STE 12.31.2011 10-Q
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
 
FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2011
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _______ to _______            
Commission File Number 1-14643
____________________________________________________
 STERIS Corporation
(Exact name of registrant as specified in its charter) 
____________________________________________________
Ohio
 
34-1482024
(State or other jurisdiction of
incorporation or organization)
 
(IRS Employer
Identification No.)
 
 
5960 Heisley Road,
Mentor, Ohio
 
44060-1834
(Address of principal executive offices)
 
(Zip code)
440-354-2600
(Registrant’s telephone number, including area code)
____________________________________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer  x
  
Accelerated Filer  o
Non-Accelerated Filer  o
(Do not check if a smaller reporting company)
  
Smaller Reporting Company  o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  x

The number of common shares outstanding as of January 31, 2012: 57,640,053

1

Table of Contents

STERIS Corporation and Subsidiaries
Form 10-Q
Index
 
 
 
Page
 
 
 
 
 


2

Table of Contents

PART 1—FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS


STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
 
 
 
December 31,
2011
 
March 31,
2011
 
 
(Unaudited)
 
 
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
143,787

 
$
193,016

Accounts receivable (net of allowances of $10,229 and $9,085, respectively)
 
251,427

 
272,248

Inventories, net
 
169,412

 
167,344

Deferred income taxes, net
 
43,881

 
56,715

Prepaid expenses and other current assets
 
23,447

 
16,483

Total current assets
 
631,954

 
705,806

Property, plant, and equipment, net
 
378,165

 
370,402

Goodwill and intangibles, net
 
333,819

 
318,810

Other assets
 
32,472

 
31,667

Total assets
 
$
1,376,410

 
$
1,426,685

Liabilities and equity
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable
 
$
70,075

 
$
90,981

Accrued payroll and other related liabilities
 
34,257

 
52,251

Accrued SYSTEM 1 Rebate Program and class action settlement
 
100,234

 
127,683

Accrued expenses and other
 
90,729

 
73,831

Total current liabilities
 
295,295

 
344,746

Long-term indebtedness
 
210,000

 
210,000

Deferred income taxes, net
 
36,144

 
26,662

Other liabilities
 
54,566

 
56,612

Total liabilities
 
$
596,005

 
$
638,020

Commitments and contingencies (see note 10)
 

 

Serial preferred shares, without par value; 3,000 shares authorized; no shares issued or outstanding
 

 

Common shares, without par value; 300,000 shares authorized; 70,040 shares issued; 57,639 and 59,122 shares outstanding, respectively
 
241,787

 
241,343

Common shares held in treasury, 12,401 and 10,918 shares, respectively
 
(353,042
)
 
(305,808
)
Retained earnings
 
880,039

 
816,846

Accumulated other comprehensive income
 
10,481

 
35,188

Total shareholders’ equity
 
779,265

 
787,569

Noncontrolling interest
 
1,140

 
1,096

Total equity
 
780,405

 
788,665

Total liabilities and equity
 
$
1,376,410

 
$
1,426,685

See notes to consolidated financial statements.

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Table of Contents

STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(Unaudited)
 
 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
 
2011
 
2010
 
2011
 
2010
Revenues:
 
 
 
 
 
 
 
 
Product
 
$
239,403

 
$
212,622

 
$
664,918

 
$
486,986

Service
 
115,812

 
115,661

 
351,643

 
342,702

Total revenues
 
355,215

 
328,283

 
1,016,561

 
829,688

Cost of revenues:
 
 
 
 
 
 
 
 
Product
 
145,976

 
123,381

 
402,214

 
340,693

Service
 
71,233

 
67,888

 
210,107

 
198,860

Total cost of revenues
 
217,209

 
191,269

 
612,321

 
539,553

Gross profit
 
138,006

 
137,014

 
404,240

 
290,135

Operating expenses:
 
 
 
 
 
 
 
 
Selling, general, and administrative
 
73,922

 
93,467

 
227,583

 
237,583

Research and development
 
9,196

 
7,739

 
26,867

 
24,391

Restructuring expenses
 
1,164

 
(23
)
 
1,522

 
423

Total operating expenses
 
84,282

 
101,183

 
255,972

 
262,397

Income from operations
 
53,724

 
35,831

 
148,268

 
27,738

Non-operating expenses, net:
 
 
 
 
 
 
 
 
Interest expense
 
3,005

 
3,049

 
9,083

 
9,052

Interest income and miscellaneous expense
 
(373
)
 
(321
)
 
(948
)
 
(671
)
Total non-operating expenses, net
 
2,632

 
2,728

 
8,135

 
8,381

Income before income tax expense
 
51,092

 
33,103

 
140,133

 
19,357

Income tax expense
 
17,443

 
11,338

 
48,189

 
7,091

Net income
 
$
33,649

 
$
21,765

 
$
91,944

 
$
12,266

Net income per common share
 
 
 
 
 
 
 
 
Basic
 
$
0.58

 
$
0.37

 
$
1.57

 
$
0.21

Diluted
 
$
0.58

 
$
0.36

 
$
1.55

 
$
0.20

Cash dividends declared per common share outstanding
 
$
0.17

 
$
0.15

 
$
0.49

 
$
0.41


See notes to consolidated financial statements.


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Table of Contents

STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
 
 
 
Nine Months Ended December 31,
 
 
2011
 
2010
Operating activities:
 
 
 
 
Net income
 
$
91,944

 
$
12,266

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation, depletion, and amortization
 
46,288

 
39,739

Deferred income taxes
 
22,758

 
(52,652
)
Share-based compensation expense
 
5,799

 
8,489

Loss on the disposal of property, plant, equipment, and intangibles, net
 
376

 
1,217

Other items
 
(1,595
)
 
3,637

Changes in operating assets and liabilities, net of effects of acquisitions:
 
 
 
 
Accounts receivable, net
 
20,019

 
2,205

Inventories, net
 
(2,404
)
 
(44,855
)
Other current assets
 
(6,954
)
 
4,188

Accounts payable
 
(21,127
)
 
7,414

Accrued SYSTEM 1 Rebate Program and class action settlement
 
(27,449
)
 
128,770

Accruals and other, net
 
(14,816
)
 
(27,021
)
Net cash provided by operating activities
 
112,839

 
83,397

Investing activities:
 
 
 
 
Purchases of property, plant, equipment, and intangibles, net
 
(54,238
)
 
(56,390
)
Proceeds from the sale of property, plant, equipment, and intangibles
 

 
1,298

Equity investment in joint venture
 

 
(16,900
)
Acquisition of business, net of cash acquired
 
(22,269
)
 
(4,000
)
Net cash used in investing activities
 
(76,507
)
 
(75,992
)
Financing activities:
 
 
 
 
Repurchases of common shares
 
(56,751
)
 
(19,900
)
Cash dividends paid to common shareholders
 
(28,751
)
 
(24,344
)
Stock option transactions, net
 
3,749

 
10,813

Tax benefit from stock options exercised
 
816

 
2,197

Net cash used in financing activities
 
(80,937
)
 
(31,234
)
Effect of exchange rate changes on cash and cash equivalents
 
(4,624
)
 
1,146

Decrease in cash and cash equivalents
 
(49,229
)
 
(22,683
)
Cash and cash equivalents at beginning of period
 
193,016

 
214,971

Cash and cash equivalents at end of period
 
$
143,787

 
$
192,288


See notes to consolidated financial statements.


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Table of Contents

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)

1. Nature of Operations and Summary of Significant Accounting Policies

Nature of Operations

STERIS Corporation, an Ohio corporation, develops, manufactures and markets infection prevention, contamination control, microbial reduction, and surgical and critical care support products and services for healthcare, pharmaceutical, scientific, research, industrial, and governmental Customers throughout the world. As used in this Quarterly Report, STERIS Corporation and its subsidiaries together are called “STERIS,” the “Company,” “we,” “us,” or “our,” unless otherwise noted.

We operate in three reportable business segments: Healthcare, Life Sciences, and STERIS Isomedix Services (“Isomedix”). We describe our business segments in note 11 to our consolidated financial statements titled, “Business Segment Information.” Our fiscal year ends on March 31. References in this Quarterly Report to a particular “year” or “year-end” mean our fiscal year. The significant accounting policies applied in preparing the accompanying consolidated financial statements of the Company are summarized below:

Interim Financial Statements

We prepared the accompanying unaudited consolidated financial statements of the Company according to accounting principles generally accepted in the United States (“U.S. GAAP”) for interim financial information and the instructions to the Quarterly Report on Form 10-Q and Rule 10-01 of Regulation S-X. This means that they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. Our unaudited interim consolidated financial statements contain all material adjustments (consisting of normal recurring accruals and adjustments) management believes are necessary to fairly state our financial condition, results of operations, and cash flows for the periods presented.

These interim consolidated financial statements should be read together with the consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended March 31, 2011, filed with the Securities and Exchange Commission (“SEC”) on May 27, 2011. The Consolidated Balance Sheet at March 31, 2011 was derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

Principles of Consolidation

We use the consolidation method to report our investment in our subsidiaries. Therefore, the accompanying consolidated financial statements include the accounts of the Company and its wholly-owned and majority-owned subsidiaries. We eliminate inter-company accounts and transactions when we consolidate these accounts.

Use of Estimates

We make certain estimates and assumptions when preparing financial statements according to U.S. GAAP that affect the reported amounts of assets and liabilities at the financial statement dates and the reported amounts of revenues and expenses during the periods presented. These estimates and assumptions involve judgments with respect to many factors that are difficult to predict and are beyond our control. Actual results could be materially different from these estimates. We revise the estimates and assumptions as new information becomes available. This means that operating results for the three and nine month periods ended December 31, 2011 are not necessarily indicative of results that may be expected for future quarters or for the full fiscal year ending March 31, 2012.

Recently Adopted Accounting Pronouncements

In September 2011, the FASB issued an accounting standard update titled “Testing Goodwill for Impairment,” which allows an entity the option of performing a qualitative assessment to determine whether it is necessary to perform the current two-step annual impairment test. The guidance permits an entity to assess qualitative factors to determine if it is more-likely-than-not that the fair value of the reporting unit exceeds the carrying amount to determine if the two-step impairment test is required. The guidance does not change how goodwill is calculated or the requirement to test goodwill annually for

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Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



impairment. The new guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. The early adoption of this standard did not have an impact on our consolidated financial position, results of operations or cash flows.

In June 2011, the FASB issued new guidance titled "Comprehensive Income," which altered the presentation of comprehensive income. More specifically, the updated guidance permits an entity to present components of net income and other comprehensive income in either one continuous statement, referred to as the statement of comprehensive income, or in two separate, but consecutive statements. The guidance now eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. These changes to the presentation of comprehensive income do not change the components that are recognized in net income or other comprehensive income under current accounting guidance. This guidance is effective for fiscal years and interim periods beginning after December 15, 2011 and will become effective for us at the beginning of our first quarter of fiscal 2013. The adoption of this standard will not have an impact on our consolidated financial position, results of operations or cash flows.

In April 2011, the FASB issued new guidance titled "Fair Value Measurement," intended to achieve common fair value measurement and disclosure requirements between GAAP and International Financial Reporting Standards. This new guidance amends current fair value measurement and disclosure guidance to include increased transparency regarding valuation inputs and investment categorization. This new guidance is effective for annual and interim periods beginning after December 15, 2011 and will become effective for us at the beginning of our first quarter of fiscal 2013. The adoption of this standard will not have an impact on our consolidated financial position, results of operations or cash flows.

In December 2010, the FASB issued an accounting standard update titled “When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts," amending Accounting Standards Codification (ASC) Topic 350, “Intangibles - Goodwill and Other.”  This guidance amends the ASC requiring entities that have a reporting unit with zero or negative carrying value to assess whether qualitative factors indicate that it is more likely than not that an impairment of goodwill exists. If the entity concludes that it is more likely than not that an impairment exists, the entity must then measure the goodwill impairment. The new guidance, amending the ASC is effective for fiscal 2012 and was applied during our annual goodwill impairment testing in the third quarter of fiscal 2012 and did not impact our results.

In October 2009, the FASB issued an accounting standard update titled “Multiple-Deliverable Revenue Arrangements,” amending Accounting Standards Codification (ASC) Topic 605, “Revenue Recognition.”  This guidance amends the ASC requiring entities to eliminate the residual method of allocation for multiple-deliverable revenue arrangements, requiring arrangement consideration be allocated at the inception of an arrangement to all deliverables using the relative selling price method.  The guidance also established a selling price hierarchy for determining the selling price of a deliverable, which includes: (1) vendor-specific objective evidence if available, (2) third-party evidence if vendor-specific objective evidence is not available, and (3) estimated selling price if neither vendor-specific nor third-party evidence is available.  The guidance was adopted and applied prospectively for multiple element revenue arrangements that are new or materially modified beginning on or after April 1, 2011.  The adoption of this guidance did not impact our financial position or results of operations.


Significant Accounting Policies

A detailed description of our significant and critical accounting policies, estimates, and assumptions is included in our consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2011, filed with the SEC on May 27, 2011. Our significant and critical accounting policies, estimates, and assumptions have not changed materially from March 31, 2011.

The Accrued SYSTEM 1 Rebate Program (the “Rebate Program”), initially recognized during the first quarter of fiscal 2011, is based upon the quantity of SYSTEM 1 processors eligible for rebates and the estimated value of rebates to be provided upon their return. Rebates of $102,313 were recognized as contra-revenue consistent with other returns and allowances offered to Customers. The estimated cost of $7,691 to facilitate the disposal of the returned SYSTEM 1 processors has been recognized as cost of revenues. Both components are recorded as current liabilities. The key assumptions involved in the estimates associated with the Rebate Program include: the number and age of SYSTEM 1 processors eligible for rebates under the Rebate Program, the number of Customers that will elect to participate in the Rebate Program, the proportion of Customers that will choose each rebate option, and the estimated per unit costs of disposal.

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Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)




The number and age of SYSTEM 1 processors has been estimated based on our historical sales and service records and we have assumed that 100% of eligible Customers will elect to participate in the Rebate Program. In order to estimate the portion of Customers that will choose each available rebate option, we first assessed trends in sales of the proprietary consumable products utilized in the SYSTEM 1 processor. We noted a decline of approximately 19% in shipments of SYSTEM 1 consumables during the period between the notice by FDA to healthcare facility administrators and infection control practitioners and the announcement of the Rebate Program, which indicated that a portion of our Customers had already transitioned away from the SYSTEM 1 technology during that period. The remaining 81% provided the best available indication of the portion of Customers projected to elect the rebate for the SYSTEM 1E processor. Order and quote data for fiscal 2011 provided indications of the proportion of Customers that are expected to choose each of the other rebate options. The per unit costs associated with disposal were estimated based on the service hours involved and quotes from our vendors using existing freight and disposal contracts.

2. Restructuring

The following summarizes our restructuring plans announced in prior fiscal years. We recognize restructuring expenses as incurred. In addition, we assess the property, plant and equipment associated with the related facilities for impairment. Additional information regarding our restructuring plans is included in our Annual Report on Form 10-K for the year ended March 31, 2011, filed with the SEC on May 27, 2011.

Fiscal 2010 Restructuring Plan

During the fourth quarter of fiscal 2010 we adopted a restructuring plan primarily related to the transfer of the remaining operations in our Erie, Pennsylvania facility to the U.S. headquarters in Mentor, Ohio and the consolidation of our European Healthcare manufacturing operations into two central locations within Europe (the “Fiscal 2010 Restructuring Plan”). In addition, we rationalized certain products and eliminated certain positions.

Since the inception of the Fiscal 2010 Restructuring Plan, we have incurred pre-tax expenses totaling $9,541 related to these actions, of which $8,512 was recorded as restructuring expenses and $1,029 was recorded in cost of revenues. We also expect to incur an additional $1,100 by the end of fiscal 2012. These actions are intended to enhance profitability and improve efficiencies.

Production has ceased in our Switzerland manufacturing facility. We recognized an impairment loss with regard to this facility based on the value of an offer to purchase that was received during the fiscal 2012 third quarter. The following tables summarize our total pre-tax restructuring expenses for the third quarter and first nine months of fiscal 2012 and fiscal 2011:
 
Three Months Ended December 31, 2011
Fiscal 2010
Restructuring
Plan (1)
Severance, payroll, and other related costs
$
7

Asset impairment and accelerated depreciation
1,157

Lease termination obligation and other
3

Total restructuring charges
$
1,167

(1)
Includes $3 in charges recorded in cost of revenues on Consolidated Statements of Income.
 
Three Months Ended December 31, 2010
Fiscal 2010
Restructuring
Plan (1)
Fiscal 2008
Restructuring
Plan
Total
Severance, payroll, and other related costs
$
489

$

$
489

Asset impairment and accelerated depreciation

(289
)
(289
)
Other
7


7

Total restructuring charges
$
496

$
(289
)
$
207

(1)
Includes $230 in charges recorded in cost of revenues on Consolidated Statements of Income.

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Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



  

Nine Months Ended December 31, 2011
Fiscal 2010
Restructuring
Plan (1)
Fiscal 2008
Restructuring
Plan
Total
Severance, payroll, and other related costs
$
(73
)
$

$
(73
)
Product rationalization
335


335

Asset impairment and accelerated depreciation
1,341


1,341

Lease termination obligation and other
3

(152
)
(149
)
Total restructuring charges
$
1,606

$
(152
)
$
1,454

(1)
Includes $(68) in charges recorded in cost of revenues on Consolidated Statements of Income.
  

Nine Months Ended December 31, 2010
Fiscal 2010
Restructuring
Plan (1)
Fiscal 2008
Restructuring
Plan
Total
Severance, payroll, and other related costs
$
498

$

$
498

Asset impairment and accelerated depreciation
356

(289
)
67

Other
88


88

Total restructuring charges
$
942

$
(289
)
$
653

(1)Includes $230 in charges recorded in cost of revenues on Consolidated Statements of Income.


Liabilities related to restructuring activities are recorded as current liabilities on the accompanying Consolidated Balance Sheets within “Accrued payroll and other related liabilities” and “Accrued expenses and other.” The following table summarizes our liabilities related to these restructuring activities:
 
 
 
Fiscal 2010 Restructuring Plan
 
 
 
 
Fiscal 2012
 
 
 
 
March 31,
2011
 
Provision
 
Payments/
Impairments (1)
 
December 31,
2011
Severance and termination benefits
 
$
1,993

 
$
(73
)
 
$
(863
)
 
$
1,057

Product rationalization
 

 
335

 
(335
)
 

Asset impairments
 

 
1,341

 
(1,341
)
 

Lease termination obligations
 
1,790

 

 
152

 
1,942

Other
 
193

 
3

 
(107
)
 
89

Total
 
$
3,976

 
$
1,606

 
$
(2,494
)
 
$
3,088

(1) Certain amounts reported include the impact of foreign currency movements relative to the U.S. dollar.
 

3. Comprehensive Income

Comprehensive income includes net income as currently reported under U.S. GAAP and other comprehensive income. Other comprehensive income considers the effects of additional economic events that are not required to be recorded in determining net income, but rather are reported as a separate component of shareholders’ equity. The following table illustrates the components of our comprehensive income:
 

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Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
 
2011
 
2010
 
2011
 
2010
Net income
 
$
33,649

 
$
21,765

 
$
91,944

 
$
12,266

Change in cumulative foreign currency translation adjustment
 
(9,823
)
 
793

 
(23,776
)
 
8,935

Amortization of pension and postretirement benefit plans costs, net of taxes
 
(269
)
 
(277
)
 
(809
)
 
(828
)
Unrealized gain (loss) on available for sale securities
 
132

 
109

 
(122
)
 
118

Total comprehensive income
 
$
23,689

 
$
22,390

 
$
67,237

 
$
20,491


4. Property, Plant and Equipment

Information related to the major categories of our depreciable assets is as follows:
 
 
 
December 31,
2011
 
March 31,
2011
Land and land improvements (1)
 
$
32,629

 
$
30,194

Buildings and leasehold improvements
 
221,249

 
201,883

Machinery and equipment
 
302,210

 
286,103

Information systems
 
107,477

 
101,934

Radioisotope
 
206,470

 
194,882

Construction in progress (1)
 
26,478

 
40,665

Total property, plant, and equipment
 
896,513

 
855,661

Less: accumulated depreciation and depletion
 
(518,348
)
 
(485,259
)
Property, plant, and equipment, net
 
$
378,165

 
$
370,402

(1)
Land is not depreciated. Construction in progress is not depreciated until placed in service.
 
5. Inventories, Net

Inventories, net are stated at the lower of cost or market. We use the last-in, first-out (“LIFO”) and first-in, first-out cost methods. An actual valuation of inventory under the LIFO method is made only at the end of the fiscal year based on the inventory levels and costs at that time. Accordingly, interim LIFO calculations are based on management’s estimates of expected year-end inventory levels and are subject to the final fiscal year-end LIFO inventory valuation. Inventory costs include material, labor, and overhead. Inventories, net consisted of the following:
 
 
 
December 31,
2011
 
March 31,
2011
Raw materials
 
$
58,249

 
$
58,375

Work in process
 
23,989

 
16,928

Finished goods
 
87,174

 
92,041

Inventories, net
 
$
169,412

 
$
167,344


6. Debt

Indebtedness was as follows:
 

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Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



 
 
December 31,
2011
 
March 31,
2011
Private Placement
 
$
210,000

 
$
210,000

Credit facility
 

 

Total long term debt
 
$
210,000

 
$
210,000


Additional information regarding our indebtedness is included in the notes to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2011, filed with the SEC on May 27, 2011.

7. Additional Consolidated Balance Sheets Information

Additional information related to our Consolidated Balance Sheets is as follows:
 
 
 
December 31,
2011
 
March 31,
2011
Accrued payroll and other related liabilities:
 
 
 
 
Compensation and related items
 
$
13,629

 
$
16,160

Accrued vacation/paid time off
 
7,638

 
6,379

Accrued bonuses
 
413

 
13,925

Accrued employee commissions
 
8,823

 
11,985

Other postretirement benefit obligations-current portion
 
3,274

 
3,274

Other employee benefit plans' obligations-current portion
 
480

 
528

Total accrued payroll and other related liabilities
 
$
34,257

 
$
52,251

Accrued expenses and other:
 
 
 
 
Deferred revenues
 
$
46,938

 
$
34,396

Self-insured risk reserves-current portion
 
3,074

 
3,610

Accrued dealer commissions
 
8,773

 
7,354

Accrued warranty
 
10,234

 
7,509

Other
 
21,710

 
20,962

Total accrued expenses and other
 
$
90,729

 
$
73,831

Other liabilities:
 
 
 
 
Self-insured risk reserves-long-term portion
 
$
10,233

 
$
10,233

Other postretirement benefit obligations-long-term portion
 
18,603

 
20,526

Defined benefit pension plans obligations-long-term portion
 
5,595

 
8,006

Other employee benefit plans obligations-long-term portion
 
4,061

 
3,897

Accrued long-term income taxes
 
6,432

 
9,140

Other
 
9,642

 
4,810

Total other liabilities
 
$
54,566

 
$
56,612


8. Income Tax Expense

Income tax expense includes United States federal, state and local, and foreign income taxes, and is based on reported pre-tax income. The effective income tax rates for the three month periods ended December 31, 2011 and 2010 were 34.1% and 34.3%, respectively. The effective income tax rates for the nine month periods ended December 31, 2011 and 2010 were 34.4% and 36.6%, respectively.

Income tax expense is provided on an interim basis based upon our estimate of the annual effective income tax rate, adjusted each quarter for discrete items. In determining the estimated annual effective income tax rate, we analyze various factors, including projections of our annual earnings and taxing jurisdictions in which the earnings will be generated, the impact of state and local income taxes, our ability to use tax credits and net operating loss carry forwards, and available tax planning alternatives.


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STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



As of March 31, 2011, we had $9,594 in unrecognized tax benefits, of which $4,975 would favorably impact the effective tax rate if recognized. As of December 31, 2011, we had $6,019 in unrecognized tax benefits, of which $1,400 would favorably impact the effective tax rate if recognized. The decrease in unrecognized tax benefits for the nine months ended December 31, 2011 is primarily due to a decrease in unrecognized tax benefits relating to prior years. We believe that it is reasonably possible that unrecognized tax benefits could decrease by up to $877 within 12 months of December 31, 2011, primarily as a result of settlements with tax authorities. As of December 31, 2011, we have recognized a liability for interest of $946 and penalties of $81.

We operate in numerous taxing jurisdictions and are subject to regular examinations by various United States federal, state, and local, as well as foreign, jurisdictions. We are no longer subject to United States federal examinations for years before fiscal 2010 and, with limited exceptions, we are no longer subject to United States state and local, or non-United States, income tax examinations by tax authorities for years before fiscal 2007. We do not expect the results of these examinations to have a material adverse affect on our consolidated financial statements.

9. Benefit Plans

We provide defined benefit pension plans for certain current and former manufacturing and plant administrative personnel throughout the world as determined by collective bargaining agreements or employee benefit standards set at the time of acquisition of certain businesses. In addition to providing pension benefits to certain employees, we sponsor an unfunded postretirement welfare benefits plan for certain United States former employees, including the same former employees who receive pension benefits under the United States defined benefit pension plan. Benefits under this plan include retiree life insurance and retiree medical coverage, including prescription drug coverage. Additional information regarding our defined benefit pension plans and other postretirement benefits plan is included in our consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2011, filed with the SEC on May 27, 2011.

Components of the net periodic benefit cost for our defined benefit pension plans and other postretirement medical benefits plan were as follows:
 
 
 
Defined Benefit Pension Plans
 
Other
Postretirement
Benefits Plan
 
 
U.S. Qualified
 
International
 
Three Months Ended December 31,
 
2011
 
2010
 
2011
 
2010
 
2011
 
2010
Service cost
 
$
51

 
$
47

 
$
114

 
$
135

 
$

 
$

Interest cost
 
609

 
654

 
66

 
88

 
248

 
292

Expected return on plan assets
 
(821
)
 
(758
)
 
(67
)
 
(95
)
 

 

Recognized losses
 
267

 
267

 

 

 
106

 
97

Amortization of prior service cost
 

 

 

 

 
(816
)
 
(816
)
Net periodic benefit cost (income)
 
$
106

 
$
210

 
$
113

 
$
128

 
$
(462
)
 
$
(427
)

 
 
Defined Benefit Pension Plans
 
Other
Postretirement
Benefits Plan
 
 
U.S. Qualified
 
International
 
Nine Months Ended December 31,
 
2011
 
2010
 
2011
 
2010
 
2011
 
2010
Service cost
 
$
154

 
$
142

 
$
341

 
$
406

 
$

 
$

Interest cost
 
1,828

 
1,963

 
198

 
262

 
743

 
876

Expected return on plan assets
 
(2,463
)
 
(2,275
)
 
(201
)
 
(285
)
 

 

Recognized losses
 
799

 
801

 

 

 
319

 
291

Amortization of prior service cost
 

 

 

 

 
(2,447
)
 
(2,447
)
Net periodic benefit cost (income)
 
$
318

 
$
631

 
$
338

 
$
383

 
$
(1,385
)
 
$
(1,280
)

We contribute amounts to the defined benefit pension plans at least sufficient to meet the minimum requirements as stated in applicable employee benefit laws and local tax laws. We record liabilities for the difference between the fair value of the plan assets and the benefit obligation (the projected benefit obligation for pension plans and the accumulated postretirement benefit

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STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



obligation for other postretirement benefits plans) on our accompanying Consolidated Balance Sheets.

10. Contingencies

We are, and will likely continue to be, involved in a number of legal proceedings, government investigations, and claims, which we believe generally arise in the course of our business, given our size, history, complexity, and the nature of our business, products, Customers, regulatory environment, and industries in which we participate. These legal proceedings, investigations and claims generally involve a variety of legal theories and allegations, including, without limitation, personal injury (e.g., slip and falls, burns, vehicle accidents), product liability or regulation (e.g., based on product operation or claimed malfunction, failure to warn, failure to meet specification, or failure to comply with regulatory requirements), product exposure (e.g., claimed exposure to chemicals, asbestos, contaminants, radiation), property damage (e.g., claimed damage due to leaking equipment, fire, vehicles, chemicals), commercial claims (e.g., breach of contract, economic loss, warranty, misrepresentation), financial (e.g., taxes, reporting), employment (e.g., wrongful termination, discrimination, benefits matters), and other claims for damage and relief.
We believe we have adequately reserved for our current litigation and claims that are probable and estimable, and further believe that the ultimate outcome of these pending lawsuits and claims will not have a material adverse affect on our consolidated financial position or results of operations taken as a whole. Due to their inherent uncertainty, however, there can be no assurance of the ultimate outcome or effect of current or future litigation, investigations, claims or other proceedings (including without limitation the matters discussed below). For certain types of claims, we presently maintain insurance coverage for personal injury and property damage and other liability coverages in amounts and with deductibles that we believe are prudent, but there can be no assurance that these coverages will be applicable or adequate to cover adverse outcomes of claims or legal proceedings against us.
As previously disclosed, we received a warning letter (the “warning letter”) from the FDA on May 16, 2008 regarding our SYSTEM 1® sterile processor and the STERIS 20 sterilant used with the processor (sometimes referred to collectively in the FDA letter and in this note 10 as the “device”). Among other matters, the warning letter included the FDA's assertion that significant changes or modifications had been made in the design, components, method of manufacture, or intended use of the device beyond the FDA's 1988 clearance, such that the FDA believed a new premarket notification submission (known within FDA regulations as a 510(k) submission) should have been made, and the assertion that our failure to make such a submission resulted in violations of applicable law. On July 30, 2008 (with an Addendum on October 9, 2008), we provided a detailed response contending that the assertions in the warning letter were not correct. On November 4, 2008, we received a letter from the FDA (dated November 3, 2008) in which the FDA stated without elaboration that, after reviewing our response, it disagreed with our position and that a new premarket notification submission was required. After discussions with the FDA regarding the November 3rd letter, we received an additional letter on November 6, 2008 from the FDA. The November 6th letter stated that the intent of the November 3rd letter was to inform us of the FDA's preliminary disagreement with our response to the warning letter and, before finalizing a position, the FDA reiterated that it wanted to meet with us to discuss the Company's response, issues related to the warning letter and next steps to resolve any differences between the Company and the FDA. We thereafter met with the FDA and, on January 20, 2009, we announced that we had submitted to the FDA a new liquid chemical sterilant processing system for 510(k) clearance, and we communicated to Customers that we would continue supporting the existing SYSTEM 1 installed base in the U.S. for at least a two year period from that date.
On December 3, 2009, the FDA provided a notice (“notice”) to healthcare facility administrators and infection control practitioners describing FDA's “concerns about the SYSTEM 1 Processor, components and accessories, and FDA recommendations.” In the notice, among other things, FDA stated its belief that the SYSTEM 1 device had been significantly modified, that FDA had not cleared or approved the modified device, and that FDA had not determined whether the SYSTEM 1 was safe or effective for its labeled claims. The notice further stated that use of a device that does not properly sterilize or disinfect a medical or surgical device poses risks to patients and users, including the transmission of pathogens, exposure to hazardous chemicals and affect the quality and functionality of reprocessed instruments. The notice stated that FDA was aware of reports of malfunctions of the SYSTEM 1 that had the potential to cause or contribute to serious injuries to patients, such as infections, or injuries to healthcare staff, such as burns. Included in FDA's December 3, 2009 notice was a recommendation from FDA that if users had acceptable alternatives to meet sterilization and disinfection needs, they should transition to that alternative as soon as possible. After its December 3, 2009 notice, we engaged in extensive discussions with the FDA regarding a comprehensive resolution of this matter. On February 2, 2010, the FDA notified healthcare facility administrators and infection control practitioners that FDA's total recommended time period for transitioning from SYSTEM 1 in the U.S. was 18 months from that date.
On April 5, 2010, we received FDA clearance of the new liquid chemical sterilant processing system (SYSTEM 1E). Also

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STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



in April 2010 we reached agreement with the FDA on the terms of a consent decree (“Consent Decree”). On April 19, 2010, a Complaint and Consent Decree were filed in the U.S. District Court for the Northern District of Ohio, and on April 20, 2010, the Court approved the Consent Decree. In general, the Consent Decree addresses regulatory matters regarding SYSTEM 1, restricts further sales of SYSTEM 1 processors in the U.S., defines certain documentation and other requirements for continued service and support of SYSTEM 1 in the U.S., prohibits the sale of liquid chemical sterilization or disinfection products in the U.S. that do not have FDA clearance, describes various process and compliance matters, and defines penalties in the event of violation of the Consent Decree.
The Consent Decree also provides that we may continue to support our Customers' use of SYSTEM 1 in the U.S., including the sale of consumables, parts and accessories and service for a transition period, not to extend beyond August 2, 2011 (later extended by FDA to August 2, 2012), subject to compliance with requirements for documentation of the Customer's need for continued support and other conditions and limitations (the “Transition Plan”). Our Transition Plan includes the “SYSTEM 1 Rebate Program” (the “Rebate Program”). In April 2010, we began to offer rebates to qualifying Customers. Generally, U.S. Customers that purchased SYSTEM 1 processors directly from us or who were users of SYSTEM 1 at the time the Rebate Program was introduced and who return their units have the option of either a pro-rated cash rebate or a rebate toward the future purchase of new STERIS capital equipment (including SYSTEM 1E) or consumable products. In addition, we provide credits for the return of SYSTEM 1 consumables in unbroken packaging and within shelf life and for the unused portion of SYSTEM 1 service contracts. As a result, we recorded a pre-tax liability of $110,004 related to the SYSTEM 1 Rebate Program during the first quarter of fiscal 2011. Of the $110,004, $102,313 is attributable to the Customer Rebate portion of the Program and was recorded as a reduction of revenues, and $7,691 is attributable to the disposal liability of the SYSTEM 1 units to be returned and was recorded as an increase in cost of revenues. This also resulted in a $110,004 reduction in operating income.
Recording the obligations associated with the Rebate Program requires the use of estimates and assumptions. The use of estimates and assumptions involves judgments with respect to factors that may impact the ultimate outcome and may be beyond management's control. The amount recognized during the first quarter of fiscal 2011 is based upon the quantity of SYSTEM 1 processors eligible for rebates and the estimated value of rebates to be provided upon their return. Rebates of $102,313 were recognized as contra-revenue consistent with other returns and allowances offered to Customers. The estimated cost of $7,691 to facilitate the return and disposal of the processors has been recognized as cost of revenues. Both components are recorded as current liabilities. The key assumptions involved in the estimates associated with the Rebate Program include: the number and age of SYSTEM 1 processors eligible for rebates under the Rebate Program, the number of Customers that will elect to participate in the Rebate Program, the proportion of Customers that will choose each rebate option, and the estimated per unit costs of disposal.
The number and age of SYSTEM 1 processors has been estimated based on our historical sales and service records and we have assumed that 100% of eligible Customers will elect to participate in the Rebate Program. In order to estimate the portion of Customers that will choose each available rebate option, we first assessed trends in sales of the proprietary consumable products utilized in the SYSTEM 1 processor. We noted a decline of approximately 19% in shipments of SYSTEM 1 consumables during the period between the notice by FDA to healthcare facility administrators and infection control practitioners and the announcement of the Rebate Program, which indicated that a portion of our Customers had already transitioned away from the SYSTEM 1 technology during that period. The remaining 81% provided the best available indication of the portion of Customers projected to elect the rebate for the SYSTEM 1E processor. Order and quote data for fiscal 2011 provided indications of the proportion of Customers that were expected to choose each of the other cash and rebate options. The per unit costs associated with disposal were estimated based on the service hours involved and quotes from our vendors using exiting freight and disposal contracts.
Our assumptions regarding the response of our Customers to the Rebate Program could be wrong and actual results could be different from these estimates. Through December 31, 2011, Customers have utilized or committed to utilize rebates totaling approximately $54,385 on orders placed since the initiation of the Rebate Program. If all eligible Customers holding the remaining outstanding SYSTEM 1 units elect the maximum incentive rebate associated with the SYSTEM 1E processor rebate, the total estimated rebate cost of $102,313 would increase to approximately $105,000. Conversely, if all eligible Customers holding the remaining outstanding SYSTEM 1 units elect the cash rebate option, the total estimated rebate cost would decrease to approximately $77,000.
The Consent Decree has defined the resolution of a number of issues regarding SYSTEM 1, and we believe our actions with respect to SYSTEM 1, including the Transition Plan, were and are not recalls, corrections or removals under FDA regulations. However, there is no assurance that these or other claims will not be brought or that judicial, regulatory, administrative or other legal or enforcement actions, notices or remedies will not be pursued, or that action will not be taken in

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STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



respect of the Consent Decree, the Transition Plan, SYSTEM 1, or otherwise with respect to regulatory or compliance matters, as described in this note 10 or in various portions of Item 1A. of Part I contained in our Annual Report on Form 10-K for the year ended March 31, 2011, filed with the SEC on May 27, 2011.
In December of 2010, we began shipping SYSTEM 1E units, after having received FDA clearance for the SYSTEM 1E chemical indicator, which is used in conjunction with the SYSTEM 1E. We also submitted a 510(k) to FDA for an optional spore-based indicator strip for use with SYSTEM 1E. Thereafter, as a result of discussions with FDA, we filed a de novo submission requesting classification of this strip in accordance with Section 513(f)(2) of the Federal Food Drug & Cosmetic Act. The de novo process is part of the initial classification for new devices. This spore-based monitoring strip is an optional accessory and is not required for the proper use of SYSTEM 1E. These actions do not affect the prior clearance of the SYSTEM 1E processor or the SYSTEM 1E chemical indicator. There is no assurance regarding the outcome or timing of the de novo submission.
On February 5, 2010, a complaint was filed by a Customer that claimed to have purchased two SYSTEM 1 devices from STERIS, Physicians of Winter Haven LLC d/b/a Day Surgery Center v. STERIS Corp., Case No. 1:1-cv-00264-CAB (N.D. Ohio). The complaint alleged statutory violations, breaches of various warranties, negligence, failure to warn, and unjust enrichment and Plaintiff sought class certification, damages, and other legal and equitable relief including, without limitation, attorneys' fees and an order requiring STERIS to replace, recall or adequately repair the product and/or to take appropriate regulatory action. On February 7, 2011 we entered into a settlement agreement in which we agreed, among other things, to provide various categories of economic relief for members of the settlement class and not object to plaintiff's counsel's application to the court for attorneys' fees and expenses up to a specified amount. Certification of a settlement class was approved and final approval of the settlement was given by the court in the first quarter of fiscal 2012. During the third quarter of fiscal 2011, we recorded in operating expenses a pre-tax charge of approximately $19,796 related to the settlement of these proceedings. The assumptions regarding the amount of this charge included, among others, the portion of class members participating in the settlement and their choice of the categories of economic relief available for such members. These assumptions may be incorrect and the costs of the settlement may be higher or lower than the charge recorded. Estimates of the actual settlement range from as low as $7,000 and as high as $22,000 depending on the options selected by the class members.
Other civil, criminal, regulatory or other proceedings involving our products or services also could possibly result in judgments, settlements or administrative or judicial decrees requiring us, among other actions, to pay damages or fines or effect recalls, or be subject to other governmental, Customer or other third party claims or remedies, which could materially affect our business, performance, prospects, value, financial condition, and results of operations.
For additional information regarding these matters, see the following portions of our Annual Report on Form 10-K for the fiscal year ended March 31, 2011: “Business - Information with respect to our Business in General - Government Regulation”, and the “Risk Factor” titled: “We may be adversely affected by product liability claims or other legal actions or regulatory or compliance matters, including the Warning Letter and Consent Decree.”, the “Risk Factor” titled: “Our business may be adversely affected as a result of the U.S. Food and Drug Administration notices to healthcare administrators and device manufacturers, and related matters,” and the “Risk Factor” titled “Compliance with the Consent Decree may be more costly and burdensome than anticipated.”
From time to time, STERIS is also involved in legal proceedings as a plaintiff involving contract, patent protection, and other claims asserted by us. Gains, if any, from these proceedings are recognized when they are realized.
We are subject to taxation from United States federal, state, and local, and foreign jurisdictions. Tax positions are settled primarily through the completion of audits within each individual jurisdiction or the closing of statute of limitation. Changes in applicable tax law or other events may also require us to revise past estimates.
We describe income taxes further in Note 8 to our consolidated financial statements titled, “Income Tax Expense”, and in our Annual Report on Form 10-K for the year ended March 31, 2011 filed with the SEC on May 27, 2011.

11. Business Segment Information

We operate and report in three business segments: Healthcare, Life Sciences, and Isomedix. “Corporate and other,” which is presented separately, contains the Defense and Industrial business unit plus costs that are associated with being a publicly traded company and certain other corporate costs.

Our Healthcare segment manufactures and sells infrastructure capital equipment, accessory, consumable, information support and service solutions to healthcare providers, including acute care hospitals and surgery and gastrointestinal centers.

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STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



These solutions aid our Customers in improving the safety, quality, productivity and utility consumption of their surgical, sterile processing, gastrointestinal, and emergency environments.

In May 2011, we acquired the stock of a privately held company with operations located near Sao Paulo, Brazil for approximately $30,000, including cash of $22,269 and contingent consideration that is expected to be paid over the next three years. The acquired company designs and manufactures small, medium, and large sterilizers used by public hospitals, clinics, dental offices and industrial companies (e.g., research laboratories and pharmaceutical research and production companies) and will be integrated into our Healthcare segment. The total purchase price has been allocated to net assets and intangible assets based on the valuation of assets acquired and liabilities assumed. Intangibles, including Customer relationships, technology, trademarks and tradename, and non-compete arrangements total approximately $8,000. The residual purchase price, after allocations to net assets and intangibles, of approximately $11,000 has been allocated to goodwill. The allocation of the purchase price for this acquisition is not final and may be subsequently adjusted.

Our Life Sciences segment manufactures and sells a broad range of capital equipment, formulated cleaning chemistries, and service solutions to pharmaceutical companies, and private and public research facilities around the globe.

Our Isomedix segment operates through a network of facilities located in North America. We sell a comprehensive array of contract sterilization services using gamma irradiation and ethylene oxide (“EO”) technologies. We offer microbial reduction services based on Customer specifications to companies that supply products to the healthcare, industrial, and consumer products industries.

Financial information for each of our segments is presented in the following table. Operating income (loss) for each segment is calculated as the segment’s gross profit less direct expenses and indirect cost allocations, which results in the full allocation of all distribution and research and development expenses, and the partial allocation of corporate costs. These allocations are based upon variables such as segment headcount and revenues. In addition, the Healthcare segment is responsible for the management of all but one manufacturing facility and uses standard cost to sell products to the Life Sciences segment. “Corporate and other” includes the gross profit and direct expense of the Defense and Industrial business unit, as well as certain unallocated corporate costs related to being a publicly traded company and legacy pension and post-retirement benefits.

The accounting policies for reportable segments are the same as those for the consolidated Company. For the three and nine month periods ended December 31, 2011, revenues from a single Customer did not represent ten percent or more of any reportable segment’s revenues. Additional information regarding our segments is included in our consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2011, filed with the SEC on May 27, 2011.

Financial information for each of our segments is presented in the following tables:

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STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



 
 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
 
2011
 
2010
 
2011
 
2010
Revenues:
 
 
 
 
 
 
 
 
Healthcare (1)
 
$
259,055

 
$
237,843

 
$
725,455

 
$
561,723

Life Sciences
 
55,892

 
51,247

 
167,675

 
151,374

Isomedix
 
39,615

 
38,081

 
121,617

 
113,721

Total reportable segments
 
354,562

 
327,171

 
1,014,747

 
826,818

Corporate and other
 
653

 
1,112

 
1,814

 
2,870

Total revenues
 
$
355,215

 
$
328,283

 
$
1,016,561

 
$
829,688

Operating income (loss):
 
 
 
 
 
 
 
 
Healthcare (2) (3)
 
$
33,951

 
$
20,389

 
$
88,213

 
$
(19,460
)
Life Sciences
 
10,297

 
7,345

 
30,820

 
23,075

Isomedix
 
11,750

 
10,250

 
35,924

 
30,858

Total reportable segments
 
55,998

 
37,984

 
154,957

 
34,473

Corporate and other
 
(2,274
)
 
(2,153
)
 
(6,689
)
 
(6,735
)
Total operating income (loss)
 
$
53,724

 
$
35,831

 
$
148,268

 
$
27,738


(1)
Includes a reduction of $102,313 resulting from the SYSTEM 1 Rebate Program in the nine months ended December 31, 2010.
(2)
Includes a reduction of $110,004 resulting from the SYSTEM 1 Rebate Program in the nine months ended December 31, 2010.
(3)
Includes a reduction of $19,796 resulting from a class action settlement in the three and nine month periods ended December 31, 2010.


12. Common Shares

We calculate basic earnings per common share based upon the weighted average number of common shares outstanding. We calculate diluted earnings per share based upon the weighted average number of common shares outstanding plus the dilutive effect of common share equivalents calculated using the treasury stock method. The following is a summary of common shares and common share equivalents outstanding used in the calculations of basic and diluted earnings per share:
 
 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
 
2011
 
2010
 
2011
 
2010
Denominator (shares in thousands):
 
 
 
 
 
 
 
 
Weighted average common shares outstanding—basic
 
57,782

 
59,233

 
58,594

 
59,329

Dilutive effect of common share equivalents
 
455

 
943

 
646

 
832

Weighted average common shares outstanding and common share equivalents—diluted
 
58,237

 
60,176

 
59,240

 
60,161


Options to purchase the following number of common shares were outstanding but excluded from the computation of diluted earnings per share because the combined exercise prices, unamortized fair values, and assumed tax benefits upon exercise were greater than the average market price for the common shares during the periods, so including these options would be anti-dilutive:
 

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STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



 
 
Three Months Ended December 31,
 
Nine Months Ended December 31,
 
 
2011
 
2010
 
2011
 
2010
 
 
(shares in thousands)
 
(shares in thousands)
Number of common share options
 
1,040

 
370

 
644

 
437


13. Repurchases of Common Shares

During the first nine months of fiscal 2012, we repurchased 1,851,510 of our common shares for an aggregate amount of $55,942, representing an average price of $30.21 per common share. We also obtained 22,927 of our common shares during the first nine months of fiscal 2012 in connection with stock based compensation award programs. At December 31, 2011, $118,460 of STERIS common shares remained authorized for repurchase pursuant to a March 2008 Board Authorization. Also, 12,400,503 common shares were held in treasury at December 31, 2011.

14. Share-Based Compensation

We maintain a long-term incentive plan that makes available common shares for grants, at the discretion of the Compensation Committee of the Board of Directors to officers, directors, and key employees in the form of stock options, restricted shares, restricted share units, and stock appreciation rights. Stock options provide the right to purchase our common shares at the market price on the date of grant, subject to the terms of the option plans and agreements. Generally, one-fourth of the stock options granted become exercisable for each full year of employment following the grant date. Stock options granted generally expire 10 years after the grant date, or earlier if the option holder is no longer employed by us. Restricted shares and restricted share units may cliff vest after three or four year periods or vest in installments after the grant date. As of December 31, 2011, 4,568,661 shares remained available for grant under the long-term incentive plan.

The fair value of share-based compensation awards was estimated at their grant date using the Black-Scholes-Merton option pricing model. This model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, characteristics that are not present in our option grants. If the model permitted consideration of the unique characteristics of employee stock options, the resulting estimate of the fair value of the stock options could be different. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our Consolidated Statements of Income. The expense is classified as cost of goods sold, selling, general and administrative expenses or research and development expenses in a manner consistent with the employee’s compensation and benefits.

The following weighted-average assumptions were used for options granted during the first nine months of fiscal 2012 and fiscal 2011:
 
 
 
Fiscal 2012
 
Fiscal 2011
Risk-free interest rate
 
2.41
%
 
2.68
%
Expected life of options
 
5.65 years

 
5.65 years

Expected dividend yield of stock
 
1.78
%
 
1.59
%
Expected volatility of stock
 
29.78
%
 
30.13
%

The risk-free interest rate is based upon the U.S. Treasury yield curve. The expected life of options is reflective of historical experience, vesting schedules and contractual terms. The expected dividend yield of stock represents our best estimate of the expected future dividend yield. The expected volatility of stock is derived by referring to our historical stock prices over a time frame similar to that of the expected life of the grant. An estimated forfeiture rate of 2.08% percent and 2.27% percent was applied in fiscal 2012 and 2011, respectively. This rate is calculated based upon historical activity and represents an estimate of the granted options not expected to vest. If actual forfeitures differ from this calculated rate, we may be required to make additional adjustments to compensation expense in future periods. The assumptions used above are reviewed at the time of each significant option grant, or at least annually.

A summary of share option activity is as follows:

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STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



 
 
 
Number of
Options
 
Weighted
Average
Exercise
Price
 
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
Outstanding at March 31, 2011
 
3,274,395

 
$
25.95

 
 
 
 
Granted
 
325,051

 
35.62

 
 
 
 
Exercised
 
(172,592
)
 
22.38

 
 
 
 
Forfeited
 
(11,084
)
 
27.25

 
 
 
 
Canceled
 
(23,240
)
 
22.93

 
 
 
 
Outstanding at December 31, 2011
 
3,392,530

 
$
27.07

 
5.40

 
$
12,354

Exercisable at December 31, 2011
 
2,505,105

 
$
25.91

 
4.41

 
$
10,464


We estimate that 874,261 of the non-vested stock options outstanding at December 31, 2011 will ultimately vest.

The aggregate intrinsic value in the table above represents the total pre-tax difference between the $29.82 closing price of our common shares on December 31, 2011 over the exercise price of the stock option, multiplied by the number of options outstanding or outstanding and exercisable, as applicable. The aggregate intrinsic value is not recorded for financial accounting purposes and the value changes daily based on the daily changes in the fair market value of our common shares.

The total intrinsic value of stock options exercised during the first nine months of fiscal 2012 and fiscal 2011 was $2,111 and $5,655, respectively. Net cash proceeds from the exercise of stock options were $3,749 and $10,813 for the nine months of fiscal 2012 and fiscal 2011, respectively. The tax benefit from stock option exercises was $816 and $2,197 for the first nine months of fiscal 2012 and fiscal 2011, respectively.

The weighted average grant date fair value of stock option grants was $9.31 and $8.80 for the first nine months of fiscal 2012 and fiscal 2011, respectively.

Stock appreciation rights (“SARS”) carry generally the same terms and vesting requirements as stock options except that they are settled in cash upon exercise and therefore, are classified as liabilities. The fair value of the outstanding SARS as of December 31, 2011 and 2010 was $763 and $1,111, respectively. The fair value of each outstanding SAR is revalued at each reporting date and the related liability and expense are adjusted appropriately.

A summary of the non-vested restricted share activity is presented below:
 
 
 
Number of
Restricted
Shares
 
Weighted-Average
Grant Date
Fair Value
Non-vested at March 31, 2011
 
400,951

 
$
29.70

Granted
 
231,215

 
35.70

Vested
 
(76,743
)
 
30.33

Canceled
 
(11,910
)
 
33.06

Non-vested at December 31, 2011
 
543,513

 
$
32.09


Restricted shares granted are valued based on the closing stock price at the grant date. The value of restricted shares that vested during the first nine months of fiscal 2012 was $2,328.

Cash settled restricted share units carry generally the same terms and vesting requirements as stock settled restricted share units except that they are settled in cash upon vesting and therefore, are classified as liabilities. The fair value of outstanding cash-settled restricted share units as of December 31, 2011 and 2010 was $1,244 and $1,282, respectively. The fair value of each cash-settled restricted share unit is revalued at each reporting date and the related liability and expense are adjusted appropriately.


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Table of Contents
STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



As of December 31, 2011, there was a total of $13,115 in unrecognized compensation cost related to non-vested share-based compensation granted under our share-based compensation plans. We expect to recognize the cost over a weighted average period of 2.42 years.

15. Financial and Other Guarantees

We generally offer a limited parts and labor warranty on capital equipment. The specific terms and conditions of those warranties vary depending on the product sold and the countries where we conduct business. We record a liability for the estimated cost of product warranties at the time product revenues are recognized. The amounts we expect to incur on behalf of our Customers for the future estimated cost of these warranties are recorded as a current liability on the accompanying Consolidated Balance Sheets. Factors that affect the amount of our warranty liability include the number and type of installed units, historical and anticipated rates of product failures, and material and service costs per claim. We periodically assess the adequacy of our recorded warranty liabilities and adjust the amounts as necessary.

Changes in our warranty liability during the first nine months of fiscal 2012 were as follows:
 
 
Fiscal 2012
Balance, March 31, 2011
$
7,509

Warranties issued during the period
5,624

Settlements made during the period
(2,899
)
Balance, December 31, 2011
$
10,234


We also sell product maintenance contracts to our Customers. These contracts range in terms from one to five years and require us to maintain and repair the product over the maintenance contract term. We initially record amounts due from Customers under these contracts as a liability for deferred service contract revenue on the accompanying Consolidated Balance Sheets within “Accrued expenses and other.” The liability recorded for such deferred service revenue was $37,200 and $24,655 as of December 31, 2011 and March 31, 2011, respectively. Such deferred revenue is then amortized on a straight-line basis over the contract term and recognized as service revenue on our accompanying Consolidated Statements of Income. The activity related to the liability for deferred service contract revenues is excluded from the table presented above.

16. Forward and Swap Contracts

From time to time, we enter into forward contracts to hedge potential foreign currency gains and losses that arise from transactions denominated in foreign currencies, including inter-company transactions. We also enter into commodity swap contracts to hedge price changes in commodities that impact raw materials included in our cost of revenues. We do not use derivative financial instruments for speculative purposes. These contracts are not designated as hedging instruments and do not receive hedge accounting treatment; therefore, changes in their fair value are not deferred but are recognized immediately in the Consolidated Statements of Income.

 
 
Asset Derivatives
 
Liability Derivatives
Balance Sheet
 
Fair Value at
 
Fair Value at
 
Fair Value at
 
Fair Value at
Location
 
December 31, 2011
 
March 31, 2011
 
December 31, 2011
 
March 31, 2011
Prepaid & Other
 
$
126

 
$
1,483

 
$

 
$

Accrued expenses and other
 
$

 
$

 
$
2,198

 
$
41


The following table presents the impact of derivative instruments and their location within the Consolidated Statements of Income:
 

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STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



 
 
Location of gain (loss)
recognized in income
 
Amount of gain (loss)
recognized in income
Nine Months Ended
December 31,
2011
 
2010
Foreign currency forward contracts
 
Selling, general and
administrative
 
$
(2,122
)
 
$
943

Commodity swap contracts
 
Cost of revenues
 
$
(1,371
)
 
$
59


17. Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date. We estimate the fair value of financial assets and liabilities using available market information and generally accepted valuation methodologies. The inputs used to measure fair value are classified into three tiers. These tiers include Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring the entity to develop its own assumptions. The following table shows the fair value of our financial assets and liabilities at December 31, 2011:
 
 
 
 
 
Fair Value Measurements at December 31, 2011 Using
 
 
Carrying Value
 
Quoted Prices
in Active Markets
for Identical Assets
 
Significant Other
Observable Inputs
 
Significant
Unobservable
Inputs
December 31, 2011
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
143,787

 
$
143,787

 
$

 
$

Forward and swap contracts (1)
 
126

 

 
126

 

Investments (2)
 
2,823

 
2,823

 

 

Liabilities:
 
 
 
 
 
 
 
 
Forward and swap contracts (1)
 
$
2,198

 
$

 
$
2,198

 
$

Deferred compensation plans (2)
 
2,823

 
2,823

 

 

Long term debt (3)
 
210,000

 

 
249,795

 

Contingent consideration obligations (4)
 
9,195

 

 

 
9,195


(1)
The fair values of forward and swap contracts are based on period-end forward rates and reflect the value of the amount that we would pay or receive for the contracts involving the same notional amounts and maturity dates.
(2)
We provide a domestic non-qualified deferred compensation plan covering certain employees, which allows for the deferral of compensation for an employee-specified term or until retirement or termination. Amounts deferred can be allocated to various hypothetical investment options. The Plan has been amended to disallow deferral elections in respect fiscal year 2013 and subsequent periods. We hold investments, primarily comprised of mutual funds, to satisfy the future obligations of the plan. Changes in the value of the investment accounts are recognized each period based on the fair value of the underlying investments. Employees making deferrals are entitled to receive distributions of their hypothetical account balances (amounts deferred, together with earnings (losses)).
(3)
We estimate the fair value of our long-term debt using discounted cash flow analysis, based on our current incremental borrowing rates for similar types of borrowing arrangements.
(4)
Contingent consideration obligations arise from prior business acquisitions. The fair values are based on discounted cash flow analyzes reflecting the possible achievement of specified performance measures or events and captures the contractual nature of the contingencies, commercial risk, and the time value of money. Contingent consideration obligations are classified in the consolidated balance sheets as accrued expense (short-term) and other liabilities (long-term), as appropriate based on the contractual payment dates.

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STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three and Nine Months Ended December 31, 2011 and 2010
(dollars in thousands, except per share amounts)



18. Subsequent Events

We have evaluated subsequent events through the date the financial statements were filed with the SEC, noting no events that require adjustment of, or disclosure in, the consolidated financial statements for the period ended December 31, 2011. These financial statements should be read in conjunction with the consolidated financial statements and related notes included in the 2011 Annual Report on Form 10-K.

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Report of Independent Registered Public Accounting Firm

Board of Directors and Shareholders
STERIS Corporation
We have reviewed the consolidated balance sheet of STERIS Corporation and subsidiaries, as of December 31, 2011, the related consolidated statements of income for the three-month and nine-month periods ended December 31, 2011 and 2010, and consolidated statements of cash flows for the nine-month periods ended December 31, 2011 and 2010. These financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the consolidated interim financial statements referred to above for them to be in conformity with US generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of STERIS Corporation and subsidiaries as of March 31, 2011, and the related consolidated statements of income, shareholders’ equity, and cash flows for the year then ended, not presented herein, and in our report dated May 27, 2011, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of March 31, 2011 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
/s/ Ernst & Young LLP
Cleveland, Ohio
February 8, 2012


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ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction

In Management’s Discussion and Analysis of Financial Condition and Results of Operations (the “MD&A”), we explain the general financial condition and the results of operations for STERIS including:
 
what factors affect our business;
what our earnings and costs were in each period presented; 
why those earnings and costs were different from prior periods;
where our earnings came from;
how this affects our overall financial condition;
what our expenditures for capital projects were; and
where cash will come from to fund future debt principal repayments, growth outside of core operations, repurchase common shares, pay cash dividends and fund future working capital needs.

As you read the MD&A, it may be helpful to refer to information in our consolidated financial statements, which present the results of our operations for the third quarter and the first nine months of fiscal 2012 and fiscal 2011. It may also be helpful to read the MD&A in our Annual Report on Form 10-K for the year ended March 31, 2011, filed with the SEC on May 27, 2011. In the MD&A, we analyze and explain the period-over-period changes in the specific line items in the Consolidated Statements of Income. Our analysis may be important to you in making decisions about your investments in STERIS.

Financial Measures

In the following sections of the MD&A, we may, at times, refer to financial measures that are not required to be presented in the consolidated financial statements under U.S. GAAP. We sometimes use the following financial measures in the context of this report: backlog; debt-to-total capital; net debt-to-total capital; and days sales outstanding. We define these financial measures as follows:
 
Backlog – We define backlog as the amount of unfilled capital equipment purchase orders at a point in time. We use this figure as a measure to assist in the projection of short-term financial results and inventory requirements.
Debt-to-total capital – We define debt-to-total capital as total debt divided by the sum of total debt and shareholders’ equity. We use this figure as a financial liquidity measure to gauge our ability to borrow and fund growth.
Net debt-to-total capital – We define net debt-to-total capital as total debt less cash (“net debt”) divided by the sum of net debt and shareholders’ equity. We also use this figure as a financial liquidity measure to gauge our ability to borrow and fund growth.
Days sales outstanding (“DSO”) – We define DSO as the average collection period for accounts receivable. It is calculated as net accounts receivable divided by the trailing four quarters’ revenues, multiplied by 365 days. We use this figure to help gauge the quality of accounts receivable and expected time to collect.

We, at times, may also refer to financial measures which are considered to be “non-GAAP financial measures” under SEC rules. We have presented these financial measures because we believe that meaningful analysis of our financial performance is enhanced by an understanding of certain additional factors underlying that performance. These financial measures should not be considered an alternative to measures required by accounting principles generally accepted in the United States. Our calculations of these measures may differ from calculations of similar measures used by other companies and you should be careful when comparing these financial measures to those of other companies. Additional information regarding these financial measures, including reconciliations of each non- GAAP financial measure, is available in the subsection of MD&A titled, "Non-GAAP Financial Measures."

Revenues – Defined

As required by Regulation S-X, we separately present revenues generated as either product revenues or service revenues on our Consolidated Statements of Income for each period presented. When we discuss revenues, we may, at times, refer to revenues summarized differently than the Regulation S-X requirements. The terminology, definitions, and applications of terms that we use to describe revenues may be different from terms used by other companies. We use the following terms to describe revenues:
 
Revenues – Our revenues are presented net of sales returns and allowances.

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Product Revenues – We define product revenues as revenues generated from sales of capital equipment, which includes steam sterilizers, low temperature liquid chemical sterilant processing systems, washing systems, VHP® technology, water stills, and pure steam generators; integrated OR; surgical lights and tables; and the consumable family of products, which includes SYSTEM 1 and SYSTEM 1E consumables, sterility assurance products, skin care products, and cleaning consumables.
Service Revenues – We define service revenues as revenues generated from parts and labor associated with the maintenance, repair, and installation of our capital equipment, as well as revenues generated from contract sterilization offered through our Isomedix segment.
Capital Equipment Revenues – We define capital equipment revenues as revenues generated from sales of capital equipment, which includes steam sterilizers, low temperature liquid chemical sterilant processing systems, including SYSTEM 1 and SYSTEM 1E, washing systems, VHP® technology, water stills, and pure steam generators; surgical lights and tables; and integrated OR.
Consumable Revenues – We define consumable revenues as revenues generated from sales of the consumable family of products, which includes SYSTEM 1 and SYSTEM 1E consumables, sterility assurance products, skin care products, and cleaning consumables.
Recurring Revenues – We define recurring revenues as revenues generated from sales of consumable products and service revenues.
Acquired Revenues – We define acquired revenues as base revenues generated from acquired businesses or assets and additional volumes driven through acquired businesses or assets. We will use such measure for up to a year after acquisition.

General Company Overview and Executive Summary
Our mission is to provide a healthier today and safer tomorrow through knowledgeable people and innovative infection prevention, decontamination and health science technologies, products, and services. Our dedicated employees around the world work together to supply a broad range of solutions by offering a combination of capital equipment, consumables, and services to healthcare, pharmaceutical, industrial, and governmental Customers.
The bulk of our revenues are derived from the healthcare and pharmaceutical industries. Much of the growth in these industries is driven by the aging of the population throughout the world, as an increasing number of individuals are entering their prime healthcare consumption years, and is dependent upon advancement in healthcare delivery, acceptance of new technologies, government policies, and general economic conditions. In addition, each of our core industries is experiencing specific trends that could increase demand. Within healthcare, there is increased concern regarding the level of hospital-acquired infections around the world. The pharmaceutical industry has been impacted by increased FDA scrutiny of cleaning and validation processes, mandating that manufacturers improve their processes. The aging population increases the demand for medical procedures, which increases the consumption of single use medical devices and surgical kits processed by our Isomedix segment.
Beyond our core markets, infection-control issues are a growing global concern, and emerging threats are prominent in the news. We are actively pursuing new opportunities to adapt our proven technologies to meet the changing needs of the global marketplace.

In May 2011, we acquired the stock of a privately held company with operations located near Sao Paulo, Brazil for approximately $30 million, including contingent consideration obligations that are expected to be paid over the next three years. The acquired company designs and manufactures small, medium, and large sterilizers used by public hospitals, clinics, dental offices and industrial companies (e.g., research laboratories and pharmaceutical research and production companies).

During the first quarter of fiscal 2011, we recorded a pre-tax liability related to the SYSTEM 1 Rebate Program. The Rebate Program reduced Healthcare revenues by $102.3 million, increased Healthcare cost of revenues by $7.7 million, and decreased gross margin and operating margin by $110.0 million. The accrual of these estimated rebates and costs increased current liabilities by $110.0 million and did not have a material impact on free cash flow during that period.

Fiscal 2011 third quarter operating expenses include a pre-tax charge of $19.8 million related to the settlement of SYSTEM 1 class action litigation. After tax, the impact of the charge was a reduction in net income of $13.1 million, or $0.22 per diluted share.

Fiscal 2012 third quarter revenues were $355.2 million representing an increase of 8.2% over prior year reflecting increases in the all three reportable business segments. Our gross margin percentage for the fiscal 2012 third quarter decreased to 38.9%, or 280 basis points (bps), from 41.7% in the fiscal 2011 third quarter. The decline in gross margin is primarily due to the reduction in SYSTEM 1 consumable volumes, a shift in mix toward capital equipment revenues, a decline in pricing, and

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an inventory write-off relating to our European consolidation efforts.

Fiscal 2012 first nine months revenues were $1,016.6 million representing an increase of 22.5% over the prior year period. The fiscal 2011 period was negatively impacted by the SYSTEM 1 Rebate Program. When compared to adjusted revenues in the prior year period, excluding the $102,313 negative impact of the SYSTEM 1 Rebate Program, fiscal 2012 first nine months revenues represent an increase of 9.1% (see subsection of MD&A titled "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Our gross margin percentage for the fiscal 2012 first nine months was 39.8%. The fiscal 2011 first nine months gross margin percentage of 35.0% was negatively impacted by the SYSTEM 1 Rebate Program. Adjusted gross margin percentage for the fiscal 2011 first nine months was 42.9% (see subsection of MD&A titled "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Compared to the adjusted gross margin percentage for the fiscal 2011 period, the 310 bps decrease was driven primarily by a shift in mix toward capital equipment, lower SYSTEM 1 consumable volume, a decline in pricing, unfavorable foreign currency fluctuations, and an inventory write-off relating to our European consolidation efforts.

Fiscal 2012 third quarter operating income was $53.7 million compared with $35.8 million for the fiscal 2011 third quarter. The prior year period was negatively impacted by the SYSTEM 1 class action settlement. Fiscal 2012 first nine months operating income was $148.3 million compared with $27.7 million for the first nine months of fiscal 2011. The prior year period was negatively impacted by the recording of the SYSTEM 1 Rebate Program liability and class action settlement.

Free cash flow was $58.6 million in the first nine months of fiscal 2012 compared to $28.3 million in the prior year first nine months, reflecting higher cash from operations resulting primarily from higher cash collections on accounts receivable and a decline in cash used for inventory purchases partially offset by the funding of the SYSTEM 1 Rebate Program (see subsection of MD&A titled "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Our debt-to-total capital ratio was 21.2% at December 31, 2011 and 21.1% at March 31, 2011. During the first nine months of fiscal 2012, we declared and paid cash dividends in the aggregate amount of $0.49 per common share.

Inventory was $169.4 million at December 31, 2011 which reflects an increase from the March 31, 2011 balance of $167.3 million. The higher inventory level is primarily driven by inventory held in support of the SYSTEM 1 Transition Plan. Inventory has declined $15.8 million during the third quarter of fiscal 2012 when compared to September 30, 2011.

Additional information regarding our fiscal 2012 third quarter and first nine months financial performance is included in the subsection below titled “Results of Operations.”

Matters Affecting Comparability

SYSTEM 1 Rebate Program and class action settlement. In April 2010, we introduced the SYSTEM 1 Rebate Program ("Rebate Program") to Customers as a component of our Transition Plan for SYSTEM 1. Generally, U.S. Customers that purchased SYSTEM 1 processors directly from us or who were users of SYSTEM 1 at the time the rebate program was introduced and who return their units have the option of either a pro-rated cash value or rebate toward the future purchase of new STERIS capital equipment or consumable products. In addition, we provide credits for SYSTEM 1 consumables in unbroken packaging and within shelf life and for the unused portion of prepaid SYSTEM 1 services contracts.

During the first quarter of fiscal 2011, we recorded a pre-tax liability related to the SYSTEM 1 Rebate Program. Of the $110.0 million recorded, $102.3 million was attributable to the Customer Rebate portion of the Program and was recorded as a reduction to revenue, and $7.7 million was attributable to the disposal liability of the SYSTEM 1 units to be returned and was recorded in cost of revenues.

Fiscal 2011 third quarter operating expenses include a pre-tax charge of $19.8 million related to the settlement of SYSTEM 1 class action litigation. After tax, the impact of the charge was a reduction in net income of $13.1 million, or $0.22 per diluted share.

International Operations. Since we conduct operations outside of the United States using various foreign currencies, our operating results are impacted by foreign currency movements relative to the U.S. dollar. During the third quarter of fiscal 2012, our revenues were unfavorably impacted by $0.1 million, or 0.1%, and income before taxes was favorably impacted by $1.9 million, or 3.9%, as a result of foreign currency movements relative to the U.S. dollar. During the first nine months of fiscal 2012, our revenues were favorably impacted by $7.7 million, or 0.8%, and income before taxes was unfavorably impacted by $2.6 million, or 1.8%, as a result of foreign currency movements relative to the U.S. dollar.

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NON-GAAP FINANCIAL MEASURES
We, at times, refer to financial measures which are considered to be “non-GAAP financial measures” under SEC rules. We, at times, also refer to our results of operations excluding certain transactions or amounts that are non-recurring or are not indicative of future results, in order to provide meaningful comparisons between the periods presented.
These non-GAAP financial measures are not intended to be, and should not be, considered separately from or as an alternative to the most directly comparable GAAP financial measures.
These non-GAAP financial measures are presented with the intent of providing greater transparency to supplemental financial information used by management and the Board of Directors in their financial analysis and operational decision-making. These amounts are disclosed so that the reader has the same financial data that management uses with the belief that it will assist investors and other readers in making comparisons to our historical operating results and analyzing the underlying performance of our operations for the periods presented.
We believe that the presentation of these non-GAAP financial measures, when considered along with our GAAP financial measures and the reconciliation to the corresponding GAAP financial measures, provide the reader with a more complete understanding of the factors and trends affecting our business than could be obtained absent this disclosure. It is important for the reader to note that the non-GAAP financial measure used may be calculated differently from, and therefore may not be comparable to, a similarly titled measure used by other companies.
We define free cash flow as net cash provided by operating activities as presented in the Consolidated Statements of Cash Flows less purchases of property, plant, equipment, and intangibles plus proceeds from the sale of property, plant, equipment, and intangibles, which are also presented in the Consolidated Statements of Cash Flows. We use this as a measure to gauge our ability to fund future debt principal repayments, growth outside of core operations, repurchase common shares, and pay cash dividends. The following table summarizes the calculation of our free cash flow for the nine month periods ended December 31, 2011 and 2010:

 
 
 
Nine Months Ended December 31,
(dollars in thousands)
 
2011
 
2010
Net cash flows provided by operating activities
 
$
112,839

 
$
83,397

Purchases of property, plant, equipment and intangibles, net
 
(54,238
)
 
(56,390
)
Proceeds from the sale of property, plant, equipment and intangibles
 

 
1,298

Free cash flow
 
$
58,601

 
$
28,305

To supplement our financial results presented in accordance with U.S. GAAP, we have sometimes referred to certain measures of revenues, gross profit, income tax expense, and the Healthcare segment results of operations in the section of MD&A titled, "Results of Operations" excluding the impact of the SYSTEM 1 Rebate Program recorded in the first quarter of fiscal 2011 and the SYSTEM 1 class action settlement recorded in the third quarter of fiscal 2011. These items had a significant impact on the fiscal 2011 first nine months measures and the corresponding trend in each of these measures. We provide adjusted measures to give the reader a more complete understanding of the factors and trends affecting our business than could be obtained absent this disclosure. These measures are used by management and the Board of Directors in making comparisons to our historical operating results and analyzing the underlying performance of our operations. The tables below provide a reconciliation of each of these measures to its most directly comparable GAAP financial measure.

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Table of Contents

(dollars in thousands)
Nine Months Ended
 
December 31, 2010
 
 
Reported revenues
$
829,688

Impact of the SYSTEM 1 Rebate Program
102,313

Adjusted revenues
$
932,001

 
 
Reported capital revenues
256,368

Impact of the SYSTEM 1 Rebate Program
102,313

Adjusted capital revenues
$
358,681

 
 
Reported United States revenues
$
601,703

Impact of the SYSTEM 1 Rebate Program
102,313

Adjusted United States Revenues
$
704,016

 
 
Reported Healthcare revenues
$
561,723

Impact of the SYSTEM 1 Rebate Program
102,313

Adjusted Healthcare revenues
$
664,036

 
 
Reported gross profit
$
290,135

Impact of the SYSTEM 1 Rebate Program
110,004

Adjusted gross profit
$
400,139

 
 
Reported gross profit percentage
35.0
 %
Impact of the SYSTEM 1 Rebate Program
7.9
 %
Adjusted gross profit percentage
42.9
 %
 
 
Reported operating income
$
27,738

Impact of the SYSTEM 1 Rebate Program and class action settlement
129,800

Adjusted operating income
$
157,538

 
 
Reported Healthcare operating (loss)
$
(19,460
)
Impact of the SYSTEM 1 Rebate Program and class action settlement
129,800

Adjusted Healthcare operating income
$
110,340

 
 
Reported income tax expense
$
7,091

Impact of the SYSTEM 1 Rebate Program and class action settlement
47,164

Adjusted income tax expense
$
54,255

 
 
Reported effective income tax rate
36.6
 %
Impact of the SYSTEM 1 Rebate Program and class action settlement
(0.2
)%
Adjusted effective income tax rate
36.4
 %

Results of Operations

In the following subsections, we discuss our earnings and the factors affecting them for the third quarter and first nine months of fiscal 2012 compared with the same fiscal 2011 periods. We begin with a general overview of our operating results and then separately discuss earnings for our operating segments.


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Revenues. The following table compares our revenues for the three and nine months ended December 31, 2011 to the revenues for the three and nine months ended December 31, 2010:
 
 
Three Months Ended
 
  
 
 
 
December 31,
 
 
 
 
(dollars in thousands)
2011
 
2010
 
Change
 
Percent Change
 
 
 
 
 
 
 
 
Total revenues
$
355,215

 
$
328,283

 
$
26,932

 
8.2
 %
 
 
 
 
 
 
 
 
Revenues by type:
 
 
 
 
 
 
 
Capital equipment revenues
165,290

 
135,121

 
30,169

 
22.3
 %
Consumable revenues
74,113

 
77,501

 
(3,388
)
 
(4.4
)%
Service revenues
115,812

 
115,661

 
151

 
0.1
 %
 
 
 
 
 
 
 
 
Revenues by geography:
 
 
 
 
 
 
 
United States revenues
263,540

 
239,975

 
23,565

 
9.8
 %
International revenues
91,675

 
88,308

 
3,367

 
3.8
 %
 
 
 
 
 
 
 
 

 
Nine Months Ended
 
  
 
 
 
December 31,
 
 
 
 
(dollars in thousands)
2011
 
2010
 
Change
 
Percent Change
 
 
 
 
 
 
 
 
Total revenues
$1,016,561
 
$829,688
 
$186,873
 
22.5
 %
 
 
 
 
 
 
 
 
Revenues by type:
 
 
 
 
 
 
 
Capital equipment revenues
439,134

 
256,368

 
182,766

 
71.3
 %
Consumable revenues
225,784

 
230,618

 
(4,834
)
 
(2.1
)%
Service revenues
351,643

 
342,702

 
8,941

 
2.6
 %
 
 
 
 
 
 
 
 
Revenues by geography:
 
 
 
 
 
 
 
United States revenues
766,011

 
601,703

 
164,308

 
27.3
 %
International revenues
250,550

 
227,985

 
22,565

 
9.9
 %
 
 
 
 
 
 
 
 
Quarter over Quarter Comparison

Revenues increased $26.9 million, or 8.2%, to $355.2 million for the quarter ended December 31, 2011, as compared to $328.3 million for the same prior year quarter. Capital equipment revenues increased $30.2 million, or 22.3%, in the third quarter of fiscal 2012, as compared to the third quarter of fiscal 2011. Capital equipment revenues increased in both the Healthcare and Life Sciences segments. Within Healthcare, the increase was primarily attributable to shipments of SYSTEM 1E units. Consumable revenues declined $3.4 million, or 4.4%, for the quarter ended December 31, 2011, as compared to the prior year quarter, attributable to reductions in SYSTEM 1 consumables within the Healthcare segment which were partially offset by growth in consumables within the Life Sciences segment. Service revenues increased $0.2 million, or 0.1%, in the third quarter of fiscal 2012 reflecting growth in Isomedix offset by declines in Healthcare and Life Sciences.

International revenues increased $3.4 million, or 3.8%, to $91.7 million for the quarter ended December 31, 2011, as compared to $88.3 million for the same prior year quarter. International revenues were favorably impacted by increases in

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capital equipment revenues which increased 2.1% primarily due to increases within Latin America and Canada. International recurring revenues increased during the third quarter of fiscal 2012 by 6.1%, led primarily by increases in consumable revenues in Europe and Latin America.

United States revenues increased $23.6 million, or 9.8%, to $263.5 million for the quarter ended December 31, 2011, as compared to $240.0 million for the same prior year quarter. Higher capital equipment revenues in both the Healthcare and Life Sciences business segments combined with growth in Isomedix service revenues drove the increase. These increases were partially offset by a decline in consumable and service revenues driven by the SYSTEM 1 transition.
First Nine Months over First Nine Months Comparison

Revenues increased $186.9 million, or 22.5%, to $1,016.6 million for the first nine months of fiscal 2012. The first nine months of fiscal 2011 was negatively impacted by the SYSTEM 1 Rebate Program. Adjusted revenues, excluding the impact of the SYSTEM 1 Rebate Program, for the first nine months of fiscal 2011 were $932.0 million (see subsection of MD&A titled "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Capital equipment revenues increased $182.8 million or 71.3%. The prior year period was negatively impacted by the SYSTEM 1 Rebate Program. Capital equipment revenues increased 22.5% when compared to adjusted capital equipment revenues for the first nine months of fiscal 2011 of $358.7 million (see subsection of MD&A titled "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). The increase was driven by improved demand within all geographies -- North America, Europe, Asia Pacific and Latin America. Recurring revenues increased $4.1 million or 0.7% for the first nine months of fiscal 2012 as a result of weaker demand in the United States for SYSTEM 1 consumables partially offset the impact of growth internationally in consumables and service.

International revenues for the first nine months of fiscal 2012 were $250.6 million, an increase of $22.6 million, or 9.9%, as compared to the first nine months of fiscal 2011. Fiscal 2012 year-to-date international revenues were favorably impacted by an 11.0% increase in capital equipment revenue and an 8.6% increase in recurring revenues, reflecting increases in both consumable and service revenues of 9.4% and 7.8%, respectively.

United States revenues for the first nine months of fiscal 2012 increased $164.3 million, or 27.3%, as compared to the first nine months of fiscal 2011. United States revenues in the prior year first nine months were negatively impacted by the SYSTEM 1 Rebate Program. Adjusted United States revenues for the first nine months of fiscal 2011 were $704.0 million. United States revenues for the first nine months of fiscal 2012 increased $62.0 million, or 8.8%, when compared to adjusted United States revenues for the first nine months of fiscal 2011 (see subsection of MD&A titled "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). The fiscal 2012 year-to-date increase in United States revenues was driven by increases in capital equipment revenues, including those derived from SYSTEM 1E, and service revenues generated by our Isomedix segment. These increases were partially offset by a 5.6% decrease in consumable revenues.
Revenues by segment are further discussed in the section of MD&A titled, "Business Segment Results of Operations."

Gross Profit. The following table compares our gross profit for the three and nine months ended December 31, 2011 to the three and nine months ended December 31, 2010:
 
 
 
Three Months Ended
 
Change
 
Percent
Change
 
 
December 31,
 
(dollars in thousands)
 
2011
 
2010
 
Gross Profit:
 
 
 
 
 
 
 
 
Product
 
$
93,427

 
$
89,241

 
$
4,186

 
4.7
 %
Service
 
44,579

 
47,773

 
(3,194
)
 
(6.7
)%
Total Gross Profit
 
$
138,006

 
$
137,014

 
$
992

 
0.7
 %
Gross Profit Percentage:
 
 
 
 
 
 
 
 
Product
 
39.0
%
 
42.0
%
 
 
 
 
Service
 
38.5
%
 
41.3
%
 
 
 
 
Total Gross Profit Percentage
 
38.9
%
 
41.7
%
 
 
 
 



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Nine Months Ended
 
Change
 
Percent
Change
 
 
December 31,
 
(dollars in thousands)
 
2011
 
2010
 
Gross Profit:
 
 
 
 
 
 
 
 
Product
 
$
262,704

 
$
146,293

 
$
116,411

 
79.6
 %
Service
 
141,536

 
143,842

 
(2,306
)
 
(1.6
)%
Total Gross Profit
 
$
404,240

 
$
290,135

 
$
114,105

 
39.3
 %
Gross Profit Percentage:
 
 
 
 
 
 
 
 
Product
 
39.5
%
 
30.0
%
 
 
 
 
Service
 
40.2
%
 
42.0
%
 
 
 
 
Total Gross Profit Percentage
 
39.8
%
 
35.0
%
 
 
 
 

Our gross profit percentage is affected by the volume, pricing, and mix of sales of our products and services, as well as the costs associated with the products and services that are sold. Gross profit percentage for the third quarter of fiscal 2012 compared to the third quarter of fiscal 2011 decreased 280 bps to 38.9% from 41.7%. The fiscal 2012 period was negatively impacted by the SYSTEM 1 transition (approximately 140 bps) primarily reflecting the decline in SYSTEM 1 consumable volumes, a shift in mix toward capital equipment revenues, a decline in pricing (approximately 30 bps), and an inventory write-off of $1.1 million relating to our European consolidation efforts.

Gross profit percentage for the first nine months of fiscal 2012 was 39.8%. The fiscal 2011 first nine month period gross profit percentage of 35.0% was negatively impacted by the SYSTEM 1 Rebate Program. Excluding the impact of the SYSTEM 1 Rebate Program, adjusted gross profit percentage for the first nine months of fiscal 2011 period was 42.9% (see subsection of MD&A titled "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Therefore, the gross profit percentage has decreased 310 bps for the first nine months of fiscal 2012 compared to the adjusted gross profit percentage for the first nine months of fiscal 2011 driven by the SYSTEM 1 transition (approximately 140 bps), including the impact of the decline in SYSTEM 1 consumable volumes, a shift in mix toward capital equipment revenues, higher material costs (approximately 40 bps), the unfavorable impact of foreign currency fluctuations (approximately 20 bps), a decline in pricing (approximately 10 bps), and an inventory write-off of $1.1 million relating to our European consolidation efforts.

Operating Expenses. The following table compares our operating expenses for the three and nine month periods ended December 31, 2011 to the three and nine month periods ended December 31, 2010:
 
  
 
Three Months Ended December 31,
 
Change
 
Percent
Change
(dollars in thousands)
 
2011
 
2010
 
Operating Expenses:
 
 
 
 
 
 
 
 
Selling, General, and Administrative
 
$
73,922

 
$
93,467

 
$
(19,545
)
 
(20.9
)%
Research and Development
 
9,196

 
7,739

 
1,457

 
18.8
 %
Restructuring expenses
 
1,164

 
(23
)
 
1,187

 
NM
Total Operating Expenses
 
$
84,282

 
$
101,183

 
$
(16,901
)
 
(16.7
)%
NM - Not meaningful.
  
 
Nine Months Ended December 31,
 
Change
 
Percent
Change
(dollars in thousands)
 
2011
 
2010
 
Operating Expenses:
 
 
 
 
 
 
 
 
Selling, General, and Administrative
 
$
227,583

 
$
237,583

 
$
(10,000
)
 
(4.2
)%
Research and Development
 
26,867

 
24,391

 
2,476

 
10.2
 %
Restructuring expenses
 
1,522

 
423