SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549FORM 10-Q
Commission File Number: 01-14010
Registrant’s telephone number, including area code: (508) 478-2000
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 and 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
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Number of shares outstanding of the Registrant’s common stock as of November 11, 2003: 121,422,740.
TABLE OF CONTENTS
WATERS CORPORATION AND SUBSIDIARIESQUARTERLY REPORT ON FORM 10-Q
INDEX
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WATERS CORPORATION AND SUBSIDIARIES
The accompanying notes are an integral part of the consolidated financial statements.
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1. Basis of Presentation and Significant Accounting Policies
Waters Corporation (“Waters” or the “Company”), an analytical instrument manufacturer, manufactures and distributes, through its Waters Division, high performance liquid chromatography (“HPLC”) instruments, chromatography columns and other consumables, and related service, as well as mass spectrometry (“MS”) instruments, which are complementary products that can be integrated and used along with other analytical instruments, especially HPLC. HPLC, the largest product segment of the analytical instrument market, is utilized in a broad range of industries to detect, identify, monitor and measure the chemical, physical and biological composition of materials, and to purify a full range of compounds. MS instruments are used in drug discovery and development, including clinical trial testing, the analysis of proteins in disease processes (known as “proteomics”) and environmental testing. Through its TA Instruments Division (“TAI”), the Company designs, manufactures and sells thermal analysis and rheology instruments which are used in predicting the suitability of polymers and viscous liquids for various industrial, consumer goods and health care products. In the third quarter of fiscal year 2003, the Company completed the integration of the Micromass field sales, service, distribution and manufacturing organization into the Waters Division and changed the internal reporting structure to reflect this integration. Accordingly, the Micromass operating segment has been integrated into the Waters operating segment. As discussed in Note 16 to the consolidated financial statements, the Company has two operating segments, which have been aggregated into one reporting segment for financial statement purposes.
The accompanying unaudited interim consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all the information and note disclosures required by generally accepted accounting principles (“GAAP”) in the United States of America. The consolidated financial statements include the accounts of the Company and its subsidiaries. All material intercompany balances and transactions have been eliminated.
Certain amounts from prior years have been reclassified in the accompanying financial statements in order to be consistent with the current year’s classifications. In particular, the Company reclassified field service expenses associated with service revenues from selling, general and administrative expenses to cost of sales in 2002. For the three months and nine months ended September 30, 2002, the amount of costs reclassified to cost of sales were $14.9 million and $42.7 million, respectively, and the gross profit as a percentage of sales decreased 6.9% and 6.7%, for each period. This change was primarily a result of the integration of the Company’s HPLC and MS field sales, service and distribution operations and to align the Company’s reporting with the majority of other companies in the same industry. In the first quarter of 2003, the Company reclassified all MS and thermal analysis demonstration (“demo”) inventory from property, plant and equipment, net, to inventories. At December 31, 2002, the amount of demo inventory reclassified to inventories was $18.7 million. The primary reason for this change was to consistently classify demo inventory across product segments.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect (i) the reported amounts of assets and liabilities, (ii) disclosure of contingent liabilities at the dates of the financial statements and (iii) the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
It is management’s opinion that the accompanying interim consolidated financial statements reflect all adjustments (which are normal and recurring) necessary for a fair presentation of the results for the interim periods. The interim consolidated financial statements should be read in conjunction with the consolidated financial statements included in the Company’s Form 10-K filing with the Securities and Exchange Commission for the year ended December 31, 2002.
Stock-Based Compensation:The Company has four stock-based compensation plans. The Company uses the intrinsic value method of accounting prescribed by Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees, and related interpretations, including Financial Interpretation (“FIN”) 44, Accounting for Certain Transactions Involving Stock Compensation, for its plans. No compensation expense has been recognized for its fixed employee stock option plans and its employee stock purchase plan since all stock-based compensation awards are granted at the current fair value of the Company’s common stock as of the date of the award.
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WATERS CORPORATION AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(IN THOUSANDS, EXCEPT PER SHARE DATA)
The following table illustrates the effect on net income and earnings per share (“EPS”) had the Company applied the fair value recognition provisions of SFAS 123 for the Company’s four stock-based compensation plans.
Change in Accounting for Patent Related Costs:In the second quarter of 2002, the Company changed its method of accounting for legal costs associated with litigating patent cases, effective January 1, 2002. Prior to the change, the Company capitalized these patent costs and amortized them over the estimated remaining economic life of the patent. Under the new method, these costs are expensed as incurred. The Company believes that this change is preferable because it provided a better comparison with the Company’s industry peers, the majority of which expense these costs as incurred. The $4.5 million cumulative effect of the change on prior years (after reduction for income taxes of $1.3 million) is included as a charge to net income as of January 1, 2002. The effect of the change on the three months ended September 30, 2002 was to decrease net income by approximately $.4 million with no effect on net income per diluted share. The effect of the change on the nine months ended September 30, 2002 was to decrease income before cumulative effect of a change in accounting principle approximately $1.7 million or $0.01 per diluted share and net income $6.2 million or $0.05 per diluted share.
Product Warranty Costs:The Company accrues estimated product warranty costs at the time of sale, which are included in cost of sales in the consolidated statements of operations. While the Company engages in extensive product quality programs and processes, including actively monitoring and evaluating the quality of its component supplies, the Company’s warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. The amount of the accrued warranty liability is based on historical information such as past experience, product failure rates, number of units repaired and estimated costs of material and labor. The liability is reviewed for reasonableness at least quarterly.
The following is a rollforward of the Company’s accrued warranty liability for the period ended September 30, 2003:
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Stockholders’ Equity:On June 25, 2002, the Company’s Board of Directors authorized the Company to repurchase up to $200.0 million of its outstanding common shares over a one-year period. During the three months ended March 31, 2003, the Company purchased 4,399 shares of its common stock for $100.6 million, thus completing its $200.0 million stock buyback program. The total shares purchased under this program were 8,477.
On May 6, 2003, the Company’s Board of Directors authorized the Company to repurchase up to $400.0 million of its outstanding common shares over a two-year period. During the three months ended September 30, 2003, the Company purchased 2,760 shares of its common stock for $84.3 million. Year to date ended September 30, 2003, the Company purchased 5,210 shares of its common stock for $151.2 million. At September 30, 2003, the Company had borrowings outstanding under its credit facility of $179.0 million principally to finance share repurchases.
In the aggregate, the Company repurchased 9,609 shares of its common stock for $251.8 million during the nine months ended September 30, 2003.
2. Restricted Cash
At December 31, 2002, restricted cash was $49.9 million, which represented credit support for a standby letter of credit issued securing damages awarded plus interest with respect to the Applera patent litigation (Note 11). In April 2003, the Company made a payment of $53.7 million for damages and interest relating to this patent litigation and, as a result, the Company is no longer required to maintain a restricted cash balance.
3. Inventories
Inventories are classified as follows:
The Company classifies demo inventory in inventories. Depreciation relating to demo inventory is included as such in the statement of cash flows. Demo inventory is depreciated over three to four years using the straight-line method. In the first quarter of 2003, the Company reclassified all MS and thermal analysis demo inventory from property, plant and equipment, net, to inventories. At December 31, 2002, the amount of demo inventory reclassified to inventories was $18.7 million. The primary reason for this change was to consistently classify demo inventory across product segments.
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4. Business Investments
From November 2000 through February 2002, the Company made minority equity investments in GeneProt™, Inc. (“GeneProt”), in amounts aggregating to $13.6 million. The investment in GeneProt was accounted for under the cost method of accounting. Due to changes in GeneProt’s ability to generate enough commercial interest to expand its business in the U.S. market, the Company recorded pre-tax charges of $6.5 million in the nine months ended September 30, 2002 and $6.1 million in the three months ended December 31, 2002, to other income (expense) in the consolidated statements of operations, for an other-than-temporary impairment of its investment in GeneProt. The investment in GeneProt was approximately $1.0 million at September 30, 2003 and December 31, 2002, and is included in other assets. In connection with GeneProt’s canceled order of up to $20.0 million of mass spectrometry equipment, related systems and services, the Company received approximately $7.7 million from GeneProt as a cancellation fee, which is recorded in other income (expense) in the consolidated statements of operations for the nine months ended September 30, 2002.
In June 2000, the Company formed a strategic alliance with Variagenics, Inc. (“Variagenics”) to develop and commercialize genetic variance reagent kits for use in the clinical development of pharmaceutical products. Variagenics was considered a leader in applying genetic variance information to the drug development process. In July 2000, the Company paid Variagenics $7.5 million for a minority common stock equity ownership and $3.0 million for a license to manufacture and sell reagents, and warrants to purchase common stock. The warrants to purchase Variagenics common stock are exercisable at $14 per share for a period of 5 years. The warrants were valued at approximately $.7 million using the Black-Scholes model at December 31, 2001. The investment in Variagenics is included in other assets and carried at fair value with unrealized gains and losses reported as a separate component of other comprehensive income (loss). During the nine months ended September 30, 2002, the Company recorded a pre-tax $1.0 million charge to other income (expense) in the consolidated statements of operations, for an other-than-temporary impairment of the equity investment and warrants resulting from Variagenics’s public stock price declines that the Company believes reflected the lack of profitable operations and a capital market that had little liquidity for small biotech companies. In the fourth quarter of 2002, the license with Variagenics described above was deemed fully impaired as the technology collaboration program ceased and the Company abandoned the technology, and the Company recorded a $2.4 million charge to impairment of long-lived intangible asset in the consolidated statements of operations. The license was being amortized on a straight-line basis over its useful life of 15 years. On January 31, 2003 Variagenics was merged with Hyseq Pharmaceuticals and is now named Nuvelo, Inc. (“Nuvelo”). The carrying amount of the investment was approximately $2.7 million and $.8 million at September 30, 2003 and December 31, 2002, respectively.
At September 30, 2003, no other investments and long-lived assets were determined to be impaired.
5. Acquisitions
Creon:
The acquisition of Creon was accounted for under the purchase method of accounting and the results of operations of Creon have been included in the consolidated results of the Company from the acquisition date. The purchase price of the acquisition was allocated to tangible and intangible assets and assumed liabilities based on their estimated fair values. In conjunction with the acquisition, the Company recorded a charge of $5.2 million for the write-off of acquired in-process research and development. The technological feasibility of in-process research and development projects had not been established at the date of acquisition and had no alternative future use. The Company has allocated $4.4 million of the purchase price to intangible assets comprised of customer lists and other purchased intangibles. The excess purchase price of $5.4 million after this allocation has been accounted for as goodwill.
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The following represents the pro forma results of the ongoing operations for Waters and Creon as though the acquisition of Creon had occurred at the beginning of the period shown. The pro forma results exclude expensed in-process research and development. The pro forma information however, is not necessarily indicative of the results that would have resulted had the acquisition occurred at the beginning of the periods presented, nor is it necessarily indicative of future results.
The Company considered a number of factors to determine the purchase price allocation, including engaging a third party valuation firm to independently appraise the fair value of certain assets acquired. The following table presents the fair values of assets and liabilities recorded in connection with the Creon acquisition.
The Company recorded $.2 million in purchase accounting liabilities relating to the Creon acquisition.
Rheometrics:
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The Company considered a number of factors to determine the purchase price allocation, including engaging a third party valuation firm to independently appraise the fair value of certain assets acquired. The following table presents the fair values of assets and liabilities recorded in connection with the Rheometrics acquisition.
The Company recorded approximately $4.1 million in purchase accounting liabilities relating to the Rheometrics acquisition. The purchase accounting liabilities included $1.2 million for severance costs for approximately 65 employees, of which 64 employees were terminated as of September 30, 2003, and $.9 million in facilities related costs for three facilities, all of which have been closed as of September 30, 2003.
The following is a rollforward of the Rheometrics acquisition schedule of amounts accrued under purchase accounting and related utilization:
Korea:
The pro forma effects of the Rheometrics and Korea acquisitions are immaterial.
6. Expensed In-Process Research and Development
In connection with Waters acquisition of Creon, the Company wrote-off the fair value of purchased in-process research and development (“IPR&D”) of various projects for the development of new products and technologies in the amount of $5.2 million. Management determined the valuation of the IPR&D using, among other factors, appraisals. The value was based primarily on the discounted cash flow method. This valuation included consideration of (i) the stage of completion of each of the projects, (ii) the technological feasibility of each of the projects, (iii) whether the projects had an alternative future use, and (iv) the estimated future residual cash flows that could be generated from the various projects and technologies over their respective projected economic lives.
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As of the Creon acquisition date, there were several projects under development at different stages of completion. The primary basis for determining the technological feasibility of these projects was whether the product has met predetermined design specifications and complex functionality. As of the acquisition date, none of the IPR&D projects had reached predetermined design specifications and complex functionality. In assessing the technological feasibility of a project, consideration was also given to the level of complexity in future technological hurdles that each project had to overcome. As of the acquisition date, none of the IPR&D projects were considered to be technologically feasible or to have any alternative future use.
Future residual cash flows that could be generated from each of the projects were determined based upon management’s estimate of future revenue and expected profitability of the various products and technologies involved. These projected cash flows were then discounted to their present values taking into account management’s estimate of future expenses that would be necessary to bring the projects to completion. The discount rates include a rate of return, which accounts for the time value of money, as well as risk factors that reflect the economic risk that the cash flows projected may not be realized. The cash flows were discounted at discount rates ranging from 55% to 60% per annum, depending on the project’s stage of completion and the type of complex functionality needed. This discounted cash flow methodology for the various projects included in the purchased IPR&D resulted in a total valuation of $5.2 million. Although work on the projects related to the IPR&D continued after the acquisition, the amount of the purchase price allocated to IPR&D was written off because the projects underlying the IPR&D that was being developed were not considered technologically feasible as of the acquisition date. As of September 30, 2003, the projects are in various stages of completion. There are currently no expected material variations between projected results from the projects versus those at the time of the acquisition.
7. Divestiture of Business
On March 26, 2003, the Company sold the net assets of its mass spectrometry inorganic product line for approximately $1.2 million in cash and the balance in notes receivable. Assets sold included inventory and certain accounts receivable, and liabilities assumed by the acquirer consisted of deferred service revenue and advance payment obligations, and warranty and installation obligations. The Company recorded a loss on disposal of approximately $5.0 million, including severance costs of approximately $.3 million. This business generated sales of approximately $14.0 million per year with no contribution to earnings.
8. Goodwill and Other Intangibles
The carrying amount of goodwill was $193.3 million and $167.9 million at September 30, 2003 and December 31, 2002, respectively. The increase is attributed to the Company’s three acquisitions (Note 5) during the period of approximately $22.9 million and currency translation adjustments of approximately $2.5 million.
The Company’s intangible assets in the consolidated balance sheets are detailed as follows:
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For the three months ended September 30, 2003 and 2002, amortization expense for intangible assets was $3.0 million and $3.1 million, respectively. For the nine months ended September 30, 2003 and 2002, amortization expense for intangible assets was $8.8 million and $8.3 million, respectively. Amortization expense for intangible assets is estimated to be approximately $12.5 million for each of the next five years.
9. Debt
At September 30, 2003 and December 31, 2002, the Company had aggregate borrowings outstanding under its $250.0 million line of credit of $179.0 million and $0, respectively. The Company’s foreign subsidiaries also had available short-term lines of credit with related short-term borrowings at September 30, 2003 and December 31, 2002 of $2.1 million and $2.7 million, respectively. In July 2003, the Company modified its Master Credit Agreement, a revolving credit facility, which allows for a newly created domestic subsidiary to be excluded as a guarantor of the Company’s borrowing under the facility.
10. Income Taxes
The Company’s effective tax rate for the three months ended September 30, 2003 and 2002, was 25.4% and 23.0%, respectively. The Company’s effective tax rate for the nine months ended September 30, 2003 and 2002, was 23.6% and 22.9%, respectively. The increase in the effective tax rates is primarily due to the expensed in-process research and development charge related to the Creon acquisition of $5.2 million in the three and nine months ended September 30, 2003 not being tax deductible under German statutory law.
11. Patent Litigation
Applera Corporation:
In March 2002, the Company was informed of a jury’s finding that the Quattro Ultima with Mass Transit ion tunnel technology infringes the patent. The same jury found that the infringement was not willful and determined damages in the amount of $47.5 million. The Court entered an injunction in which the Company is enjoined from making, using and selling in the U.S. the Quattro Ultima triple quadrupole mass spectrometer incorporating features of the patent.
On March 11, 2003, the District Court’s decision was affirmed on appeal. In April 2003, the Company paid total damages and interest of approximately $53.7 million to the plaintiffs. These instruments are manufactured in the United Kingdom and shipments to the rest of the world outside of the United States are not subject to this litigation. Similar claims have been asserted against the Company by the plaintiffs in Japan and Canada, and there is a possibility that claims may be made with respect to other products in the mass spectrometry product line. Based on the facts available to management, the Company believes the outcome of any such claims, should they be brought, cannot be predicted with certainty, but could be material to the Company’s financial position, results of operations and liquidity. The Company believes, however, that the results of the current U.S. litigation will not control the decisions in other countries.
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The Company believes that any liability ultimately incurred in this matter, in current and potential future litigation, will not likely exceed the provisions recorded, including interest, court costs, legal fees and other charges. However, in the event of an unanticipated adverse final determination in respect of certain matters, the Company’s consolidated net income for the period in which such determination occurs could be materially affected. Although uncertainties exist to preclude the Company from precisely determining the amount of the exact liability, the accrued patent litigation expenses of $19.9 million and $74.9 million recorded as of September 30, 2003 and December 31, 2002, respectively, in the consolidated balance sheets, is the Company’s best estimate of its exposure for this liability based on information currently available. During the nine months ended September 30, 2003, the Company recorded a $.5 million pre-tax charge for additional liabilities associated with interest costs. During the nine months ended September 30, 2003, the Company paid damages and interest of $53.7 million, made legal payments of $.4 million, and reversed approximately $.9 million of interest as a credit to interest expense in the quarter. The Company believes it has meritorious arguments in each case, although the outcome is not certain.
MDS, Inc. and Applied BioSystems/MDS Sciex Instruments (the “Plaintiffs”) filed a civil action against Micromass UK Limited, Waters Limited, wholly owned subsidiaries of the Company, and the Company, in the High Court of Justice, Chancery Division, Patents Court, UK on October 31, 2003. The Plaintiffs allege that certain of the Company’s mass spectrometry products infringe European Patent (UK) No. 0 373 835 (the “European Patent”). To the Company’s knowledge, the European Patent is owned by MDS, Inc. and licensed to a joint venture with Applied BioSystems/MDS Sciex Instruments. The Plaintiffs are seeking an injunction against the Company to restrain it from infringing the Patent and an unspecified award of damages. The Company believes it has meritorious arguments of non-infringement of the Patent, although the outcome is not certain.
Hewlett-Packard Company:The Company filed suit in the U.S. against Hewlett-Packard Company and Hewlett-Packard GmbH (collectively, “HP”), seeking a declaration that certain products sold under the mark “Alliance” do not constitute an infringement of one or more patents owned by HP or its foreign subsidiaries (the “HP patents”). The action in the U.S. was dismissed for lack of controversy. Actions seeking revocation or nullification of foreign HP patents were filed by the Company in Germany, France and England. A German patent tribunal found the HP German patent to be valid. In Germany, France and England, HP and its successor, Agilent Technologies Deutschland GmbH, have brought an action alleging that certain features of the Alliance pump may infringe the HP patents. In England, the Court of Appeal has found the HP patent valid and infringed. The Company’s petitions for leave to appeal to the House of Lords have been denied. In France, the Paris District Court has found the HP patent valid and infringed by the Alliance pump. The Company has appealed the French decision. A German court has found the patent infringed. The Company has appealed the German decision. The Company recorded a provision in the second quarter of 2002 for estimated damages incurred with respect to this ongoing litigation. This provision represents management’s best estimate of the probable and reasonably estimable loss related to this litigation.
Perkin-Elmer Corporation:The Company, through its subsidiary TAI, asserted a claim against The Perkin-Elmer Corporation (“PE”) alleging patent infringement of three patents owned by TAI (the “TAI patents”). PE counterclaimed for infringement of a patent owned by PE (the “PE patent”). The U.S. District Court for the District of Delaware granted judgment as a matter of law in favor of TAI and enjoined PE from infringing the TAI patents. PE appealed the District Court judgment in favor of TAI to the federal appellate court. The District Court’s judgment, with respect to PE’s infringement of the TAI patents, was affirmed. The District Court’s judgment with respect to TAI’s non-infringement of the PE patent was reversed and remanded to the District Court for further proceedings.
On remand to the District Court in October 2002, a jury found PE liable to TAI for damages of $13.3 million and found TAI did not infringe the PE patent. In May 2003, the District Court entered judgment on the jury’s verdict in favor of the Company. PE has appealed the judgment with respect to TAI’s non-infringement of the PE patent. As of September 30, 2003, no gain has been recorded and all litigation costs have been expensed as incurred.
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12. Environmental Contingency
In July 2003, the Company entered into a settlement agreement (the “Settlement Agreement”) with the Commonwealth of Massachusetts, acting by and through the Attorney General and the Department of Environmental Protection, with respect to alleged non-compliance with state environmental laws at its Taunton, Massachusetts facility. Pursuant to the terms of a final judgment entered in the Superior Court of the Commonwealth on July 10, 2003, the Company paid a civil penalty of $5.9 million. In addition, the Company has agreed to conduct a Supplemental Environmental Project in the amount of $.6 million, comprised of investments in capital infrastructure, to study the effects of bio-filtration on certain air emissions from the Taunton facility and for the purchase of equipment in connection therewith. Pursuant to the terms of the Settlement Agreement, the Company has also agreed to undertake a variety of actions to ensure that air emissions from the facility do not exceed certain limits and that the facility is brought into full compliance with all applicable environmental regulations.
13. Restructuring and Other Unusual Charges (Credits), net
In July 2002, the Company took action to restructure and combine the Company’s field sales, service and distribution organizations of its Micromass and HPLC operations. In May 2003, the Company took action to restructure and combine the Company’s Micromass and HPLC manufacturing operations. The objective of these integrations is to leverage the strengths of both divisions and align and reduce operating expenses. The integration efforts impacted the U.S., Canada, continental Europe and the United Kingdom. Approximately 50 employees were to be terminated, all of which had left the Company as of September 30, 2003. In addition, the Company has committed to closing three selling and distribution facilities, one of which was closed by September 30, 2003. The Company is in various stages of terminating distributor contracts, one of which was terminated as of September 30, 2003. The provision of $1.9 million for the nine months ended September 30, 2003 represents costs incurred including severance costs for 10 employees and other directly related incremental costs of this integration effort. During the three months ended September 30, 2003, the Company reversed approximately $.9 million in restructuring reserves, primarily attributable to distribution settlements being less than previously estimated and the retention of certain employees previously selected for termination.
At September 30, 2003, approximately $1.6 million of the Company’s liability for non-cancelable lease obligations is included in other long-term liabilities in the consolidated balance sheet with a portion to be paid extending out to 2012. The remaining $1.9 million of the liability is expected to be paid in 2003 and is included in other current liabilities in the consolidated balance sheet.
The following is a rollforward of the Company’s Micromass and HPLC restructuring liability and other unusual charges:
For the nine months ended September 30, 2003, the Company recorded an unrelated restructuring provision of $.1 million at its TAI subsidiary for severance and other related costs. There will be further restructuring costs incurred in subsequent periods relating to the integration of Rheometrics and the integration of the mass spectrometry and HPLC manufacturing operations.
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14. Earnings Per Share
Basic and diluted earnings per share calculations are detailed as follows:
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For the three months and nine months ended September 30, 2003, the Company had 3,595 and 3,641 stock option securities that were antidilutive, respectively. For the three months and nine months ended September 30, 2002, the Company had 3,838 and 3,805 stock option securities that were antidilutive, respectively. These securities were not included in the computation of diluted EPS. The effect of dilutive securities was calculated using the treasury stock method.
15. Comprehensive Income
Comprehensive income details follow:
16. Business Segment Information
In the third quarter of fiscal year 2003, the Company completed the integration of the Micromass field sales, service, distribution and manufacturing organization into the Waters Division and changed the internal reporting structure to reflect this integration. Accordingly, the Micromass operating segment has been integrated into the Waters operating segment.
The Company evaluated its business activities that are regularly reviewed by the Chief Executive Officer for which discrete financial information is available. As a result of this evaluation, the Company determined that it has two operating segments: Waters and TAI.
Waters is in the business of manufacturing and distributing HPLC instruments, columns, other consumables and mass spectrometry instruments that can be integrated and used along with other analytical instruments. TAI is in the business of manufacturing and distributing thermal analysis and rheology instruments. The Company’s two operating segments have similar economic characteristics, product processes, products and services, types and classes of customers, methods of distribution, and regulatory environments. Because of these similarities, the two segments have been aggregated into one reporting segment for financial statement purposes. Please refer to the consolidated financial statements for financial information regarding the one reportable segment of the Company.
17. Recent Accounting Standards Changes
In May 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS 150 established standards for how to classify and measure certain financial instruments with characteristics of both liabilities and equity. The provisions of SFAS 150 were effective for financial instruments entered into or modified after May 31, 2003. The application of SFAS 150 did not have a material impact on the Company’s financial position, results of operations, or cash flows.
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In April 2003, the FASB issued SFAS 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” The changes in SFAS 149 improve financial reporting by requiring that contracts with similar characteristics be accounted for similarly. SFAS 149 is effective, with some exceptions, for contracts entered into or modified after June 30, 2003. The application of SFAS 149 did not have a material impact on the Company’s financial position, results of operations, or cash flows.
In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities.” This interpretation clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” relating to consolidation of certain entities. FIN 46 requires identification of the Company’s participation in variable interest entities (“VIE”), which are defined as entities with a level of invested equity that is not sufficient to fund future activities to permit them to operate on a stand alone basis, or whose equity holders lack certain characteristics of a controlling financial interest. For entities identified as a VIE, FIN 46 sets forth a model to evaluate potential consolidation based on an assessment of which party to the VIE, if any, bears a majority of the risk to its expected losses, or stands to gain from a majority of its expected returns. FIN 46 applies immediately to VIEs created or acquired after January 31, 2003. The Company has not invested in any variable interest in any VIEs subsequent to January 31, 2003. FIN 46 also sets forth certain disclosures regarding interests in VIE’s that are deemed significant, even if consolidation is not required. The application of FIN 46 did not have a material impact on the Company’s financial position, results of operations, or cash flows.
In November 2002, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” EITF Issue 00-21 provides guidance on how to determine when an arrangement that involves multiple revenue-generating activities or deliverables should be divided into separate units of accounting for revenue recognition purposes, and if this division is required, how the arrangement consideration should be allocated among the separate units of accounting. The guidance in the consensus is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF Issue 00-21 did not have a material effect on the Company’s financial position, results of operations, or cash flows.
18. Subsequent Events
MDS, Inc. and Applied BioSystems/MDS Sciex Instruments (the “Plaintiffs”) filed a civil action against Micromass UK Limited, Waters Limited, wholly owned subsidiaries of the Company, and the Company, in the High Court of Justice, Chancery Division, Patents Court, UK on October 31, 2003. The Plaintiffs allege that certain of the Company’s mass spectrometry products infringe European Patent (UK) No. 0 373 835 (the “Patent”). To the Company’s knowledge, the Patent is owned by MDS, Inc. and licensed to a joint venture with Applied BioSystems/MDS Sciex Instruments. The Plaintiffs are seeking an injunction against the Company to restrain it from infringing the Patent and an unspecified award of damages. The Company believes it has meritorious arguments of non-infringement of the Patent, although the outcome is not certain.
Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Results of Operations
Net Sales:
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With respect to the Company’s performance by product line (excluding the effects of currency translation), HPLC sales, in the 2003 Quarter and the 2003 Period, grew approximately 5% and 3%, respectively. In the 2003 Quarter and the 2003 Period chemistry grew approximately 12% and 10%, respectively, primarily as a result of continued strength in sales related to pharmaceutical production. Service grew 14% for each of these periods due to increased sales of service plans to our installed base of customers. Growth in chemistry and service were offset by a decline in instrument sales of 2% and 4% during the 2003 Quarter and the 2003 Period, respectively. The decline in instrument sales is largely attributable to a combination of postponement’s and delay’s in purchase decisions for such instruments by the Company’s customers for new and replacement products. Geographically, sales in the U.S strengthened in the 2003 Quarter, as business conditions within pharmaceutical accounts improved modestly, while U.S. sales in the 2003 Period remained relatively flat. Sales within Europe remained weak this quarter while sales in Asia continued to grow strongly.
Mass spectrometry sales declined approximately 10% in the 2003 Quarter and the 2003 Period, excluding the impact of the disposal of the inorganic product line. The European and Japanese markets continued to experience sales declines in the 2003 Quarter. The U.S. markets had strong sales growth in the 2003 Quarter, despite weakened sales for the 2003 Period, as a result of improving business conditions within U.S. based pharmaceutical Company’s.
Sales for thermal analysis products continued to be strong in the 2003 Quarter and 2003 Period, with growth of approximately 9% and 22.1% respectively, excluding the impact of the recently acquired rheology business. The growth of this business is geographically broad-based with increased spending by core industrial chemical and pharmaceutical companies. The impact to sales in the 2003 Quarter and 2003 Period from the rheology business acquisition added an additional 18% and 14%, respectively, to the thermal analysis business growth.
Gross Profit:
Selling, General, and Administrative Expenses:
The increase of $13.1 million in operating expenses for the 2003 Period is primarily attributed to foreign exchange translation of approximately $11.4 million. Realized and unrealized foreign currency transaction gains and losses were gains of approximately $.3 million and $2.3 million in the 2003 Quarter and 2003 Period, respectively, compared to $0 and a loss of $1.0 million in the 2002 Quarter and 2002 Period, respectively.
Research and Development Expenses:
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Purchased Intangibles Amortization:
Litigation Provisions:
Loss on Disposal of Business:
Restructuring and Other Unusual Charges (Credits), net:
The integration efforts impacted the U.S., Canada, continental Europe and the United Kingdom. Approximately 50 employees were to be terminated, of which all had left the Company as of September 30, 2003. In addition, the Company has committed to closing three selling and distribution facilities, of which one was closed by September 30, 2003. The Company is in various stages of terminating distributor contracts, of which one was terminated as of September 30, 2003.
The following table provides additional information about the Micromass and HPLC restructuring and other unusual charges:
The amount of expected annual cost savings is approximately $6 million. The Company began realizing savings of approximately $1.5 million per quarter beginning in the second quarter of 2003. The Company believes that there were no material increases in other expenses or reductions in revenues as a result of this restructuring. The annual cost savings is comprised of head count reductions of approximately $4.2 million, reductions in related travel, promotional and other expenses of approximately $1.6 million and facility closures of approximately $.2 million.
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Expensed In-Process Research and Development:
Future residual cash flows that could be generated from each of the projects were determined based upon management’s estimate of future revenue and expected profitability of the various products and technologies involved. These projected cash flows were then discounted to there present values taking into account management’s estimate of future expenses that would be necessary to bring the projects to completion. The discount rates include a rate of return, which accounts for the time value of money, as well as risk factors that reflect the economic risk that the cash flows projected may not be realized. The cash flows were discounted at discount rates ranging from 55% to 60% per annum, depending on the project’s stage of completion and the type of complex functionality needed. This discounted cash flow methodology for the various projects included in the purchased IPR&D resulted in a total valuation of $5.2 million. Although work on the projects related to the IPR&D continued after the acquisition, the amount of the purchase price allocated to IPR&D was written off because the projects underlying the IPR&D that was being developed were not considered technologically feasible as of the acquisition date. As of September 30, 2003, the projects are in various stages of completion. There are currently no expected material variations between projected results from the projects versus those at the time of the acquisition.
Operating Income:
Other Income (Expense), Net:
Interest Expense:
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Interest Income:Interest income for the 2003 Quarter and the 2003 Period was $1.9 million and $5.4 million, respectively, compared to $1.9 million for the 2002 Quarter and $5.4 million for the 2002 Period. There was no change in interest income between the 2003 Quarter and the 2002 Quarter, and the 2003 Period and the 2002 Period as average cash balances and investment yields were approximately the same.
Provision for Income Taxes:The Company’s effective income tax rate was 25.4% in the 2003 Quarter and 23.6% in the 2003 Period, compared to 23.0% in the 2002 Quarter and 22.9% in the 2002 Period. The 2003 Quarter and Period rate increased primarily due to lower effective tax rates on special charges and the expensed in-process research and development charge related to the Creon acquisition of $5.2 million in the 2003 Quarter not being tax deductible under German statutory law.
Cumulative Effect of Change in Accounting Principle:In the 2002 Quarter, the method of accounting for patent related costs associated with patent litigation was changed effective January 1, 2002 from a method of capitalizing the patent related costs and amortizing them over their estimated remaining economic life, to expensing the costs as incurred. The Company believes that this change is preferable because it will provide a better comparison with the Company’s industry peers, the majority of which expense these costs as incurred. The $4.5 million cumulative effect of the change on prior years (after reduction for income taxes of $1.3 million) is included as a charge to net income for the nine months ended September 30, 2002.
Liquidity and Capital Resources
During the 2003 Period, net cash provided by the Company’s operating activities was $91.4 million, primarily as a result of net income for the 2003 Period and adding back depreciation of $16.5 million, amortization of intangible assets of $8.7 million, loss on sale of business of $5.0 million, tax benefits related to stock option exercises of $8.5 million, expensing of in-process research and development of $5.2 million and a decrease in working capital needs. During the 2003 Period, the Company paid approximately $59.6 million in connection with both the Applera patent litigation and the DEP settlement. Excluding the effects of currency translation and the Rheometrics and Creon acquisitions, accounts receivable decreased approximately $16.0 million due to an expected decrease in sales volume in the 2003 Period compared to the same period in 2002. Days-sales-outstanding were approximately 77 days at September 30, 2003, 4 days unfavorable in constant exchange rates versus the same period last year. Within liabilities, a decrease in accounts payable and other current liabilities used $25.7 million, primarily as income and other tax liabilities, and annual incentive payments were made.
The Company completed its $200 million stock repurchase program during the 2003 Period by purchasing $100.6 million of the Company’s common stock. On May 6, 2003 the Company’s Board of Directors authorized the Company to repurchase up to an additional $400 million in outstanding common shares over a two-year period. The Company believes that the share repurchase program is beneficial to shareholders by increasing earnings per share via reducing the outstanding shares through open market purchases. The Company believes it has the resources to fund this effort as well as to pursue acquisition opportunities in the future. As of September 30, 2003, 5,210 shares had been purchased under the 2003 plan for $151.2 million. In the aggregate, the Company repurchased 9,609 shares of its common stock for $251.8 million during the nine months ended September 30, 2003. The Company had net borrowings at the end of the 2003 Period of $181.1 million, primarily relating to borrowings in the U.S. under the Company’s credit facility for the stock repurchases. The Credit Agreement provides a $250.0 million line of credit, is unsecured in nature and has a five-year term. Loans under the Credit Agreement bear interest for each calendar quarter at an annual rate equal to, at the Company’s option, 1) the applicable LIBOR rate plus a varying margin between .60% and 1.50% or 2) prime rate. Other uses of cash flow during the 2003 Period were $35.2 million for acquisitions (Note 5) and $27.0 million for property, plant and equipment and software capitalization investments. From financing activities, the Company received $16.3 million of proceeds from the exercise of stock options and the purchase of shares pursuant to the employee stock purchase plans.
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In the fourth quarter of 2003, the Company intends to expand its existing $250 million Senior Revolving Credit Agreement dated February 2002 by $125 million. In addition the Company intends to amend the Senior Revolving Credit Agreement. The applicable interest to be charged will change from being based off of Debt to Total Capitalization to Debt to EBITDA. Loans under the amended Senior Revolving Credit Agreement will bear interest for each calendar quarter at an annual rate equal to, at the Company’s option 1) at the applicable LIBOR rate plus a varying margin between .60% and 1.50% or 2) prime rate. All of the other material terms and conditions will be substantially the same.
The Company believes that the existing cash and cash equivalent balance of $288.1 million and expected cash flow from operating activities together with borrowings available from its credit facility will be sufficient to fund working capital, capital spending requirements, authorized share repurchase amounts and any adverse final determination of ongoing litigation for at least the next twelve months. Management believes, as of the date of this report, its financial position along with expected future cash flows from earnings based on historical trends and the ability to raise funds from a number of financing alternatives and external sources, will be sufficient to meet future operating and investing needs beyond twelve months. The Company also held approximately $49.9 million of restricted cash at December 31, 2002 in connection with the standby letter of credit issued by the Company in 2002 for the unfavorable judgment in the Applera patent litigation (Note 11). As a result of the March 2003 affirmed judgment in the case, the Company paid approximately $53.7 million to Applera in April 2003. As a result of that payment, the Company is no longer required to maintain a restricted cash balance. In July 2003, the Company paid $5.9 million in settlement of the environmental matter with the Commonwealth of Massachusetts (Note 12).
Commitments:
At September 30, 2003, the Company had aggregate borrowings outstanding under its $250.0 million line of credit of $179.0 million. The Company’s foreign subsidiaries also had available short-term lines of credit with related short-term borrowings at September 30, 2003 of $2.1 million.
In May 2003, the Company’s Board of Directors authorized the Company to repurchase up to $400 million of its outstanding common stock over the next two years. As of September 30, 2003, approximately $151.2 million of common stock had been repurchased under this new stock repurchase program.
As a publicly held company, the Company has not paid any dividends and does not plan to pay any dividends in the foreseeable future. The amount of capital expenditures in the 2003 Period represents ongoing capital needs for the business and is not expected to proportionately change in a material manner for the remainder of the year. The Company’s commitments for lease agreements in the aggregate have not changed significantly from December 31, 2002.
Critical Accounting Policies and Estimates
In the Company’s Form 10-K for the year ended December 31, 2002, the Company’s most critical accounting policies and estimates upon which its financial status depends upon were identified as those relating to revenue recognition, loss provisions on accounts receivable and inventory, valuation of equity investments, long-lived assets, intangible assets and goodwill, warranty, income taxes and litigation. The Company reviewed its policies and determined that those policies remain the Company’s most critical accounting policies for the 2003 Period. The Company did not make any changes in those policies during the quarter.
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Forward-Looking Information
Safe Harbor Statement under Private Securities Litigation Reform Act of 1995
The statements included in this quarterly report on form 10-Q may contain “forward-looking” statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 regarding future results and events, including statements regarding expected financial results, future growth and customer demand and uncertainty relating to patent litigation that involve a number of risks and uncertainties. For this purpose, any statements contained herein that are not statements of historical fact may be deemed forward-looking statements. Without limiting the foregoing, the words, “believes”, “anticipates”, “plans”, “expects”, “intends”, “appears”, “estimates”, “projects”, and similar expressions are intended to identify forward-looking statements. The Company’s actual future results may differ significantly from the results discussed in the forward-looking statements within this quarterly report for a variety of reasons, including and without limitation, loss of market share through competition, introduction of competing products by other companies, pressures on prices from competitors and/or customers, the outcome of ongoing patent litigation, regulatory obstacles to new product introductions, lack of acceptance of new products, changes in the demands of the Company’s healthcare and pharmaceutical company customers, changes in the healthcare market and the pharmaceutical industry, changes in the distribution of the Company’s products, the availability of component parts from suppliers, the short-term effect on sales and expenses as a result of the recently completed combination of the Waters and Micromass sales, service and distribution organizations, and foreign exchange fluctuations. Such factors and others are discussed more fully in the section entitled “Risk Factors” of the Company’s Form 10-K for the year ended December 31, 2002, as filed with the Securities and Exchange Commission, which “Risk Factors” discussion is incorporated by reference in this quarterly report. The forward-looking statements included in this quarterly report represent the Company’s estimates or views as of the date of this quarterly report and should not be relied upon as representing the Company’s estimates or views as of any date subsequent to the date of this quarterly report. The Company specifically disclaims any obligation to update these forward-looking statements in the future.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes in the Company’s market risk during the nine months ended September 30, 2003. For additional information, refer to the Company’s Form 10-K, Item 7a for the year ended December 31, 2002.
Item 4. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
(b) Changes in Internal Controls
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Part II: OTHER INFORMATION
Item 1. Legal Proceedings
MDS, Inc. and Applied BioSystems/MDS Sciex Instruments:MDS, Inc. and Applied BioSystems/MDS Sciex Instruments (the “Plaintiffs”) filed a civil action against Micromass UK Limited, Waters Limited, wholly owned subsidiaries of the Company, and the Company, in the High Court of Justice, Chancery Division, Patents Court, UK on October 31, 2003. The Plaintiff’s allege that certain of the Company’s mass spectrometry products infringe European Patent (UK) No. 0 373 835 (the “European Patent”). To the Company’s knowledge, the European Patent is owned by MDS, Inc. and licensed to a joint venture with Applied BioSystems/MDS Sciex Instruments. The Plaintiffs are seeking an injunction against the Company to restrain it from infringing the Patent together with an unspecified award of damages. The Company believes it has meritorious arguments of non-infringement of the Patent, although the outcome is not certain.
Perkin-Elmer Corporation:The Company, through its subsidiary TAI, asserted a claim against The Perkin-Elmer Corporation (“PE”) alleging patent infringement of three patents owned by TAI (the “TAI patents”). PE counterclaimed for infringement of a patent owned by PE (the “PE patent”). The U.S. District Court for the District of Delaware granted judgment as a matter of law in favor of TAI and enjoined PE from infringing the TAI patents. PE appealed the District Court judgment in favor of TAI to the federal appellate court. The District Court’s judgment, with respect to PE’s infringement of the TAI patents, was affirmed. The District Court’s judgment with respect to TAI’s non-infringement of the PE patent was reversed and remanded to the District Court for further proceedings. On remand to the District Court in October 2002, a jury found PE liable to TAI for damages of $13.3 million and found TAI did not infringe the PE patent. In May 2003, the District Court entered judgment on the jury’s verdict in favor of the Company. PE has appealed the judgment with respect to TAI’s non-infringement of the PE patent. As of September 30, 2003, no gain has been recorded and all litigation costs have been expensed as incurred.
Environmental Legal Proceedings:In July 2003, the Company entered into a settlement agreement (the “Settlement Agreement”) with the Commonwealth of Massachusetts, acting by and through the Attorney General and the Department of Environmental Protection, with respect to alleged non-compliance with state environmental laws at its Taunton, Massachusetts facility. Pursuant to the terms of a final judgment entered in the Superior Court of the Commonwealth on July 10, 2003, the Company has paid a civil penalty of $5.9 million, in July 2003. In addition, the Company has agreed to conduct a Supplemental Environmental Project in the amount of $.6 million, comprised of investments in capital infrastructure, to study the effects of bio-filtration on certain air emissions from the Taunton facility and for the purchase of equipment in connection therewith. Pursuant to the terms of the Settlement Agreement, the Company has also agreed to undertake a variety of actions to ensure that air emissions from the facility do not exceed certain limits and that the facility is brought into full compliance with all applicable environmental regulations.
Item 2. Changes in Securities and Use of Proceeds Not Applicable
Item 3. Defaults Upon Senior Securities Not Applicable
Item 4. Submission of Matters to a Vote of Security Holders Not Applicable
Item 5. Other Information Not Applicable
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Item 6. Exhibits and Reports on Form 8-K
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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