UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
ý | QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended October 24, 2014 |
Commission File Number 1-7707
MEDTRONIC, INC. | |
(Exact name of registrant as specified in its charter) | |
Minnesota | 41-0793183 |
(State of incorporation) | (I.R.S. Employer Identification No.) |
710 Medtronic Parkway
Minneapolis, Minnesota 55432
(Address of principal executive offices) (Zip Code)
(763) 514-4000
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ý 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 and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes ý No o
Yes ý 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 | 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 ý
Shares of common stock, $.10 par value, outstanding on November 24, 2014: 984,316,549
TABLE OF CONTENTS
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PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
MEDTRONIC, INC.
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
(Unaudited)
Three months ended | Six months ended | ||||||||||||||
October 24, 2014 | October 25, 2013 | October 24, 2014 | October 25, 2013 | ||||||||||||
(in millions, except per share data) | |||||||||||||||
Net sales | $ | 4,366 | $ | 4,194 | $ | 8,639 | $ | 8,277 | |||||||
Costs and expenses: | |||||||||||||||
Cost of products sold | 1,142 | 1,090 | 2,247 | 2,112 | |||||||||||
Research and development expense | 374 | 372 | 739 | 732 | |||||||||||
Selling, general, and administrative expense | 1,507 | 1,438 | 3,013 | 2,854 | |||||||||||
Special charges | 100 | — | 100 | 40 | |||||||||||
Restructuring charges, net | — | — | 30 | 18 | |||||||||||
Certain litigation charges, net | — | 24 | — | 24 | |||||||||||
Acquisition-related items | 61 | — | 102 | (96 | ) | ||||||||||
Amortization of intangible assets | 89 | 88 | 176 | 174 | |||||||||||
Other expense, net | 63 | 33 | 114 | 77 | |||||||||||
Interest expense, net | 8 | 33 | 13 | 73 | |||||||||||
Total costs and expenses | 3,344 | 3,078 | 6,534 | 6,008 | |||||||||||
Earnings before income taxes | 1,022 | 1,116 | 2,105 | 2,269 | |||||||||||
Provision for income taxes | 194 | 214 | 406 | 414 | |||||||||||
Net earnings | $ | 828 | $ | 902 | $ | 1,699 | $ | 1,855 | |||||||
Basic earnings per share | $ | 0.84 | $ | 0.90 | $ | 1.72 | $ | 1.85 | |||||||
Diluted earnings per share | $ | 0.83 | $ | 0.89 | $ | 1.70 | $ | 1.83 | |||||||
Basic weighted average shares outstanding | 981.9 | 998.9 | 987.5 | 1,004.5 | |||||||||||
Diluted weighted average shares outstanding | 993.0 | 1,009.4 | 999.4 | 1,015.5 | |||||||||||
Cash dividends declared per common share | $ | 0.305 | $ | 0.280 | $ | 0.610 | $ | 0.560 | |||||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
1
MEDTRONIC, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
Three months ended | Six months ended | ||||||||||||||
October 24, 2014 | October 25, 2013 | October 24, 2014 | October 25, 2013 | ||||||||||||
(in millions) | |||||||||||||||
Net earnings | $ | 828 | $ | 902 | $ | 1,699 | $ | 1,855 | |||||||
Other comprehensive (loss) income, net of tax: | |||||||||||||||
Unrealized (loss) gain on available-for-sale securities, net of tax (benefit) expense of $(19), $17, $13, and $(37), respectively | (34 | ) | 31 | 20 | (64 | ) | |||||||||
Translation adjustment | (130 | ) | 62 | (129 | ) | 57 | |||||||||
Net change in retirement obligations, net of tax expense of $6, $8, $12, and $17, respectively | 25 | 9 | 42 | 23 | |||||||||||
Unrealized gain (loss) on derivatives, net of tax expense (benefit) of $68, $(53), $89, and $(52), respectively | 121 | (93 | ) | 158 | (91 | ) | |||||||||
Other comprehensive (loss) income | (18 | ) | 9 | 91 | (75 | ) | |||||||||
Comprehensive income | $ | 810 | $ | 911 | $ | 1,790 | $ | 1,780 | |||||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
2
MEDTRONIC, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
October 24, 2014 | April 25, 2014 | ||||||
(in millions, except per share data) | |||||||
ASSETS | |||||||
Current assets: | |||||||
Cash and cash equivalents | $ | 1,287 | $ | 1,403 | |||
Investments | 13,177 | 12,838 | |||||
Accounts receivable, less allowances of $109 and $115, respectively | 3,750 | 3,811 | |||||
Inventories | 1,873 | 1,725 | |||||
Tax assets | 696 | 736 | |||||
Prepaid expenses and other current assets | 814 | 697 | |||||
Total current assets | 21,597 | 21,210 | |||||
Property, plant, and equipment | 6,320 | 6,439 | |||||
Accumulated depreciation | (3,959 | ) | (4,047 | ) | |||
Property, plant, and equipment, net | 2,361 | 2,392 | |||||
Goodwill | 11,024 | 10,593 | |||||
Other intangible assets, net | 2,437 | 2,286 | |||||
Long-term tax assets | 183 | 300 | |||||
Other assets | 1,178 | 1,162 | |||||
Total assets | $ | 38,780 | $ | 37,943 | |||
LIABILITIES AND SHAREHOLDERS’ EQUITY | |||||||
Current liabilities: | |||||||
Short-term borrowings | $ | 3,970 | $ | 1,613 | |||
Accounts payable | 723 | 742 | |||||
Accrued compensation | 806 | 1,015 | |||||
Accrued income taxes | 168 | 164 | |||||
Deferred tax liabilities | 18 | 19 | |||||
Other accrued expenses | 1,267 | 2,006 | |||||
Total current liabilities | 6,952 | 5,559 | |||||
Long-term debt | 9,708 | 10,315 | |||||
Long-term accrued compensation and retirement benefits | 681 | 662 | |||||
Long-term accrued income taxes | 1,322 | 1,343 | |||||
Long-term deferred tax liabilities | 420 | 386 | |||||
Other long-term liabilities | 259 | 235 | |||||
Total liabilities | 19,342 | 18,500 | |||||
Commitments and contingencies (Notes 3 and 19) | |||||||
Shareholders’ equity: | |||||||
Preferred stock— par value $1.00 | — | — | |||||
Common stock— par value $0.10 | 98 | 100 | |||||
Retained earnings | 19,846 | 19,940 | |||||
Accumulated other comprehensive loss | (506 | ) | (597 | ) | |||
Total shareholders’ equity | 19,438 | 19,443 | |||||
Total liabilities and shareholders’ equity | $ | 38,780 | $ | 37,943 | |||
The accompanying notes are an integral part of these condensed consolidated financial statements.
3
MEDTRONIC, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) | |||||||
Six months ended | |||||||
October 24, 2014 | October 25, 2013 | ||||||
(in millions) | |||||||
Operating Activities: | |||||||
Net earnings | $ | 1,699 | $ | 1,855 | |||
Adjustments to reconcile net earnings to net cash provided by operating activities: | |||||||
Depreciation and amortization | 423 | 421 | |||||
Amortization of debt issuance costs | 32 | 4 | |||||
Acquisition-related items | 6 | (96 | ) | ||||
Provision for doubtful accounts | 17 | 24 | |||||
Deferred income taxes | (61 | ) | (19 | ) | |||
Stock-based compensation | 82 | 75 | |||||
Other, net | (40 | ) | (12 | ) | |||
Change in operating assets and liabilities, net of acquisitions: | |||||||
Accounts receivable, net | (64 | ) | (16 | ) | |||
Inventories | (170 | ) | (111 | ) | |||
Accounts payable and accrued liabilities | 26 | (540 | ) | ||||
Other operating assets and liabilities | 73 | 413 | |||||
Certain litigation charges, net | — | 24 | |||||
Certain litigation payments | (800 | ) | (3 | ) | |||
Net cash provided by operating activities | 1,223 | 2,019 | |||||
Investing Activities: | |||||||
Acquisitions, net of cash acquired | (578 | ) | (210 | ) | |||
Additions to property, plant, and equipment | (210 | ) | (196 | ) | |||
Purchases of investments | (3,024 | ) | (5,719 | ) | |||
Sales and maturities of investments | 2,665 | 4,291 | |||||
Other investing activities, net | (6 | ) | (18 | ) | |||
Net cash used in investing activities | (1,153 | ) | (1,852 | ) | |||
Financing Activities: | |||||||
Acquisition-related contingent consideration | (5 | ) | (1 | ) | |||
Change in short-term borrowings, net | 1,611 | 1,546 | |||||
Repayment of short-term borrowings (maturities greater than 90 days) | — | (125 | ) | ||||
Proceeds from short-term borrowings (maturities greater than 90 days) | 150 | 310 | |||||
Payments on long-term debt | (7 | ) | (6 | ) | |||
Dividends to shareholders | (602 | ) | (560 | ) | |||
Issuance of common stock | 312 | 817 | |||||
Repurchase of common stock | (1,620 | ) | (2,053 | ) | |||
Other financing activities | 34 | 13 | |||||
Net cash used in financing activities | (127 | ) | (59 | ) | |||
Effect of exchange rate changes on cash and cash equivalents | (59 | ) | 39 | ||||
Net change in cash and cash equivalents | (116 | ) | 147 | ||||
Cash and cash equivalents at beginning of period | 1,403 | 919 | |||||
Cash and cash equivalents at end of period | $ | 1,287 | $ | 1,066 | |||
Supplemental Cash Flow Information | |||||||
Cash paid for: | |||||||
Income taxes | $ | 357 | $ | 225 | |||
Interest | 250 | 197 | |||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
4
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1 – Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S.) (U.S. GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information necessary for a fair presentation of results of operations, comprehensive income, financial condition, and cash flows in conformity with U.S. GAAP. In the opinion of management, the condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the results of Medtronic, Inc. and its subsidiaries (Medtronic or the Company) for the periods presented. Operating results for interim periods are not necessarily indicative of results that may be expected for the fiscal year as a whole. The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses, and the related disclosures at the date of the financial statements and during the reporting period. Actual results could materially differ from these estimates. For further information, refer to the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended April 25, 2014.
The Company’s fiscal years 2015, 2014, and 2013 will end or ended on April 24, 2015, April 25, 2014, and April 26, 2013, respectively.
Note 2 – New Accounting Pronouncements
Recently Adopted
In July 2013, the FASB issued amended guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, similar tax loss, or tax credit carryforward exists. The guidance requires an unrecognized tax benefit, or a portion of an unrecognized tax benefit, to be presented as a reduction of a deferred tax asset when a net operating loss carryforward, similar tax loss, or tax credit carryforward exists, with certain exceptions. The Company prospectively adopted this accounting guidance in the first quarter of fiscal year 2015 and its adoption did not have a material impact on the Company’s consolidated financial statements.
In March 2013, the FASB issued amended guidance on a parent company's accounting for the cumulative translation adjustment (CTA) recorded in accumulated other comprehensive income (AOCI) associated with a foreign entity. The amendment requires a parent to release into net income the CTA related to its investment in a foreign entity when it either sells a part or all of its investment, or no longer holds a controlling financial interest, in a subsidiary or group of assets within a foreign entity. This accounting guidance was effective prospectively for the Company in the first quarter of fiscal year 2015. This amended guidance has had no impact on the Company's financial position or results of operations as the Company has had no event or transaction described above.
Not Yet Adopted
In April 2014, the FASB issued amended guidance for reporting discontinued operations. The amended guidance changes the criteria for determining when the results of operations are to be reported as discontinued operations and expands the related disclosure requirements. The guidance defines a discontinued operation as a disposal of a component or group of components that is disposed of or classified as held for sale which is a strategic shift that has, or will have, a major effect on financial position and results of operations. This accounting guidance is effective prospectively for the Company beginning in the first quarter of fiscal year 2016, with early adoption permitted. The adoption is not expected to have a material impact on the Company’s consolidated financial statements.
In May 2014, the FASB issued amended revenue recognition guidance to clarify the principles for recognizing revenue from contracts with customers. The guidance requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods or services. The guidance also requires expanded disclosures relating to the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Additionally, qualitative and quantitative disclosures are required about customer contracts, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. This accounting guidance is effective for the Company beginning in the first quarter of fiscal year 2018 using one of two prescribed retrospective methods. Early adoption is not permitted. The Company is evaluating the impact of the amended revenue recognition guidance on the Company’s consolidated financial statements.
5
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 3 – Acquisitions and Acquisition-Related Items
The Company had various acquisitions and other acquisition-related activity during the first two quarters of fiscal years 2015 and 2014. Certain acquisitions were accounted for as business combinations as noted below. In accordance with authoritative guidance on business combination accounting, the assets and liabilities of the company acquired were recorded as of the acquisition date, at their respective fair values, and consolidated. The pro forma impact of these acquisitions was not significant, individually or in the aggregate, to the results of the Company for the three and six months ended October 24, 2014 or October 25, 2013. The results of operations related to each company acquired have been included in the Company's condensed consolidated statements of earnings since the date each company was acquired.
Pending Acquisition of Covidien plc
On June 15, 2014, Medtronic, Inc. entered into a Transaction Agreement (the Transaction Agreement) by and among Medtronic, Inc., Covidien public limited company, an Irish public limited company (Covidien), Medtronic Holdings Limited (f/k/a Kalani I Limited), a private limited company organized under the laws of Ireland that will be renamed Medtronic plc (New Medtronic), Makani II Limited, a private limited company organized under the laws of Ireland and a wholly-owned subsidiary of New Medtronic (IrSub), Aviation Acquisition Co., Inc., a Minnesota corporation (U.S. AcquisitionCo), and Aviation Merger Sub, LLC, a Minnesota limited liability company and a wholly-owned subsidiary of U.S. AcquisitionCo (MergerSub). Under the terms of the Transaction Agreement, (i) New Medtronic and IrSub will acquire Covidien (the Acquisition) pursuant to the Irish Scheme of Arrangement under Section 201, involving the cancellation of Covidien's issued share capital under Sections 72 and 74, of the Irish Companies Act of 1963 (the Arrangement) and (ii) MergerSub will merge with and into Medtronic, Inc., with Medtronic, Inc. continuing as the surviving corporation in the merger (such merger, the Merger, and the Merger together with the Acquisition, the Pending Acquisition). As a result of the Pending Acquisition, both Medtronic, Inc. and Covidien will become wholly-owned subsidiaries of New Medtronic. Prior to the closing of the transaction, New Medtronic will re-register as a public limited company, the ordinary shares of which are expected to be listed on the New York Stock Exchange under the symbol "MDT".
At the effective time of the Arrangement, Covidien shareholders will be entitled to receive $35.19 in cash and 0.956 of a newly issued New Medtronic share (the Arrangement Consideration) in exchange for each Covidien share held by such shareholders, and at the effective time of the Merger, each share of Medtronic, Inc. common stock will be converted into the right to receive one New Medtronic share. The total cash and stock value of the Pending Acquisition is approximately $46.5 billion (based on Medtronic, Inc.’s closing share price of $69.38 on November 13, 2014). It is expected that immediately after the closing of the Pending Acquisition, Covidien shareholders will own approximately 30 percent of New Medtronic on a fully diluted basis.
The Transaction Agreement may be terminated by mutual written consent of the parties. The Transaction Agreement also contains certain termination rights, including, among others, the right of either party to terminate if (a) the Arrangement has not become effective by March 15, 2015 (the End Date), subject to certain conditions, provided that the End Date will be extended to June 15, 2015 in certain circumstances, (b) the Covidien or Medtronic, Inc. shareholder approvals are not obtained, (c) the other party breaches its representations and covenants and such breach would result in the closing conditions not being satisfied, subject to a cure period, (d) the Irish High Court declines to sanction the Arrangement, unless both parties agree to appeal the decision, or (e) there is a failure of the tax condition as described in Medtronic, Inc.’s Current Report on Form 8-K filed with the SEC on June 16, 2014. Covidien also has the right, prior to the receipt of Covidien shareholder approval, to terminate the Transaction Agreement to accept a Covidien Superior Proposal (as defined in the Transaction Agreement) in certain circumstances.
The Transaction Agreement also provides that Medtronic, Inc. must pay Covidien a termination fee of $850 million if the Transaction Agreement is terminated because the Medtronic, Inc. board of directors changes its recommendation for the transaction and the Medtronic, Inc. shareholders vote against the Transaction, and either (i) Covidien obtained the requisite Covidien shareholder approval or (ii) Medtronic, Inc. effected such termination prior to the completion of the Covidien shareholder meeting.
The consummation of the Pending Acquisition is subject to certain conditions, including approvals by Medtronic, Inc. and Covidien shareholders. The special meetings of shareholders of Medtronic and Covidien have been scheduled for January 6, 2015. In addition, the proposed transaction requires approval of the Irish High Court and regulatory approvals in the U.S., the European Union, China, and certain other countries. The Pending Acquisition is expected to close in early 2015. Covidien is a global health care products company that creates innovative medical solutions for better patient outcomes and delivers value through clinical leadership and excellence. Covidien develops, manufactures, and sells a diverse range of industry-leading medical device and supply products.
6
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
See Note 8 to the condensed consolidated financial statements for further information regarding the financing of the Pending Acquisition.
NGC Medical S.p.A.
On August 26, 2014, the Company acquired NGC Medical S.p.A. (NGC), a privately-held Italian company that offers a broad suite of hospital managed services. Total consideration for this transaction was approximately $340 million. Medtronic had previously invested in NGC and held a 30 percent ownership position in that company. Net of this ownership position, the transaction value was approximately $238 million. Based upon a preliminary acquisition valuation, the Company acquired $177 million of customer-related intangible assets and tradenames with an estimated useful life of 20 years at the time of acquisition and $184 million of goodwill. The acquired goodwill is not deductible for tax purposes.
The fair values of the assets acquired and liabilities assumed are as follows:
(in millions) | |||
Current assets | $ | 55 | |
Property, plant, and equipment | 15 | ||
Intangible assets | 177 | ||
Goodwill | 184 | ||
Other assets | 2 | ||
Total assets acquired | 433 | ||
Current liabilities | 34 | ||
Long-term deferred tax liabilities, net | 55 | ||
Other long-term liabilities | 4 | ||
Total liabilities assumed | 93 | ||
Net assets acquired | $ | 340 | |
Sapiens Steering Brain Stimulation
On August 25, 2014, the Company acquired Sapiens Steering Brain Stimulation (Sapiens), a privately-held developer of deep brain stimulation technologies. Total consideration for the transaction was approximately $203 million. Based upon a preliminary acquisition valuation, the Company acquired $30 million of IPR&D and $170 million of goodwill. The acquired goodwill is not deductible for tax purposes.
The fair values of the assets acquired and liabilities assumed are as follows:
(in millions) | |||
Current assets | $ | 3 | |
Property, plant, and equipment | 1 | ||
IPR&D | 30 | ||
Goodwill | 170 | ||
Other assets | 3 | ||
Total assets acquired | 207 | ||
Current liabilities | 4 | ||
Total liabilities assumed | 4 | ||
Net assets acquired | $ | 203 | |
7
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Visualase, Inc.
On July 25, 2014, the Company acquired Visualase, Inc. (Visualase), a privately-held developer of minimally invasive MRI guided laser ablation for surgical applications. Total consideration for the transaction was approximately $97 million. Based upon a preliminary acquisition valuation, the Company acquired $66 million of technology-based intangible assets with an estimated useful life of 10 years at the time of acquisition and $49 million of goodwill. The acquired goodwill is not deductible for tax purposes.
Corventis, Inc.
On June 20, 2014, the Company acquired Corventis, Inc. (Corventis), a privately-held developer of wearable, wireless technologies for cardiac disease. Total consideration for the transaction was approximately $131 million, including settlement of outstanding debt to Medtronic of $50 million. Based upon a preliminary acquisition valuation, the Company acquired $80 million of technology-based intangible assets with an estimated useful life of 16 years at the time of acquisition and $50 million of goodwill. The acquired goodwill is not deductible for tax purposes.
TYRX, Inc.
On December 30, 2013, the Company acquired TYRX, Inc. (TYRX), a privately-held developer of antibiotic drug and implanted medical device combinations. TYRX's products include those designed to reduce surgical site infections associated with implantable pacemakers, defibrillators, and spinal cord neurostimulators. Under the terms of the agreement, the transaction included an initial up-front payment of $159 million, representing a purchase price amount that was net of acquired cash, including the assumption and settlement of existing TYRX debt and direct acquisition costs. Total consideration for the transaction was approximately $222 million, which included estimated fair values for product development-based and revenue-based contingent consideration of $25 million and $35 million, respectively. The product development-based contingent consideration includes a future potential payment of $40 million upon achieving certain milestones, and the revenue-based contingent consideration payments would be equal to TYRX's actual annual revenue growth for the Company's fiscal years 2015 and 2016. Based upon a preliminary acquisition valuation, the Company acquired $94 million of technology-based intangible assets with an estimated useful life of 14 years at the time of acquisition and $132 million of goodwill. The acquired goodwill is not deductible for tax purposes.
The fair values of the assets acquired and liabilities assumed are as follows:
(in millions) | |||
Current assets | $ | 6 | |
Property, plant, and equipment | 1 | ||
Intangible assets | 94 | ||
Goodwill | 132 | ||
Total assets acquired | 233 | ||
Current liabilities | 4 | ||
Long-term deferred tax liabilities, net | 7 | ||
Total liabilities assumed | 11 | ||
Net assets acquired | $ | 222 | |
The Company accounted for the acquisitions of NGC, Sapiens, Corventis, Visualase, and TYRX as business combinations using the acquisition method of accounting.
Acquisition-Related Items
During the three and six months ended October 24, 2014, the Company recorded acquisition-related items of $61 million and $102 million, respectively, primarily due to costs incurred in connection with the pending Covidien acquisition (bridge financing fees, legal fees, and other transaction-related costs).
During the three months ended October 25, 2013, the Company's acquisition-related items were not significant. During the six months ended October 25, 2013, the Company recorded net income from acquisition-related items of $96 million related to the change in fair value of contingent consideration associated with the Ardian, Inc. acquisition.
8
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Contingent Consideration
Certain of the Company’s business combinations and purchases of intellectual property involve the potential for the payment of future contingent consideration upon the achievement of certain product development milestones and/or various other favorable operating conditions. Payment of the additional consideration is generally contingent on the acquired company reaching certain performance milestones, including attaining specified revenue levels or achieving product development targets. For business combinations subsequent to April 24, 2009, a liability is recorded for the estimated fair value of the contingent consideration on the acquisition date. The fair value of the contingent consideration is remeasured at each reporting period and the change in fair value recognized as income or expense within acquisition-related items in the condensed consolidated statements of earnings. The Company measures the liability on a recurring basis using Level 3 inputs. See Note 7 for further information regarding fair value measurements.
The fair value of contingent consideration is measured using projected payment dates, discount rates, probabilities of payment, and projected revenues (for revenue-based considerations). Projected contingent payment amounts are discounted back to the current period using a discounted cash flow model. Projected revenues are based on the Company’s most recent internal operational budgets and long-range strategic plans. Increases (decreases) in projected revenues, probabilities of payment, discount rates, or projected payment dates may result in a higher (lower) fair value measurement. Fluctuations in any of the inputs may result in a significantly lower (higher) fair value measurement.
The recurring Level 3 fair value measurements of contingent consideration include the following significant unobservable inputs:
Fair Value at | ||||||||
($ in millions) | October 24, 2014 | Valuation Technique | Unobservable Input | Range | ||||
Discount rate | 13.5% - 24% | |||||||
Revenue-based payments | $65 | Discounted cash flow | Probability of payment | 100% | ||||
Projected fiscal year of payment | 2015 - 2019 | |||||||
Discount rate | 5.5% | |||||||
Product development-based payments | $26 | Discounted cash flow | Probability of payment | 75% | ||||
Projected fiscal year of payment | 2018 | |||||||
At October 24, 2014, the estimated maximum amount of undiscounted future contingent consideration that the Company is expected to make associated with all completed business combinations or purchases of intellectual property prior to April 24, 2009 was approximately $197 million. The Company estimates the milestones or other conditions associated with the contingent consideration will be reached in fiscal year 2015 and thereafter.
The fair value of contingent consideration associated with acquisitions subsequent to April 24, 2009, as of October 24, 2014 and April 25, 2014, was $91 million and $68 million, respectively. As of October 24, 2014, $66 million was reflected in other long-term liabilities and $25 million was reflected in other accrued expenses in the condensed consolidated balance sheets. As of April 25, 2014, $51 million was reflected in other long-term liabilities and $17 million was reflected in other accrued expenses in the condensed consolidated balance sheets. The portion of the contingent consideration paid related to the acquisition date fair value is reported as financing activities in the condensed consolidated statements of cash flows. Amounts paid in excess of the original acquisition date fair value are reported as operating activities in the condensed consolidated statements of cash flows. The following table provides a reconciliation of the beginning and ending balances of contingent consideration associated with acquisitions subsequent to April 24, 2009:
Three months ended | Six months ended | ||||||||||||||
(in millions) | October 24, 2014 | October 25, 2013 | October 24, 2014 | October 25, 2013 | |||||||||||
Beginning Balance | $ | 87 | $ | 45 | $ | 68 | $ | 142 | |||||||
Purchase price contingent consideration | — | — | 23 | — | |||||||||||
Contingent consideration payments | — | — | (5 | ) | (1 | ) | |||||||||
Change in fair value of contingent consideration | 4 | — | 5 | (96 | ) | ||||||||||
Ending Balance | $ | 91 | $ | 45 | $ | 91 | $ | 45 | |||||||
9
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 4 – Special Charges and Certain Litigation Charges, Net
Special Charges
During the three and six months ended October 24, 2014, consistent with the Company's commitment to improving the health of people and communities throughout the world, the Company made a $100 million charitable cash contribution to meet the multi-year funding needs of the Medtronic Foundation. The Medtronic Foundation is a related party non-profit organization.
During the three months ended October 25, 2013, there were no special charges. During the six months ended October 25, 2013, the Company made a $40 million charitable contribution to the Medtronic Foundation.
Certain Litigation Charges, Net
The Company classifies material litigation reserves and gains recognized as certain litigation charges, net. During the three and six months ended October 24, 2014, there were no certain litigation charges, net.
During the three and six months ended October 25, 2013, the Company recorded certain litigation charges, net of $24 million, which includes $12 million related to patent litigation and $12 million related to Other Matters litigation.
Note 5 – Restructuring Charges, Net
Fiscal Year 2014 Initiative
The fiscal year 2014 initiative primarily related to the Company's renal denervation business, certain manufacturing shut-downs, and a reduction of back-office support functions in Europe. In the fourth quarter of fiscal year 2014, the Company recorded a $116 million restructuring charge, which consisted of employee termination costs of $65 million, asset write-downs of $26 million, contract termination costs of $3 million, and other related costs of $22 million. Of the $26 million of asset write-downs, $10 million related to inventory write-offs of discontinued product lines and production-related asset impairments, and therefore, was recorded within cost of products sold in the condensed consolidated statements of earnings. In the first quarter of fiscal year 2015, the Company recorded a $38 million restructuring charge, which was the final charge related to the fiscal year 2014 initiative and consisted primarily of contract termination and other related costs of $28 million. The fiscal year 2014 initiative is scheduled to be substantially complete by the end of the fourth quarter of fiscal year 2015.
As a result of certain employees identified for elimination finding other positions within the Company and revisions to particular strategies, the Company recorded a $6 million reversal of excess restructuring reserves in the first quarter of fiscal year 2015.
A summary of the activity related to the fiscal year 2014 initiative is presented below:
(in millions) | Employee Termination Costs | Asset Write-downs | Other Costs | Total | |||||||||||
Balance as of April 25, 2014 | $ | 64 | $ | — | $ | 11 | $ | 75 | |||||||
Restructuring charges | 1 | 9 | 28 | 38 | |||||||||||
Payments/write-downs | (17 | ) | (9 | ) | (19 | ) | (45 | ) | |||||||
Reversal of excess accrual | (6 | ) | — | — | (6 | ) | |||||||||
Balance as of July 25, 2014 | $ | 42 | $ | — | $ | 20 | $ | 62 | |||||||
Payments | (15 | ) | — | (7 | ) | (22 | ) | ||||||||
Balance as of October 24, 2014 | $ | 27 | $ | — | $ | 13 | $ | 40 | |||||||
Fiscal Year 2013 Initiative
The fiscal year 2013 initiative was designed to scale back the Company's infrastructure in slower growing areas of the business, while continuing to invest in geographies, businesses, and products where faster growth is anticipated. A number of factors have contributed to ongoing challenging market dynamics, including increased pricing pressure, various governmental austerity measures, and the U.S. medical device excise tax. In the fourth quarter of fiscal year 2013, the Company recorded a $192 million restructuring charge, which consisted of employee termination costs of $150 million, asset write-downs of $13 million, contract termination costs of $18 million, and other related costs of $11 million. Of the $13 million of asset write-downs, $10 million related to inventory write-offs of discontinued product lines and production-related asset impairments, and therefore, was recorded within cost of products sold in the condensed consolidated statements of earnings. In the first quarter of fiscal
10
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
year 2014, the Company recorded an $18 million restructuring charge, which was the final charge related to the fiscal year 2013 initiative and consisted primarily of contract termination costs of $14 million and other related costs of $4 million.
In the first quarter of fiscal year 2015, the Company recorded a $2 million reversal of excess restructuring reserves as a result of certain employees identified for elimination finding other positions within the Company and revisions to particular strategies.
As a result of certain legal requirements outside the U.S., the fiscal year 2013 initiative is scheduled to be substantially complete by the end of the third quarter of fiscal year 2016.
A summary of the activity related to the fiscal year 2013 initiative is presented below:
(in millions) | Employee Termination Costs | Other Costs | Total | ||||||||
Balance as of April 25, 2014 | $ | 23 | $ | 1 | $ | 24 | |||||
Payments | (5 | ) | (1 | ) | (6 | ) | |||||
Reversal of excess accrual | (2 | ) | — | (2 | ) | ||||||
Balance as of July 25, 2014 | $ | 16 | $ | — | $ | 16 | |||||
Payments | (3 | ) | — | (3 | ) | ||||||
Balance as of October 24, 2014 | $ | 13 | $ | — | $ | 13 | |||||
11
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 6 – Investments
The Company holds investments consisting primarily of marketable debt and equity securities.
Information regarding the Company’s investments at October 24, 2014 is as follows:
(in millions) | Cost | Unrealized Gains | Unrealized Losses | Fair Value | |||||||||||
Available-for-sale securities: | |||||||||||||||
Corporate debt securities | $ | 5,596 | $ | 69 | $ | (12 | ) | $ | 5,653 | ||||||
Auction rate securities | 109 | — | (10 | ) | 99 | ||||||||||
Mortgage-backed securities | 1,257 | 13 | (6 | ) | 1,264 | ||||||||||
U.S. government and agency securities | 2,868 | 11 | (19 | ) | 2,860 | ||||||||||
Foreign government and agency securities | 80 | — | — | 80 | |||||||||||
Certificates of deposit | 46 | — | — | 46 | |||||||||||
Other asset-backed securities | 469 | 2 | — | 471 | |||||||||||
Debt funds | 2,775 | 22 | (55 | ) | 2,742 | ||||||||||
Marketable equity securities | 41 | 18 | (13 | ) | 46 | ||||||||||
Trading securities: | |||||||||||||||
Exchange-traded funds | 56 | 14 | — | 70 | |||||||||||
Cost method, equity method, and other investments | 563 | — | — | NA | |||||||||||
Total | $ | 13,860 | $ | 149 | $ | (115 | ) | $ | 13,331 | ||||||
Information regarding the Company’s investments at April 25, 2014 is as follows:
(in millions) | Cost | Unrealized Gains | Unrealized Losses | Fair Value | |||||||||||
Available-for-sale securities: | |||||||||||||||
Corporate debt securities | $ | 5,504 | $ | 55 | $ | (17 | ) | $ | 5,542 | ||||||
Auction rate securities | 109 | — | (12 | ) | 97 | ||||||||||
Mortgage-backed securities | 1,337 | 7 | (8 | ) | 1,336 | ||||||||||
U.S. government and agency securities | 3,138 | 7 | (29 | ) | 3,116 | ||||||||||
Foreign government and agency securities | 67 | — | — | 67 | |||||||||||
Certificates of deposit | 54 | — | — | 54 | |||||||||||
Other asset-backed securities | 540 | 2 | — | 542 | |||||||||||
Debt funds | 2,143 | 9 | (29 | ) | 2,123 | ||||||||||
Marketable equity securities | 47 | 15 | (13 | ) | 49 | ||||||||||
Trading securities: | |||||||||||||||
Exchange-traded funds | 54 | 13 | — | 67 | |||||||||||
Cost method, equity method, and other investments | 666 | — | — | NA | |||||||||||
Total | $ | 13,659 | $ | 108 | $ | (108 | ) | $ | 12,993 | ||||||
Information regarding the Company’s condensed consolidated balance sheets presentation at October 24, 2014 and April 25, 2014 is as follows:
October 24, 2014 | April 25, 2014 | ||||||||||||||
(in millions) | Investments | Other Assets | Investments | Other Assets | |||||||||||
Available-for-sale securities | $ | 13,107 | $ | 154 | $ | 12,771 | $ | 155 | |||||||
Trading securities | 70 | — | 67 | — | |||||||||||
Cost method, equity method, and other investments | — | 563 | — | 666 | |||||||||||
Total | $ | 13,177 | $ | 717 | $ | 12,838 | $ | 821 | |||||||
12
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The following tables show the gross unrealized losses and fair values of the Company’s available-for-sale securities that have been in a continuous unrealized loss position deemed to be temporary, aggregated by investment category as of October 24, 2014 and April 25, 2014:
October 24, 2014 | |||||||||||||||
Less than 12 months | More than 12 months | ||||||||||||||
(in millions) | Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | |||||||||||
Corporate debt securities | $ | 1,305 | $ | (8 | ) | $ | 97 | $ | (4 | ) | |||||
Auction rate securities | — | — | 99 | (10 | ) | ||||||||||
Mortgage-backed securities | 327 | (2 | ) | 311 | (4 | ) | |||||||||
U.S. government and agency securities | 368 | (1 | ) | 681 | (18 | ) | |||||||||
Debt funds | 1,372 | (40 | ) | 133 | (15 | ) | |||||||||
Marketable equity securities | 17 | (13 | ) | — | — | ||||||||||
Total | $ | 3,389 | $ | (64 | ) | $ | 1,321 | $ | (51 | ) | |||||
April 25, 2014 | |||||||||||||||
Less than 12 months | More than 12 months | ||||||||||||||
(in millions) | Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | |||||||||||
Corporate debt securities | $ | 1,601 | $ | (14 | ) | $ | 50 | $ | (3 | ) | |||||
Auction rate securities | — | — | 97 | (12 | ) | ||||||||||
Mortgage-backed securities | 682 | (7 | ) | 28 | (1 | ) | |||||||||
U.S. government and agency securities | 1,500 | (27 | ) | 46 | (2 | ) | |||||||||
Debt funds | 1,224 | (29 | ) | — | — | ||||||||||
Marketable equity securities | 25 | (13 | ) | — | — | ||||||||||
Total | $ | 5,032 | $ | (90 | ) | $ | 221 | $ | (18 | ) | |||||
Activity related to the Company’s investment portfolio is as follows:
(a) Includes available-for-sale debt securities.
Three months ended | |||||||||||||||
October 24, 2014 | October 25, 2013 | ||||||||||||||
(in millions) | Debt (a) | Equity (b) | Debt (a) | Equity (b) | |||||||||||
Proceeds from sales | $ | 806 | $ | 7 | $ | 2,072 | $ | 24 | |||||||
Gross realized gains | 4 | 39 | — | 15 | |||||||||||
Gross realized losses | (2 | ) | — | (1 | ) | — | |||||||||
Impairment losses recognized | — | (20 | ) | — | — | ||||||||||
Six months ended | |||||||||||||||
October 24, 2014 | October 25, 2013 | ||||||||||||||
(in millions) | Debt (a) | Equity (b) | Debt (a) | Equity (b) | |||||||||||
Proceeds from sales | $ | 2,636 | $ | 29 | $ | 4,235 | $ | 56 | |||||||
Gross realized gains | 16 | 58 | 6 | 33 | |||||||||||
Gross realized losses | (5 | ) | — | (6 | ) | — | |||||||||
Impairment losses recognized | — | (20 | ) | — | — | ||||||||||
(b) Includes marketable equity securities, cost method, equity method, exchange-traded funds, and other investments.
Credit losses represent the difference between the present value of cash flows expected to be collected on certain mortgage-backed securities and auction rate securities and the amortized cost of these securities. Based on the Company’s assessment of the credit quality of the underlying collateral and credit support available to each of the remaining securities in which invested, the Company believes it has recorded all necessary other-than-temporary impairments as the Company does not have the intent to sell, nor is it more likely than not that the Company will be required to sell, before recovery of the amortized cost.
13
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
As of October 24, 2014 and April 25, 2014, the credit loss portion of other-than-temporary impairments on debt securities was $4 million. The total reductions for available-for-sale debt securities sold during the three and six months ended October 24, 2014 and October 25, 2013 were not significant. The total other-than-temporary impairment losses on available-for-sale debt securities for the three and six months ended October 24, 2014 and October 25, 2013 were not significant.
The October 24, 2014 balance of available-for-sale debt securities, excluding debt funds which have no single maturity date, by contractual maturity is shown in the following table. Within the table, maturities of mortgage-backed securities have been allocated based upon timing of estimated cash flows, assuming no change in the current interest rate environment. Actual maturities may differ from contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties.
(in millions) | October 24, 2014 | ||
Due in one year or less | $ | 1,714 | |
Due after one year through five years | 6,046 | ||
Due after five years through ten years | 2,559 | ||
Due after ten years | 154 | ||
Total | $ | 10,473 | |
The Company holds investments in marketable equity securities which are classified as investments in the condensed consolidated balance sheets. The aggregate carrying amount of these investments was $46 million and $49 million as of October 24, 2014 and April 25, 2014, respectively. During the three and six months ended October 24, 2014, the Company determined that the fair value of certain marketable equity securities were below their carrying values and that the carrying values of these investments were not expected to be recoverable within a reasonable period of time. As a result, the Company recognized $7 million in impairment charges for the three and six months ended October 24, 2014, which were recorded in other expense, net in the condensed consolidated statements of earnings. The Company did not record any significant impairment charges related to marketable equity securities during the three and six months ended October 25, 2013.
As of October 24, 2014 and April 25, 2014, the aggregate carrying amount of equity and other securities without a quoted market price and accounted for using the cost or equity method was $563 million and $666 million, respectively. The total carrying value of these investments is reviewed quarterly for changes in circumstance or the occurrence of events that suggest the Company’s investment may not be recoverable. The value of cost or equity method investments is not adjusted if there are no identified events or changes in circumstances that may have a material adverse effect on the fair value of the investment.
Gains and losses realized on trading securities and available-for-sale debt securities are recorded in interest expense, net in the condensed consolidated statements of earnings. Gains and losses realized on marketable equity securities, cost method, equity method, and other investments are recorded in other expense, net in the condensed consolidated statements of earnings. In addition, unrealized gains and losses on available-for-sale debt securities are recorded in other comprehensive income (loss) in the condensed consolidated statements of comprehensive income and unrealized gains and losses on trading securities are recorded in interest expense, net in the condensed consolidated statements of earnings. Gains and losses from the sale of investments are calculated based on the specific identification method.
14
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 7 – Fair Value Measurements
The Company follows the authoritative guidance on fair value measurements and disclosures with respect to assets and liabilities that are measured at fair value on both a recurring and nonrecurring basis. Under this guidance, fair value is defined as the exit price, or the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. The authoritative guidance also establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs market participants would use in valuing the asset or liability, based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the factors market participants would use in valuing the asset or liability developed based upon the best information available in the circumstances. The categorization of financial assets and financial liabilities within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The hierarchy is broken down into three levels. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). Descriptions of the three levels of the fair value hierarchy are discussed in Note 6 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended April 25, 2014.
See the section below titled Valuation Techniques for further discussion of how the Company determines fair value for investments.
Assets and Liabilities That Are Measured at Fair Value on a Recurring Basis
The authoritative guidance is principally applied to financial assets and liabilities such as marketable equity securities and debt and equity securities that are classified and accounted for as trading, available-for-sale, derivative instruments, and contingent consideration associated with acquisitions subsequent to April 24, 2009. Derivatives include cash flow hedges, freestanding derivative forward contracts, and fair value hedges. These items are marked-to-market at each reporting period.
The following tables provide information by level for assets and liabilities that are measured at fair value on a recurring basis:
Fair Value as of October 24, 2014 | Fair Value Measurements Using Inputs Considered as | ||||||||||||||
(in millions) | Level 1 | Level 2 | Level 3 | ||||||||||||
Assets: | |||||||||||||||
Corporate debt securities | $ | 5,653 | $ | — | $ | 5,644 | $ | 9 | |||||||
Auction rate securities | 99 | — | — | 99 | |||||||||||
Mortgage-backed securities | 1,264 | — | 1,264 | — | |||||||||||
U.S. government and agency securities | 2,860 | 1,199 | 1,661 | — | |||||||||||
Foreign government and agency securities | 80 | — | 80 | — | |||||||||||
Certificates of deposit | 46 | — | 46 | — | |||||||||||
Other asset-backed securities | 471 | — | 471 | — | |||||||||||
Debt funds | 2,742 | — | 2,742 | — | |||||||||||
Marketable equity securities | 46 | 46 | — | — | |||||||||||
Exchange-traded funds | 70 | 70 | — | — | |||||||||||
Derivative assets | 350 | 260 | 90 | — | |||||||||||
Total assets | $ | 13,681 | $ | 1,575 | $ | 11,998 | $ | 108 | |||||||
Liabilities: | |||||||||||||||
Derivative liabilities | $ | 57 | $ | 27 | $ | 30 | $ | — | |||||||
Contingent consideration associated with acquisitions subsequent to April 24, 2009 | 91 | — | — | 91 | |||||||||||
Total liabilities | $ | 148 | $ | 27 | $ | 30 | $ | 91 | |||||||
15
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Fair Value as of April 25, 2014 | Fair Value Measurements Using Inputs Considered as | ||||||||||||||
(in millions) | Level 1 | Level 2 | Level 3 | ||||||||||||
Assets: | |||||||||||||||
Corporate debt securities | $ | 5,542 | $ | — | $ | 5,533 | $ | 9 | |||||||
Auction rate securities | 97 | — | — | 97 | |||||||||||
Mortgage-backed securities | 1,336 | — | 1,336 | — | |||||||||||
U.S. government and agency securities | 3,116 | 1,251 | 1,865 | — | |||||||||||
Foreign government and agency securities | 67 | — | 67 | — | |||||||||||
Certificates of deposit | 54 | — | 54 | — | |||||||||||
Other asset-backed securities | 542 | — | 542 | — | |||||||||||
Debt funds | 2,123 | — | 2,123 | — | |||||||||||
Marketable equity securities | 49 | 49 | — | — | |||||||||||
Exchange-traded funds | 67 | 67 | — | — | |||||||||||
Derivative assets | 175 | 89 | 86 | — | |||||||||||
Total assets | $ | 13,168 | $ | 1,456 | $ | 11,606 | $ | 106 | |||||||
Liabilities: | |||||||||||||||
Derivative liabilities | $ | 127 | $ | 116 | $ | 11 | $ | — | |||||||
Contingent consideration associated with acquisitions subsequent to April 24, 2009 | 68 | — | — | 68 | |||||||||||
Total liabilities | $ | 195 | $ | 116 | $ | 11 | $ | 68 | |||||||
Valuation Techniques
Financial assets that are classified as Level 1 securities include highly liquid government bonds within U.S. government and agency securities, marketable equity securities, and exchange-traded funds for which quoted market prices are available. In addition, the Company has determined that foreign currency forward contracts will be included in Level 1 as these are valued using quoted market prices in active markets which have identical assets or liabilities.
The valuation for most fixed maturity securities are classified as Level 2. Financial assets that are classified as Level 2 include corporate debt securities, U.S. government and agency securities, foreign government and agency securities, certificates of deposit, other asset-backed securities, debt funds, and certain mortgage-backed securities whose value is determined using inputs that are observable in the market or can be derived principally from, or corroborated by, observable market data such as pricing for similar securities, recently executed transactions, cash flow models with yield curves, and benchmark securities. In addition, interest rate swaps are included in Level 2 as the Company uses inputs other than quoted prices that are observable for the asset. The Level 2 derivative instruments are primarily valued using standard calculations and models that use readily observable market data as their basis.
Financial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies, or similar techniques, and at least one significant model assumption or input is unobservable. Level 3 financial assets also include certain investment securities for which there is limited market activity such that the determination of fair value requires significant judgment or estimation. Level 3 investment securities include certain corporate debt securities, auction rate securities, and certain mortgage-backed securities. With the exception of auction rate securities, these securities were valued using third-party pricing sources that incorporate transaction details such as contractual terms, maturity, timing, and amount of expected future cash flows, as well as assumptions about liquidity and credit valuation adjustments by market participants. The fair value of auction rate securities is estimated by the Company using a discounted cash flow model, which incorporates significant unobservable inputs. The significant unobservable inputs used in the fair value measurement of the Company’s auction rate securities are years to principal recovery and the illiquidity premium that is incorporated into the discount rate. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value of the securities. Additionally, the Company uses Level 3 inputs in the measurement of contingent consideration and related liabilities for all acquisitions subsequent to April 24, 2009. See Note 3 to the condensed consolidated financial statements for further information regarding contingent consideration.
16
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The following table represents the range of the unobservable inputs utilized in the fair value measurement of the auction rate securities classified as Level 3 as of October 24, 2014:
Valuation Technique | Unobservable Input | Range (Weighted Average) | |
Auction rate securities | Discounted cash flow | Years to principal recovery | 2 yrs. - 12 yrs. (3 yrs.) |
Illiquidity premium | 6% | ||
The Company reviews the fair value hierarchy classification on a quarterly basis. Changes in the ability to observe valuation inputs may result in a reclassification of levels for certain securities within the fair value hierarchy. The Company’s policy is to recognize transfers into and out of levels within the fair value hierarchy at the end of the fiscal quarter in which the actual event or change in circumstances that caused the transfer occurs. There were no transfers between Level 1, Level 2, or Level 3 during the three and six months ended October 24, 2014 or October 25, 2013. When a determination is made to classify an asset or liability within Level 3, the determination is based upon the significance of the unobservable inputs to the overall fair value measurement.
The following tables provide a reconciliation of the beginning and ending balances of items measured at fair value on a recurring basis that used significant unobservable inputs (Level 3) for the three and six months ended October 24, 2014 and October 25, 2013:
Three months ended October 24, 2014 | |||||||||||||||
(in millions) | Total Level 3 Investments | Corporate debt securities | Auction rate securities | Mortgage- backed securities | |||||||||||
Balance as of July 25, 2014 | $ | 108 | $ | 9 | $ | 99 | $ | — | |||||||
Total unrealized gains included in other comprehensive income | — | — | — | — | |||||||||||
Balance as of October 24, 2014 | $ | 108 | $ | 9 | $ | 99 | $ | — | |||||||
Three months ended October 25, 2013 | |||||||||||||||
(in millions) | Total Level 3 Investments | Corporate debt securities | Auction rate securities | Mortgage- backed securities | |||||||||||
Balance as of July 26, 2013 | $ | 132 | $ | 10 | $ | 107 | $ | 15 | |||||||
Total realized losses and other-than-temporary impairment losses included in earnings | (2 | ) | — | (2 | ) | — | |||||||||
Total unrealized gains included in other comprehensive income | 1 | — | 1 | — | |||||||||||
Settlements | (13 | ) | (1 | ) | (1 | ) | (11 | ) | |||||||
Balance as of October 25, 2013 | $ | 118 | $ | 9 | $ | 105 | $ | 4 | |||||||
Six months ended October 24, 2014 | |||||||||||||||
(in millions) | Total Level 3 Investments | Corporate debt securities | Auction rate securities | Mortgage- backed securities | |||||||||||
Balance as of April 25, 2014 | $ | 106 | $ | 9 | $ | 97 | $ | — | |||||||
Total unrealized gains included in other comprehensive income | 2 | — | 2 | — | |||||||||||
Balance as of October 24, 2014 | $ | 108 | $ | 9 | $ | 99 | $ | — | |||||||
Six months ended October 25, 2013 | |||||||||||||||
(in millions) | Total Level 3 Investments | Corporate debt securities | Auction rate securities | Mortgage- backed securities | |||||||||||
Balance as of April 26, 2013 | $ | 127 | $ | 10 | $ | 103 | $ | 14 | |||||||
Total realized losses and other-than-temporary impairment losses included in earnings | (2 | ) | — | (2 | ) | — | |||||||||
Total unrealized gains included in other comprehensive income | 6 | — | 5 | 1 | |||||||||||
Settlements | (13 | ) | (1 | ) | (1 | ) | (11 | ) | |||||||
Balance as of October 25, 2013 | $ | 118 | $ | 9 | $ | 105 | $ | 4 | |||||||
17
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Assets and Liabilities That Are Measured at Fair Value on a Nonrecurring Basis
Non-financial assets such as equity and other securities that are accounted for using the cost or equity method, goodwill and IPR&D, intangible assets, and property, plant, and equipment are measured at fair value when there is an indicator of impairment and recorded at fair value only when an impairment is recognized.
The Company holds investments in equity and other securities that are accounted for using the cost or equity method, which are classified as other assets in the condensed consolidated balance sheets. The aggregate carrying amount of these investments was $563 million as of October 24, 2014 and $666 million as of April 25, 2014. These cost or equity method investments are measured at fair value on a nonrecurring basis. The fair value of the Company’s cost or equity method investments is not estimated if there are no identified events or changes in circumstance that may have a significant adverse effect on the fair value of these investments. During the three and six months ended October 24, 2014, the Company determined that the fair values of certain cost method investments were below their carrying values and that the carrying values of these investments were not expected to be recoverable within a reasonable period of time. As a result, the Company recognized $13 million in impairment charges during the three and six months ended October 24, 2014, which were recorded in other expense, net in the condensed consolidated statements of earnings. The Company did not record any significant impairment charges related to cost method investments during the three and six months ended October 25, 2013. These investments fall within Level 3 of the fair value hierarchy, due to the use of significant unobservable inputs to determine fair value, as the investments are privately-held entities without quoted market prices. To determine the fair value of these investments, the Company used all pertinent financial information available related to the entities, including financial statements and market participant valuations from recent and proposed equity offerings.
The Company assesses the impairment of goodwill annually in the third quarter and whenever an event occurs or circumstances change that would indicate that the carrying amount may be impaired. The aggregate carrying amount of goodwill was $11.024 billion and $10.593 billion as of October 24, 2014 and April 25, 2014, respectively.
Impairment testing for goodwill is performed at the reporting unit level. The test for impairment of goodwill requires the Company to make several estimates about fair value, most of which are based on projected future cash flows. The Company calculates the excess of each reporting unit's fair value over its carrying amount, including goodwill, utilizing a discounted cash flow analysis. The Company did not record any goodwill impairments during the three and six months ended October 24, 2014 or October 25, 2013.
The recently acquired businesses of Cardiocom, LLC (Cardiocom) and Kanghui are separate reporting units and are tested for goodwill impairment independently; therefore, they are more sensitive to changes in assumptions impacting fair value. The carrying amount of goodwill was $410 million and $123 million for the Kanghui and Cardiocom reporting units, respectively, as of October 24, 2014. As of the date of the annual goodwill impairment test, the fair values of these two reporting units exceeded their respective carrying values by more than 10 percent.
The Company assesses the impairment of IPR&D annually in the third quarter and whenever an event occurs or circumstances change that would indicate that the carrying amount may be impaired. The aggregate carrying amount of IPR&D was $138 million and $119 million as of October 24, 2014 and April 25, 2014, respectively. The majority of IPR&D at October 24, 2014 is related to IN.PACT family of drug-eluting balloons. Similar to the goodwill impairment test, the IPR&D impairment test requires the Company to make several estimates about fair value, most of which are based on projected future cash flows. The Company calculates the excess of IPR&D asset fair values over their carrying values utilizing a discounted future cash flow analysis. The Company did not record any IPR&D impairments during the three or six months ended October 24, 2014 or October 25, 2013. Due to the nature of IPR&D projects, the Company may experience future delays or failures to obtain regulatory approvals to conduct clinical trials, failures of such clinical trials, delays or failures to obtain required market clearances or other failures to achieve a commercially viable product, and as a result, may record impairment losses in the future.
The Company assesses intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an intangible asset (asset group) may not be recoverable. The aggregate carrying amount of intangible assets, excluding IPR&D, was $2.299 billion as of October 24, 2014 and $2.167 billion as of April 25, 2014. When events or changes in circumstances indicate that the carrying amount of an intangible asset may not be recoverable, the Company calculates the excess of an intangible asset's carrying value over its undiscounted future cash flows. If the carrying value is not recoverable, an impairment loss is recorded based on the amount by which the carrying value exceeds the fair value. The inputs used in the fair value analysis fall within Level 3 of the fair value hierarchy due to the use of significant unobservable inputs to determine fair value. The Company did not record any significant intangible asset impairments during the three or six months ended October 24, 2014 or October 25, 2013.
18
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The Company assesses the impairment of property, plant, and equipment whenever events or changes in circumstances indicate that the carrying amount of property, plant, and equipment assets may not be recoverable. The Company did not record any significant impairments of Property, plant, and equipment during the three months ended October 24, 2014. As part of the Company’s restructuring initiatives, the Company recorded Property, plant, and equipment impairments of $9 million during the six months ended October 24, 2014 in restructuring charges, net in the condensed consolidated statements of earnings. For further discussion of the restructuring initiatives refer to Note 5. The Company did not record any significant impairments of Property, plant, and equipment during the three or six months ended October 25, 2013.
Financial Instruments Not Measured at Fair Value
The estimated fair value of the Company’s long-term debt, including the short-term portion, as of October 24, 2014 was $11.842 billion compared to a principal value of $11.375 billion, and as of April 25, 2014 was $11.856 billion compared to a principal value of $11.375 billion. Fair value was estimated using quoted market prices for the publicly registered senior notes, classified as Level 1 within the fair value hierarchy. The fair values and principal values consider the terms of the related debt and exclude the impacts of debt discounts and derivative/hedging activity.
Note 8 – Financing Arrangements
Commercial Paper
The Company maintains a commercial paper program that allows the Company to have a maximum of $2.250 billion in commercial paper outstanding, with maturities up to 364 days from the date of issuance. As of October 24, 2014, outstanding commercial paper totaled $1.755 billion. No amounts were outstanding as of April 25, 2014. During the three and six months ended October 24, 2014, the weighted average original maturity of the commercial paper outstanding was approximately 47 days and 42 days, respectively, and the weighted average interest rate was 0.11 percent for both periods. The issuance of commercial paper reduces the amount of credit available under the Company’s existing Credit Facility, as defined below.
Line of Credit
The Company has a $2.250 billion syndicated credit facility which expires on December 17, 2017 (Credit Facility) pursuant to a senior unsecured revolving credit agreement dated as of December 17, 2012, among Medtronic, the lenders from time to time party thereto, and Bank of America N.A., as administrative agent and issuing bank. The Credit Facility provides the Company with the ability to increase its borrowing capacity by an additional $750 million at any time during the term of the agreement. At each anniversary date of the Credit Facility, but not more than twice prior to the maturity date, the Company can also request a one-year extension of the maturity date. The Credit Facility provides backup funding for the commercial paper program. As of October 24, 2014 and April 25, 2014, no amounts were outstanding on the committed Credit Facility.
Interest rates are determined by a pricing matrix, based on the Company’s long-term debt ratings, assigned by Standard & Poor’s Ratings Services and Moody’s Investors Service. Facility fees are payable on the Credit Facility and are determined in the same manner as the interest rates. The agreement also contains customary covenants, all of which the Company remains in compliance with as of October 24, 2014.
Other Credit Agreements
In conjunction with the Pending Acquisition of Covidien, Medtronic, Inc. initially contemplated financing a substantial portion of the cash component of the acquisition consideration through an intercompany loan from one or more of its non-U.S. subsidiaries to IrSub. However, as announced on October 3, 2014, following the September 22, 2014 announcement by the U.S. Treasury Department and the U.S. Internal Revenue Service (IRS), Medtronic, Inc. now expects that it will incur approximately $16.3 billion in external indebtedness to finance the cash component of the acquisition consideration and certain transaction expenses. Medtronic, Inc. expects that a substantial portion of such external indebtedness will be incurred by Medtronic, Inc. prior to the consummation of the transaction and will be guaranteed by New Medtronic, either at or shortly following the closing of the Covidien acquisition. As a result, Medtronic, Inc., or its affiliates, will have a sufficient amount of cash available to it by the time of the consummation of the transaction to fund the cash component of the acquisition consideration.
New Bridge Credit Agreement
On November 7, 2014, Medtronic, Inc. entered into a 364-day senior unsecured bridge credit agreement (the New Bridge Credit Agreement), among Medtronic, Inc., New Medtronic, Medtronic Global Holdings SCA, a partnership limited by shares incorporated in Luxembourg and a wholly-owned indirect subsidiary of New Medtronic (Medtronic Luxco), the lenders from time to time party thereto and Bank of America, N.A., as administrative agent. Under the New Bridge Credit Agreement, the lenders party thereto have committed to provide Medtronic, Inc. with unsecured bridge financing in an aggregate principal
19
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
amount of up to $11.3 billion. The commitments are intended to be available to finance, in part, the cash component of the acquisition consideration and certain transaction expenses to the extent Medtronic, Inc. does not arrange for alternative financing prior to the consummation of the transaction. New Medtronic and Medtronic Luxco have guaranteed the obligations of Medtronic, Inc. under the New Bridge Credit Agreement. If Medtronic, Inc. draws loans under the New Bridge Credit Agreement, it intends to refinance any such loans with the proceeds of other external indebtedness.
Term Loan Credit Agreement
On November 7, 2014, Medtronic, Inc. also entered into the three-year senior unsecured term loan credit agreement (the Term Loan Credit Agreement and, together with the New Bridge Credit Agreement, the New Credit Agreements), among Medtronic, Inc., New Medtronic, Medtronic Luxco, the lenders from time to time party thereto and Bank of America, N.A., as administrative agent. Under the Term Loan Credit Agreement, the lenders party thereto have committed to provide Medtronic, Inc. with unsecured term loan financing in an aggregate principal amount of up to $5.0 billion. Medtronic, Inc. intends to draw upon such commitments on the consummation of the transaction to finance, in part, the cash component of the acquisition consideration and certain transaction expenses. New Medtronic and Medtronic Luxco have guaranteed the obligations of Medtronic, Inc. under the Term Loan Credit Agreement.
Termination of Existing Bridge Credit Agreements
In connection with its entrance into the New Bridge Credit Agreement and the Term Loan Credit Agreement, on November 7, 2014, Medtronic, Inc. terminated the unsecured bridge commitments previously provided to it in an aggregate principal amount of $2.8 billion under the 364-day senior unsecured bridge credit agreement dated as of June 15, 2014. On the same date, IrSub terminated the unsecured bridge commitments previously provided to it in an aggregate principal amount of $13.5 billion under the 60-day senior unsecured cash bridge credit agreement dated as of June 15, 2014.
Amended and Restated Revolving Credit Agreement
On November 7, 2014, Medtronic, Inc. also entered into an amendment and restatement agreement (the Revolver
Amendment Agreement), among Medtronic, Inc., New Medtronic, Medtronic Luxco, the lenders from time to time party thereto and Bank of America, N.A., as administrative agent and issuing bank. Under the Revolver Amendment Agreement, the parties thereto have agreed to enter into an amendment and restatement (the Amended and Restated Revolving Credit Agreement) of Medtronic’s existing $2.250 billion Credit Facility. The effectiveness of the Amended and Restated Revolving Credit Agreement is conditioned on, among other things, the consummation of the acquisition. Under the Amended and Restated Revolving Credit Agreement, the lenders party thereto will provide Medtronic, Inc. and Medtronic Luxco with unsecured revolving credit commitments in an aggregate principal amount of up to $3.5 billion. The commitments are intended to be used for general corporate purposes, including acquisitions and working capital of Medtronic, Inc. and Medtronic Luxco, and to replace the revolving credit facility currently available to Covidien. Medtronic, Inc. and Medtronic Luxco will be coborrowers under the Amended and Restated Revolving Credit Agreement and each of Medtronic, Inc., Medtronic Luxco and New Medtronic will also guarantee the obligations of the co-borrowers under the Amended and Restated Revolving Credit Agreement.
For further information regarding the Pending Acquisition, see Note 3 to the condensed consolidated financial statements.
Bank Borrowings
Bank borrowings consist primarily of borrowings at interest rates considered favorable by management and where natural hedges can be gained for foreign exchange purposes.
20
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Long-Term Debt
Long-term debt consisted of the following:
(in millions, except interest rates) | Maturity by Fiscal Year | Payable as of October 24, 2014 | Payable as of April 25, 2014 | |||||||
4.750 percent ten-year 2005 senior notes | 2016 | $ | — | $ | 600 | |||||
2.625 percent five-year 2011 senior notes | 2016 | 500 | 500 | |||||||
Floating rate three-year 2014 senior notes | 2017 | 250 | 250 | |||||||
0.875 percent three-year 2014 senior notes | 2017 | 250 | 250 | |||||||
1.375 percent five-year 2013 senior notes | 2018 | 1,000 | 1,000 | |||||||
5.600 percent ten-year 2009 senior notes | 2019 | 400 | 400 | |||||||
4.450 percent ten-year 2010 senior notes | 2020 | 1,250 | 1,250 | |||||||
4.125 percent ten-year 2011 senior notes | 2021 | 500 | 500 | |||||||
3.125 percent ten-year 2012 senior notes | 2022 | 675 | 675 | |||||||
2.750 percent ten-year 2013 senior notes | 2023 | 1,250 | 1,250 | |||||||
3.625 percent ten-year 2014 senior notes | 2024 | 850 | 850 | |||||||
6.500 percent thirty-year 2009 senior notes | 2039 | 300 | 300 | |||||||
5.550 percent thirty-year 2010 senior notes | 2040 | 500 | 500 | |||||||
4.500 percent thirty-year 2012 senior notes | 2042 | 400 | 400 | |||||||
4.000 percent thirty-year 2013 senior notes | 2043 | 750 | 750 | |||||||
4.625 percent thirty-year 2014 senior notes | 2044 | 650 | 650 | |||||||
Interest rate swaps | 2016 - 2022 | 61 | 56 | |||||||
Deferred gains from interest rate swap terminations | - | 10 | 20 | |||||||
Capital lease obligations | 2016 - 2025 | 132 | 139 | |||||||
Bank borrowings | 2017 | 3 | — | |||||||
Discount | 2017 - 2044 | (23 | ) | (25 | ) | |||||
Total Long-Term Debt | $ | 9,708 | $ | 10,315 | ||||||
Senior Notes
The Company has outstanding unsecured senior obligations including those indicated as "senior notes" in the long-term debt table above (collectively, the Senior Notes). The Senior Notes rank equally with all other unsecured and unsubordinated indebtedness of the Company. The indentures under which the Senior Notes were issued contain customary covenants, all of which the Company remains in compliance with as of October 24, 2014. The Company used the net proceeds from the sale of the Senior Notes primarily for working capital and general corporate uses, which includes the repayment of other indebtedness of the Company. For additional information regarding the terms of these agreements, refer to Note 8 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended April 25, 2014.
As of October 24, 2014, the Company had interest rate swap agreements designated as fair value hedges of certain underlying fixed rate obligations including the Company’s $1.250 billion 3.000 percent 2010 Senior Notes and $600 million 4.750 percent 2005 Senior Notes (both classified as short-term borrowings), $500 million 2.625 percent 2011 Senior Notes, $500 million 4.125 percent 2011 Senior Notes, and $675 million 3.125 percent 2012 Senior Notes. For additional information regarding the interest rate swap agreements, refer to Note 9 to the condensed consolidated financial statements.
21
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 9 – Derivatives and Foreign Exchange Risk Management
The Company uses operational and economic hedges, as well as currency exchange rate derivative contracts and interest rate derivative instruments to manage the impact of currency exchange and interest rate changes on earnings and cash flows. In order to minimize earnings and cash flow volatility resulting from currency exchange rate changes, the Company enters into derivative instruments, principally forward currency exchange rate contracts. These contracts are designed to hedge anticipated foreign currency transactions and changes in the value of specific assets and liabilities. At inception of the forward contract, the derivative is designated as either a freestanding derivative or a cash flow hedge. The primary currencies of the derivative instruments are the Euro and Japanese Yen. The Company does not enter into currency exchange rate derivative contracts for speculative purposes. The gross notional amount of all currency exchange rate derivative instruments outstanding at October 24, 2014 and April 25, 2014 was $6.790 billion and $8.051 billion, respectively. The aggregate currency exchange rate gains for the three and six months ended October 24, 2014 were $14 million and $2 million, respectively. The aggregate currency exchange rate gains for the three months ended October 25, 2013 were not significant and for the six months ended October 25, 2013 were $3 million. These gains represent the net impact to the condensed consolidated statements of earnings for the exchange rate derivative instruments presented below, as well as the remeasurement gains on foreign currency denominated assets and liabilities.
The information that follows explains the various types of derivatives and financial instruments used by the Company, how and why the Company uses such instruments, how such instruments are accounted for, and how such instruments impact the Company’s condensed consolidated balance sheets, statements of earnings, and statements of cash flows.
Freestanding Derivative Forward Contracts
Freestanding derivative forward contracts are used to offset the Company’s exposure to the change in value of specific foreign currency denominated assets and liabilities. These derivatives are not designated as hedges, and therefore, changes in the value of these forward contracts are recognized in earnings, thereby offsetting the current earnings effect of the related change in value of foreign currency denominated assets and liabilities. The cash flows from these contracts are reported as operating activities in the condensed consolidated statements of cash flows. The gross notional amount of these contracts, not designated as hedging instruments, outstanding at October 24, 2014 and April 25, 2014, was $1.901 billion and $2.202 billion, respectively.
The amount and location of the gains (losses) in the condensed consolidated statements of earnings related to derivative instruments, not designated as hedging instruments, for the three and six months ended October 24, 2014 and October 25, 2013 are as follows:
(in millions) | Three months ended | |||||||||
Derivatives Not Designated as Hedging Instruments | Location | October 24, 2014 | October 25, 2013 | |||||||
Foreign currency exchange rate contracts | Other expense, net | $ | 73 | $ | (46 | ) | ||||
(in millions) | Six months ended | |||||||||
Derivatives Not Designated as Hedging Instruments | Location | October 24, 2014 | October 25, 2013 | |||||||
Foreign currency exchange rate contracts | Other expense, net | $ | 49 | $ | (17 | ) | ||||
Cash Flow Hedges
Foreign Currency Exchange Rate Risk
Forward contracts designated as cash flow hedges are designed to hedge the variability of cash flows associated with forecasted transactions denominated in a foreign currency that will take place in the future. For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive loss and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. No gains or losses relating to ineffectiveness of cash flow hedges were recognized in earnings during the three or six months ended October 24, 2014 or October 25, 2013. No components of the hedge contracts were excluded in the measurement of hedge ineffectiveness and no hedges were derecognized or discontinued during the three or six months ended October 24, 2014 or October 25, 2013. The cash flows from these contracts are reported as operating activities in the condensed consolidated statements of cash flows. The gross notional amount of these contracts, designated as cash flow hedges, outstanding at October 24, 2014 and April 25, 2014, was $4.889 billion and $5.849 billion, respectively, and will mature within the subsequent three-year period.
22
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The amount of gains (losses) and location of the gains (losses) in the condensed consolidated statements of earnings and other comprehensive income (OCI) related to foreign currency exchange rate contract derivative instruments designated as cash flow hedges for the three and six months ended October 24, 2014 and October 25, 2013 are as follows:
Three months ended October 24, 2014 | ||||||||||
Gross Gains (Losses) Recognized in OCI on Effective Portion of Derivative | Effective Portion of Gains (Losses) on Derivative Reclassified from AOCI into Income | |||||||||
(in millions) | ||||||||||
Derivatives in Cash Flow Hedging Relationships | Amount | Location | Amount | |||||||
Foreign currency exchange rate contracts | $ | 229 | Other expense, net | $ | 20 | |||||
Cost of products sold | 1 | |||||||||
Total | $ | 229 | $ | 21 | ||||||
Three months ended October 25, 2013 | ||||||||||
Gross Gains (Losses) Recognized in OCI on Effective Portion of Derivative | Effective Portion of Gains (Losses) on Derivative Reclassified from AOCI into Income | |||||||||
(in millions) | ||||||||||
Derivatives in Cash Flow Hedging Relationships | Amount | Location | Amount | |||||||
Foreign currency exchange rate contracts | $ | (130 | ) | Other expense, net | $ | 23 | ||||
Cost of products sold | (14 | ) | ||||||||
Total | $ | (130 | ) | $ | 9 | |||||
Six months ended October 24, 2014 | ||||||||||
Gross Gains (Losses) Recognized in OCI on Effective Portion of Derivative | Effective Portion of Gains (Losses) on Derivative Reclassified from AOCI into Income | |||||||||
(in millions) | ||||||||||
Derivatives in Cash Flow Hedging Relationships | Amount | Location | Amount | |||||||
Foreign currency exchange rate contracts | $ | 291 | Other expense, net | $ | 21 | |||||
Cost of products sold | (2 | ) | ||||||||
Total | $ | 291 | $ | 19 | ||||||
Six months ended October 25, 2013 | ||||||||||
Gross Gains (Losses) Recognized in OCI on Effective Portion of Derivative | Effective Portion of Gains (Losses) on Derivative Reclassified from AOCI into Income | |||||||||
(in millions) | ||||||||||
Derivatives in Cash Flow Hedging Relationships | Amount | Location | Amount | |||||||
Foreign currency exchange rate contracts | $ | (154 | ) | Other expense, net | $ | 55 | ||||
Cost of products sold | (29 | ) | ||||||||
Total | $ | (154 | ) | $ | 26 | |||||
Forecasted Debt Issuance Interest Rate Risk
Forward starting interest rate derivative instruments designated as cash flow hedges are designed to manage the exposure to interest rate volatility with regard to future issuances of fixed-rate debt. The effective portion of the gains or losses on the forward starting interest rate derivative instrument that is designated and qualifies as a cash flow hedge is reported as a component of accumulated other comprehensive loss. Beginning in the period in which the planned debt issuance occurs and the related derivative instrument is terminated, the effective portion of the gains or losses is then reclassified into interest expense, net over the term of the related debt. Any portion of the gains or losses that is determined to be ineffective is immediately recognized in interest expense, net. In the second quarter of fiscal year 2015, the Company entered into $1.425 billion of fixed pay, forward starting interest rate swaps with a weighted average fixed rate of 2.88 percent in advance of planned debt issuances. As of October 24, 2014, the Company had $1.675 billion of fixed pay, forward starting interest rate swaps with a weighted average fixed rate of 2.87 percent in anticipation of planned debt issuances.
For the three and six months ended October 24, 2014, the Company reclassified $2 million and $4 million, respectively, of the effective portion of the net losses on forward starting interest rate derivative instruments from accumulated other comprehensive loss to interest expense, net.
23
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
For the three and six months ended October 25, 2013, the Company reclassified $2 million and $4 million, respectively, of the effective portion of the net losses on forward starting interest rate derivative instruments from accumulated other comprehensive loss to interest expense, net.
The unrealized (loss) gain on outstanding forward starting interest rate swap derivative instruments as of October 24, 2014 and April 25, 2014 was $(21) million and $7 million, respectively. Unrealized (losses) gains on outstanding forward starting interest rate swap derivative instruments were recorded in other assets and long-term liabilities, with the offset recorded in accumulated other comprehensive loss in the condensed consolidated balance sheets.
As of October 24, 2014 and April 25, 2014, the Company had $114 million and $(44) million, respectively, in after-tax net unrealized gains (losses) associated with cash flow hedging instruments recorded in accumulated other comprehensive loss. The Company expects that $79 million of after-tax net unrealized gains as of October 24, 2014 will be reclassified into the condensed consolidated statements of earnings over the next 12 months.
Fair Value Hedges
For derivative instruments that are designated and qualify as fair value hedges, the gain or loss on the derivatives as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in earnings.
Interest rate derivative instruments designated as fair value hedges are designed to manage the exposure to interest rate movements and to reduce borrowing costs by converting fixed-rate debt into floating-rate debt. Under these agreements, the Company agrees to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated by reference to an agreed-upon notional principal amount.
The gains (losses) from terminated interest rate swap agreements are recorded in long-term debt, increasing (decreasing) the outstanding balances of the debt, and amortized as a reduction (addition) of interest expense, net over the remaining life of the related debt. The cash flows from the termination of the interest rate swap agreements are reported as operating activities in the condensed consolidated statements of cash flows.
As of both October 24, 2014 and April 25, 2014, the Company had interest rate swaps in gross notional amounts of $2.625 billion designated as fair value hedges of underlying fixed rate obligations. As of October 24, 2014, the Company had interest rate swap agreements designated as fair value hedges of underlying fixed rate obligations including the Company’s $1.250 billion 3.000 percent 2010 Senior Notes and the $600 million 4.750 percent 2005 Senior Notes classified as short-term borrowings, the $500 million 2.625 percent 2011 Senior Notes, the $500 million 4.125 percent 2011 Senior Notes, and the $675 million 3.125 percent 2012 Senior Notes. For additional information regarding the terms of the Company’s interest rate swap agreements, refer to Note 9 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended April 25, 2014.
The market value of outstanding interest rate swap agreements was a net $81 million unrealized gain and the market value of the hedged item was a net $81 million unrealized loss at October 24, 2014, which were recorded in other assets, prepaid expenses and other current assets, and other long-term liabilities with the offsets recorded in long-term debt and short-term borrowings in the condensed consolidated balance sheets. No hedge ineffectiveness was recorded as a result of these fair value hedges for the three and six months ended October 24, 2014 or October 25, 2013.
During the three and six months ended October 24, 2014 and October 25, 2013, the Company did not have any ineffective fair value hedging instruments. In addition, the Company did not recognize any gains or losses during the three and six months ended October 24, 2014 or October 25, 2013 on firm commitments that no longer qualify as fair value hedges.
24
MEDTRONIC, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Balance Sheet Presentation
The following tables summarize the location and fair value amounts of derivative instruments reported in the condensed consolidated balance sheets as of October 24, 2014 and April 25, 2014. The fair value amounts are presented on a gross basis and are segregated between derivatives that are designated and qualify as hedging instruments and those that are not, and are further segregated by type of contract within those two categories.
October 24, 2014 | |||||||||||
Asset Derivatives | Liability Derivatives | ||||||||||
(in millions) | Balance Sheet Location | Fair Value | Balance Sheet Location | Fair Value | |||||||
Derivatives designated as hedging instruments | |||||||||||
Interest rate contracts | Prepaid expenses and other current assets | $ | 20 | Other accrued expenses | |||||||