Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
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þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended June 30, 2016
OR
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o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
Commission File No. 1-11083
BOSTON SCIENTIFIC CORPORATION
(Exact name of registrant as specified in its charter)
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DELAWARE | 04-2695240 |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) |
300 BOSTON SCIENTIFIC WAY, MARLBOROUGH, MASSACHUSETTS 01752-1234
(Address of principal executive offices) (zip code)
(508) 683-4000
(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 þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted 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 þ 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.
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Large accelerated filer þ | Accelerated filer o | Non-Accelerated filer o | Smaller reporting company o |
| | (Do not check if a smaller reporting company) | |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
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| | Shares outstanding |
Class | | as of July 29, 2016 |
Common Stock, $.01 par value | | 1,360,743,339 |
TABLE OF CONTENTS
PART I
FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
BOSTON SCIENTIFIC CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
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| | | | | | | | | | | | | | | |
| Three Months Ended June 30, | | Six Months Ended June 30, |
in millions, except per share data | 2016 | | 2015 | | 2016 | | 2015 |
| | | | | | | |
Net sales | $ | 2,126 |
| | $ | 1,843 |
| | $ | 4,090 |
| | $ | 3,611 |
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Cost of products sold | 639 |
| | 540 |
| | 1,211 |
| | 1,060 |
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Gross profit | 1,487 |
| | 1,303 |
| | 2,879 |
| | 2,551 |
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Operating expenses: | | | | | | | |
Selling, general and administrative expenses | 779 |
| | 700 |
| | 1,497 |
| | 1,367 |
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Research and development expenses | 222 |
| | 220 |
| | 431 |
| | 412 |
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Royalty expense | 20 |
| | 18 |
| | 39 |
| | 36 |
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Amortization expense | 135 |
| | 116 |
| | 271 |
| | 229 |
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Intangible asset impairment charges | — |
| | 9 |
| | — |
| | 9 |
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Contingent consideration expense (benefit) | 33 |
| | 19 |
| | 37 |
| | 46 |
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Restructuring charges | 14 |
| | 3 |
| | 17 |
| | 9 |
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Litigation-related charges (credits) | 618 |
| | (1 | ) | | 628 |
| | 192 |
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Pension termination charges | — |
| | — |
| | — |
| | 8 |
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| 1,821 |
| | 1,084 |
| | 2,920 |
| | 2,308 |
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Operating income (loss) | (334 | ) | | 219 |
| | (41 | ) | | 243 |
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Other income (expense): | | | | | | | |
Interest expense | (59 | ) | | (106 | ) | | (118 | ) | | (167 | ) |
Other, net | (4 | ) | | (8 | ) | | (10 | ) | | (22 | ) |
Income (loss) before income taxes | (397 | ) | | 105 |
| | (169 | ) | | 54 |
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Income tax expense (benefit) | (190 | ) | | 3 |
| | (164 | ) | | (47 | ) |
Net income (loss) | $ | (207 | ) | | $ | 102 |
| | $ | (5 | ) | | $ | 101 |
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Net income (loss) per common share — basic | $ | (0.15 | ) | | $ | 0.08 |
| | $ | (0.00 | ) | | $ | 0.08 |
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Net income (loss) per common share — assuming dilution | $ | (0.15 | ) | | $ | 0.08 |
| | $ | (0.00 | ) | | $ | 0.07 |
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Weighted-average shares outstanding | | | | | | | |
Basic | 1,357.4 |
| | 1,341.3 |
| | 1,353.9 |
| | 1,337.5 |
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Assuming dilution | 1,357.4 |
| | 1,361.8 |
| | 1,353.9 |
| | 1,359.7 |
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See notes to the unaudited condensed consolidated financial statements.
BOSTON SCIENTIFIC CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED)
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| Three Months Ended June 30, | | Six Months Ended June 30, |
(in millions) | 2016 | | 2015 | | 2016 | | 2015 |
Net income (loss) | $ | (207 | ) | | $ | 102 |
| | $ | (5 | ) | | $ | 101 |
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Other comprehensive income (loss): | | | | | | | |
Foreign currency translation adjustment | (21 | ) | | 5 |
| | (5 | ) | | (30 | ) |
Net change in unrealized gains and losses on derivative financial instruments, net of tax | (84 | ) | | (43 | ) | | (153 | ) | | (15 | ) |
Net change in certain retirement plans, net of tax | — |
| | — |
| | — |
| | 5 |
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Total other comprehensive income (loss) | (105 | ) | | (38 | ) | | (158 | ) | | (40 | ) |
Total comprehensive income (loss) | $ | (312 | ) | | $ | 64 |
| | $ | (163 | ) | | $ | 61 |
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See notes to the unaudited condensed consolidated financial statements.
BOSTON SCIENTIFIC CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
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| As of |
| June 30, | | December 31, |
in millions, except share and per share data | 2016 | | 2015 |
| (Unaudited) | | |
ASSETS | | | |
Current assets: | | | |
Cash and cash equivalents | $ | 438 |
| | $ | 319 |
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Trade accounts receivable, net | 1,387 |
| | 1,275 |
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Inventories | 981 |
| | 1,016 |
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Deferred and prepaid income taxes | 78 |
| | 496 |
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Other current assets | 446 |
| | 365 |
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Total current assets | 3,330 |
| | 3,471 |
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Property, plant and equipment, net | 1,487 |
| | 1,490 |
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Goodwill | 6,475 |
| | 6,473 |
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Other intangible assets, net | 5,930 |
| | 6,194 |
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Other long-term assets | 616 |
| | 505 |
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TOTAL ASSETS | $ | 17,838 |
| | $ | 18,133 |
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LIABILITIES AND STOCKHOLDERS’ EQUITY | | | |
Current liabilities: | | | |
Current debt obligations | $ | 254 |
| | $ | 3 |
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Accounts payable | 284 |
| | 209 |
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Accrued expenses | 2,236 |
| | 1,970 |
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Other current liabilities | 408 |
| | 248 |
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Total current liabilities | 3,182 |
| | 2,430 |
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Long-term debt | 5,173 |
| | 5,674 |
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Deferred income taxes | 24 |
| | 735 |
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Other long-term liabilities | 3,239 |
| | 2,974 |
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Commitments and contingencies |
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Stockholders’ equity | | | |
Preferred stock, $.01 par value - authorized 50,000,000 shares, none issued and outstanding |
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Common stock, $.01 par value - authorized 2,000,000,000 shares - issued 1,606,264,833 shares as of June 30, 2016 and 1,594,213,786 shares as of December 31, 2015 | 18 |
| | 16 |
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Treasury stock, at cost - 247,566,270 shares as of June 30, 2016 and 247,566,270 shares as of December 31, 2015 | (1,717 | ) | | (1,717 | ) |
Additional paid-in capital | 16,923 |
| | 16,860 |
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Accumulated deficit | (8,934 | ) | | (8,927 | ) |
Accumulated other comprehensive income (loss), net of tax | (70 | ) | | 88 |
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Total stockholders’ equity | 6,220 |
| | 6,320 |
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TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY | $ | 17,838 |
| | $ | 18,133 |
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See notes to the unaudited condensed consolidated financial statements.
BOSTON SCIENTIFIC CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
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| Six Months Ended June 30, |
in millions | 2016 | | 2015 |
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Cash provided by (used for) operating activities | $ | 537 |
| | $ | (137 | ) |
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Investing activities: | | | |
Purchases of property, plant and equipment | (138 | ) | | (92 | ) |
Proceeds from disposal of property, plant and equipment | 29 |
| | — |
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Purchases of privately-held securities | (36 | ) | | (140 | ) |
Purchases of notes receivable | (5 | ) | | — |
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Payments for acquisitions of businesses, net of cash acquired | — |
| | (63 | ) |
Payments for investments and acquisitions of certain technologies | — |
| | (2 | ) |
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Cash provided by (used for) investing activities | (150 | ) | | (297 | ) |
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Financing activities: | | | |
Payments on long-term borrowings | (250 | ) | | (1,000 | ) |
Proceeds from long-term borrowings, net of debt issuance costs | — |
| | 1,831 |
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Payment of contingent consideration | (35 | ) | | (87 | ) |
Proceeds from borrowings on credit facilities | 40 |
| | 395 |
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Payments on borrowings from credit facilities | (40 | ) | | (395 | ) |
Cash used to net share settle employee equity awards | (56 | ) | | (62 | ) |
Proceeds from issuances of shares of common stock | 73 |
| | 70 |
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Cash provided by (used for) financing activities | (268 | ) | | 752 |
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Effect of foreign exchange rates on cash | — |
| | (2 | ) |
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Net increase (decrease) in cash and cash equivalents | 119 |
| | 316 |
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Cash and cash equivalents at beginning of period | 319 |
| | 587 |
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Cash and cash equivalents at end of period | $ | 438 |
| | $ | 903 |
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Supplemental Information | | | |
Stock-based compensation expense | $ | 58 |
| | $ | 53 |
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Fair value of contingent consideration recorded in purchase accounting | — |
| | 31 |
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See notes to the unaudited condensed consolidated financial statements.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE A – BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements of Boston Scientific Corporation have been prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP) and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for fair presentation have been included. Operating results for the three and six month periods ended June 30, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016. For further information, refer to the consolidated financial statements and footnotes thereto included in Item 8 of our most recent Annual Report on Form 10-K.
Subsequent Events
We evaluate events occurring after the date of our most recent accompanying unaudited condensed consolidated balance sheets for potential recognition or disclosure in our financial statements. We did not identify any material subsequent events requiring adjustment to our accompanying unaudited condensed consolidated financial statements (recognized subsequent events) for the three and six month periods ended June 30, 2016. Those items requiring disclosure (unrecognized subsequent events) in the financial statements have been disclosed accordingly. Refer to Note B - Acquisitions and Strategic Investments, Note H - Income Taxes and Note I - Commitments and Contingencies for more information.
Pension Termination Charges
Following our 2006 acquisition of Guidant Corporation, we sponsored the Guidant Retirement Plan, a frozen noncontributory defined benefit plan covering a select group of current and former employees. The plan was partially frozen as of September 25, 1995 and completely frozen as of May 31, 2007. The plan was subsequently terminated effective December 1, 2014. During 2015, we finalized the termination process and settled the plan’s obligations, and as a result, we recorded pension termination charges of $8 million during the first half of 2015 and an additional $36 million during the third quarter of 2015 for a total of $44 million of pension termination charges in the year ended December 31, 2015. We do not expect to record any additional pension termination charges in 2016 related to the termination of the Guidant Retirement Plan.
NOTE B – ACQUISITIONS AND STRATEGIC INVESTMENTS
2016 Acquisitions
We did not close any material acquisitions during the first half of 2016.
On July 27, 2016, we acquired Cosman Medical, Inc. (Cosman), a privately held manufacturer of radiofrequency ablation systems, expanding our Neuromodulation portfolio and offering physicians treating patients with chronic pain a wider choice of non-opioid therapeutic options. We plan to begin the process of integrating Cosman into our Neuromodulation business during the second half of 2016.
2015 Acquisitions
Xlumena, Inc.
On April 2, 2015, we acquired Xlumena, Inc. (Xlumena), a medical device company that developed minimally invasive devices for Endoscopic Ultrasound (EUS) guided transluminal drainage of targeted areas within the gastrointestinal tract. The purchase agreement called for an up-front payment of $63 million, an additional payment of $13 million upon FDA clearance of the HOT AXIOS™ product, and further sales-based milestones based on sales achieved through 2018. We are in the process of integrating Xlumena into our Endoscopy business, and expect the integration to be substantially complete by the end of 2016.
Purchase Price Allocation
We accounted for the acquisition of Xlumena as a business combination and, in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification® (ASC) Topic 805, Business Combinations, we have recorded the assets acquired and liabilities assumed at their respective fair values as of the acquisition date. The components of the aggregate purchase price are as follows (in millions):
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Cash, net of cash acquired | $ | 63 |
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Fair value of contingent consideration | 31 |
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| $ | 94 |
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The following summarizes the aggregate purchase price allocation for the 2015 acquisition as of June 30, 2015 (in millions):
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Goodwill | $ | 30 |
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Amortizable intangible assets | 68 |
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Inventory | 1 |
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Other net assets | 2 |
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Deferred income taxes | (7 | ) |
| $ | 94 |
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We allocated a portion of the purchase price to specific intangible asset categories as follows:
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| Amount Assigned (in millions) | | Weighted Average Amortization Period (in years) | | Range of Risk- Adjusted Discount Rates used in Purchase Price Allocation |
Amortizable intangible assets: | | | | | |
Technology-related | $ | 68 |
| | 11 | | 15 | % |
| $ | 68 |
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Contingent Consideration
Certain of our acquisitions involve contingent consideration arrangements. Payment of additional consideration is generally contingent on the acquired company reaching certain performance milestones, including attaining specified revenue levels, achieving product development targets and/or obtaining regulatory approvals. In accordance with U.S. GAAP, we recognize a liability equal to the fair value of the contingent payments we expect to make as of the acquisition date. We re-measure this liability each reporting period and record changes in the fair value through a separate line item within our condensed consolidated statements of operations.
We recorded net expenses related to the changes in fair value of our contingent consideration liabilities of $33 million during the second quarter of 2016, $37 million during the first half of 2016, $19 million during the second quarter of 2015 and $46 million during the first half of 2015. We paid contingent consideration of $14 million during the second quarter of 2016, $77 million during the first half of 2016, $11 million during the second quarter of 2015 and $110 million during the first half of 2015.
Changes in the fair value of our contingent consideration liabilities were as follows (in millions):
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Balance as of December 31, 2015 | $ | 246 |
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Other amounts recorded related to prior acquisitions | 1 |
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Fair value adjustments | 37 |
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Contingent payments related to prior period acquisitions | (77 | ) |
Balance as of June 30, 2016 | $ | 207 |
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As of June 30, 2016, the maximum amount of future contingent consideration (undiscounted) that we could be required to pay was approximately $1.572 billion.
Contingent consideration liabilities are remeasured to fair value each reporting period using projected revenues, discount rates, probabilities of payment and projected payment dates. The recurring Level 3 fair value measurements of our contingent consideration liabilities include the following significant unobservable inputs:
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Contingent Consideration Liabilities | Fair Value as of June 30, 2016 | Valuation Technique | Unobservable Input | Range |
R&D, regulatory and commercialization-based Milestones | $17 million | Discounted Cash Flow | Discount Rate | 2.0% - 2.9% |
Probability of Payment | 0% - 64% |
Projected Year of Payment | 2018 - 2021 |
Revenue-based Payments | $41 million | Discounted Cash Flow | Discount Rate | 14% - 15% |
Projected Year of Payment | 2017 - 2020 |
$149 million | Monte Carlo | Revenue Volatility | 20% |
Risk Free Rate | LIBOR Term Structure & Cost of Debt Structure |
Projected Year of Payment | 2016 - 2022 |
Increases or decreases in the fair value of our contingent consideration liabilities can result from changes in discount periods and rates, as well as changes in the timing and amount of revenue estimates or in the timing or likelihood of achieving R&D, regulatory commercialization-based and revenue-based milestones. Projected contingent payment amounts related to some of our R&D, regulatory and commercialization-based and revenue-based milestones are discounted back to the current period using a discounted cash flow (DCF) model. Other revenue-based payments are valued using a Monte Carlo valuation model, which simulates future revenues during the earn-out period using management's best estimates. Projected revenues are based on our most recent internal operational budgets and long-range strategic plans. Increases in projected revenues and probabilities of payment may result in higher fair value measurements. Increases in discount rates and the time to payment may result in lower fair value measurements. Increases or decreases in any of those inputs together, or in isolation, may result in a significantly lower or higher fair value measurement.
Strategic Investments
We did not close any material strategic investments during the first half of 2016.
On April 30, 2015, we acquired a 27 percent ownership interest in Preventice, Inc. (Preventice), which includes 18.5 percent of Preventice's common stock. Preventice is a privately-held company headquartered in Minneapolis, MN, and a leading developer of mobile health solutions and services. Preventice offers a full portfolio of wearable cardiac monitors, including Holter monitors, cardiac event monitors and mobile cardiac telemetry. In addition to the equity agreement, we entered into a commercial agreement with Preventice, under which we have become Preventice’s exclusive, worldwide sales and marketing representative. We believe this partnership strengthens our portfolio of cardiac monitoring and broader disease management capabilities.
On April 13, 2015, we acquired 25 percent of the common stock of Frankenman Medical Equipment Company (Frankenman). Frankenman is a privately-held company headquartered in Suzhou, China, and is a local market leader in surgical staplers. Additionally, we entered into co-promotional and co-selling agreements with Frankenman to jointly commercialize selected products in China. We believe this alliance will enable us to reach more clinicians and treat more patients in China by providing access to training on less invasive endoscopic technologies with clinical and economic benefits.
We account for certain of our strategic investments as equity method investments, in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 323, Investments - Equity Method and Joint Ventures. The book value of investments that we accounted for under the equity method of accounting was $221 million as of June 30, 2016 and $173 million as of December 31, 2015. The aggregate value of our cost method investments was $25 million as of June 30, 2016 and $45 million as of December 31, 2015. In addition we had notes receivable from certain companies that we account for under the cost method of $32 million as of June 30, 2016 and $30 million as of December 31, 2015.
As of June 30, 2016, the book value of our equity method investments exceeded our share of the book value of the investees’ underlying net assets by approximately $140 million, which represents amortizable intangible assets and in-process research and
development, corresponding deferred tax liabilities, and goodwill. During the three and six months ended June 30, 2016 and June 30, 2015, the net losses from our equity method adjustments, presented within the Other, net caption of our condensed consolidated statement of operations were immaterial.
NOTE C – GOODWILL AND OTHER INTANGIBLE ASSETS
The gross carrying amount of goodwill and other intangible assets and the related accumulated amortization for intangible assets subject to amortization and accumulated write-offs of goodwill as of June 30, 2016 and December 31, 2015 are as follows:
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| As of |
| June 30, 2016 | | December 31, 2015 |
| Gross Carrying | | Accumulated Amortization/ | | Gross Carrying | | Accumulated Amortization/ |
(in millions) | Amount | | Write-offs | | Amount | | Write-offs |
Amortizable intangible assets | | | | | | | |
Technology-related | $ | 8,948 |
| | $ | (4,257 | ) | | $ | 8,948 |
| | $ | (4,054 | ) |
Patents | 522 |
| | (366 | ) | | 520 |
| | (358 | ) |
Other intangible assets | 1,531 |
| | (666 | ) | | 1,529 |
| | (610 | ) |
| $ | 11,001 |
| | $ | (5,289 | ) | | $ | 10,997 |
| | $ | (5,022 | ) |
Unamortizable intangible assets | | | | | | | |
Goodwill | $ | 16,375 |
| | $ | (9,900 | ) | | $ | 16,373 |
| | $ | (9,900 | ) |
In-process research and development (IPR&D) | 98 |
| | — |
| | 99 |
| | — |
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Technology-related | 120 |
| | — |
| | 120 |
| | — |
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| $ | 16,593 |
| | $ | (9,900 | ) | | $ | 16,592 |
| | $ | (9,900 | ) |
Our technology-related intangible assets that are not subject to amortization represent technical processes, intellectual property and/or institutional understanding acquired through business combinations that are fundamental to the on-going operations of our business and have no limit to their useful life. Our technology-related intangible assets that are not subject to amortization are comprised primarily of certain acquired balloon and other technology, which is foundational to our continuing operations within the Cardiovascular market and other markets within interventional medicine. We assess our indefinite-lived intangible assets at least annually for impairment and reassess their classification as indefinite-lived assets. We assess qualitative factors to determine whether the existence of events and circumstances indicate that it is more likely than not that our indefinite-lived intangible assets are impaired. If we conclude that it is more likely than not that the asset is impaired, we then determine the fair value of the intangible asset and perform the quantitative impairment test by comparing the fair value with the carrying value in accordance with ASC Topic 350, Intangibles - Goodwill and Other.
The following represents our goodwill balance by global reportable segment:
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(in millions) | Cardiovascular | | Rhythm Management | | MedSurg | | Total |
Balance as of December 31, 2015 | $ | 3,451 |
| | $ | 292 |
| | $ | 2,730 |
| | $ | 6,473 |
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Purchase price adjustments | — |
| | — |
| | 2 |
| | 2 |
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Balance as of June 30, 2016 | $ | 3,451 |
| | $ | 292 |
| | $ | 2,732 |
| | $ | 6,475 |
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Goodwill Impairment Testing
In the second quarter of 2016, we performed our annual goodwill impairment test for all of our reporting units and concluded the fair value of each reporting unit exceeded its carrying value. Based on the criteria prescribed in FASB ASC Topic 350 - Intangibles - Goodwill and Other, we assess goodwill for impairment at the reporting unit level, which is defined as an operating segment or one level below an operating segment, referred to as a component. In 2016 and 2015, we identified six operating segments including Interventional Cardiology, Peripheral Interventions, Rhythm Management, Endoscopy, Urology and Pelvic Health, and Neuromodulation. For purposes of identifying our reporting units, we then assessed whether any components of these segments constitute a business for which discrete financial information is available and where segment management regularly reviews the operating results of that component. We identified Rhythm Management as having two components: Cardiac Rhythm Management and Electrophysiology.
For our 2016 and 2015 annual impairment assessment, we identified seven reporting units, which align to our seven core businesses: Interventional Cardiology, Peripheral Interventions, Cardiac Rhythm Management, Electrophysiology, Endoscopy, Urology and
Pelvic Health, and Neuromodulation. For our 2016 annual impairment assessment the Cardiac Rhythm Management and Electrophysiology reporting units, components of the Rhythm Management operating segment, were aggregated due to a reorganization commencing in 2015 which resulted in integrated leadership, shared resources and consolidation of certain sites in 2016. Because our global Electrophysiology reporting unit was identified as being at higher risk of potential goodwill impairment during our 2015 annual test, it was tested for impairment on a stand-alone basis in the second quarter of 2016, immediately prior to aggregating it with our global Cardiac Rhythm Management reporting unit. The fair value exceeded the carrying value by approximately 36 percent. In comparison, the global Electrophysiology reporting unit had excess fair value of approximately 28 percent as of our 2015 annual test.
As of the date of our 2016 annual goodwill impairment test, the aggregated global Electrophysiology and Cardiac Rhythm Management reporting unit (Rhythm Management) had excess fair value over carrying value of approximately 70 percent and held $292 million of allocated goodwill. As such, it was not deemed at higher risk of future impairment. Changes in our reporting units or in the structure of our business as a result of future reorganizations, acquisitions or divestitures of assets or businesses could result in future impairments of goodwill within our reporting units. Refer to Critical Accounting Policies and Estimates within our Management's Discussion and Analysis of Financial Condition and Results of Operations contained in Item 2 of this Quarterly Report on Form 10-Q for a discussion of key assumptions used in our testing.
On a quarterly basis, we monitor the key drivers of fair value to detect events or other changes that would warrant an interim impairment test of our goodwill. The key variables that drive the cash flows of our reporting units and amortizable intangibles are estimated revenue growth rates and levels of profitability. Terminal value growth rate assumptions, as well as the Weighted Average Cost of Capital (WACC) rate applied are additional key variables for reporting unit cash flows. These assumptions are subject to uncertainty, including our ability to grow revenue and improve profitability levels. The estimates used for our future cash flows and discount rates represent management's best estimates, which we believe to be reasonable, but future declines in business performance may impair the recoverability of our goodwill.
Future events that could have a negative impact on the levels of excess fair value over carrying value of our reporting units include, but are not limited to:
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• | decreases in estimated market sizes or market growth rates due to greater-than-expected declines in procedural volumes, pricing pressures, reductions in reimbursement levels, product actions, and/or competitive technology developments; |
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• | declines in our market share and penetration assumptions due to increased competition, an inability to develop or launch new and next-generation products and technology features in line with our commercialization strategies, and market and/or regulatory conditions that may cause significant launch delays or product recalls; |
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• | decreases in our forecasted profitability due to an inability to successfully implement and achieve timely and sustainable cost improvement measures consistent with our expectations; |
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• | negative developments in intellectual property litigation that may impact our ability to market certain products or increase our costs to sell certain products; |
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• | the level of success of ongoing and future research and development efforts, including those related to recent acquisitions, and increases in the research and development costs necessary to obtain regulatory approvals and launch new products; |
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• | the level of success in managing the growth of acquired companies, achieving sustained profitability consistent with our expectations, establishing government and third-party payer reimbursement, supplying the market, and increases in the costs and time necessary to integrate acquired businesses into our operations successfully; |
| |
• | changes in our reporting units or in the structure of our business as a result of future reorganizations, acquisitions or divestitures of assets or businesses; and |
| |
• | increases in our market-participant risk-adjusted WACC, and increases in our market-participant tax rate, and/or changes in tax laws or macroeconomic conditions. |
Negative changes in one or more of these factors, among others, could result in impairment charges.
The following is a rollforward of accumulated goodwill write-offs by global reportable segment:
|
| | | | | | | | | | | | | | | |
(in millions) | Cardiovascular | | Rhythm Management | | MedSurg | | Total |
Accumulated write-offs as of December 31, 2015 | $ | (1,479 | ) | | $ | (6,960 | ) | | $ | (1,461 | ) | | $ | (9,900 | ) |
Goodwill written off | — |
| | — |
| | — |
| | — |
|
Accumulated write-offs as of June 30, 2016 | $ | (1,479 | ) | | $ | (6,960 | ) | | $ | (1,461 | ) | | $ | (9,900 | ) |
Intangible Asset Impairment Testing
On a quarterly basis, we monitor for events or other potential indicators of impairment that would warrant an interim impairment test of our intangible assets. We did not record any intangible asset impairment charges during the six months ended June 30, 2016.
2015 Charges
During the second quarter of 2015, in conjunction with our annual strategic planning process and annual goodwill impairment test, we performed an interim impairment test on certain of our IPR&D projects and core technology assets. Based on our impairment assessment, we recorded an impairment charge of $9 million in the second quarter of 2015.
The nonrecurring Level 3 fair value measurements of our intangible asset impairment analysis included the following significant unobservable inputs:
|
| | | | | |
Intangible Asset | Valuation Date | Fair Value | Valuation Technique | Unobservable Input | Rate |
In-Process R&D | June 30, 2015 | $6 million | Income Approach - Excess Earnings Method | Discount Rate | 16.5 - 20% |
NOTE D – FAIR VALUE MEASUREMENTS
Derivative Instruments and Hedging Activities
We address market risk from changes in foreign currency exchange rates and interest rates through a risk management program that includes the use of derivative financial instruments, and we operate the program pursuant to documented corporate risk management policies. Our derivative instruments do not subject our earnings or cash flows to material risk, as gains and losses on these derivatives generally offset losses and gains on the item being hedged. We do not enter into derivative transactions for speculative purposes, and we do not have any non-derivative instruments that are designated as hedging instruments pursuant to FASB ASC Topic 815, Derivatives and Hedging (Topic 815).
Currency Hedging
We are exposed to currency risk consisting primarily of foreign currency denominated monetary assets and liabilities, forecasted foreign currency denominated intercompany and third-party transactions and net investments in certain subsidiaries. We manage our exposure to changes in foreign currency exchange rates on a consolidated basis to take advantage of offsetting transactions. We use derivative instruments and non-derivative transactions to reduce the risk that our earnings and cash flows associated with these foreign currency denominated balances and transactions will be adversely affected by foreign currency exchange rate changes.
Currently or Previously Designated Foreign Currency Hedges
All of our designated currency hedge contracts outstanding as of June 30, 2016 and December 31, 2015 were cash flow hedges under Topic 815 intended to protect the U.S. dollar value of our forecasted foreign currency denominated transactions. We record the effective portion of any change in the fair value of foreign currency cash flow hedges in other comprehensive income (OCI) until the related third-party transaction occurs. Once the related third-party transaction occurs, we reclassify the effective portion of any related gain or loss on the foreign currency cash flow hedge to earnings. In the event the hedged forecasted transaction does not occur, or it becomes no longer probable that it will occur, we reclassify the amount of any gain or loss on the related cash flow hedge to earnings at that time. We had currency derivative instruments designated as cash flow hedges outstanding in the contract amount of $2.476 billion as of June 30, 2016 and $1.458 billion as of December 31, 2015.
We recognized net gains of $32 million in earnings on our cash flow hedges during the second quarter of 2016 and $80 million for the first half of 2016, as compared to net gains of $53 million during the second quarter of 2015 and $102 million for the first half of 2015. All currency cash flow hedges outstanding as of June 30, 2016 mature within 60 months. As of June 30, 2016, $7 million of net loss, net of tax, was recorded in accumulated other comprehensive income (AOCI) to recognize the effective portion of the fair value of any currency derivative instruments that are, or previously were, designated as foreign currency cash flow hedges, as compared to net gains, net of tax, of $145 million as of December 31, 2015. As of June 30, 2016, $49 million of net gains, net of tax, may be reclassified to earnings within the next twelve months.
The success of our hedging program depends, in part, on forecasts of transaction activity in various currencies (primarily British pound sterling, Euro and Japanese yen). We may experience unanticipated currency exchange gains or losses to the extent that there are differences between forecasted and actual activity during periods of currency volatility. In addition, changes in foreign currency exchange rates related to any unhedged transactions may impact our earnings and cash flows.
Non-designated Foreign Currency Contracts
We use currency forward contracts as a part of our strategy to manage exposure related to foreign currency denominated monetary assets and liabilities. These currency forward contracts are not designated as cash flow, fair value or net investment hedges under Topic 815; are marked-to-market with changes in fair value recorded to earnings; and are entered into for periods consistent with currency transaction exposures, generally less than one year. We had currency derivative instruments not designated as hedges under Topic 815 outstanding in the contract amount of $2.389 billion as of June 30, 2016 and $2.090 billion as of December 31, 2015.
Interest Rate Hedging
Our interest rate risk relates primarily to U.S. dollar borrowings, partially offset by U.S. dollar cash investments. We have historically used interest rate derivative instruments to manage our earnings and cash flow exposure to changes in interest rates by converting floating-rate debt into fixed-rate debt or fixed-rate debt into floating-rate debt. We had no interest rate derivative instruments outstanding as of June 30, 2016.
We designate these derivative instruments either as fair value or cash flow hedges under Topic 815. We record changes in the value of fair value hedges in interest expense, which is generally offset by changes in the fair value of the hedged debt obligation. Interest payments made or received related to our interest rate derivative instruments are included in interest expense. We record the effective portion of any change in the fair value of derivative instruments designated as cash flow hedges as unrealized gains or losses in OCI, net of tax, until the hedged cash flow occurs, at which point the effective portion of any gain or loss is reclassified to earnings. We record the ineffective portion of our cash flow hedges in interest expense. In the event the hedged cash flow does not occur, or it becomes no longer probable that it will occur, we reclassify the amount of any gain or loss on the related cash flow hedge to interest expense at that time.
In the fourth quarter of 2013, we entered into interest rate derivative contracts having a notional amount of $450 million to convert fixed-rate debt into floating-rate debt, which we designated as fair value hedges. During the first quarter of 2015, we terminated these hedges, and we received total proceeds of approximately $35 million, which included approximately $7 million of net accrued interest receivable. We assessed at inception, and re-assessed on an ongoing basis, whether the interest rate derivative contracts were highly effective in offsetting changes in the fair value of the hedged fixed-rate debt. We recognized no gains or losses in interest expense, related to fair value hedges, during the second quarter of 2015. During the first half of 2015, we recognized, in interest expense, an $8 million loss on our hedged debt and an $8 million gain on the related interest rate derivative contract.
We are amortizing the gains and losses on previously terminated interest rate derivative instruments, including fixed-to-floating interest rate contracts designated as fair value hedges, and forward starting interest rate derivative contracts and treasury locks designated as cash flow hedges upon termination into earnings as a component of interest expense over the remaining term of the hedged debt, in accordance with Topic 815. The carrying amount of certain of our senior notes included unamortized gains of $57 million as of June 30, 2016 and $63 million as of December 31, 2015. We had immaterial unamortized losses as of June 30, 2016 and December 31, 2015 related to the fixed-to-floating interest rate contracts. In addition, we had pre-tax net gains within AOCI related to terminated forward starting interest rate derivative contracts and treasury locks of $9 million as of June 30, 2016 and $10 million as of December 31, 2015. The net gains that we recognized as a reduction of interest expense in earnings related to previously terminated interest rate derivatives were approximately $3 million during the second quarter of 2016 and $6 million during the first half of 2016, as compared to $5 million during the second quarter of 2015 and $7 million during the first half of 2015. As of June 30, 2016, $13 million of pre-tax net gains may be reclassified to earnings within the next twelve months as a reduction to interest expense from amortization of our terminated interest rate derivative contracts.
Counterparty Credit Risk
We do not have significant concentrations of credit risk arising from our derivative financial instruments, whether from an individual counterparty or a related group of counterparties. We manage the concentration of counterparty credit risk on our derivative instruments by limiting acceptable counterparties to a diversified group of major financial institutions with investment grade credit ratings, limiting the amount of credit exposure to each counterparty, and actively monitoring their credit ratings and outstanding fair values on an ongoing basis. Furthermore, none of our derivative transactions are subject to collateral or other security arrangements, and none contain provisions that are dependent on our credit ratings from any credit rating agency.
We also employ master netting arrangements that reduce our counterparty payment settlement risk on any given maturity date to the net amount of any receipts or payments due between us and the counterparty financial institution. Thus, the maximum loss due to counterparty credit risk is limited to the unrealized gains in such contracts net of any unrealized losses should any of these counterparties fail to perform as contracted. Although these protections do not eliminate concentrations of credit risk, as a result of the above considerations, we do not consider the risk of counterparty default to be significant.
Fair Value of Derivative Instruments
The following presents the effect of our derivative instruments designated as cash flow hedges under Topic 815 on our accompanying unaudited condensed consolidated statements of operations during the second quarter and first half of 2016 and 2015 (in millions):
|
| | | | | | | | | |
| Amount of Pre-tax Gain (Loss) Recognized in OCI (Effective Portion) | | Amount of Pre-tax Gain (Loss) Reclassified from AOCI into Earnings (Effective Portion) | | Location in Statement of Operations |
Three Months Ended June 30, 2016 | | | | | |
Currency hedge contracts | $ | (99 | ) | | $ | 32 |
| | Cost of products sold |
| $ | (99 | ) | | $ | 32 |
| | |
Three Months Ended June 30, 2015 | | | | | |
Currency hedge contracts | $ | (25 | ) | | $ | 53 |
| | Cost of products sold |
Interest rate derivative contracts | $ | 10 |
| | $ | 1 |
| | Interest Expense |
| $ | (15 | ) | | $ | 54 |
| | |
Six Months Ended June 30, 2016 | | | | | |
Currency hedge contracts | $ | (158 | ) | | $ | 80 |
| | Cost of products sold |
| $ | (158 | ) | | $ | 80 |
| | |
Six Months Ended June 30, 2015 | | | | | |
Currency hedge contracts | $ | 68 |
| | $ | 102 |
| | Cost of products sold |
Interest rate derivative contracts | $ | 11 |
| | $ | 2 |
| | Interest Expense |
| $ | 79 |
| | $ | 104 |
| | |
The amount of gain (loss) recognized in earnings related to the ineffective portion of hedging relationships was immaterial for all periods presented.
Net gains and losses on currency hedge contracts not designated as hedging instruments were offset by net losses and gains from foreign currency transaction exposures, as shown in the following table:
|
| | | | | | | | | | | | | | | | | | |
in millions | | Location in Statement of Operations | | Three Months Ended | | Six Months Ended |
| | June 30, | | June 30, |
| | 2016 | | 2015 | | 2016 | | 2015 |
Gain (loss) on currency hedge contracts | | Other, net | | $ | (28 | ) | | $ | (9 | ) | | $ | (67 | ) | | $ | 14 |
|
Gain (loss) on foreign currency transaction exposures | | Other, net | | 29 |
| | 4 |
| | 63 |
| | (28 | ) |
Net foreign currency gain (loss) | | Other, net | | $ | 1 |
| | $ | (5 | ) | | $ | (4 | ) | | $ | (14 | ) |
Topic 815 requires all derivative instruments to be recognized at their fair values as either assets or liabilities on the balance sheet. We determine the fair value of our derivative instruments using the framework prescribed by FASB ASC Topic 820, Fair Value Measurements and Disclosures (Topic 820), by considering the estimated amount we would receive or pay to transfer these instruments at the reporting date and by taking into account current interest rates, foreign currency exchange rates, the creditworthiness of the counterparty for the assets and our creditworthiness for liabilities. In certain instances, we may utilize financial models to measure fair value. In doing so, we use inputs that include quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; other observable inputs for the asset or liability; and inputs derived principally from, or corroborated by, observable market data by correlation or other means. As of June 30, 2016, we have classified all of our derivative assets and liabilities within Level 2 of the fair value hierarchy prescribed by Topic 820, as discussed below, because these observable inputs are available for substantially the full term of our derivative instruments.
The following are the balances of our derivative assets and liabilities as of June 30, 2016 and December 31, 2015:
|
| | | | | | | | |
| | As of |
| | June 30, | | December 31, |
(in millions) | Location in Balance Sheet (1) | 2016 | | 2015 |
Derivative Assets: | | | | |
Currently or Previously Designated Hedging Instruments | | | |
Currency hedge contracts | Other current assets | $ | 88 |
| | $ | 138 |
|
Currency hedge contracts | Other long-term assets | 13 |
| | 66 |
|
| | 101 |
| | 204 |
|
Non-Designated Hedging Instruments | | | | |
Currency hedge contracts | Other current assets | 43 |
| | 33 |
|
Total Derivative Assets | | $ | 144 |
| | $ | 237 |
|
| | | | |
Derivative Liabilities: | | | | |
Currently or Previously Designated Hedging Instruments | | | |
Currency hedge contracts | Other current liabilities | $ | 21 |
| | $ | 1 |
|
Currency hedge contracts | Other long-term liabilities | 99 |
| | — |
|
| | 120 |
| | 1 |
|
Non-Designated Hedging Instruments | | | | |
Currency hedge contracts | Other current liabilities | 79 |
| | 22 |
|
Total Derivative Liabilities | | $ | 199 |
| | $ | 23 |
|
| |
(1) | We classify derivative assets and liabilities as current when the remaining term of the derivative contract is one year or less. |
Other Fair Value Measurements
Recurring Fair Value Measurements
On a recurring basis, we measure certain financial assets and financial liabilities at fair value based upon quoted market prices, where available. Where quoted market prices or other observable inputs are not available, we apply valuation techniques to estimate fair value. Topic 820 establishes a three-level valuation hierarchy for disclosure of fair value measurements. The categorization of financial assets and financial liabilities within the valuation hierarchy is based upon the lowest level of input that is significant to the measurement of fair value. The three levels of the hierarchy are defined as follows:
| |
• | Level 1 – Inputs to the valuation methodology are quoted market prices for identical assets or liabilities. |
| |
• | Level 2 – Inputs to the valuation methodology are other observable inputs, including quoted market prices for similar assets or liabilities and market-corroborated inputs. |
| |
• | Level 3 – Inputs to the valuation methodology are unobservable inputs based on management’s best estimate of inputs market participants would use in pricing the asset or liability at the measurement date, including assumptions about risk. |
Assets and liabilities measured at fair value on a recurring basis consist of the following as of June 30, 2016 and December 31, 2015:
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| June 30, 2016 | | As of December 31, 2015 |
(in millions) | Level 1 | | Level 2 | | Level 3 | | Total | | Level 1 | | Level 2 | | Level 3 | | Total |
Assets | | | |
| | | | | | | | |
| | | | |
Money market and government funds | $ | 77 |
| | $ | — |
| | $ | — |
| | $ | 77 |
| | $ | 118 |
| | $ | — |
| | $ | — |
| | $ | 118 |
|
Currency hedge contracts | — |
| | 144 |
| | — |
| | 144 |
| | — |
| | 237 |
| | — |
| | 237 |
|
| $ | 77 |
| | $ | 144 |
| | $ | — |
| | $ | 221 |
| | $ | 118 |
| | $ | 237 |
| | $ | — |
| | $ | 355 |
|
Liabilities | | | | | | | | | | | | | | | |
Currency hedge contracts | $ | — |
| | $ | 199 |
| | $ | — |
| | $ | 199 |
| | $ | — |
| | $ | 23 |
| | $ | — |
| | $ | 23 |
|
Accrued contingent consideration | — |
| | — |
| | 207 |
| | 207 |
| | — |
| | — |
| | 246 |
| | 246 |
|
| $ | — |
| | $ | 199 |
| | $ | 207 |
| | $ | 406 |
| | $ | — |
| | $ | 23 |
| | $ | 246 |
| | $ | 269 |
|
Our investments in money market and government funds are classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices. These investments are classified as cash and cash equivalents within our accompanying unaudited condensed consolidated balance sheets, in accordance with U.S. GAAP and our accounting policies. In addition to $77 million invested in money market and government funds as of June 30, 2016, we had $60 million in short-term time deposits and $301 million in interest bearing and non-interest bearing bank accounts. In addition to $118 million invested in money market and government funds as of December 31, 2015, we had $31 million in short-term deposits and $170 million in interest bearing and non-interest bearing bank accounts.
Our recurring fair value measurements using significant unobservable inputs (Level 3) relate solely to our contingent consideration liabilities. Refer to Note B - Acquisitions and Strategic Investments for a discussion of the changes in the fair value of our contingent consideration liabilities.
Non-Recurring Fair Value Measurements
We hold certain assets and liabilities that are measured at fair value on a non-recurring basis in periods subsequent to initial recognition. The fair value of a cost method investment is not estimated if there are no identified events or changes in circumstances that may have a significant adverse effect on the fair value of the investment. Refer to Note B – Acquisitions and Strategic Investments for a discussion of our strategic investments.
The fair value of our outstanding debt obligations was $5.878 billion as of June 30, 2016 and $5.887 billion as of December 31, 2015, which was determined by using primarily quoted market prices for our publicly registered senior notes, classified as Level 1 within the fair value hierarchy. Refer to Note E – Borrowings and Credit Arrangements for a discussion of our debt obligations.
NOTE E – BORROWINGS AND CREDIT ARRANGEMENTS
We had total debt of $5.427 billion as of June 30, 2016 and $5.677 billion as of December 31, 2015. The debt maturity schedule for the significant components of our debt obligations as of June 30, 2016 is as follows:
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | |
(in millions) | 2016 | | 2017 | | 2018 | | 2019 | | 2020 | | Thereafter | | Total |
Senior Notes | $ | — |
| | $ | 250 |
| | $ | 600 |
| | $ | — |
| | $ | 1,450 |
| | $ | 2,350 |
| | $ | 4,650 |
|
Term Loans | — |
| | — |
| | 225 |
| | 150 |
| | 375 |
| | — |
| | 750 |
|
| $ | — |
| | $ | 250 |
| | $ | 825 |
| | $ | 150 |
| | $ | 1,825 |
| | $ | 2,350 |
| | $ | 5,400 |
|
|
| |
Note: | The table above does not include unamortized discounts associated with our senior notes, or amounts related to interest rate contracts used to hedge the fair value of certain of our senior notes. |
Revolving Credit Facility
On April 10, 2015, we entered into a new $2.000 billion revolving credit facility (the 2015 Facility) with a global syndicate of commercial banks and terminated our previous $2.000 billion revolving credit facility. The 2015 Facility matures on April 10, 2020. Eurodollar and multicurrency loans under the 2015 Facility bear interest at LIBOR plus an interest margin of between 0.900 percent and 1.500 percent, based on our corporate credit ratings and consolidated leverage ratio (1.300 percent as of June 30, 2016). In addition, we are required to pay a facility fee based on our credit ratings, consolidated leverage ratio and the total amount of revolving credit commitment, regardless of usage, under the credit agreement (0.200 percent per year as of June 30, 2016). The 2015 Facility contains covenants which, among other things, require that we maintain a minimum interest coverage ratio of 3.0 times consolidated EBITDA and a maximum leverage ratio of 4.5 times consolidated EBITDA for the first four fiscal quarter-ends following the closing of the acquisition of the American Medical Systems male urology portfolio (AMS Portfolio Acquisition) on August 3, 2015, and decreasing to 4.25 times, 4.0 times, and 3.75 times consolidated EBITDA for the next three fiscal quarter-ends after such four fiscal quarter-ends, respectively, and then to 3.50 times for each fiscal quarter-end thereafter. There were no amounts borrowed under our current and prior revolving credit facilities as of June 30, 2016 or December 31, 2015.
|
| | | |
| Covenant Requirement as of June 30, 2016 | | Actual as of June 30, 2016 |
Maximum leverage ratio (1) | 4.5 times | | 2.6 times |
Minimum interest coverage ratio (2) | 3.0 times | | 8.8 times |
| |
(1) | Ratio of total debt to consolidated EBITDA, as defined by the credit agreement, for the preceding four consecutive fiscal quarters. |
| |
(2) | Ratio of consolidated EBITDA, as defined by the credit agreement, to interest expense for the preceding four consecutive fiscal quarters. |
The credit agreement for the 2015 Facility provides for an exclusion from the calculation of consolidated EBITDA, as defined by the credit agreement, through the credit agreement maturity, of any non-cash charges and up to $620 million in restructuring charges and restructuring-related expenses related to our current or future restructuring plans. As of June 30, 2016, we had $523 million of the restructuring charge exclusion remaining. In addition, any cash litigation payments (net of any cash litigation receipts), as defined by the agreement, are excluded from the calculation of consolidated EBITDA and any new debt issued to fund any tax deficiency payments is excluded from consolidated total debt, as defined in the agreement, provided that the sum of any excluded net cash litigation payments and any new debt issued to fund any tax deficiency payments not exceed $2.000 billion in the aggregate. As of June 30, 2016, we had $1.543 billion of the combined legal and debt exclusion remaining.
As of and through June 30, 2016, we were in compliance with the required covenants.
Term Loans
As of June 30, 2016, we had an aggregate of $750 million outstanding under our unsecured term loan facilities and $1.000 billion outstanding as of December 31, 2015. These facilities include an unsecured term loan facility entered into in August 2013 (2013 Term Loan) which had $150 million outstanding as of June 30, 2016 and $250 million outstanding as of December 31, 2015, along with an unsecured term loan credit facility entered into in April 2015 (2015 Term Loan) which had $600 million outstanding as of June 30, 2016 and $750 million outstanding as of December 31, 2015.
Borrowings under the 2013 Term Loan bear interest at LIBOR plus an interest margin between 1.00 percent and 1.75 percent (currently 1.50 percent) based on our corporate credit ratings and consolidated leverage ratio. We repaid $150 million of our 2013 Term Loan facility in the fourth quarter of 2015 and repaid an additional $100 million during the second quarter of 2016. As a result and in accordance with the credit agreement, the outstanding balance of $150 million is the remaining principal amount due at the final maturity date in August 2018. The 2013 Term Loan borrowings are repayable at any time without premium or penalty. Our term loan facility requires that we comply with certain covenants, including financial covenants with respect to maximum leverage and minimum interest coverage, consistent with the 2015 Term Loan facility. The maximum leverage ratio requirement is 4.5 times, and our actual leverage ratio as of June 30, 2016 is 2.6 times. The minimum interest coverage ratio requirement is 3.0 times, and our actual interest coverage ratio as of June 30, 2016 is 8.8 times.
On April 10, 2015, we entered into a new $750 million unsecured term loan credit facility (2015 Term Loan) which matures on August 3, 2020. The 2015 Term Loan was funded on August 3, 2015 and was used to partially fund the AMS Portfolio Acquisition, including the payment of fees and expenses. Term loan borrowings under this facility bear interest at LIBOR plus an interest margin of between 1.00 percent and 1.75 percent (currently 1.50 percent), based on our corporate credit ratings and consolidated
leverage ratio. We repaid $150 million of our 2015 Term Loan during the second quarter of 2016. The remaining 2015 Term Loan requires quarterly principal payments of $38 million commencing in the third quarter of 2018, and the remaining principal amount is due at the final maturity date of August 3, 2020. The 2015 Term Loan agreement requires that we comply with certain covenants, including financial covenants with respect to maximum leverage and minimum interest coverage, consistent with our revolving credit facility. The maximum leverage ratio requirement is 4.5 times, and our actual leverage ratio as of June 30, 2016 is 2.6 times. The minimum interest coverage ratio requirement is 3.0 times, and our actual interest coverage ratio as of June 30, 2016 is 8.8 times.
Senior Notes
We had senior notes outstanding of $4.650 billion as of June 30, 2016 and December 31, 2015. In May 2015, we completed the offering of $1.850 billion in aggregate principal amount of senior notes consisting of $600 million in aggregate principal amount of 2.850% notes due 2020, $500 million in aggregate principal amount of 3.375% notes due 2022 and $750 million in aggregate principal amount of 3.850% notes due 2025. The net proceeds from the offering of the notes, after deducting underwriting discounts and estimated offering expenses, were approximately $1.831 billion. We used a portion of the net proceeds from the senior notes offering to redeem $400 million aggregate principal amount of our 5.500% notes due November 2015 and $600 million aggregate principal amount of our 6.400% notes due June 2016. The remaining senior notes offering proceeds, together with the 2015 Term Loan, were used to fund the AMS Portfolio Acquisition. We recorded a charge of $45 million in interest expense, during the second quarter of 2015, for premiums, accelerated amortization of debt issuance costs, and investor discount costs net of interest rate hedge gains related to the early debt extinguishment.
Our senior notes were issued in public offerings, are redeemable prior to maturity and are not subject to any sinking fund requirements. Our senior notes are unsecured, unsubordinated obligations and rank on parity with each other. These notes are effectively junior to borrowings under our credit and security facility, to the extent if borrowed by our subsidiaries and to liabilities of our subsidiaries (see Other Arrangements below).
Other Arrangements
We maintain a $300 million credit and security facility secured by our U.S. trade receivables maturing on June 9, 2017. The credit and security facility requires that we maintain a maximum leverage covenant consistent with our revolving credit facility. The maximum leverage ratio requirement is 4.5 times, and our actual leverage ratio as of June 30, 2016 is 2.6 times. We had no borrowings outstanding under this facility as of June 30, 2016 and December 31, 2015.
We have accounts receivable factoring programs in certain European countries that we account for as sales under FASB ASC Topic 860, Transfers and Servicing. These agreements provide for the sale of accounts receivable to third parties, without recourse, of up to approximately $400 million as of June 30, 2016. We have no retained interests in the transferred receivables, other than collection and administrative responsibilities and, once sold, the accounts receivable are no longer available to satisfy creditors in the event of bankruptcy. We de-recognized $169 million of receivables as of June 30, 2016 at an average interest rate of 1.8 percent, and $151 million as of December 31, 2015 at an average interest rate of 2.4 percent.
In addition, we have uncommitted credit facilities with a commercial Japanese bank that provide for borrowings, promissory notes discounting and receivables factoring of up to 21.000 billion Japanese yen (approximately $204 million as of June 30, 2016). We de-recognized $170 million of notes receivable and factored receivables as of June 30, 2016 at an average interest rate of 1.6 percent and $132 million of notes receivable as of December 31, 2015 at an average interest rate of 1.6 percent. De-recognized accounts and notes receivable are excluded from trade accounts receivable, net in the accompanying unaudited condensed consolidated balance sheets.
As of June 30, 2016 we had outstanding letters of credit of $43 million, as compared to $44 million as of December 31, 2015, which consisted primarily of bank guarantees and collateral for workers' compensation insurance arrangements. As of June 30, 2016 and December 31, 2015, none of the beneficiaries had drawn upon the letters of credit or guarantees; accordingly, we did not recognize a related liability for our outstanding letters of credit in our consolidated balance sheets as of June 30, 2016 or December 31, 2015. We believe we will generate sufficient cash from operations to fund these arrangements and intend to fund these arrangements without drawing on the letters of credit.
NOTE F – RESTRUCTURING-RELATED ACTIVITIES
On an ongoing basis, we monitor the dynamics of the economy, the healthcare industry, and the markets in which we compete. We continue to assess opportunities for improved operational effectiveness and efficiency, and better alignment of expenses with revenues, while preserving our ability to make the investments in research and development projects, capital and our people that we believe are essential to our long-term success. As a result of these assessments, we have undertaken various restructuring initiatives in order to enhance our growth potential and position us for long-term success. These initiatives are described below.
2016 Restructuring Plan
On June 6, 2016, our Board of Directors approved, and we committed to, a restructuring initiative (the 2016 Restructuring Plan). The 2016 Restructuring Plan is intended to develop global commercialization, technology and manufacturing capabilities in key growth markets, build on our Plant Network Optimization (PNO) strategy which is intended to simplify our manufacturing plant structure by transferring certain production lines among facilities, and expand operational efficiencies in support of our operating income margin goals. Key activities under the 2016 Restructuring Plan include strengthening global infrastructure through evolving global real estate and workplaces, developing global commercial and technical competencies, enhancing manufacturing and distribution expertise in certain regions, and continuing implementation of our ongoing PNO strategy. These activities initiated in the second quarter of 2016 and are expected to be substantially completed by the end of 2018.
The implementation of the 2016 Restructuring Plan is expected to result in total pre-tax charges of approximately $175 million to $225 million, and approximately $160 million to $210 million of these charges are estimated to result in cash outlays, of which we have made payments of $5 million through June 30, 2016. We have recorded related costs of $19 million since the inception of the plan through June 30, 2016, and recorded a portion of these expenses as restructuring charges and the remaining portion through other lines within our consolidated statements of operations.
The following table provides a summary of our estimates of costs associated with the 2016 Restructuring Plan through the end of 2018 by major type of cost:
|
| |
Type of cost | Total estimated amount expected to be incurred |
Restructuring charges: | |
Termination benefits | $65 million to $80 million |
Other (1) | $15 million to $25 million |
Restructuring-related expenses: | |
Other (2) | $95 million to $120 million |
| $175 million to $225 million |
(1) Consists primarily of consulting fees and costs associated with contract cancellations.
(2) Comprised of other costs directly related to the 2016 Restructuring Plan, including program management, accelerated depreciation, and costs to transfer product lines among facilities.
2014 Restructuring Plan
On October 22, 2013, our Board of Directors approved, and we committed to, a restructuring initiative (the 2014 Restructuring Plan). The 2014 Restructuring Plan is intended to build on the progress we have made to address financial pressures in a changing global marketplace, further strengthen our operational effectiveness and efficiency and support new growth investments. Key activities under the plan include continued implementation of our ongoing PNO strategy, continued focus on driving operational efficiencies and ongoing business and commercial model changes. The PNO strategy is intended to simplify our manufacturing plant structure by transferring certain production lines among facilities. Other activities involve rationalizing organizational reporting structures to streamline various functions, eliminate bureaucracy, increase productivity and better align resources to business strategies and marketplace dynamics. These activities were initiated in the fourth quarter of 2013 and were substantially completed by the end of 2015, except for certain ongoing actions associated with our PNO strategy, which we expect to be substantially completed by the end of 2016.
The implementation of the 2014 Restructuring Plan is expected to result in total pre-tax charges of approximately $255 million to $270 million, and approximately $240 million to $255 million of these charges are estimated to result in cash outlays, of which we have made payments of $224 million through June 30, 2016. We have recorded related costs of $249 million since the inception of the plan, and recorded a portion of these expenses as restructuring charges and the remaining portion through other lines within our consolidated statements of operations.
The following table provides a summary of our estimates of costs associated with the 2014 Restructuring Plan through the end of 2016 by major type of cost:
|
| |
Type of cost | Total estimated amount expected to be incurred |
Restructuring charges: | |
Termination benefits | $95 million to $100 million |
Other (1) | $30 million to $35 million |
Restructuring-related expenses: | |
Other (2) | $130 million to $135 million |
| $255 million to $270 million |
(1) Consists primarily of consulting fees and costs associated with contract cancellations.
(2) Comprised of other costs directly related to the 2014 Restructuring Plan, including program management, accelerated depreciation, and costs to transfer product lines among facilities.
We recorded net restructuring charges pursuant to our restructuring plans of $14 million in the second quarter of 2016, $3 million in the second quarter of 2015, $17 million in the first half of 2016 and $9 million in the first half of 2015. In addition, we recorded expenses within other lines of our accompanying unaudited condensed consolidated statements of operations related to our restructuring initiatives of $12 million in the second quarter of 2016, $12 million in the second quarter of 2015, $22 million in the first half of 2016 and $28 million in the first half of 2015.
The following presents these costs (credits) by major type and line item within our accompanying unaudited condensed consolidated statements of operations, as well as by program:
|
| | | | | | | | | | | | | | | | | | | |
Three Months Ended June 30, 2016 | | | | | | | | | |
(in millions) | Termination Benefits | | Accelerated Depreciation | | Transfer Costs | | Other | | Total |
Restructuring charges | $ | 14 |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | 14 |
|
Restructuring-related expenses: | | | | | | | | | |
Cost of products sold | — |
| | — |
| | 7 |
| | — |
| | 7 |
|
Selling, general and administrative expenses | — |
| | 3 |
| | — |
| | 2 |
| | 5 |
|
| — |
| | 3 |
| | 7 |
| | 2 |
| | 12 |
|
| $ | 14 |
| | $ | 3 |
| | $ | 7 |
| | $ | 2 |
| | $ | 26 |
|
| | | | | | | | | |
(in millions) | Termination Benefits | | Accelerated Depreciation | | Transfer Costs | | Other | | Total |
2016 Restructuring Plan | $ | 18 |
| | $ | — |
| | $ | 1 |
| | $ | — |
| | $ | 19 |
|
2014 Restructuring Plan | (4 | ) | | 3 |
| | 6 |
| | 2 |
| | 7 |
|
| $ | 14 |
| | $ | 3 |
| | $ | 7 |
| | $ | 2 |
| | $ | 26 |
|
|
| | | | | | | | | | | | | | | | | | | |
Three Months Ended June 30, 2015 | | | | | | | | | |
(in millions) | Termination Benefits | | Accelerated Depreciation | | Transfer Costs | | Other | | Total |
Restructuring charges | $ | 3 |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | 3 |
|
Restructuring-related expenses: | | | | | | | | | |
Cost of products sold | — |
| | — |
| | 8 |
| | — |
| | 8 |
|
Selling, general and administrative expenses | — |
| | 1 |
| | — |
| | 3 |
| | 4 |
|
| — |
| | 1 |
| | 8 |
| | 3 |
| | 12 |
|
| $ | 3 |
| | $ | 1 |
| | $ | 8 |
| | $ | 3 |
| | $ | 15 |
|
All charges incurred in the second quarter of 2015 were related to the 2014 Restructuring Plan.
|
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | |
Six Months Ended June 30, 2016 | | | | | | | | | |
(in millions) | Termination Benefits | | Accelerated Depreciation | | Transfer Costs | | Other | | Total |
Restructuring charges | $ | 15 |
| | $ | — |
| | $ | — |
| | $ | 2 |
| | $ | 17 |
|
Restructuring-related expenses: | | | | | | | | | |
Cost of products sold | — |
| | — |
| | 12 |
| | — |
| | 12 |
|
Selling, general and administrative expenses | — |
| | 4 |
| | — |
| | 6 |
| | 10 |
|
| — |
| | 4 |
| | 12 |
| | 6 |
| | 22 |
|
| $ | 15 |
| | $ | 4 |
| | $ | 12 |
| | $ | 8 |
| | $ | 39 |
|
| | | | | | | | | |
(in millions) | Termination Benefits | | Accelerated Depreciation | | Transfer Costs | | Other | | Total |
2016 Restructuring Plan | $ | 18 |
| | $ | — |
| | $ | 1 |
| | $ | — |
| | $ | 19 |
|
2014 Restructuring Plan | (3 | ) | | 4 |
| | 11 |
| | 8 |
| | 20 |
|
| $ | 15 |
| | $ | 4 |
| | $ | 12 |
| | $ | 8 |
| | $ | 39 |
|
| | | | | | | | | |
Six Months Ended June 30, 2015 | | | | | | | | | |
(in millions) | Termination Benefits | | Accelerated Depreciation | | Transfer Costs | | Other | | Total |
Restructuring charges | $ | 8 |
| | $ | — |
| | $ | — |
| | $ | 1 |
| | $ | 9 |
|
Restructuring-related expenses: | | | | | | | | | |
Cost of products sold | — |
| | — |
| | 16 |
| | — |
| | 16 |
|
Selling, general and administrative expenses | — |
| | 2 |
| | — |
| | 10 |
| | 12 |
|
| — |
| | 2 |
| | 16 |
| | 10 |
| | 28 |
|
| $ | 8 |
| | $ | 2 |
| | $ | 16 |
| | $ | 11 |
| | $ | 37 |
|
| | | | | | | | | |
(in millions) | Termination Benefits | | Accelerated Depreciation | | Transfer Costs | | Other | | Total |
2014 Restructuring Plan | $ | 11 |
| | $ | 2 |
| | $ | 16 |
| | $ | 11 |
| | $ | 40 |
|
Substantially completed restructuring programs | (3 | ) | | — |
| | — |
| | — |
| | (3 | ) |
| $ | 8 |
| | $ | 2 |
| | $ | 16 |
| | $ | 11 |
| | $ | 37 |
|
Termination benefits represent amounts incurred pursuant to our ongoing benefit arrangements and amounts for “one-time” involuntary termination benefits, and have been recorded in accordance with FASB ASC Topic 712, Compensation – Non-retirement Postemployment Benefits and FASB ASC Topic 420, Exit or Disposal Cost Obligations (Topic 420). We expect to record additional termination benefits related to our 2016 Restructuring Plan throughout the rest of 2016 when we identify with more specificity the job classifications, functions and locations of headcount reductions. We do not expect to record any additional termination benefits related to our 2014 Restructuring Plan. Other restructuring costs, which represent primarily consulting fees and costs related to contract cancellations, are being recorded as incurred in accordance with Topic 420. Accelerated depreciation is being recorded over the adjusted remaining useful life of the related assets, and program management and production line transfer costs are being recorded as incurred.
As of June 30, 2016, we incurred cumulative restructuring charges related to our 2016 Restructuring Plan and our 2014 Restructuring Plan of $142 million and restructuring-related costs of $126 million since we committed to the plans. The following presents these costs by major type:
|
| | | | | | | | | | | |
(in millions) | 2016 Restructuring Plan | | 2014 Restructuring Plan | | Total |
Termination benefits | $ | 18 |
| | $ | 93 |
| | $ | 111 |
|
Other | — |
| | 31 |
| | 31 |
|
Total restructuring charges | 18 |
| | 124 |
| | 142 |
|
Accelerated depreciation | — |
| | 12 |
| | 12 |
|
Transfer costs | 1 |
| | 66 |
| | 67 |
|
Other | — |
| | 47 |
| | 47 |
|
Restructuring-related expenses | 1 |
| | 125 |
| | 126 |
|
| $ | 19 |
| | $ | 249 |
| | $ | 268 |
|
We made cash payments of $17 million in the second quarter of 2016 and $40 million in the first half of 2016 associated with our restructuring initiatives, and as of June 30, 2016, we had made total cash payments of $229 million related to our 2016 Restructuring Plan and 2014 Restructuring Plan since committing to the plans. These payments were made using cash generated from operations, and are comprised of the following:
|
| | | | | | | | | | | |
(in millions) | 2016 Restructuring Plan | | 2014 Restructuring Plan | | Total |
Three Months Ended June 30, 2016 | | | | | |
Termination benefits | $ | 4 |
| | $ | 3 |
| | $ | 7 |
|
Transfer costs | 1 |
| | 6 |
| | 7 |
|
Other | — |
| | 3 |
| | 3 |
|
| $ | 5 |
| | $ | 12 |
| | $ | 17 |
|
| | | | | |
Six Months Ended June 30, 2016 | | | | | |
Termination benefits | $ | 4 |
| | $ | 17 |
| | $ | 21 |
|
Transfer costs | 1 |
| | 11 |
| | 12 |
|
Other | — |
| | 7 |
| | 7 |
|
| $ | 5 |
| | $ | 35 |
| | $ | 40 |
|
| | | | | |
Program to Date | | | | | |
Termination benefits | $ | 4 |
| | $ | 86 |
| | $ | 90 |
|
Transfer costs | 1 |
| | 66 |
| | 67 |
|
Other | — |
| | 72 |
| | 72 |
|
| $ | 5 |
| | $ | 224 |
| | $ | 229 |
|
Our restructuring liability is primarily comprised of accruals for termination benefits. The following is a rollforward of the termination benefit liability associated with our 2016 Restructuring Plan and our 2014 Restructuring Plan, which is reported as a component of accrued expenses included in our accompanying unaudited condensed balance sheets:
|
| | | | | | | | | | | |
(in millions) | 2016 Restructuring Plan | | 2014 Restructuring Plan | | Total |
Accrued as of December 31, 2015 | $ | — |
| | $ | 29 |
| | $ | 29 |
|
Charges (credits) | 18 |
| | (3 | ) | | 15 |
|
Cash payments | (4 | ) | | (17 | ) | | (21 | ) |
Accrued as of June 30, 2016 | $ | 14 |
| | $ | 9 |
| | $ | 23 |
|
In addition to our accrual for termination benefits, we had a $4 million liability as of June 30, 2016 and a $3 million liability as of December 31, 2015 for other restructuring-related items.
NOTE G – SUPPLEMENTAL BALANCE SHEET INFORMATION
Components of selected captions in our accompanying unaudited condensed consolidated balance sheets are as follows:
Trade accounts receivable, net
|
| | | | | | | | |
| | As of |
(in millions) | | June 30, 2016 | | December 31, 2015 |
Accounts receivable | | $ | 1,512 |
| | $ | 1,394 |
|
Less: allowance for doubtful accounts | | (80 | ) | | (75 | ) |
Less: allowance for sales returns | | (45 | ) | | (44 | ) |
| | $ | 1,387 |
| | $ | 1,275 |
|
The following is a rollforward of our allowance for doubtful accounts for the second quarter and first half of 2016 and 2015:
|
| | | | | | | | | | | | | | | | |
| | Three Months Ended June 30, | | Six Months Ended June 30, |
(in millions) | | 2016 | | 2015 | | 2016 | | 2015 |
Beginning balance | | $ | 80 |
| | $ | 72 |
| | $ | 75 |
| | $ | 76 |
|
Charges to expenses | | 3 |
| | 6 |
| | 7 |
| | 8 |
|
Utilization of allowances | | (3 | ) | | (1 | ) | | (2 | ) | | (7 | ) |
Ending balance | | $ | 80 |
| | $ | 77 |
| | $ | 80 |
| | $ | 77 |
|
Inventories
|
| | | | | | | | |
| | As of |
(in millions) | | June 30, 2016 | | December 31, 2015 |
Finished goods | | $ | 654 |
| | $ | 706 |
|
Work-in-process | | 108 |
| | 102 |
|
Raw materials | | 219 |
| | 208 |
|
| | $ | 981 |
| | $ | 1,016 |
|
Property, plant and equipment, net
|
| | | | | | | | |
| | As of |
(in millions) | | June 30, 2016 | | December 31, 2015 |
Land | | $ | 83 |
| | $ | 86 |
|
Buildings and improvements | | 966 |
| | 981 |
|
Equipment, furniture and fixtures | | 2,904 |
| | 2,793 |
|
Capital in progress | | 183 |
| | 202 |
|
| | 4,136 |
| | 4,062 |
|
Less: accumulated depreciation | | 2,649 |
| | 2,572 |
|
| | $ | 1,487 |
| | $ | 1,490 |
|
Depreciation expense was $62 million for the second quarter of 2016, $65 million for the second quarter of 2015, $126 million for the first half of 2016, and $130 million for the first half of 2015.
Accrued expenses
|
| | | | | | | | |
| | As of |
(in millions) | | June 30, 2016 | | December 31, 2015 |
Legal reserves | | $ | 1,075 |
| | $ | 773 |
|
Payroll and related liabilities | | 500 |
| | 504 |
|
Accrued contingent consideration | | 102 |
| | 119 |
|
Other | | 559 |
| | 574 |
|
| | $ | 2,236 |
| | $ | 1,970 |
|
Other long-term liabilities
|
| | | | | | | | |
| | As of |
(in millions) | | June 30, 2016 | | December 31, 2015 |
Accrued income taxes | | $ | 1,291 |
| | $ | 1,253 |
|
Legal reserves | | 1,300 |
| | 1,163 |
|
Accrued contingent consideration | | 105 |
| | 127 |
|
Other long-term liabilities | | 543 |
| | 431 |
|
| | $ | 3,239 |
| | $ | 2,974 |
|
Accrued warranties
We offer warranties on certain of our product offerings. The majority of our warranty liability relates to implantable devices offered by our Cardiac Rhythm Management (CRM) business, which include defibrillator and pacemaker systems. Our CRM products come with a standard limited warranty covering the replacement of these devices. We offer a full warranty for a portion of the period post-implant, and a partial warranty for a period of time thereafter. We estimate the costs that we may incur under our warranty programs based on the number of units sold, historical and anticipated rates of warranty claims and cost per claim, and record a liability equal to these estimated costs as cost of products sold at the time the product sale occurs. We reassess the adequacy of our recorded warranty liabilities on a quarterly basis and adjust these amounts as necessary. The current portion of our warranty accrual is included in other accrued expenses in the table above and the non-current portion of our warranty accrual is included in other long-term liabilities in the table above. Changes in our product warranty accrual during the first half of 2016 and 2015 consisted of the following (in millions):
|
| | | | | | | | |
| | Six Months Ended June 30, |
| | 2016 | | 2015 |
Beginning Balance | | $ | 23 |
| | $ | 25 |
|
Provision | | 10 |
| | 10 |
|
Settlements/reversals | | (13 | ) | | (9 | ) |
Ending Balance | | $ | 20 |
| | $ | 26 |
|
NOTE H – INCOME TAXES
Our effective tax rates from continuing operations for the three months ended June 30, 2016 and June 30, 2015, were 47.8% and 2.9%, respectively. For the first half of 2016 and 2015 our effective tax rates from continuing operations were 97.0% and (86.9)%, respectively. The change in our reported tax rate for the second quarter and first half of 2016, as compared to the same periods in 2015, relates primarily to the impact of certain receipts and charges that are taxed at different rates than our effective tax rate, including acquisition-related items, contingent consideration, litigation-related and restructuring-related items, as well as the impact of certain discrete tax items.
As of June 30, 2016, we had $1.058 billion of gross unrecognized tax benefits, of which a net $902 million, if recognized, would affect our effective tax rate. As of December 31, 2015, we had $1.056 billion of gross unrecognized tax benefits, of which a net $900 million, if recognized, would affect our effective tax rate.
We have received Notices of Deficiency from the Internal Revenue Service (IRS) reflecting proposed audit adjustments for Guidant Corporation for its 2001 through 2006 tax years and for Boston Scientific Corporation for its 2006 and 2007 tax years. The total incremental tax liability asserted by the IRS for the applicable periods is $1.162 billion plus interest. The primary issue in dispute for all years is the transfer pricing associated with the technology license agreements between domestic and foreign subsidiaries of Guidant. In addition, the IRS has proposed adjustments in connection with the financial terms of our Transaction Agreement with Abbott Laboratories pertaining to the sale of Guidant's vascular intervention business to Abbott in April 2006. During 2014, we received a Revenue Agent Report from the IRS reflecting significant proposed audit adjustments to our 2008, 2009, and 2010 tax years based upon the same transfer pricing methodologies that the IRS applied to our 2001 through 2007 tax years.
We do not agree with the transfer pricing methodologies applied by the IRS or its resulting assessments. We have filed petitions with the U.S. Tax Court (Tax Court) contesting the Notices of Deficiency for the 2001 through 2007 tax years in challenge and submitted a letter to the IRS Office of Appeals (IRS Appeals) protesting the Revenue Agent Report for the 2008 through 2010 tax years and requesting an administrative appeal hearing. The issues in dispute were scheduled to be heard in Tax Court in late July 2016. On July 19, 2016, we entered into a Stipulation of Settled Issues with the IRS intended to resolve all of the aforementioned transfer pricing issues, as well as the issues related to our transaction with Abbott. The Stipulation of Settled Issues is contingent upon IRS Appeals applying the same basis of settlement to all transfer pricing issues for the Company’s 2008, 2009, and 2010 tax years, and if applicable, review by the U.S. Congress Joint Committee on Taxation.
In the event that the conditions in the Stipulation of Settled Items are satisfied, we expect to make net tax payments to the IRS of approximately $275 million, plus interest through the date of payment. No payments will be required until the dispute, including its resolution with IRS Appeals, is definitively resolved and our tax liability, including interest, for each individual year has been recalculated by the IRS. Based on experiences of other companies, we expect to make payment within the next 12 to 24 months. We believe our income tax reserves associated with these matters are adequate as of June 30, 2016 and do not expect any additional charges related to the resolution of this controversy.
We recognize interest and penalties related to income taxes as a component of income tax expense. We had $535 million accrued for gross interest and penalties as of June 30, 2016 and $500 million as of December 31, 2015. We recognized net tax expense related to interest and penalties of $13 million during the second quarter of 2016, $10 million during the second quarter of 2015, $23 million during the first half of 2016 and $21 million during the first half of 2015.
It is reasonably possible that within the next 12 months we will resolve multiple issues including transfer pricing and transactional-related issues with foreign, federal and state taxing authorities, in which case we could record a reduction in our balance of unrecognized tax benefits of up to approximately $767 million.
In November 2015, the FASB issued ASC Update No. 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. This update simplifies the presentation of deferred income taxes by requiring all deferred tax assets and liabilities, along with any related valuation allowance, to be classified as noncurrent on the balance sheet. The new guidance is effective for all public Companies for annual periods beginning after December 15, 2016, and interim periods within those annual periods, with early adoption permitted. We elected to early adopt this standard prospectively at the beginning of 2016.
NOTE I – COMMITMENTS AND CONTINGENCIES
The medical device market in which we primarily participate is largely technology driven. As a result, intellectual property rights, particularly patents and trade secrets, play a significant role in product development and differentiation. Over the years, there has been litigation initiated against us by others, including our competitors, claiming that our current or former product offerings infringe patents owned or licensed by them. Intellectual property litigation is inherently complex and unpredictable. In addition, competing parties frequently file multiple suits to leverage patent portfolios across product lines, technologies and geographies and to balance risk and exposure between the parties. In some cases, several competitors are parties in the same proceeding, or in a series of related proceedings, or litigate multiple features of a single class of devices. These forces frequently drive settlement not only for individual cases, but also for a series of pending and potentially related and unrelated cases. Although monetary and injunctive relief is typically sought, remedies and restitution are generally not determined until the conclusion of the trial court proceedings and can be modified on appeal. Accordingly, the outcomes of individual cases are difficult to time, predict or quantify and are often dependent upon the outcomes of other cases in other geographies.
During recent years, we successfully negotiated closure of several long-standing legal matters and have received favorable rulings in several other matters; however, there continues to be outstanding intellectual property litigation. Adverse outcomes in one or more of these matters could have a material adverse effect on our ability to sell certain products and on our operating margins, financial position, results of operations and/or liquidity.
In the normal course of business, product liability, securities and commercial claims are asserted against us. Similar claims may be asserted against us in the future related to events not known to management at the present time. We maintain an insurance policy providing limited coverage against securities claims, and we are substantially self-insured with respect to product liability claims and fully self-insured with respect to intellectual property infringement claims. The absence of significant third-party insurance coverage increases our potential exposure to unanticipated claims or adverse decisions. Product liability claims, securities and commercial litigation, and other legal proceedings in the future, regardless of their outcome, could have a material adverse effect on our financial position, results of operations and/or liquidity.
In addition, like other companies in the medical device industry, we are subject to extensive regulation by national, state and local government agencies in the United States and other countries in which we operate. From time to time we are the subject of qui tam actions and governmental investigations often involving regulatory, marketing and other business practices. These qui tam actions and governmental investigations could result in the commencement of civil and criminal proceedings, substantial fines, penalties and administrative remedies and have a material adverse effect on our financial position, results of operations and/or liquidity.
In accordance with ASC Topic 450, Contingencies, we accrue anticipated costs of settlement, damages, losses for product liability claims and, under certain conditions, costs of defense, based on historical experience or to the extent specific losses are probable and estimable. Otherwise, we expense these costs as incurred. If the estimate of a probable loss is a range and no amount within the range is more likely, we accrue the minimum amount of the range.
Our accrual for legal matters that are probable and estimable was $2.375 billion as of June 30, 2016 and $1.936 billion as of December 31, 2015, and includes certain estimated costs of settlement, damages and defense. We recorded $628 million of litigation-related charges during the first half of 2016 and $192 million of litigation-related charges during the first half of 2015. We continue to assess certain litigation and claims to determine the amounts, if any, that management believes will be paid as a result of such claims and litigation and, therefore, additional losses may be accrued and paid in the future, which could materially adversely impact our operating results, cash flows and/or our ability to comply with our debt covenants.
In management's opinion, we are not currently involved in any legal proceedings other than those disclosed in our most recent Annual Report on Form 10-K and our Quarterly Report on Form 10-Q for the quarter ended March 31, 2016 and those specifically identified below, which, individually or in the aggregate, could have a material adverse effect on our financial condition, operations and/or cash flows. Unless included in our legal accrual or otherwise indicated below, a range of loss associated with any individual material legal proceeding cannot be estimated.
Patent Litigation
On April 19, 2016, a subsidiary of Boston Scientific filed suit against Edwards Lifesciences Corporation in the United States District Court for the District of Delaware for patent infringement. We allege that Edwards’ SAPIEN 3 valve infringes a patent related to adaptive sealing technology. On June 9, 2016, Edwards filed a counterclaim alleging that our Lotus™ transcatheter heart valve system infringes three patents owned by Edwards.
Product Liability Litigation
As of August 1, 2016, over 39,000 product liability cases or claims related to transvaginal surgical mesh products designed to treat stress urinary incontinence and pelvic organ prolapse have been asserted against us. The pending cases are in various federal and state courts in the United States and include eight putative class actions. There were also fewer than 20 cases in Canada, inclusive of four putative class actions, and fewer than 20 claims in the United Kingdom. Generally, the plaintiffs allege personal injury associated with use of our transvaginal surgical mesh products. The plaintiffs assert design and manufacturing claims, failure to warn, breach of warranty, fraud, violations of state consumer protection laws and loss of consortium claims. Over 3,100 of the cases have been specially assigned to one judge in state court in Massachusetts. On February 7, 2012, the Judicial Panel on Multi-District Litigation (MDL) established MDL-2326 in the U.S. District Court for the Southern District of West Virginia and transferred the federal court transvaginal surgical mesh cases to MDL-2326 for coordinated pretrial proceedings. During the fourth quarter of 2013, we received written discovery requests from certain state attorneys general offices regarding our transvaginal surgical mesh products. We have responded to those requests. As of August 1, 2016, we have entered into master settlement agreements with certain plaintiffs' counsel to resolve an aggregate of approximately 11,000 cases and claims. These master settlement agreements provide that the settlement and distribution of settlement funds to participating claimants are conditional upon, among other things, achieving minimum required claimant participation thresholds. Of the 11,000 cases and claims, 6,000 have met the conditions of the settlement and are final. All settlement agreements were entered into solely by way of compromise and without any admission or concession by us of any liability or wrongdoing. In addition, we continue to engage in discussions with various
plaintiffs’ counsel regarding potential resolution of pending cases and claims and, as of August 1, 2016, have made substantial progress in discussions with plaintiffs’ counsel representing approximately 8,000 additional cases and claims.
We have established a product liability accrual for known and estimated future cases and claims asserted against us as well as with respect to the actions that have resulted in verdicts against us and the costs of defense thereof associated with our transvaginal surgical mesh products. While we believe that our accrual associated with this matter is adequate, changes to this accrual may be required in the future as additional information becomes available. While we continue to engage in discussions with plaintiffs’ counsel regarding potential resolution of pending cases and claims and intend to vigorously contest the cases and claims asserted against us; that do not settle, the final resolution of the cases and claims is uncertain and could have a material impact on our results of operations, financial condition and/or liquidity. Initial trials involving our transvaginal surgical mesh products have resulted in both favorable and unfavorable judgments for us. We do not believe that the judgment in any one trial is representative of potential outcomes of all cases or claims related to our transvaginal surgical mesh products.
Governmental Investigations and Qui Tam Matters
On May 5, 2014, we were served with a subpoena from the U.S. Department of Health and Human Services, Office of the Inspector General. The subpoena seeks information relating to the launch of the Cognis and Teligen line of devices in 2008, the performance of those devices from 2007 to 2009, and the operation of the Physician Guided Learning Program. On May 6, 2016, a qui tam lawsuit in this matter was unsealed in the U.S. District Court for the District of Minnesota. At the same time, we learned that U.S. Government and the State of California had earlier declined to intervene in that lawsuit on April 15, 2016. The complaint was served on us on July 21, 2016
Other Proceedings
On September 28, 2011, we served a complaint against Mirowski Family Ventures LLC in the U.S. District Court for the Southern District of Indiana for a declaratory judgment that we have paid all royalties owed and did not breach any contractual or fiduciary obligations arising out of a license agreement. Mirowski answered and filed counterclaims requesting damages. On May 13, 2013, Mirowski Family Ventures served us with a complaint alleging breach of contract in Montgomery County Circuit Court, Maryland, and they amended this complaint on August 1, 2013. On July 29, 2013, the Indiana case was dismissed. On September 10, 2013, we removed the case to the United States District Court for the District of Maryland. On June 5, 2014, the District Court granted Mirowski’s motion to remand the case to the Montgomery County Circuit Court. On September 24, 2014, following a jury verdict against us, the Montgomery County Circuit Court entered a judgment that we breached our license agreement with Mirowski and awarded damages of $308 million. On October 28, 2014, the Montgomery County Circuit Court denied our post-trial motions seeking to overturn the judgment. On November 19, 2014, we filed an appeal with the Maryland Court of Special Appeals. On January 29, 2016, the Maryland Court of Special Appeals affirmed the decision of the Montgomery County Circuit Court. On February 2, 2016, we filed a motion for reconsideration, which was denied. On July 12, 2016, the Maryland Court of Appeals denied our petition for certiorari. We plan to seek United States Supreme Court review. On July 26, 2016, we paid $366 million in satisfaction of the judgment and interest, subject to a right of rescission should the judgment be reversed.
Refer to Note H - Income Taxes for information regarding our tax litigation.
Matters Concluded Since December 31, 2015
On April 24, 2014, Dr. Qingsheng Zhu and Dr. Julio Spinelli, acting jointly on behalf of the stockholder representative committee of Action Medical, Inc. (Action Medical), filed a lawsuit against us and our subsidiary, Cardiac Pacemakers, Inc. (CPI), in the U.S. District Court for the District of Delaware. The stockholder representatives alleged that we and CPI breached a contractual duty to pursue development and commercialization of certain patented heart pacing methods and devices and to return certain patents. On March 15, 2016, the Court granted summary judgment in our favor as to all of plaintiffs’ claims for damages. The parties subsequently reached a resolution on the remaining claim and counterclaim concerning specific performance, and the case was dismissed on June 29, 2016.