid by us to the freight service company were not subsequently remitted to our freight carriers due to an employee fraud and a breakdown in internal controls, both at the freight service company, concluding in significant losses and the resulting bankruptcy. In response, we recorded a $3.9 million loss related to these unremitted amounts in general and administrative expense during the year ended December 31, 2013. We continue to monitor the freight service company’s bankruptcy proceeding, but we cannot be certain of any recovery at this time.
Interest Income and Interest Expense
Interest income was $1.9 million for both the years ended December 31, 2013 and 2012.
Interest expense was $5.4 million for the year ended December 31, 2013 compared to $3.8 million for the same period of the prior year. The increase in interest expense was due primarily to higher average balances outstanding on our unsecured revolving credit facility and senior notes that we issued and sold through a private placement in an aggregate amount of $150 million in December 2013. The senior notes consist of $75 million of 3.94% Series A Senior Notes due December 11, 2023 and $75 million of 4.04% Series B Senior Notes due December 11, 2025. See Note 11 to the consolidated financial statements included in this Annual Report on Form 10-K for additional information about our senior notes.
Provision for Income Taxes
Our effective income tax rate was 28.7% for the year ended December 31, 2013 and 31.6% for the year ended December 31, 2012. The decrease in our effective income tax rate for the year ended December 31, 2013, as compared to the year ended December 31, 2012, was due primarily to the research and development (“R&D”) tax credit. For the year ended December 31, 2012, the U.S. legislation authorizing the R&D tax credit had expired and no associated tax benefit was recognized within this period. On January 2, 2013, U.S. federal legislation was enacted that retroactively allowed an R&D tax credit for all of 2012 and extended the R&D tax credit through the year ending December 31, 2013. Because the related legislation was enacted in 2013, the full benefit of the R&D tax credit related to the prior year’s activities was recognized in 2013. In addition, higher relative earnings subject to international tax rates that are lower than domestic tax rates also contributed to the decrease in our effective income tax rate.
RECENT ACCOUNTING PRONOUNCEMENTS
A discussion of recent accounting pronouncements is included in Note 2 to the consolidated financial statements for the year ended December 31, 2014 included in this Annual Report on Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
We fund the capital needs of our business through cash on hand, funds generated from operations, and amounts available under our unsecured revolving credit facility, which we refinanced in June 2014 by entering into an amended and restated five-year unsecured revolving credit facility in the principal amount of $700 million (the amended and restated credit facility and the previous credit facility are referred to collectively as the “Credit Facility”). In addition, we issued $150 million, $125 million, $75 million and $150 million of our senior notes in December 2013, July 2014, September 2014 and February 2015, respectively. At December 31, 2014 and December 31, 2013, we had $322.5 million and $279.1 million, respectively, of cash and cash equivalents, and negative working capital of ($61.5) million and working capital of $174.4 million, respectively. Additionally, at December 31, 2014, we had remaining borrowing availability of $150 million under our $700 million Credit Facility. We believe that, if necessary, we could obtain additional borrowings at similar rates to our existing borrowings to fund our growth objectives. We further believe that current cash and cash equivalents, funds generated from operations, and committed borrowing availability will be sufficient to fund our operations, capital purchase requirements, and anticipated growth needs for the next twelve months. We believe that these resources, coupled with our ability, as needed, to obtain additional financing on favorable terms will be sufficient for the foreseeable future to fund our business as currently conducted.
We consider the majority of the operating earnings of certain non-U.S. subsidiaries to be indefinitely invested outside the U.S. No provision has been made for the payment of U.S. federal and state or international taxes that may result from future remittances of these undistributed earnings of non-U.S. subsidiaries. Changes to this position could have adverse tax consequences. A determination of the related tax liability that would be paid on these undistributed earnings if repatriated is not practicable. We manage our worldwide cash requirements considering available funds among all of our subsidiaries. Our foreign cash balances are generally available without restrictions to fund ordinary business operations outside the U.S. Of our total cash and cash equivalents at December 31, 2014, approximately $321.5 million was held by our foreign subsidiaries and was subject to material repatriation tax effects. As of December 31, 2014, 64% of the cash and cash equivalents held by our foreign subsidiaries was invested in money market funds restricted to U.S. government and agency securities and 36% was held as bank deposits. As of December 31, 2014, approximately 66% of the cash and cash equivalents held by our foreign subsidiaries was held in U.S. dollars.
Should we require more capital in the U.S. than is generated by our operations domestically, for example to fund significant discretionary activities, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in higher effective tax rates or increased interest expense and other dilution of our earnings. We have borrowed funds domestically and continue to have the ability to borrow funds domestically at reasonable interest rates.
The following table presents additional key information concerning working capital:
| For the Three Months Ended | |||||||||||||||
| December 31, | September 30, | June 30, | March 31, | December 31, | |||||||||||
| 2014 | 2014 | 2014 | 2014 | 2013 | |||||||||||
| Days sales outstanding (1) | 40.6 | 39.2 | 40.8 | 42.8 | 39.9 | ||||||||||
| Inventory turns (2) | 1.7 | 1.8 | 1.8 | 1.8 | 1.9 |
(1) Days sales outstanding represents the average of the accounts receivable balances at the beginning and end of each quarter divided by revenue for that quarter, the result of which is then multiplied by 91.25 days.
(2) Inventory turns represent inventory-related cost of product revenue for the 12 months preceding each quarter-end divided by the inventory balance at the end of the quarter.
Sources and Uses of Cash
The following table presents cash provided (used):
| For the Years Ended December 31, | ||||||||||
| (dollars in thousands) | 2014 | 2013 | Dollar Change | |||||||
| Net cash provided by operating activities | $ | 235,846 | $ | 245,996 | $ | (10,150) | ||||
| Net cash used by investing activities | (80,413) | (86,059) | 5,646 | |||||||
| Net cash used by financing activities | (103,438) | (102,451) | (987) | |||||||
| Net effect of changes in exchange rates on cash | (8,517) | (2,414) | (6,103) | |||||||
| Net increase in cash and cash equivalents | $ | 43,478 | $ | 55,072 | $ | (11,594) |
Operating Activities. Cash provided by operating activities was $235.8 million for the year ended December 31, 2014 compared to $246.0 million for the same period in 2013. The total of net income and net non-cash charges, excluding the impact of reclassifying the tax benefit from share-based compensation arrangements to a financing activity, was $261.6 million for the year ended December 31, 2014 compared to $263.2 million for the same period in 2013, resulting in a reduction in operating cash flows of $1.6 million driven primarily by the decrease in net income, partly offset by higher depreciation and amortization. The total of changes in operating assets and liabilities and the tax benefit from share-based compensation arrangements decreased cash by $25.8 million during the year ended December 31, 2014, compared to a decrease of $17.2 million for the year ended December 31, 2013, resulting in an incremental increase in cash of $8.6 million.
The following table presents cash flows from changes in operating assets and liabilities and the tax benefit from share-based compensation arrangements:
| For the Years Ended December 31, | ||||||||||
| (dollars in thousands) | 2014 | 2013 | Dollar Change | |||||||
| Accounts receivable | $ | (3,626) | $ | (15,946) | $ | 12,320 | ||||
| Inventories | (38,310) | (1,347) | (36,963) | |||||||
| Other assets | (25,073) | (4,325) | (20,748) | |||||||
| Accounts Payable | 6,703 | (4,399) | 11,102 | |||||||
| Accrued liabilities | 36,392 | 16,512 | 19,880 | |||||||
| Deferred revenue | 14,195 | 6,442 | 7,753 | |||||||
| Tax benefit from share-based compensation arrangements | (16,078) | (14,158) | (1,920) | |||||||
| Total change in cash due to changes in operating assets and liabilities and the tax benefit from share-based compensation arrangements | $ | (25,797) | $ | (17,221) | $ | (8,576) |
The incremental cash used by inventory during the year ended December 31, 2014 as compared to the prior year was due primarily to support higher expected demand for our CAG diagnostic instruments, as well as higher inventory levels for our kits and consumables to support our all-direct strategy in the U.S. The increase in cash used by other assets during the year ended December 31, 2014 as compared to the prior year was due primarily to higher income taxes receivable resulting from the Tax Increase Prevention Act that was enacted late in the year and the deferred cost of Catalyst instrument placements under our Catalyst One introductory offer launched in the first quarter of 2014. The Tax Increase Prevention Act retroactively extended the R&D tax credit and bonus depreciation and reduced our income taxes due related to the year ended December 31, 2014. The increase in cash provided by accrued liabilities during the year ended December 31, 2014 was greater than the prior year due primarily to the timing of income tax payments, higher accruals related to employee incentive programs, contingent consideration related to business combinations and accrued interest related to higher borrowings under our senior notes at December 31, 2014 as compared to the prior year end. The decrease in cash used by accounts receivable during the year ended December 31, 2014 resulted primarily from the impact of lower revenues in the fourth quarter of 2014 as compared to the fourth quarter of 2013 related to our all-direct strategy in the U.S. The increase in cash provided by accounts payable during the year ended December 31, 2014 as compared to the prior year was due primarily to the timing of vendor payments. The incremental cash provided by deferred revenue for the year ended December 31, 2014 as compared to the prior year was due primarily to sales under our Catalyst One introductory offer.
We historically have experienced proportionally lower net cash flows from operating activities during the first quarter and proportionally higher cash flows from operating activities for the remainder of the year and for the annual period driven primarily by payments related to annual employee incentive programs in the first quarter following the year for which the bonuses were earned and the seasonality of vector-borne disease testing, which has historically resulted in significant increases in accounts receivable balances during the first quarter of the year.
Investing Activities. Cash used by investing activities was $80.4 million for the year ended December 31, 2014 compared to $86.1 million for the same period in 2013. The decrease in cash used by investing activities during the year ended December 31, 2014 was due primarily to reduced capital expenditures, resulting from the completion of our headquarters facility expansion in August 2013, partly offset by incremental cash used to acquire businesses during the year ended December 31, 2014. See Note 3 to the consolidated financial statements included in this Annual Report on Form 10-K for additional information about our business acquisitions.
Our total capital expenditure plan for 2015 is estimated to be approximately $85 million, which includes capital investments in manufacturing and reference laboratory equipment, investments in internal use software and information technology infrastructure and the renovation and expansion of our facilities and reference laboratories.
Financing Activities. Cash used by financing activities was $103.4 million for the year ended December 31, 2014 compared to cash used of $102.5 million for the same period in 2013. The increase in cash used to repurchase common stock was offset by higher relative net borrowings under the Credit Facility and a $50 million increase in the issuance of long-term debt during the year ended December 31, 2014 as compared to the prior year.
Cash used to repurchase shares of our common stock increased by $250.4 million during the year ended December 31, 2014 compared to the prior year. From the inception of our share repurchase program in August 1999 to December 31, 2014, we have repurchased 53.9 million shares. During the year ended December 31, 2014, we purchased 4.9 million shares for an aggregate cost of $618.2 million compared to purchases of 4.0 million shares for an aggregate cost of $367.8 million during 2013. We believe that the repurchase of our common stock is a favorable means of returning value to our shareholders and we also repurchase our stock to offset the dilutive effect of our share-based compensation programs. Repurchases of our common stock may vary depending upon the level of other investing activities and the share price. See Note 17 to the consolidated financial statements included in this Annual Report on Form 10-K for additional information about our share repurchases.
As noted above, in June 2014, we refinanced our existing $450 million Credit Facility and increased the principal amount thereunder to $700 million. The Credit Facility matures on June 18, 2019 and requires no scheduled prepayments before that date. Although the Credit Facility does not mature until June 18, 2019, all individual borrowings under the terms of the Credit Facility have a stated term between 30 and 180 days. At the end of each term, the obligation is either repaid or rolled over into a new borrowing. The Credit Facility contains a subjective material adverse event clause, which allows the debt holders to call the loans under the Credit Facility if we fail to provide prompt written notice to the syndicate of such an event. Based on the stated term and the existence of the subjective material adverse event clause, this Credit Facility is reflected in the current liabilities section of our consolidated balance sheets. Applicable interest rates on borrowings under the Credit Facility generally range from 0.875 to 1.375 percentage points above the London interbank offered rate or the Canadian Dollar-denominated bankers’ acceptance rate, based on our leverage ratio, or the prevailing prime rate plus a maximum spread of up to 0.375%, based on our leverage ratio.
Net borrowing and repayment activity under the Credit Facility resulted in incremental cash provided of $207.0 million during the year ended December 31, 2014 compared to the prior year. At December 31, 2014, we had $549.0 million outstanding under the Credit Facility. The general availability of funds under the Credit Facility was further reduced by $1.0 million for a letter of credit that was issued in connection with claims under our workers’ compensation policy. The Credit Facility contains affirmative, negative and financial covenants customary for financings of this type. The negative covenants include restrictions on liens, indebtedness of subsidiaries of the Company, fundamental changes, investments, transactions with affiliates and certain restrictive agreements. The financial covenant is a consolidated leverage ratio test that requires our ratio of debt to earnings before interest, taxes, depreciation, amortization and share-based compensation not to exceed 3.5-to-1. At December 31, 2014, we were in compliance with the covenants of the Credit Facility. The obligations under the Credit Facility may be accelerated upon the occurrence of an event of default under the Credit Facility, which includes customary events of default including payment defaults, defaults in the performance of the affirmative, negative and financial covenants, the inaccuracy of representations or warranties, bankruptcy and insolvency related defaults, defaults relating to judgments, certain events related to employee pension benefit plans under the Employee Retirement Income Security Act of 1974, the failure to pay specified indebtedness, cross-acceleration to specified indebtedness and a change of control default.
In December 2013, we issued and sold through a private placement an aggregate principal amount of $150 million of senior notes consisting of $75 million of 3.94% Series A Senior Notes due December 11, 2023 (the “2023 Notes”) and $75 million of 4.04% Series B Senior Notes due December 11, 2025 (the “2025 Notes” and together with the 2023 Notes, the “December Notes”) under a Note Purchase Agreement among the Company, New York Life Insurance Company and the accredited institutional purchasers named therein (the “December 2013 Note Agreement”).
In July 2014, we issued and sold through a private placement an aggregate principal amount of $125 million of senior notes consisting of $75 million of 3.76% Series B Senior Notes due July 21, 2024 (the “2024 Notes”) and $50 million of 3.32% Series A Senior Notes due July 21, 2021 (the “2021 Notes” and together with the 2024 Notes, the “Prudential Notes”) under a Note Purchase and Private Shelf Agreement among the Company, Prudential Investment Management, Inc. and the accredited institutional purchasers named therein (the “July 2014 Note Agreement”).
In September 2014, we issued and sold through a private placement an aggregate principal amount of $75 million of 3.72% Senior Notes due September 4, 2026 (the “2026 Notes” and together with the Prudential Notes and the December Notes, the “Senior Notes”) under a Note Purchase Agreement dated as of July 22, 2014 among the Company, New York Life Insurance Company and the accredited institutional purchasers named therein (such agreement, together with July 2014 Note Agreement and December 2013 Note Agreement, the “Senior Note Agreements”).
The Senior Note Agreements contain affirmative, negative and financial covenants customary for agreements of this type. The negative covenants include restrictions on liens, indebtedness of our subsidiaries, priority indebtedness, fundamental changes, investments, transactions with affiliates, certain restrictive agreements and violations of laws and regulations. The financial covenant is a consolidated leverage ratio test that requires our ratio of debt to earnings before interest, taxes, depreciation, amortization and share-based compensation, as defined in the Senior Note Agreements, not to exceed 3.5-to-1. At December 31, 2014, we were in compliance with the covenants of the Senior Note Agreements.
Should we elect to prepay the Senior Notes, such aggregate prepayment will include the applicable make-whole amount(s), as defined within the applicable Senior Note Agreements. Additionally, in the event of a change in control of the Company or upon the disposition of certain assets of the Company the proceeds of which are not reinvested (as defined in the Senior Note Agreements), we may be required to prepay all or a portion of the Senior Notes. The obligations under the Senior Notes may be accelerated upon the occurrence of an event of default under the applicable Senior Note Agreement, each of which includes customary events of default including payment defaults, defaults in the performance of the affirmative, negative and financial covenants, the inaccuracy of representations or warranties, bankruptcy and insolvency related defaults, defaults relating to judgments, certain events related to employee pension benefit plans under the Employee Retirement Income Security Act of 1974, the failure to pay specified indebtedness and cross-acceleration to specified indebtedness.
Other Commitments, Contingencies and Guarantees
Under our workers’ compensation insurance policies for U.S. employees, we have retained the first $300,000, $250,000 and $250,000 in claim liability per incident with aggregate maximum claim liabilities per year of $2.3 million for the year ended December 31, 2014 and $2.0 million for each of the years ended December 31, 2013 and 2012, respectively. We have recognized cumulative expenses of $1.1 million, $0.5 million, and $0.6 million for claims incurred during the years ended December 31, 2014, 2013 and 2012, respectively. Our estimated liability for workers’ compensation was $1.4 million and $1.2 million as of December 31, 2014 and 2013, respectively. Claims incurred during the years ended December 31, 2014 and 2013 are relatively undeveloped as of December 31, 2014. Therefore, it is possible that we could incur additional healthcare and wage indemnification costs beyond those previously recognized up to our aggregate liability for each of the respective claim years. For the years ended on or prior to December 31, 2012, based on our retained claim liability per incident and our aggregate claim liability per year, our maximum liability in excess of the amounts deemed probable and previously recognized is not material as of December 31, 2014. As of December 31, 2014, we had outstanding letters of credit totaling $1.3 million to the insurance companies as security for these claims in connection with these policies.
Under our current employee healthcare insurance policy for U.S. employees, we retain claims liability risk up to $375,000, $325,000 and $300,000 per incident per year in 2014, 2013 and 2012, respectively. We recognized employee healthcare claim expense of $32.0 million, $29.2 million and $23.0 million during the years ended December 31, 2014, 2013 and 2012, respectively, which includes actual claims paid and an estimate of our liability for the uninsured portion of employee healthcare obligations that have been incurred but not paid. Should employee health insurance claims exceed our estimated liability, we would have further obligations. Our estimated liability for healthcare claims that have been incurred but not paid as of December 31, 2014 and 2013 was $4.1 million and $4.3 million, respectively.
We have total contingent liabilities outstanding of up to $11.8 million primarily related to the achievement of certain revenue milestones. We have recorded $6.3 million of contingent commitments on our consolidated balance sheet at December 31, 2014. The amount of contingent consideration recorded on our consolidated balance sheet at December 31, 2013 was not material. We have not accrued for $5.5 million of contingent liabilities, related to the acquisition of an intangible asset in 2008, as we do not deem the achievement of associated revenue milestones to be probable of occurring as of December 31, 2014.
We are contractually obligated to make the following payments in the years below:
| Contractual obligations (in thousands) | Total | Less than 1 year | 1-3 years | 3-5 years | More than 5 years | ||||||||||||||||||
| Long-term debt obligations (1) | $ | 480,661 | $ | 13,255 | $ | 26,510 | $ | 26,510 | $ | 414,386 | |||||||||||||
| Operating leases | 77,492 | 17,228 | 28,229 | 16,779 | 15,256 | ||||||||||||||||||
| Purchase obligations (2) | 154,947 | 146,189 | 5,798 | 1,840 | 1,120 | ||||||||||||||||||
| Minimum royalty payments | 3,265 | 665 | 1,091 | 1,031 | 478 | ||||||||||||||||||
| Total contractual cash obligations | $ | 716,365 | $ | 177,337 | $ | 61,628 | $ | 46,160 | $ | 431,240 | |||||||||||||
| (1) | Long-term debt amounts include interest payments associated with long-term debt. |
|---|
| (2) | Purchase obligations include agreements and purchase orders to purchase goods or services that are enforceable and legally binding and that specify all significant terms, including fixed or minimum quantities, pricing, and approximate timing of purchase transactions. |
|---|
These commitments do not reflect unrecognized tax benefits of $5.9 million and deferred compensation liabilities of $2.7 million as of December 31, 2014 as the timing of recognition is uncertain. Refer to Note 11 of the consolidated financial statements for the year ended December 31, 2014 included in this Annual Report on Form 10-K for additional discussion of unrecognized tax benefits.
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