XNYS:STE Steris Corp Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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

For the quarterly period ended June 30, 2012
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

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

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

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

The number of common shares outstanding as of July 27, 2012: 58,091,568

1


STERIS Corporation and Subsidiaries
Form 10-Q
Index
 


2


PART 1—FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS

STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
 
 
 
June 30,
2012
 
March 31,
2012
 
 
(Unaudited)
 
 
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
186,731

 
$
150,821

Accounts receivable (net of allowances of $9,719 and $11,428, respectively)
 
245,587

 
280,324

Inventories, net
 
162,085

 
157,712

Deferred income taxes, net
 
40,451

 
43,211

Prepaid expenses and other current assets
 
20,651

 
19,815

Total current assets
 
655,505

 
651,883

Property, plant, and equipment, net
 
385,847

 
386,409

Goodwill and intangibles, net
 
331,852

 
337,784

Other assets
 
30,142

 
29,620

Total assets
 
$
1,403,346

 
$
1,405,696

Liabilities and equity
 
 
 
 
Current liabilities:
 
 
 
 
Accounts payable
 
$
73,716

 
$
83,188

Accrued income taxes
 
5,887

 

Accrued payroll and other related liabilities
 
33,085

 
29,899

Accrued SYSTEM 1 Rebate Program and class action settlement
 
59,823

 
69,065

Accrued expenses and other
 
97,703

 
96,243

Total current liabilities
 
270,214

 
278,395

Long-term indebtedness
 
210,000

 
210,000

Deferred income taxes, net
 
40,017

 
42,703

Other liabilities
 
49,721

 
51,934

Total liabilities
 
$
569,952

 
$
583,032

Commitments and contingencies (see note 9)
 

 

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

 

Common shares, without par value; 300,000 shares authorized; 70,040 shares issued; 58,082 and 57,733 shares outstanding, respectively
 
238,704

 
244,091

Common shares held in treasury, 11,958 and 12,307 shares, respectively
 
(340,624
)
 
(350,718
)
Retained earnings
 
934,888

 
914,401

Accumulated other comprehensive income
 
(824
)
 
13,627

Total shareholders’ equity
 
832,144

 
821,401

Noncontrolling interest
 
1,250

 
1,263

Total equity
 
833,394

 
822,664

Total liabilities and equity
 
$
1,403,346

 
$
1,405,696

See notes to consolidated financial statements.
STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(Unaudited)
 
 
 
Three Months Ended June 30,
 
 
2012
 
2011
Revenues:
 
 
 
 
Product
 
$
213,753

 
$
202,013

Service
 
123,207

 
116,626

Total revenues
 
336,960

 
318,639

Cost of revenues:
 
 
 
 
Product
 
125,482

 
117,433

Service
 
74,226

 
68,281

Total cost of revenues
 
199,708

 
185,714

Gross profit
 
137,252

 
132,925

Operating expenses:
 
 
 
 
Selling, general, and administrative
 
79,774

 
77,009

Research and development
 
9,312

 
8,757

Restructuring expenses
 
(136
)
 
258

Total operating expenses
 
88,950

 
86,024

Income from operations
 
48,302

 
46,901

Non-operating expenses, net:
 
 
 
 
Interest expense
 
2,972

 
2,997

Interest income and miscellaneous expense
 
(260
)
 
107

Total non-operating expenses, net
 
2,712

 
3,104

Income before income tax expense
 
45,590

 
43,797

Income tax expense
 
15,236

 
15,066

Net income
 
$
30,354

 
$
28,731

Net income per common share
 
 
 
 
Basic
 
$
0.52

 
$
0.48

Diluted
 
$
0.52

 
$
0.48

Cash dividends declared per common share outstanding
 
$
0.17

 
$
0.15


See notes to consolidated financial statements.

STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
(Unaudited)

 
Three Months Ended June 30,
 
2012
 
2011
Net income
$
30,354

 
$
28,731

Unrealized (loss) gain on available for sale securities
(98
)
 
7

Amortization of pension and postretirement benefit plans costs, net of taxes
(175
)
 
(270
)
Change in cummulative foreign currency translation adjustment
(14,178
)
 
9,313

Total other comprehensive (loss) income
(14,451
)
 
9,050

Comprehensive income
$
15,903

 
$
37,781


See notes to consolidated financial statements.



STERIS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
 
 
 
Three Months Ended June 30,
 
 
2012
 
2011
Operating activities:
 
 
 
 
Net income
 
$
30,354

 
$
28,731

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
Depreciation, depletion, and amortization
 
14,337

 
14,435

Deferred income taxes
 
(432
)
 
9,828

Share-based compensation expense
 
1,660

 
1,918

Loss on the disposal of property, plant, equipment, and intangibles, net
 
174

 
314

Other items
 
(230
)
 
2,937

Changes in operating assets and liabilities, net of effects of acquisitions:
 
 
 
 
Accounts receivable, net
 
32,257

 
34,164

Inventories, net
 
(7,286
)
 
(20,830
)
Other current assets
 
(1,014
)
 
(3,422
)
Accounts payable
 
(8,300
)
 
(23,357
)
Accrued SYSTEM 1 Rebate Program and class action settlement
 
(9,242
)
 
(6,536
)
Accruals and other, net
 
8,989

 
(26,201
)
Net cash provided by operating activities
 
61,267

 
11,981

Investing activities:
 
 
 
 
Purchases of property, plant, equipment, and intangibles, net
 
(15,542
)
 
(15,588
)
Proceeds from the sale of property, plant, equipment, and intangibles
 
17

 

Acquisition of business, net of cash acquired
 

 
(22,269
)
Net cash used in investing activities
 
(15,525
)
 
(37,857
)
Financing activities:
 
 
 
 
Repurchases of common shares
 
(1,117
)
 
(6,131
)
Cash dividends paid to common shareholders
 
(9,867
)
 
(8,913
)
Stock option and other equity transactions, net
 
3,457

 
2,457

Tax benefit from stock options exercised
 
525

 
610

Net cash used in financing activities
 
(7,002
)
 
(11,977
)
Effect of exchange rate changes on cash and cash equivalents
 
(2,830
)
 
953

Increase (decrease) in cash and cash equivalents
 
35,910

 
(36,900
)
Cash and cash equivalents at beginning of period
 
150,821

 
193,016

Cash and cash equivalents at end of period
 
$
186,731

 
$
156,116


See notes to consolidated financial statements.


3


STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
For the Three Months Ended June 30, 2012 and 2011
(dollars in thousands, except per share amounts)

1. Nature of Operations and Summary of Significant Accounting Policies

Nature of Operations

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

We operate in three reportable business segments: Healthcare, Life Sciences, and STERIS Isomedix Services (“Isomedix”). We describe our business segments in note 10 to our consolidated financial statements titled, “Business Segment Information.” Our fiscal year ends on March 31. References in this Quarterly Report to a particular “year” or “year-end” mean our fiscal year. The significant accounting policies applied in preparing the accompanying consolidated financial statements of the Company are summarized below:

Interim Financial Statements

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

These interim consolidated financial statements should be read together with the consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended March 31, 2012 dated May 29, 2012. The Consolidated Balance Sheet at March 31, 2012 was derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

Principles of Consolidation

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

Use of Estimates

We make certain estimates and assumptions when preparing financial statements according to U.S. GAAP that affect the reported amounts of assets and liabilities at the financial statement dates and the reported amounts of revenues and expenses during the periods presented. These estimates and assumptions involve judgments with respect to many factors that are difficult to predict and are beyond our control. Actual results could be materially different from these estimates. We revise the estimates and assumptions as new information becomes available. This means that operating results for the three month period ended June 30, 2012 are not necessarily indicative of results that may be expected for future quarters or for the full fiscal year ending March 31, 2013.

Recently Adopted Accounting Pronouncements

    In June 2011, the FASB issued an accounting standard update titled "Presentation of Comprehensive Income," amending Accounting Standards Codification ASC Topic 220, "Comprehensive Income." This guidance requires that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This guidance became effective retrospectively for the interim periods and annual periods beginning after December 15, 2011; however, the FASB agreed to an indefinite deferral of the reclassification requirement as defined in accounting standard update titled "Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income," issued in December 2011. The adoption of this standard did not have an impact on our consolidated financial position, results of operations or cash flows.

Significant Accounting Policies

A detailed description of our significant and critical accounting policies, estimates, and assumptions is included in our consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2012 dated May 29, 2012. Our significant and critical accounting policies, estimates, and assumptions have not changed materially from March 31, 2012.

2. Restructuring

The following summarizes our restructuring plans announced in prior fiscal years. We recognize restructuring expenses as incurred. In addition, we assess the property, plant and equipment associated with the related facilities for impairment. Additional information regarding our restructuring plans is included in our Annual Report on Form 10-K for the year ended March 31, 2012 dated May 29, 2012.

Fiscal 2010 Restructuring Plan.

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

Since the inception of the Fiscal 2010 Restructuring Plan, we have incurred pre-tax expenses totaling $8,072 related to these actions, of which $6,975 was recorded as restructuring expenses and $1,097 was recorded in cost of revenues. We do not expect to incur any significant restructuring expenses related to this plan. These actions are intended to enhance profitability and improve efficiencies.

The following table summarizes our total pre-tax restructuring expenses for the first quarters of fiscal 2013 and fiscal 2012: 
Three Months Ended June 30,
Fiscal 2010
Restructuring
Plan (1)
Fiscal 2008
Restructuring
Plan
Total
 
2012
2011
2012
2011
2012
2011
Severance and other compensation related costs
$
(119
)
$
(55
)
$

$

$
(119
)
$
(55
)
Product rationalization

335




335

Asset impairment and accelerated depreciation
(17
)
92



(17
)
92

Lease termination obligation and other



(152
)

(152
)
Total restructuring charges
$
(136
)
$
372

$

$
(152
)
$
(136
)
$
220

(1)
Includes $(38) in charges recorded in cost of revenues on Consolidated Statements of Income for 2011.
  
Liabilities related to restructuring activities are recorded as current liabilities on the accompanying Consolidated Balance Sheets within “Accrued payroll and other related liabilities” and “Accrued expenses and other.” The following table summarizes our liabilities related to these restructuring activities:
 

4

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three Months Ended June 30, 2012 and 2011
(dollars in thousands)



 
 
Fiscal 2010 Restructuring Plan
 
 
 
 
Fiscal 2013
 
 
 
 
March 31,
2012
 
Provision (1)
 
Payments/
Impairments (2)
 
June 30,
2012
Severance and termination benefits
 
$
659

 
$
(119
)
 
$
28

 
$
568

Asset impairments and accelerated depreciation
 

 
(17
)
 
17

 

Lease termination obligations
 
947

 

 
(336
)
 
611

Other
 
76

 

 

 
76

Total
 
$
1,682

 
$
(136
)
 
$
(291
)
 
$
1,255

(1) Includes curtailment benefit of $125 related to International defined benefit plan. Additional information is included in note 8, "Benefit Plans."
(2) Certain amounts reported include the impact of foreign currency movements relative to the U.S. dollar.
 
3. Property, Plant and Equipment

Information related to the major categories of our depreciable assets is as follows:
 
 
 
June 30,
2012
 
March 31,
2012
Land and land improvements (1)
 
$
33,960

 
$
33,099

Buildings and leasehold improvements
 
227,844

 
230,823

Machinery and equipment
 
302,893

 
301,665

Information systems
 
106,120

 
110,130

Radioisotope
 
216,176

 
210,899

Construction in progress (1)
 
27,170

 
22,811

Total property, plant, and equipment
 
914,163

 
909,427

Less: accumulated depreciation and depletion
 
(528,316
)
 
(523,018
)
Property, plant, and equipment, net
 
$
385,847

 
$
386,409

(1)
Land is not depreciated. Construction in progress is not depreciated until placed in service.

4. Inventories, Net

Inventories, net are stated at the lower of cost or market. We use the last-in, first-out (“LIFO”) and first-in, first-out cost methods. An actual valuation of inventory under the LIFO method is made only at the end of the fiscal year based on the inventory levels and costs at that time. Accordingly, interim LIFO calculations are based on management’s estimates of expected year-end inventory levels and are subject to the final fiscal year-end LIFO inventory valuation. Inventory costs include material, labor, and overhead. Inventories, net consisted of the following:
 
 
 
June 30,
2012
 
March 31,
2012
Raw materials
 
$
56,881

 
$
56,525

Work in process
 
25,823

 
25,236

Finished goods
 
108,790

 
109,422

LIFO reserve
 
(15,783
)
 
(18,158
)
Reserve for excess and obsolete inventory
 
(13,626
)
 
(15,313
)
Inventories, net
 
$
162,085

 
$
157,712


5. Debt

Indebtedness was as follows:
 
 
 
June 30,
2012
 
March 31,
2012
Private Placement
 
$
210,000

 
$
210,000

Credit facility
 

 

Total long term debt
 
$
210,000

 
$
210,000


Additional information regarding our indebtedness is included in the notes to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2012 dated May 29, 2012.

6. Additional Consolidated Balance Sheet Information

Additional information related to our Consolidated Balance Sheets is as follows:
 
 
 
June 30,
2012
 
March 31,
2012
Accrued payroll and other related liabilities:
 
 
 
 
Compensation and related items
 
$
13,162

 
$
9,273

Accrued vacation/paid time off
 
6,045

 
6,583

Accrued bonuses
 
4,927

 
750

Accrued employee commissions
 
5,399

 
9,845

Other postretirement benefit obligations-current portion
 
3,255

 
3,255

Other employee benefit plans' obligations-current portion
 
297

 
193

Total accrued payroll and other related liabilities
 
$
33,085

 
$
29,899

Accrued expenses and other:
 
 
 
 
Deferred revenues
 
$
53,220

 
$
51,412

Self-insured risk reserves-current portion
 
3,266

 
3,006

Accrued dealer commissions
 
8,677

 
9,171

Accrued warranty
 
12,616

 
11,189

Other
 
19,924

 
21,465

Total accrued expenses and other
 
$
97,703

 
$
96,243

Other liabilities:
 
 
 
 
Self-insured risk reserves-long-term portion
 
$
8,786

 
$
8,786

Other postretirement benefit obligations-long-term portion
 
20,841

 
21,639

Defined benefit pension plans obligations-long-term portion
 
8,925

 
9,881

Other employee benefit plans obligations-long-term portion
 
4,196

 
4,486

Accrued long-term income taxes
 
1,983

 
1,925

Other
 
4,990

 
5,217

Total other liabilities
 
$
49,721

 
$
51,934


7. Income Tax Expense

Income tax expense includes United States federal, state and local, and foreign income taxes, and is based on reported pre-tax income. The effective income tax rates for the three-month periods ended June 30, 2012 and 2011 were 33.4% and 34.4% respectively. During the first quarter of fiscal 2013, we benefited from higher projected income in lower tax rate jurisdictions.

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

As of June 30, 2012 and March 31, 2012, we had $1,527 in unrecognized tax benefits, of which $1,242 would favorably impact the effective tax rate if recognized. We believe that it is reasonably possible that unrecognized tax benefits could decrease by up to $1,124 within 12 months of June 30, 2012, primarily as a result of settlements with tax authorities. As of June 30, 2012, we have recognized a liability for interest of $994 and penalties of $64.

We operate in numerous taxing jurisdictions and are subject to regular examinations by various United States federal, state, and local, as well as foreign jurisdictions. We are no longer subject to United States federal examinations for years before fiscal 2010 and, with limited exceptions, we are no longer subject to United States state and local, or non-United States, income tax examinations by tax authorities for years before fiscal 2008. We remain subject to tax authority audits in various jurisdictions wherever we do business. We do not expect the results of these examinations to have a material adverse affect on our consolidated financial statements.

8. Benefit Plans

We provide defined benefit pension plans for certain current and former manufacturing and plant administrative personnel throughout the world as determined by collective bargaining agreements or employee benefit standards set at the time of acquisition of certain businesses. In addition to providing pension benefits to certain employees, we sponsor an unfunded postretirement welfare benefits plan for two groups of United States employees; including the same employees who receive pension benefits under the United States defined benefit pension plan. Benefits under this plan include retiree life insurance and retiree medical coverage, including prescription drug coverage. Additional information regarding our defined benefit pension plans and other postretirement benefits plan is included in our consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2012, dated May 29, 2012.

Components of the net periodic benefit cost for our defined benefit pension plans and other postretirement medical benefits plan were as follows:
 
 
 
Defined Benefit Pension Plans
 
Other
Postretirement
Benefits Plan
 
 
U.S. Qualified
 
International
 
Three Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
 
2012
 
2011
Service cost
 
$
37

 
$
51

 
$
20

 
$
127

 
$

 
$

Interest cost
 
523

 
609

 
18

 
74

 
217

 
248

Expected return on plan assets
 
(834
)
 
(821
)
 
(24
)
 
(75
)
 

 

Amortization of loss
 
333

 
267

 

 

 
181

 
106

Curtailment
 

 

 
(125
)
 

 

 

Amortization of prior service cost
 

 

 

 

 
(816
)
 
(816
)
Net periodic benefit cost (income)
 
$
59

 
$
106

 
$
(111
)
 
$
126

 
$
(418
)
 
$
(462
)

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

9. Commitments and contingencies

We are, and will likely continue to be, involved in a number of legal proceedings, government investigations, and claims, which we believe generally arise in the course of our business, given our size, history, complexity, and the nature of our business, products, Customers, regulatory environment, and industries in which we participate. These legal proceedings, investigations and claims generally involve a variety of legal theories and allegations, including, without limitation, personal injury (e.g., slip and falls, burns, vehicle accidents), product liability or regulation (e.g., based on product operation or claimed malfunction, failure to warn, failure to meet specification, or failure to comply with regulatory requirements), product exposure (e.g., claimed exposure to chemicals, asbestos, contaminants, radiation), property damage (e.g., claimed damage due to leaking equipment, fire, vehicles, chemicals), commercial claims (e.g., breach of contract, economic loss, warranty, misrepresentation), financial (e.g., taxes, reporting), employment (e.g., wrongful termination, discrimination, benefits matters), and other claims for damage and relief.
We believe we have adequately reserved for our current litigation and claims that are probable and estimable, and further believe that the ultimate outcome of these pending lawsuits and claims will not have a material adverse affect on our consolidated financial position or results of operations taken as a whole. Due to their inherent uncertainty, however, there can be no assurance of the ultimate outcome or effect of current or future litigation, investigations, claims or other proceedings (including without limitation the matters discussed below). For certain types of claims, we presently maintain insurance coverage for personal injury and property damage and other liability coverages in amounts and with deductibles that we believe are prudent, but there can be no assurance that these coverages will be applicable or adequate to cover adverse outcomes of claims or legal proceedings against us.
As previously disclosed, we received a warning letter (the “warning letter”) from the FDA on May 16, 2008 regarding our SYSTEM 1® sterile processor and the STERIS 20 sterilant used with the processor (sometimes referred to collectively in the FDA letter and in this note 9 as the “device”). Among other matters, the warning letter included the FDA's assertion that significant changes or modifications had been made in the design, components, method of manufacture, or intended use of the device beyond the FDA's 1988 clearance, such that the FDA believed a new premarket notification submission (known within FDA regulations as a 510(k) submission) should have been made, and the assertion that our failure to make such a submission resulted in violations of applicable law. On July 30, 2008 (with an Addendum on October 9, 2008), we provided a detailed response contending that the assertions in the warning letter were not correct. On November 4, 2008, we received a letter from the FDA (dated November 3, 2008) in which the FDA stated without elaboration that, after reviewing our response, it disagreed with our position and that a new premarket notification submission was required. After discussions with the FDA regarding the November 3rd letter, we received an additional letter on November 6, 2008 from the FDA. The November 6th letter stated that the intent of the November 3rd letter was to inform us of the FDA's preliminary disagreement with our response to the warning letter and, before finalizing a position, the FDA reiterated that it wanted to meet with us to discuss the Company's response, issues related to the warning letter and next steps to resolve any differences between the Company and the FDA. We thereafter met with the FDA and, on January 20, 2009, we announced that we had submitted to the FDA a new liquid chemical sterilant processing system for 510(k) clearance, and we communicated to Customers that we would continue supporting the existing SYSTEM 1 installed base in the U.S. for at least a two year period from that date.
On December 3, 2009, the FDA provided a notice (“notice”) to healthcare facility administrators and infection control practitioners describing FDA's “concerns about the SYSTEM 1 Processor, components and accessories, and FDA recommendations.” In the notice, among other things, FDA stated its belief that the SYSTEM 1 device had been significantly modified, that FDA had not cleared or approved the modified device, and that FDA had not determined whether the SYSTEM 1 was safe or effective for its labeled claims. The notice further stated that use of a device that does not properly sterilize or disinfect a medical or surgical device poses risks to patients and users, including the transmission of pathogens, exposure to hazardous chemicals and may affect the quality and functionality of reprocessed instruments. The notice stated that FDA was aware of reports of malfunctions of the SYSTEM 1 that had the potential to cause or contribute to serious injuries to patients, such as infections, or injuries to healthcare staff, such as burns. Included in FDA's December 3, 2009 notice was a recommendation from FDA that if users had acceptable alternatives to meet sterilization and disinfection needs, they should transition to that alternative as soon as possible. After its December 3, 2009 notice, we engaged in extensive discussions with the FDA regarding a comprehensive resolution of this matter. On February 2, 2010, the FDA notified healthcare facility administrators and infection control practitioners that FDA's total recommended time period for transitioning from SYSTEM 1 in the U.S. was 18 months from that date.
On April 5, 2010, we received FDA clearance of the new liquid chemical sterilant processing system (SYSTEM 1E). Also in April 2010 we reached agreement with the FDA on the terms of a consent decree (“Consent Decree”). On April 19, 2010, a Complaint and Consent Decree were filed in the U.S. District Court for the Northern District of Ohio, and on April 20, 2010, the Court approved the Consent Decree. In general, the Consent Decree addresses regulatory matters regarding SYSTEM 1, restricts further sales of SYSTEM 1 processors in the U.S., defines certain documentation and other requirements for continued service and support of SYSTEM 1 in the U.S., prohibits the sale of liquid chemical sterilization or disinfection products in the U.S. that do not have FDA clearance, describes various process and compliance matters, and defines penalties in the event of violation of the Consent Decree.
The Consent Decree also provides that we may continue to support our Customers' use of SYSTEM 1 in the U.S., including the sale of consumables, parts and accessories and service for a transition period, not to extend beyond August 2, 2011 (later extended by FDA to August 2, 2012), subject to compliance with requirements for documentation of the Customer's need for continued support and other conditions and limitations (the “Transition Plan”). Our Transition Plan includes the “SYSTEM 1 Rebate Program” (the “Rebate Program”). In April 2010, we began to offer rebates to qualifying Customers. Generally, U.S. Customers that purchased SYSTEM 1 processors directly from us or who were users of SYSTEM 1 at the time the Rebate Program was introduced and who return their units have the option of either a pro-rated cash rebate or a rebate toward the future purchase of new STERIS capital equipment (including SYSTEM 1E) or consumable products. In addition, we provide credits for the return of SYSTEM 1 consumables in unbroken packaging and within shelf life and for the unused portion of SYSTEM 1 service contracts.
Recording the obligations associated with the Rebate Program requires the use of estimates and assumptions. The use of estimates and assumptions involves judgments with respect to factors that may impact the ultimate outcome and may be beyond management's control. The key assumptions involved in the estimates associated with the Rebate Program include: the number and age of SYSTEM 1 processors eligible for rebates under the Rebate Program, the number of Customers that will elect to participate in the Rebate Program, the proportion of Customers that will choose each rebate option, and the estimated per unit costs of disposal.
Our assumptions regarding the response of our Customers to the Rebate Program could be wrong and actual results could be different from these estimates. Through June 30, 2012, Customers have utilized or committed to utilize rebates totaling approximately $63,600 on orders placed since the initiation of the Rebate Program. If all eligible Customers holding the remaining outstanding SYSTEM 1 units elect the maximum incentive rebate associated with the SYSTEM 1E processor rebate, the total estimated rebate program cost would increase to approximately $93,000. Conversely, if all eligible Customers holding the remaining outstanding SYSTEM 1 units elect the cash rebate option, the total estimated rebate program cost would decrease to approximately $75,000.
The Consent Decree has defined the resolution of a number of issues regarding SYSTEM 1, and we believe our actions with respect to SYSTEM 1, including the Transition Plan, were and are not recalls, corrections or removals under FDA regulations. However, there is no assurance that these or other claims will not be brought or that judicial, regulatory, administrative or other legal or enforcement actions, notices or remedies will not be pursued, or that action will not be taken in respect of the Consent Decree, the Transition Plan, SYSTEM 1, or otherwise with respect to regulatory or compliance matters, as described in this note 9 and in various portions of Item 1A. of Part I of our Annual Report on Form 10-K for the year ended March 31, 2012 dated May 29, 2012.
In December of 2010, we began shipping SYSTEM 1E units, after having received FDA clearance for the SYSTEM 1E chemical indicator, which is used in conjunction with the SYSTEM 1E. We also submitted a 510(k) to FDA for an optional spore-based indicator strip for use with SYSTEM 1E. Thereafter, as a result of discussions with FDA, we filed a de novo submission requesting classification of this strip in accordance with Section 513(f)(2) of the Federal Food Drug & Cosmetic Act. The de novo process is part of the initial classification for new devices. This spore-based monitoring strip received FDA clearance on March 30, 2012. This new clearance does not affect the prior clearance of the SYSTEM 1E processor or the SYSTEM 1E chemical indicator.
On February 5, 2010, a complaint was filed by a Customer that claimed to have purchased two SYSTEM 1 devices from STERIS, Physicians of Winter Haven LLC d/b/a Day Surgery Center v. STERIS Corp., Case No. 1:1-cv-00264-CAB (N.D. Ohio). The complaint alleged statutory violations, breaches of various warranties, negligence, failure to warn, and unjust enrichment and Plaintiff sought class certification, damages, and other legal and equitable relief including, without limitation, attorneys' fees and an order requiring STERIS to replace, recall or adequately repair the product and/or to take appropriate regulatory action. On February 7, 2011 we entered into a settlement agreement in which we agreed, among other things, to provide various categories of economic relief for members of the settlement class and not object to plaintiff's counsel's application to the court for attorneys' fees and expenses up to a specified amount. Certification of a settlement class was approved and final approval of the settlement was given by the court in the first quarter of fiscal 2012. During the third quarter of fiscal 2011, we recorded in operating expenses a pre-tax charge of approximately $19,796 related to the settlement of these proceedings. The assumptions regarding the amount of this charge included, among others, the portion of class members participating in the settlement and their choice of the categories of economic relief available for such members. These assumptions may be incorrect and the costs of the settlement may be higher or lower than the charge recorded. Estimates of the actual settlement range from as low as $7,000 and as high as $22,000 depending on the options selected by the class members.
On May 31, 2012, our Albert Browne Limited subsidiary received a warning letter from the FDA regarding chemical indicators manufactured in the United Kingdom. These devices are intended for the monitoring of certain sterilization and other processes. The FDA warning letter states that the agency has concerns regarding operational business processes. We do not believe that the FDA's concerns are related to product performance, or that they result from Customer complaints. We do not currently believe that the impact of this event will have a material adverse effect on our financial results.
Other civil, criminal, regulatory or other proceedings involving our products or services also could possibly result in judgments, settlements or administrative or judicial decrees requiring us, among other actions, to pay damages or fines or effect recalls, or be subject to other governmental, Customer or other third party claims or remedies, which could materially affect our business, performance, prospects, value, financial condition, and results of operations.
For additional information regarding these matters, see the following portions of our Annual Report on Form 10-K for the fiscal year ended March 31, 2012: “Business - Information with respect to our Business in General - Government Regulation”, and the “Risk Factor” titled “We may be adversely affected by product liability claims or other legal actions or regulatory or compliance matters, including the Warning Letter and Consent Decree” and the "Risk Factor” titled “Compliance with the Consent Decree may be more costly and burdensome than anticipated.”
From time to time, STERIS is also involved in legal proceedings as a plaintiff involving contract, patent protection, and other claims asserted by us. Gains, if any, from these proceedings are recognized when they are realized.
We are subject to taxation from United States federal, state and local, and foreign jurisdictions. Tax positions are settled primarily through the completion of audits within each individual jurisdiction or the closing of statute of limitation. Changes in applicable tax law or other events may also require us to revise past estimates.
Additional information regarding our contingencies is included in Item 7 of Part II titled, “Management's Discussion and Analysis of Financial Conditions and Results of Operations,” of our Annual Report on Form 10-K for the year ended March 31, 2012 dated May 29, 2012, and in Item 1 of Part II of this Form 10-Q titled, “Legal Proceedings.”

10. Business Segment Information

We operate and report in three business segments: Healthcare, Life Sciences, and Isomedix. Corporate and other, which is presented separately, contains the Defense and Industrial business unit plus costs that are associated with being a publicly traded company and certain other corporate costs.
Our Healthcare segment manufactures and sells capital equipment, accessory, consumable, and service solutions to healthcare providers, including acute care hospitals and surgery centers. These solutions aid our Customers in improving the safety, quality, and productivity of their surgical, sterile processing, gastrointestinal, and emergency environments.
Our Life Sciences segment manufactures and sells engineered capital equipment, formulated cleaning chemistries, and service solutions to pharmaceutical companies, and private and public research facilities around the globe.
Our Isomedix segment operates through a network of facilities located in North America. We sell a comprehensive array of contract sterilization services using gamma irradiation, and ethylene oxide (“EO”) technologies. We provide sterilization and microbial reduction services to companies that supply products to the healthcare, industrial, and consumer products industries.
Financial information for each of our segments is presented in the following table. Operating income (loss) for each segment is calculated as the segment’s gross profit less direct expenses and indirect cost allocations, which results in the full allocation of all distribution and research and development expenses, and the partial allocation of corporate costs. These allocations are based upon variables such as segment headcount and revenues. In addition, the Healthcare segment is responsible for the management of all but one manufacturing facility and uses standard cost to sell products to the Life Sciences segment. Corporate and other includes the gross profit and direct expenses of the Defense and Industrial business unit, as well as certain unallocated corporate costs related to being a publicly traded company and legacy pension and post-retirement benefits.

The accounting policies for reportable segments are the same as those for the consolidated Company. For the three month period ended June 30, 2012, revenues from a single Customer did not represent ten percent or more of any reportable segment’s revenues. Additional information regarding our segments is included in our consolidated financial statements included in our Annual Report on Form 10-K for the year ended March 31, 2012, dated with the SEC on May 29, 2012.

Financial information for each of our segments is presented in the following tables:
 
 
 
Three Months Ended June 30,
 
 
2012
 
2011
Revenues:
 
 
 
 
Healthcare
 
$
229,514

 
$
223,224

Life Sciences
 
60,496

 
52,868

Isomedix
 
46,056

 
42,003

Total reportable segments
 
336,066

 
318,095

Corporate and other
 
894

 
544

Total revenues
 
$
336,960

 
$
318,639

Operating income:
 
 
 
 
Healthcare
 
$
22,730

 
$
26,268

Life Sciences
 
11,854

 
9,459

Isomedix
 
15,578

 
12,959

Total reportable segments
 
50,162

 
48,686

Corporate and other
 
(1,860
)
 
(1,785
)
Total operating income
 
$
48,302

 
$
46,901


11. Common Shares

We calculate basic earnings per common share based upon the weighted average number of common shares outstanding. We calculate diluted earnings per share based upon the weighted average number of common shares outstanding plus the dilutive effect of common share equivalents calculated using the treasury stock method. The following is a summary of common shares and common share equivalents outstanding used in the calculations of basic and diluted earnings per share:
 
 
 
Three Months Ended June 30,
 
 
2012
 
2011
Denominator (shares in thousands):
 
 
 
 
Weighted average common shares outstanding—basic
 
57,911

 
59,255

Dilutive effect of common share equivalents
 
401

 
848

Weighted average common shares outstanding and common share equivalents—diluted
 
58,312

 
60,103


Options to purchase the following number of common shares were outstanding but excluded from the computation of diluted earnings per share because the combined exercise prices, unamortized fair values, and assumed tax benefits upon exercise were greater than the average market price for the common shares during the periods, so including these options would be anti-dilutive:
 
 
 
Three Months Ended June 30,
 
 
2012
 
2011
(shares in thousands)
 
 
Number of common share options
 
1,124

 
306


12. Repurchases of Common Shares

During the first quarter of fiscal 2013, we obtained 42,151 of our common shares in connection with stock based compensation award programs. At June 30, 2012, $118,460 of STERIS common shares remained authorized for repurchase pursuant to the most recent Board approved repurchase authorization (the March 2008 Board Authorization). Also, 11,957,838 common shares were held in treasury at June 30, 2012.

5

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three Months Ended June 30, 2012 and 2011
(dollars in thousands)




13. Share-Based Compensation

We maintain a long-term incentive plan that makes available common shares for grants, at the discretion of the Compensation Committee of the Board of Directors to officers, directors, and key employees in the form of stock options, restricted shares, restricted share units, and stock appreciation rights. Stock options provide the right to purchase our common shares at the market price on the date of grant, subject to the terms of the option plans and agreements. Generally, one-fourth of the stock options granted become exercisable for each full year of employment following the grant date. Stock options granted generally expire 10 years after the grant date, or earlier if the option holder is no longer employed by us. Restricted shares and restricted share units generally may cliff vest after a three or four year period or vest in tranches of one-fourth of the number granted for each full year of employment after the grant date. As of June 30, 2012, 4,086,493 shares remained available for grant under the long-term incentive plan.

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

The following weighted-average assumptions were used for options granted during the first three months of fiscal 2013 and fiscal 2012:
 
 
 
Fiscal 2013
 
Fiscal 2012
Risk-free interest rate
 
1.22
%
 
2.40%
Expected life of options
 
5.64 years

 
5.53 years
Expected dividend yield of stock
 
2.14
%
 
1.31%
Expected volatility of stock
 
31.19
%
 
29.92%

The risk-free interest rate is based upon the U.S. Treasury yield curve. The expected life of options is reflective of historical experience, vesting schedules and contractual terms. The expected dividend yield of stock represents our best estimate of the expected future dividend yield. The expected volatility of stock is derived by referring to our historical stock prices over a time frame similar to that of the expected life of the grant. An estimated forfeiture rate of 1.83% and 2.08% was applied in fiscal 2013 and 2012, respectively. This rate is calculated based upon historical activity and represents an estimate of the granted options not expected to vest. If actual forfeitures differ from this calculated rate, we may be required to make additional adjustments to compensation expense in future periods. The assumptions used above are reviewed at the time of each significant option grant, or at least annually.

A summary of share option activity is as follows:
 
 
 
Number of
Options
 
Weighted
Average
Exercise
Price
 
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
Outstanding at March 31, 2012
 
3,312,602

 
$
27.16

 
 
 
 
Granted
 
264,771

 
29.94

 
 
 
 
Exercised
 
(166,030
)
 
22.12

 
 
 
 
Forfeited
 
(5,308
)
 
30.98

 
 
 
 
Canceled
 
(3,800
)
 
19.60

 
 
 
 
Outstanding at June 30, 2012
 
3,402,235

 
$
27.62

 
5.50
 years
 
$
14,391

Exercisable at June 30, 2012
 
2,661,323

 
$
26.74

 
4.60
 years
 
$
12,867



6

STERIS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
For the Three Months Ended June 30, 2012 and 2011
(dollars in thousands)



We estimate that 721,086 of the non-vested stock options outstanding at June 30, 2012 will ultimately vest.

The aggregate intrinsic value in the table above represents the total pre-tax difference between the $31.37 closing price of our common shares on June 30, 2012 over the exercise prices of the stock options, multiplied by the number of options outstanding or outstanding and exercisable, as applicable. The aggregate intrinsic value is not recorded for financial accounting purposes and the value changes daily based on the daily changes in the fair market value of our common shares.

The total intrinsic value of stock options exercised during the first three months of fiscal 2013 and fiscal 2012 was $1,364 and $1,578, respectively. Net cash proceeds from the exercise of stock options were $3,457 and $2,457 for the first three months of fiscal 2013 and fiscal 2012, respectively. The tax benefit from stock option exercises was $525 and $610 for the first three months of fiscal 2013 and fiscal 2012, respectively.

The weighted average grant date fair value of stock option grants was $7.18 and $9.97 for the first three months of fiscal 2013 and fiscal 2012, respectively.

Stock appreciation rights (“SARS”) carry generally the same terms and vesting requirements as stock options except that they are settled in cash upon exercise and therefore, are classified as liabilities. The fair value of the outstanding SARS as of June 30, 2012 and 2011 was $767 and $1,198, respectively. The fair value of outstanding SARs is revalued at each reporting date and the related liability and expense are adjusted appropriately.

A summary of the non-vested restricted share activity is presented below:
 
 
 
Number of
Restricted
Shares
 
Weighted-Average
Grant Date
Fair Value
Non-vested at March 31, 2012
 
533,027

 
$
32.10

Granted
 
225,143

 
29.94

Vested
 
(98,089
)
 
24.63

Canceled
 
(4,460
)
 
33.53

Non-vested at June 30, 2012
 
655,621

 
$
32.46


Restricted shares granted are valued based on the closing stock price at the grant date. The value of restricted shares that vested during the first three months of fiscal 2013 was $2,416.

Cash settled restricted share units carry generally the same terms and vesting requirements as stock settled restricted share units except that they are settled in cash upon vesting and therefore, are classified as liabilities. The fair value of outstanding cash-settled restricted share units as of June 30, 2012 and 2011 was $1,091 and $1,614, respectively. The fair value of each cash-settled restricted share unit is revalued at each reporting date and the related liability and expense are adjusted appropriately.

As of June 30, 2012, there was a total of $17,846 in unrecognized compensation cost related to nonvested share-based compensation granted under our share-based compensation plans. We expect to recognize the cost over a weighted average period of 2.81 years.

14. Financial and Other Guarantees

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

Changes in our warranty liability during the first three months of fiscal 2013 were as follows:
 
 
 
Balance, March 31, 2012
$
11,189

Warranties issued during the period
5,619

Settlements made during the period
(4,192
)
Balance, June 30, 2012
$
12,616


We also sell product maintenance contracts to our Customers. These contracts range in terms from one to five years and require us to maintain and repair the product over the maintenance contract term. We initially record amounts due from Customers under these contracts as a liability for deferred service contract revenue on the accompanying Consolidated Balance Sheets within “Accrued expenses and other.” The liability recorded for such deferred service revenue was $44,790 and $43,252 as of June 30, 2012 and March 31, 2012, respectively. Such deferred revenue is then amortized on a straight-line basis over the contract term and recognized as service revenue on our accompanying Consolidated Statements of Income. The activity related to the liability for deferred service contract revenues is excluded from the table presented above.

15. Forward and Swap Contracts

From time to time, we enter into forward contracts to hedge potential foreign currency gains and losses that arise from transactions denominated in foreign currencies, including inter-company transactions. We also enter into commodity swap contracts to hedge price changes in commodities that impact raw materials included in our cost of revenues. We do not use derivative financial instruments for speculative purposes. These contracts are not designated as hedging instruments and do not receive hedge accounting treatment; therefore, changes in their fair value are not deferred but are recognized immediately in the Consolidated Statements of Income. At June 30, 2012, we held foreign currency forward contracts to buy 106.3 million Mexican peso's and 2.3 million Canadian dollars. At June 30, 2012, we held commodity swap contracts to buy 391,000 pounds of nickel.

 
 
Asset Derivatives
 
Liability Derivatives
Balance Sheet
 
Fair Value at
 
Fair Value at
 
Fair Value at
 
Fair Value at
Location
 
June 30, 2012
 
March 31, 2012
 
June 30, 2012
 
March 31, 2012
Prepaid & Other
 
$
103

 
$
12

 
$

 
$

Accrued expenses and other
 
$

 
$

 
$
791

 
$
863


The following table presents the impact of derivative instruments and their location within the Consolidated Statements of Income:
 
 
 
Location of gain (loss)
recognized in income
 
Amount of gain (loss)
recognized in income
Three Months Ended June 30,
2012
 
2011
Foreign currency forward contracts
 
Selling, general and
administrative
 
$
(317
)
 
$
266

Commodity swap contracts
 
Cost of revenues
 
$
(220
)
 
$
(479
)

16. Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date. We estimate the fair value of financial assets and liabilities using available market information and generally accepted valuation methodologies. The inputs used to measure fair value are classified into three tiers. These tiers include Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring the entity to develop its own assumptions. The following table shows the fair value of our financial assets and liabilities at June 30, 2012:
 
 
 
 
 
 
Fair Value Measurements at June 30, Using
 
 
Carrying Value
 
Quoted Prices
in Active Markets
for Identical Assets
 
Significant Other
Observable Inputs
 
Significant
Unobservable
Inputs
 
 
Level 1
 
Level 2
 
Level 3
2012
2011
2012
2011
 
2012
2011
 
2012
2011
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
186,731

$
156,116

 
$
186,731

$
156,116

 
$

$

 
$

$

Forward and swap contracts (1)
 
103

346

 


 
103

346

 


Investments (2)
 
3,007

2,790

 
3,007

2,790

 


 


Liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
Forward and swap contracts (1)
 
$
791

$
324

 
$

$

 
$
791

$
324

 
$

$

Deferred compensation plans (2)
 
2,988

2,790

 
2,988

2,790

 


 


Long term debt (3)
 
210,000

210,000

 


 
246,306

240,957

 


Contingent consideration obligations (4)
 
6,555

10,138

 


 


 
6,555

10,138

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

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis at June 30, 2012 are summarized as follows:
 
Contingent Consideration
Balance at March 31, 2012
$
6,953

Losses
33

Settlements
(9
)
Foreign currency translation adjustments (1)
(422
)
Balance at June 30, 2012
$
6,555

(1) Reported in other comprehensive income (loss).


17. Subsequent Events

We have evaluated subsequent events through the date the financial statements were filed with the SEC, noting no events that require adjustment of, or disclosure in, the consolidated financial statements for the period ended June 30, 2012, except for the acquisition noted below. These financial statements should be read in conjunction with the consolidated financial statements and related notes included in our 2012 Annual Report on Form 10-K.
On July 17, 2012, STERIS Corporation announced the signing of a definitive agreement to acquire all the outstanding shares of privately-owned United States Endoscopy Group, Inc. (US Endoscopy). US Endoscopy is a leader in the design, manufacture and sale of therapeutic and diagnostic medical devices and support accessories used in the gastrointestinal (GI) endoscopy markets worldwide. STERIS has agreed to pay $270,000 in an all cash transaction to acquire US Endoscopy.
The transaction is subject to certain closing conditions and is expected to close by the end of the second quarter of fiscal 2013. STERIS will finance the acquisition through a combination of cash on hand and borrowings under its existing credit facility. The business will be integrated into STERIS's Healthcare business segment. STERIS will also be purchasing certain land and buildings utilized by the US Endoscopy business for approximately $7,000.


7


Report of Independent Registered Public Accounting Firm

Board of Directors and Shareholders
STERIS Corporation
We have reviewed the consolidated balance sheet of STERIS Corporation and subsidiaries, as of June 30, 2012, the related consolidated statements of income for the three-month periods ended June 30, 2012 and 2011, the consolidated statements of comprehensive income for the three-month periods ended June 30, 2012 and 2011, and cash flows for the three-month periods ended June 30, 2012 and 2011. These financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards established by the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the consolidated interim financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States of America.
We have previously audited, in accordance with the standards generally accepted in the United States of America, the consolidated balance sheet of STERIS Corporation and subsidiaries as of March 31, 2012, and the related consolidated statements of income, shareholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated May 29, 2012, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of March 31, 2012 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
/s/ Ernst & Young LLP
Cleveland, Ohio
August 2, 2012


8



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

Introduction

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

As you read the MD&A, it may be helpful to refer to information in our consolidated financial statements, which present the results of our operations for the first quarter of fiscal 2013 and fiscal 2012. It may also be helpful to read the MD&A in our Annual Report on Form 10-K for the year ended March 31, 2012, dated with the SEC on May 29, 2012. In the MD&A, we analyze and explain the period-over-period changes in the specific line items in the Consolidated Statements of Income. Our analysis may be important to you in making decisions about your investments in STERIS.

Financial Measures

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

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

Revenues – Defined

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

9


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

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

Fiscal 2013 first quarter revenues were $337.0 million representing an increase of 5.7% over the prior year reflecting increases in all three reportable business segments. Our gross margin percentage for the fiscal 2013 first quarter was 40.7% compared to 41.7% in the fiscal 2012 period. The 100 basis point decrease is driven primarily by lower SYSTEM 1 consumable volume. Fiscal 2013 first quarter operating income was $48.3 million compared with $46.9 million for the fiscal 2012 first quarter.

Cash flows from operations were $61.3 million and free cash flow was $45.7 million in the first three months of fiscal 2013 compared to a negative $3.6 million in the prior year first three months, reflecting lower working capital requirements specifically the anticipated reduction of SYSTEM 1E related inventory, lower days sales outstanding and lower cash usage to fund compensation related obligations (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Our debt-to-total capital ratio was 20.2% at June 30, 2012 and 20.4% at March 31, 2012. During the first three months of fiscal 2013, we declared and paid quarterly cash dividends of $0.17 per common share.

Additional information regarding our fiscal 2013 first quarter financial performance is included in the subsection below titled “Results of Operations.”

Matters Affecting Comparability


10


International Operations. Since we conduct operations outside of the United States using various foreign currencies, our operating results are impacted by foreign currency movements relative to the U.S. dollar. During the first quarter of fiscal 2013, our revenues were unfavorably impacted by $3.8 million, or 1.10%, and income before taxes was favorably impacted by $3.2 million, or 7.45%, as a result of foreign currency movements relative to the U.S. dollar.

NON-GAAP FINANCIAL MEASURES
We, at times, refer to financial measures which are considered to be “non-GAAP financial measures” under SEC rules. We, at times, also refer to our results of operations excluding certain transactions or amounts that are non-recurring or are not indicative of future results, in order to provide meaningful comparisons between the periods presented.
These non-GAAP financial measures are not intended to be, and should not be, considered separately from or as an alternative to the most directly comparable GAAP financial measures.
These non-GAAP financial measures are presented with the intent of providing greater transparency to supplemental financial information used by management and the Board of Directors in their financial analysis and operational decision-making. These amounts are disclosed so that the reader has the same financial data that management uses with the belief that it will assist investors and other readers in making comparisons to our historical operating results and analyzing the underlying performance of our operations for the periods presented.
We believe that the presentation of these non-GAAP financial measures, when considered along with our GAAP financial measures and the reconciliation to the corresponding GAAP financial measures, provide the reader with a more complete understanding of the factors and trends affecting our business than could be obtained absent this disclosure. It is important for the reader to note that the non-GAAP financial measure used may be calculated differently from, and therefore may not be comparable to, a similarly titled measure used by other companies.
We define free cash flow as net cash provided by operating activities as presented in the Consolidated Statements of Cash Flows less purchases of property, plant, equipment, and intangibles plus proceeds from the sale of property, plant, equipment, and intangibles, which are also presented in the Consolidated Statements of Cash Flows. We use this as a measure to gauge our ability to fund future debt principal repayments, growth outside of core operations, repurchase common shares, and pay cash dividends. The following table summarizes the calculation of our free cash flow for the three month periods ended June 30, 2012 and 2011: 
 
 
Three Months Ended June 30,
(dollars in thousands)
 
2012
 
2011
Net cash flows provided by operating activities
 
$
61,267

 
$
11,981

Purchases of property, plant, equipment and intangibles, net
 
(15,542
)
 
(15,588
)
Proceeds from the sale of property, plant, equipment and intangibles
 
17

 

Free cash flow (usage)
 
$
45,742

 
$
(3,607
)

Results of Operations

In the following subsections, we discuss our earnings and the factors affecting them for the first quarter of fiscal 2013 compared with the same fiscal 2012 period. We begin with a general overview of our operating results and then separately discuss earnings for our operating segments.

Revenues. The following table compares our revenues for the three months ended June 30, 2012 to the revenues for the three months ended June 30, 2011:
 

11


 
Three Months Ended June 30,
 
  
 
 
 
(dollars in thousands)
2012
 
2011
 
Change
 
Percent Change
 
 
 
 
 
 
 
 
 
 
Total revenues
$
336,960

 
$
318,639

 
$
18,321

 
5.7
 %
 
 
 
 
 
 
 
 
 
 
Revenues by type:
 
 
 
 
 
 
 
 
Capital equipment revenues
138,418

 
124,619

 
13,799

 
11.1
 %
 
Consumable revenues
75,335

 
77,394

 
(2,059
)
 
(2.7
)%
 
Service revenues
123,207

 
116,626

 
6,581

 
5.6
 %
 
 
 
 
 
 
 
 
 
 
Revenues by geography:
 
 
 
 
 
 
 
 
United States revenues
262,404

 
244,836

 
17,568

 
7.2
 %
 
International revenues
74,556

 
73,803

 
753

 
1.0
 %
 
 
 
 
 
 
 
 
 
 
NM - Not meaningful.

Revenues increased $18.3 million, or 5.7%, to $337.0 million for the quarter ended June 30, 2012, as compared to $318.6 million for the same prior year quarter. Capital revenues increased $13.8 million in the first quarter of fiscal 2013, as compared to the first quarter of fiscal 2012. Capital equipment revenues increased in both the Healthcare and Life Sciences segments. Within Healthcare, the increase was attributable to growth in both surgical and infection prevention technologies, including SYSTEM 1E units. Within Life Sciences, capital equipment revenue growth occurred across all geographies and was driven primarily by replacement product purchases by pharmaceutical Customers. Consumable revenues decreased $2.1 million for the quarter ended June 30, 2012, as compared to the prior year quarter, primarily driven by decreases within the Healthcare segment attributable to reductions in SYSTEM 1 consumable volume. Service revenues increased $6.6 million in the first quarter of fiscal 2013 primarily driven by an increase in Isomedix, although both the Healthcare and Life Sciences business segments also experienced growth in service revenues of 3%.

United States revenues increased $17.6 million, or 7.2%, to $262.4 million for the quarter ended June 30, 2012, as compared to $244.8 million for the same prior year quarter. Increases in capital equipment revenues in both the Healthcare and Life Sciences business segments combined with growth in service revenues drove the increase. These increases were partially offset by a decline in consumable revenues driven by the decline in SYSTEM 1 consumable volume.

International revenues increased $0.8 million, or 1.0%, to $74.6 million for the quarter ended June 30, 2012, as compared to $73.8 million for the same prior year quarter. Increases in capital equipment revenues in Canada and Europe more than offset declines in international consumable and service revenues.


Gross Profit. The following table compares our gross profit for the three months ended June 30, 2012 to the three months ended June 30, 2011:
 
 
 
Three Months Ended June 30,
 
Change
 
Percent
Change
(dollars in thousands)
 
2012
 
2011
 
Gross profit:
 
 
 
 
 
 
 
 
Product
 
$
88,271

 
$
84,580

 
$
3,691

 
4.4
%
Service
 
48,981

 
48,345

 
636

 
1.3
%
Total gross profit
 
$
137,252

 
$
132,925

 
$
4,327

 
3.3
%
Gross profit percentage:
 
 
 
 
 
 
 
 
Product
 
41.3
%
 
41.9
%
 
 
 
 
Service
 
39.8
%
 
41.5
%
 
 
 
 
Total gross profit percentage
 
40.7
%
 
41.7
%
 
 
 
 


12


Our gross profit percentage is affected by the volume, pricing, and mix of sales of our products and services, as well as the costs associated with the products and services that are sold. Gross profit percentage for the first quarter of fiscal 2013 amounted to 40.7% as compared to the first quarter of fiscal 2012 gross profit percentage of 41.7%. The gross profit percentage decreased 100 basis points. The decrease resulted primarily from a net reduction of 190 basis points due to declines in volume, particularly the decline in SYSTEM 1 consumable volume, which was partially offset by a 80 basis point favorable impact of changes in foreign currency.

Operating Expenses. The following table compares our operating expenses for the three months ended June 30, 2012 to the three months ended June 30, 2011:
 
  
 
Three Months Ended June 30,
 
Change
 
Percent
Change
(dollars in thousands)
 
2012
 
2011
 
Operating expenses:
 
 
 
 
 
 
 
 
Selling, general, and administrative
 
$
79,774

 
$
77,009

 
$
2,765

 
3.6
%
Research and development
 
9,312

 
8,757

 
555

 
6.3
%
Restructuring expenses
 
(136
)
 
258

 
(394
)
 
NM
Total operating expenses
 
$
88,950

 
$
86,024

 
$
2,926

 
3.4
%
NM - Not meaningful.

Significant components of total selling, general, and administrative expenses (“SG&A”) are compensation and benefit costs, fees for professional services, travel and entertainment, facilities costs, and other general and administrative expenses. The increase of 3.6% in the first quarter of fiscal 2013 over the first quarter of fiscal 2012 is attributable to volume related fees and increased spending related to SYSTEM 1E product reliability within our Healthcare business segment during fiscal 2013.

For the three month period ended June 30, 2012, research and development expenses increased 6.3%. Research and development expenses are influenced by the number and timing of in-process projects and labor hours and other costs associated with these projects. Our research and development initiatives continue to emphasize new product development, product improvements, and the development of new technological platform innovations. During the first quarter of fiscal 2013, our investments in research and development continued to be focused on, but were not limited to, enhancing capabilities of sterile processing combination technologies, surgical products and accessories, and the areas of emerging infectious agents such as Prions and Nanobacteria.

Restructuring expenses incurred during the first quarters of fiscal 2013 and fiscal 2012 related to a previously announced restructuring plans. The following table summarizes our total pre-tax restructuring expenses for the first quarters of fiscal 2013 and fiscal 2012:
Three Months Ended June 30,
Fiscal 2010
Restructuring
Plan (1)
Fiscal 2008
Restructuring
Plan
Total
 
2012
2011
2012
2011
2012
2011
Severance and other compensation related costs
$
(119
)
$
(55
)
$

$

$
(119
)
$
(55
)
Product rationalization

335




335

Asset impairment and accelerated depreciation
(17
)
92



(17
)
92

Lease termination obligation and other



(152
)

(152
)
Total restructuring charges
$
(136
)
$
372

$

$
(152
)
$
(136
)
$
220

(1)
Includes $(38) in charges recorded in cost of revenues on Consolidated Statements of Income for 2011.


Liabilities related to restructuring activities are recorded as current liabilities on the accompanying Consolidated Balance Sheets within “Accrued payroll and other related liabilities” and “Accrued expenses and other.” The following table summarizes our liabilities related to these restructuring activities:
 

13


 
 
Fiscal 2010 Restructuring Plan
 
 
March 31,
2012
 
Fiscal 2013
 
June 30,
2012
(dollars in thousands)
 
Provision (1)
 
Payments/
Impairments (2)
 
Severance and termination benefits
 
$
659

 
$
(119
)
 
$
28

 
$
568

Asset impairments and accelerated depreciation
 

 
(17
)
 
17

 

Lease termination obligations
 
947

 

 
(336
)
 
611

Other
 
76

 

 

 
76

Total
 
$
1,682

 
$
(136
)
 
$
(291
)
 
$
1,255

(1) Includes curtailment benefit of $125 related to International defined benefit plan. Additional information is included in note 8, "Benefit Plans."
(2) Certain amounts reported include the impact of foreign currency movements relative to the U.S. dollar.

Non-Operating Expenses, Net. Non-operating expenses, net consists of interest expense on debt, offset by interest earned on cash, cash equivalents, short-term investment balances, and other miscellaneous expense. The following table compares our net non-operating expenses for the three months ended June 30, 2012 and 2011:
 
 
 
Three Months Ended June 30,
 
 
(dollars in thousands)
 
2012
 
2011
 
Change
Non-operating expenses, net:
 
 
 
 
 
 
Interest expense
 
$
2,972

 
$
2,997

 
$
(25
)
Interest income and miscellaneous expense
 
(260
)
 
107

 
(367
)
Non-operating expenses, net
 
$
2,712

 
$
3,104

 
$
(392
)

Interest expense during the three month periods was approximately the same. Interest income and miscellaneous expense decreased $0.4 million for the three month period as compared with the same prior year period as interest income exceeded miscellaneous expense.

Income Tax Expense. The following table compares our income tax expense and effective income tax rates for the three months ended June 30, 2012 to the three months ended June 30, 2011:
 
 
 
Three Months Ended June 30,
 
Change
 
Percent
Change
(dollars in thousands)
 
2012
 
2011
 
Income tax expense
 
$
15,236

 
$
15,066

 
$
170

 
1.1%
Effective income tax rate
 
33.4
%
 
34.4
%
 
 
 
 
 
Income tax expense includes United States federal, state and local, and foreign income taxes, and is based on reported pre-tax income. The effective income tax rates for continuing operations for the three month period ended June 30, 2012 was 33.4% compared with 34.4% for the same prior year period. We benefited from higher projected income mix in lower tax rate jurisdictions.

We record income tax expense during interim periods based on our estimate of the annual effective income tax rate, adjusted each quarter for discrete items. We analyze various factors to determine the estimated annual effective income tax rate, including projections of our annual earnings and taxing jurisdictions in which the earnings will be generated, the impact of state and local income taxes, our ability to use tax credits and net operating loss carryforwards, and available tax planning alternatives.

Business Segment Results of Operations. We operate in three reportable business segments: Healthcare, Life Sciences, and Isomedix. Corporate and other, which is presented separately, contains the Defense and Industrial business unit plus costs that are associated with being a publicly traded company and certain other corporate costs. These costs include executive office costs, Board of Directors compensation, shareholder services and investor relations, external audit fees, and legacy pension and post-retirement benefit costs. Our Annual Report on Form 10-K for the year ended March 31, 2012, dated May 29, 2012, provides additional information regarding each business segment. The following table compares business segment revenues for

14


the three months ended June 30, 2012 and 2011:
 
(dollars in thousands)
 
Three Months Ended June 30,
 
Change
 
Percent
Change
2012
 
2011
 
Revenues:
 
 
 
 
 
 
 
 
Healthcare
 
$
229,514

 
$
223,224

 
$
6,290

 
2.8
%
Life Sciences
 
60,496

 
52,868

 
7,628

 
14.4
%
Isomedix
 
46,056

 
42,003

 
4,053

 
9.6
%
Total reportable segments
 
336,066

 
318,095

 
17,971

 
5.6
%
Corporate and other
 
894

 
544

 
350

 
64.3
%
Total Revenues
 
$
336,960

 
$
318,639

 
$
18,321

 
5.7
%
 
Healthcare revenues increased $6.3 million, or 2.8%, to $229.5 million for the quarter ended June 30, 2012, as compared to $223.2 million for the same prior year quarter. The increase is primarily attributable to growth in capital equipment revenues related to both infection prevention and surgical equipment, including revenue associated with SYSTEM 1E products in the United States. Service revenues increased 2.7% reflecting higher installation activity including activity related to SYSTEM 1E units. These increases were partially offset by the decline in consumable revenues driven by lower demand in the United States for SYSTEM 1 consumables. At June 30, 2012, the Healthcare segment’s backlog amounted to $99.4 million, decreasing $34.4 million, or 25.7%, compared to the backlog of $133.8 million at June 30, 2011. SYSTEM 1E related backlog was $2.2 million as of June 30, 2012, as compared to $24.0 million as of June 30, 2011. Healthcare backlog decreased $3.1 million, or 3.0%, compared to the backlog of $102.5 million at March 31, 2012.

Life Sciences revenues increased $7.6 million, or 14.4%, to $60.5 million for the quarter ended June 30, 2012, as compared to $52.9 million for the same prior year quarter. The increase in Life Sciences revenues was driven by increases of 35.9% in capital equipment revenues, 3.9% in consumable revenues, and 3.4% in service revenues. The increase in capital equipment revenues occurred in the United States, Europe and the Asia Pacific region and was primarily attributable to replacement product purchases from pharmaceutical Customers. At June 30, 2012, the Life Sciences segment’s backlog amounted to $47.4 million, increasing $0.8 million, or 1.7% compared to the backlog of $46.6 million at June 30, 2011. Life Sciences backlog decreased $2.7 million, or 5.4%, compared to the backlog of $50.1 million at March 31, 2012.

Isomedix segment revenues increased $4.1 million, or 9.6%, to $46.1 million for the quarter ended June 30, 2012, as compared to $42.0 million for the same prior year quarter. Revenues were favorably impacted by increased demand from our medical device Customers, as well as the recent acquisition of Biotest, which provides validation services to our Customers with lab operations in Minneapolis Minnesota.

The following table compares our business segment operating results for the three months ended June 30, 2012 to the three months ended June 30, 2011:
 
 
 
Three Months Ended June 30,
 
Change
 
Percent
Change
(dollars in thousands)
 
2012
 
2011
 
Operating income:
 
 
 
 
 
 
 
 
Healthcare
 
$
22,730

 
$
26,268

 
$
(3,538
)
 
(13.5
)%
Life Sciences
 
11,854

 
9,459

 
2,395

 
25.3
 %
Isomedix
 
15,578

 
12,959

 
2,619

 
20.2
 %
Total reportable segments
 
50,162

 
48,686

 
1,476

 
3.0
 %
Corporate and other
 
(1,860
)
 
(1,785
)
 
(75
)
 
4.2
 %
Total operating income
 
$
48,302

 
$
46,901

 
$
1,401

 
3.0
 %

Segment operating income is calculated as the segment’s gross profit less direct expenses and indirect cost allocations, which results in the full allocation of all distribution and research and development expenses, and the partial allocation of corporate costs. Corporate cost allocations are based on each segment’s percentage of revenues, headcount, or other variables in relation to those of the total Company. In addition, the Healthcare segment is responsible for the management of all but one manufacturing facility and uses standard cost to sell products to the Life Sciences segment. Corporate and other includes the revenues, gross profit and direct expenses of the Defense and Industrial business unit, as well as certain unallocated corporate

15


costs related to being a publicly traded company and legacy pension and post-retirement benefits, as previously discussed.

The Healthcare segment’s operating income decreased $3.5 million, to $22.7 million for the first quarter of fiscal 2013 as compared to $26.3 million in the same prior year period. The decrease in operating income reflects lower gross margins driven primarily by lower SYSTEM 1 consumable volumes, higher spending on research and development along with higher expenses related to SYSTEM 1E product reliability compared to the prior year period. We have experienced a sequential decrease in expenses related to SYSTEM 1E. However, the expenses related to SYSTEM 1E product reliability increased sequentially on a quarterly basis in the prior fiscal year, with the first quarter being the low point.

The Life Sciences segment’s operating income increased $2.4 million for the first quarter of fiscal 2013 as compared to the same prior year period. The segment’s operating margin was 19.6% for the first quarter of fiscal 2013. The increase was the result of volume increases and improved operating leverage.

The Isomedix segment’s operating income increased $2.6 million for the first quarter of fiscal 2013 as compared to the same prior year period. The segment’s operating margin was 33.8% for the first quarter of fiscal 2013. The increase in operating income reflects the benefit of increased revenues.

Liquidity and Capital Resources

The following table summarizes significant components of our cash flows for the three months ended June 30, 2012 and 2011:
 
 
 
Three Months Ended June 30,
(dollars in thousands)
 
2012
 
2011
Operating activities:
 
 
 
 
Net income
 
$
30,354

 
$
28,731

Non-cash items
 
15,509

 
29,432

Change in Accrued SYSTEM 1 Rebate Program and class action settlement
 
(9,242
)
 
(6,536
)
Changes in operating assets and liabilities
 
24,646

 
(39,646
)
Net cash provided by operating activities
 
$
61,267

 
$
11,981

Investing activities:
 
 
 
 
Purchases of property, plant, equipment, and intangibles, net
 
$
(15,542
)
 
$
(15,588
)
Proceeds from the sale of property, plant, equipment, and intangibles
 
17

 

Investments in businesses, net of cash acquired
 

 
(22,269
)
Net cash used in investing activities
 
$
(15,525
)
 
$
(37,857
)
Financing activities:
 
 
 
 
Repurchases of common shares
 
$
(1,117
)
 
$
(6,131
)
Cash dividends paid to common shareholders
 
(9,867
)
 
(8,913
)
Stock option and other equity transactions, net
 
3,457

 
2,457

Tax benefit from stock options exercised
 
525

 
610

Net cash used in financing activities
 
$
(7,002
)
 
$
(11,977
)
Debt-to-total capital ratio
 
20.2
%
 
20.5
%
Free cash flow (usage)
 
$
45,742

 
$
(3,607
)

Net Cash Provided by Operating Activities. The net cash provided by our operating activities was $61.3 million for the first three months of fiscal 2013 as compared with $12.0 million for the first three months of fiscal 2012. The increase in net cash provided by operating activities in fiscal 2013 is attributable to lower working capital requirements specifically the anticipated reduction of SYSTEM 1E related inventory, lower days sales outstanding and lower cash usage to fund compensation related obligations.
 
Net Cash Used In Investing Activities – The net cash we used in investing activities totaled $15.5 million for the first three months of fiscal 2013 compared with $37.9 million for the first three months of fiscal 2012. The following discussion summarizes the significant changes in our investing cash flows for the first three months of fiscal 2013 and fiscal 2012:
 
Purchases of property, plant, equipment, and intangibles, net – Capital expenditures were $15.5 million for the first three months of fiscal 2013 as compared to $15.6 million during the same prior year period.

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Investment in business, net of cash acquired – During the first quarter of fiscal 2012, we used $22.3 million in cash to acquire the stock of a privately held company with operations located near Sao Paulo, Brazil.

Net Cash Used In Financing Activities – The net cash used in financing activities amounted to $7.0 million for the first three months of fiscal 2013 compared with net cash used in financing activities of $12.0 million for the first three months of fiscal 2012. The following discussion summarizes the significant changes in our financing cash flows for the first three months of fiscal 2013 and fiscal 2012:
 
Repurchases of common shares – During the first three months of fiscal 2013, we obtained 42,151 of our common shares in connection with share-based compensation award programs. During the same period in fiscal 2012 , we repurchased 170,000 of our common shares for an aggregate amount of $5.8 million. We also obtained 21,329 of our common shares during the first quarter of fiscal 2012 in connection with stock based compensation award programs.
Cash dividends paid to common shareholders – During the first three months of fiscal 2013, we paid total cash dividends of $9.9 million, or $0.17 per outstanding common share. During the first three months of fiscal 2012, we paid total cash dividends of $8.9 million, or $0.15 per outstanding common share.
Stock option and other equity transactions, net – We receive cash for issuing common shares under our various employee stock option programs. During the first three months of fiscal 2013 and fiscal 2012, we received cash proceeds totaling $3.5 million and $2.5 million, respectively, under these programs.

Cash Flow Measures. Free cash flow was $45.7 million in the first three months of fiscal 2013 compared to a negative $3.6 million in the prior year first three months due to lower working capital requirements specifically the anticipated reduction of SYSTEM 1E related inventory builds, lower days sales outstanding and lower cash usage to fund compensation related obligations (see subsection of MD&A titled, "Non-GAAP Financial Measures" for additional information and related reconciliation of non-GAAP financial measures to the most comparable GAAP measures). Our debt-to-total capital ratio was 20.2% at June 30, 2012 and 20.5% at June 30, 2011.

Sources of Credit and Contractual and Commercial Commitments. Information related to our sources of credit and contractual and commercial commitments is included in our Annual Report on Form 10-K for the year ended March 31, 2012, dated May 29, 2012. Our commercial commitments were approximately $39.1 million at June 30, 2012 reflecting a net increase of $0.8 million in surety bonds and other commercial commitments from March 31, 2012. We entered into a new credit facility on April 13, 2012 (the "Facility"). The maximum aggregate borrowing limit under the Facility is $300.0 million, $100.0 million less than the amount under the prior facility. The maximum aggregate borrowing limit of $300.0 million under the Facility is reduced by outstanding borrowings and letters of credit issued under a sub-limit within the Facility. There were no outstanding borrowings and letters of credit at June 30, 2012.

Cash Requirements. Currently, we intend to use our existing cash and cash equivalent balances, cash generated from operations, and our existing credit facilities for short-term and long-term capital expenditures and our other liquidity needs. We believe that these amounts will be sufficient to meet working capital needs, capital requirements, and commitments for at least the next twelve months. However, our capital requirements will depend on many uncertain factors, including our rate of sales growth, our Customers’ acceptance of our products and services, the costs of obtaining adequate manufacturing capacities, the timing and extent of our research and development projects, and changes in our operating expenses. To the extent that our existing sources of cash are not sufficient to fund our future activities, we may need to raise additional funds through additional borrowings or selling equity securities. We cannot assure you that we will be able to obtain additional funds on terms favorable to us, or at all.

Critical Accounting Policies, Estimates, and Assumptions

Information related to our critical accounting policies, estimates, and assumptions is included in our Annual Report on Form 10-K for the year ended March 31, 2012, dated May 29, 2012. Our critical accounting policies, estimates, and assumptions have not changed materially from March 31, 2012.


Contingencies

We are, and will likely continue to be, involved in a number of legal proceedings, government investigations, and claims, which we believe generally arise in the course of our business, given our size, history, complexity, and the nature of our business, products, Customers, regulatory environment, and industries in which we participate. These legal proceedings, investigations and claims generally involve a variety of legal theories and allegations, including, without limitation, personal injury (e.g., slip and falls, burns, vehicle accidents), product liability or regulation (e.g., based on product operation or claimed

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malfunction, failure to warn, failure to meet specification, or failure to comply with regulatory requirements), product exposure (e.g., claimed exposure to chemicals, asbestos, contaminants, radiation), property damage (e.g., claimed damage due to leaking equipment, fire, vehicles, chemicals), commercial claims (e.g., breach of contract, economic loss, warranty, misrepresentation), financial (e.g., taxes, reporting), employment (e.g., wrongful termination, discrimination, benefits matters), and other claims for damage and relief.
We record a liability for such contingencies to the extent we conclude that their occurrence is both probable and estimable. We consider many factors in making these assessments, including the professional judgment of experienced members of management and our legal counsel. We have made estimates as to the likelihood of unfavorable outcomes and the amounts of such potential losses. In our opinion, the ultimate outcome of these proceedings and claims is not anticipated to have a material adverse affect on our consolidated financial position, results of operations, or cash flows. However, the ultimate outcome of proceedings, government investigations, and claims is unpredictable and actual results could be materially different from our estimates. We record expected recoveries under applicable insurance contracts when we are assured of recovery. Refer to Part II, Item 1, “Legal Proceedings” for additional information.

We are subject to taxation from United States federal, state and local, and foreign jurisdictions. Tax positions are settled primarily through the completion of audits within each individual tax jurisdiction or the closing of a statute of limitation. Changes in applicable tax law or other events may also require us to revise past estimates. The IRS routinely conducts audits of our federal income tax returns. We are no longer subject to United States federal examinations for years before fiscal 2010 and, with limited exceptions, we are no longer subject to United States state and local, or non-United States, income tax examinations by tax authorities for years before fiscal 2008. We remain subject to tax authority audits in various other jurisdictions in which we operate. If we prevail in matters for which accruals have been recorded, or are required to pay amounts in excess of recorded accruals, our effective income tax rate in a given financial statement period could be materially impacted.
Additional information regarding our commitments and contingencies is included in note 9 to our consolidated financial statements titled, “Commitments and Contingencies.”

International Operations

Since we conduct operations outside of the United States using various foreign currencies, our operating results are impacted by foreign currency movements relative to the U.S. dollar. During the first quarter of fiscal 2013, our revenues were unfavorably impacted by $3.8 million, or 1.1%, and income before taxes was favorably impacted by $3.2 million, or 7.5%, as a result of foreign currency movements relative to the U.S. dollar.

Forward-Looking Statements

This Form 10-Q may contain statements concerning certain trends, expectations, forecasts, estimates, or other forward-looking information affecting or relating to the Company or its industry, products or activities that are intended to qualify for the protections afforded "forward-looking statements" under the Private Securities Litigation Reform Act of 1995 and other laws and regulations. Forward-looking statements speak only as to the date of this press release, and may be identified by the use of forward-looking terms such as "may," "will," "expects," "believes," "anticipates," "plans," "estimates," "projects," "targets," "forecasts," "outlook," "impact," "potential," "confidence," "improve," "optimistic," "deliver," "comfortable," "trend", and "seeks," or the negative of such terms or other variations on such terms or comparable terminology. Many important factors could cause actual results to differ materially from those in the forward-looking statements including, without limitation, disruption of production or supplies, changes in market conditions, political events, pending or future claims or litigation, competitive factors, technology advances, actions of regulatory agencies, and changes in laws, government regulations, labeling or product approvals or the application or interpretation thereof. Other risk factors are described herein and in the Company's Form 10-K and other securities filings. Many of these important factors are outside STERIS's control. No assurances can be provided as to any result or the timing of any outcome regarding matters described herein or otherwise with respect to any regulatory action, administrative proceedings, government investigations, litigation, warning letters, consent decree, rebate program, transition, cost reductions, business strategies, earnings or revenue trends or future financial results (including without limitation the settlement of the SYSTEM 1 class action litigation and the regulatory matters related to SYSTEM 1E or its accessories). References to products, the consent decree, the transition or rebate program, or the class action settlement, are summaries only and should not be considered the specific terms of the decree, settlement, program or product clearance or literature. Unless legally required, the Company does not undertake to update or revise any forward-looking statements even if events make clear that any projected results, express or implied, will not be realized. Other potential risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements include, without limitation, (a) the potential for increased pressure on pricing or costs that leads to erosion of profit margins, (b) the possibility that market demand will not develop for new technologies, products or applications or the Company's rebate

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program, transition plan or other business initiatives will take longer, cost more or produce lower benefits than anticipated, (c) the possibility that application of or compliance with laws, court rulings, certifications, regulations, regulatory actions, including without limitation those relating to FDA warning notices or letters, government investigations, the April 20, 2010 consent decree and related transition plan and rebate program, the SYSTEM 1E device, the outcome of any pending FDA requests, inspections or submissions, or other requirements or standards may delay, limit or prevent new product introductions, affect the production and marketing of existing products or services or otherwise affect Company performance, results, prospects or value, (d) the potential of international unrest, economic downturn or effects of currencies, tax assessments, adjustments or anticipated rates, raw material costs or availability, benefit or retirement plan costs, or other regulatory compliance costs, (e) the possibility of reduced demand, or reductions in the rate of growth in demand, for the Company's products and services, (f) the possibility that anticipated growth, cost savings, rebate assumptions, new product acceptance, performance or approvals, including without limitation SYSTEM 1E and accessories thereto, or other results may not be achieved, or that transition, labor, competition, timing, execution, regulatory, governmental, or other issues or risks associated with our business, industry or initiatives including, without limitation, the consent decree, rebate program, and the transition from the SYSTEM 1 processing system and adjustments to related reserves or those matters described in our Form 10-K for the year ended March 31, 2012 and other securities filings, may adversely impact company performance, results, prospects or value, (g) the possibility that anticipated benefits and results of the US Endoscopy transaction will not be realized or will be other than anticipated, (h) the effect of the contraction in credit availability, as well as the ability of our Customers and suppliers to adequately access the credit markets when needed, and (i) those risks described in our securities filings including our Annual Report on Form 10-K for the year ended March 31, 2012, and other securities filings.


Availability of Securities and Exchange Commission Filings

We make available free of charge on or through our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to these reports as soon as reasonably practicable after we file such material with, or furnish such material to, the Securities Exchange Commission ("SEC.") You may access these documents on the Investor Relations page of our website at http://www.steris-ir.com. The information on our website is not incorporated by reference into this report. You may also obtain copies of these documents by visiting the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549, or by accessing the SEC’s website at http://www.sec.gov. You may obtain information on the Public Reference Room by calling the SEC at 1-800-SEC-0330.

 
ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In the ordinary course of business, we are subject to interest rate, foreign currency, and commodity risks. Information related to these risks and our management of these exposures is included in Part II, Item 7A, “Quantitative and Qualitative Disclosures about Market Risk,” in our Annual Report on Form 10-K for the year ended March 31, 2012, dated with the SEC on May 29, 2012. Our exposures to market risks have not changed materially since March 31, 2012.

ITEM 4.
CONTROLS AND PROCEDURES

Under the supervision of and with the participation of our management, including the Principal Executive Officer (“PEO”) and Principal Financial Officer (“PFO”), we evaluated the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as of the end of the period covered by this Quarterly Report. Based on that evaluation, including the assessment and input of our management, the PEO and PFO concluded that, as of the end of the period covered by this Quarterly Report, our disclosure controls and procedures were effective.

There were no changes in our internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) promulgated under the Securities Exchange Act of 1934, that occurred during the quarter ended June 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II—OTHER INFORMATION
 
ITEM 1.
LEGAL PROCEEDINGS

We are, and will likely continue to be, involved in a number of legal proceedings, government investigations, and claims, which we believe generally arise in the course of our business, given our size, history, complexity, and the nature of our business, products, Customers, regulatory environment, and industries in which we participate. These legal proceedings, investigations and claims generally involve a variety of legal theories and allegations, including, without limitation, personal injury (e.g., slip and falls, burns, vehicle accidents), product liability or regulation (e.g., based on product operation or claimed malfunction, failure to warn, failure to meet specification, or failure to comply with regulatory requirements), product exposure (e.g., claimed exposure to chemicals, asbestos, contaminants, radiation), property damage (e.g., claimed damage due to leaking equipment, fire, vehicles, chemicals), commercial claims (e.g., breach of contract, economic loss, warranty, misrepresentation), financial (e.g., taxes, reporting), employment (e.g., wrongful termination, discrimination, benefits matters), and other claims for damage and relief.
 
We believe we have adequately reserved for our current litigation and claims that are probable and estimable, and further believe that the ultimate outcome of these pending lawsuits and claims will not have a material adverse affect on our consolidated financial position or results of operations taken as a whole. Due to their inherent uncertainty, however, there can be no assurance of the ultimate outcome or effect of current or future litigation, investigations, claims or other proceedings (including without limitation the FDA-related matters discussed below). For certain types of claims, we presently maintain insurance coverage for personal injury and property damage and other liability coverages in amounts and with deductibles that we believe are prudent, but there can be no assurance that these coverages will be applicable or adequate to cover adverse outcomes of claims or legal proceedings against us.
 
As previously disclosed, we received a warning letter (the “warning letter”) from the FDA on May 16, 2008 regarding our SYSTEM 1 sterile processor and the STERIS® 20 sterilant used with the processor (sometimes referred to collectively in the FDA letter and in this Item 1 as the “device”). Among other matters, the warning letter included the FDA's assertion that significant changes or modifications had been made in the design, components, method of manufacture, or intended use of the device beyond the FDA's 1988 clearance, such that the FDA believed a new premarket notification submission (known within FDA regulations as a 510(k) submission) should have been made, and the assertion that our failure to make such a submission resulted in violations of applicable law. On July 30, 2008 (with an Addendum on October 9, 2008), we provided a detailed response contending that the assertions in the warning letter were not correct. On November 4, 2008, we received a letter from the FDA (dated November 3, 2008) in which the FDA stated without elaboration that, after reviewing our response, it disagreed with our position and that a new premarket notification submission was required. After discussions with the FDA regarding the November 3rd letter, we received an additional letter on November 6, 2008 from the FDA. The November 6th letter stated that the intent of the November 3rd letter was to inform us of the FDA's preliminary disagreement with our response to the warning letter and, before finalizing a position, the FDA reiterated that it wanted to meet with us to discuss the Company's response, issues related to the warning letter and next steps to resolve any differences between the Company and the FDA. We thereafter met with the FDA and, on January 20, 2009, we announced that we had submitted to the FDA a new liquid chemical sterilant processing system for 510(k) clearance, and we communicated to Customers that we would continue supporting the existing SYSTEM 1 installed base in the U.S. for at least a two year period from that date.
 
On December 3, 2009, the FDA provided a notice (“notice”) to healthcare facility administrators and infection control practitioners describing FDA's “concerns about the SYSTEM 1 Processor, components and accessories, and FDA recommendations.” In the notice, among other things, FDA stated its belief that the SYSTEM 1 device had been significantly modified, that FDA had not cleared or approved the modified device, and that FDA had not determined whether the SYSTEM 1 was safe or effective for its labeled claims. The notice further stated that use of a device that does not properly sterilize or disinfect a medical or surgical device poses risks to patients and users, including the transmission of pathogens, exposure to hazardous chemicals and may affect the quality and functionality of reprocessed instruments. The notice stated that FDA was aware of reports of malfunctions of the SYSTEM 1 that had the potential to cause or contribute to serious injuries to patients, such as infections, or injuries to healthcare staff, such as burns. Included in FDA's December 3, 2009 notice was a recommendation from FDA that if users had acceptable alternatives to meet sterilization and disinfection needs, they should transition to that alternative as soon as possible. After its December 3, 2009 notice, we engaged in extensive discussions with the FDA regarding a comprehensive resolution of this matter. On February 2, 2010, the FDA notified healthcare facility administrators and infection control practitioners that FDA's total recommended time period for transitioning from SYSTEM 1 in the U.S. was 18 months from that date.
 
On April 5, 2010, we received FDA clearance of the new liquid chemical sterilant processing system (SYSTEM 1E). Also in April 2010 we reached agreement with the FDA on the terms of a consent decree (“Consent Decree”). On April 19, 2010, a

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Complaint and Consent Decree were filed in the U.S. District Court for the Northern District of Ohio, and on April 20, 2010, the Court approved the Consent Decree. In general, the Consent Decree addresses regulatory matters regarding SYSTEM 1, restricts further sales of SYSTEM 1 processors in the U.S., defines certain documentation and other requirements for continued service and support of SYSTEM 1 in the U.S., prohibits the sale of liquid chemical sterilization or disinfection products in the U.S. that do not have FDA clearance, describes various process and compliance matters, and defines penalties in the event of violation of the Consent Decree.
 
The Consent Decree also provides that we may continue to support our Customers' use of SYSTEM 1 in the U.S., including the sale of consumables, parts and accessories and service for a transition period, not to extend beyond August 2, 2011, subject to compliance with requirements for documentation of the Customer's need for continued support and other conditions and limitations (the “Transition Plan”). This transition period has since been extended by the FDA until August 2, 2012. Our Transition Plan includes the “SYSTEM 1 Rebate Program” (the “Rebate Program”). In April 2010, we began to offer rebates to qualifying Customers. Generally, U.S. Customers that purchased SYSTEM 1 processors directly from us or who were users of SYSTEM 1 at the time the Rebate Program was introduced and who return their units have the option of either a pro-rated cash rebate or rebate toward the future purchase of new STERIS capital equipment (including SYSTEM 1E) or consumable products. In addition, we provide credits for the return of SYSTEM 1 consumables in unbroken packaging and within shelf life and for the unused portion of SYSTEM 1 service contracts.

The Consent Decree has defined the resolution of a number of issues regarding SYSTEM 1, and we believe our actions with respect to SYSTEM 1, including the Transition Plan, were and are not recalls, corrections or removals under FDA regulations. However, there is no assurance that these or other claims will not be brought or that judicial, regulatory, administrative or other legal or enforcement actions, notices or remedies will not be pursued, or that action will not be taken in respect of the Consent Decree, the Transition Plan, SYSTEM 1, or otherwise with respect to regulatory or compliance matters, as described in this Item 1 and in various portions of Item 1A. of Part I of our Annual Report on Form 10-K for the year ended March 31, 2012 dated May&#