Notes to Condensed Consolidated Financial Statements (Unaudited)

(Dollars in millions except per share data)

1.  Summary of Significant Accounting Policies

Basis of Presentation and Principles of Consolidation

Unless the context otherwise requires, the terms “Hill-Rom,” “we,” “our” and “us” refer to Hill-Rom Holdings, Inc. and our wholly-owned subsidiaries.  The unaudited Condensed Consolidated Financial Statements appearing in this Quarterly Report on Form 10-Q should be read in conjunction with the audited Consolidated Financial Statements and notes thereto included in our latest Annual Report on Form 10-K for the fiscal year ended September 30, 2010 (“2010 Form 10-K”) as filed with the United States (“U.S.”) Securities and Exchange Commission.  The September 30, 2010 Condensed Consolidated Balance Sheet was derived from audited Consolidated Financial Statements, but does not include all disclosures required by accounting principles generally accepted in the U.S.  In the opinion of management, the Condensed Consolidated Financial Statements herein include all adjustments, consisting only of normal recurring adjustments, necessary to state fairly the financial position, results of operations and cash flows for the interim periods presented.  Quarterly results are not necessarily indicative of annual results.

The Condensed Consolidated Financial Statements include the accounts of Hill-Rom and its subsidiaries.  All subsidiaries are wholly-owned as of June 30, 2011.  During the first quarter of our fiscal 2011 we acquired the remaining 40 percent noncontrolling interest in a former joint venture (Note 3).  Intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the amounts reported in these Condensed Consolidated Financial Statements including the accompanying notes.  Actual results could differ from those estimates.  Examples of such estimates include our accounts receivable reserves (Note 2), investments (Note 6), income taxes (Note 9), accrued warranties (Note 12) and accrued litigation and self insurance reserves (Note 14), among others.

Investment Securities

At June 30, 2011, investment securities consisted primarily of AAA rated student loan auction rate securities (“ARS”).  These securities are generally insured through the U.S. government’s Federal Family Education Loan Program, to the extent the borrowers meet certain prescribed criteria in their underlying lending practices.  These securities are classified as available-for-sale and changes in their fair value are recorded in Accumulated Other Comprehensive Loss (“AOCL”).

We regularly evaluate all investments classified as available-for-sale for possible impairment based on current economic conditions, credit loss experience and other criteria.  The evaluation of investments for impairment requires significant judgments to be made including (i) the identification of potentially impaired securities; (ii) the determination of their estimated fair value; (iii) the assessment of whether any decline in estimated fair value is other-than-temporary; and (iv) the likelihood of selling before recovery.  If there is a decline in a security’s net realizable value that is other-than-temporary and we are not likely to sell before recovery, the decline is separated into the amount of impairment related to credit loss and the amount of impairment related to all other factors.  The decline related to the credit loss is recognized in earnings, while the decline related to all other factors is recognized in AOCL.

Taxes Collected from Customers and Remitted to Governmental Units

Taxes assessed by a governmental authority that are directly imposed on a revenue producing transaction between us and our customers, including but not limited to sales taxes, use taxes and value added taxes, are accounted for on a net (excluded from revenues and costs) basis.

 

Income Taxes

We and our eligible domestic subsidiaries file a consolidated U.S. income tax return.  Foreign operations file income tax returns in a number of jurisdictions.  Deferred income taxes are computed using an asset and liability approach to reflect the net tax effects of temporary differences between the financial reporting carrying amounts of assets and liabilities and the corresponding income tax amounts.  We have a variety of deferred tax assets in numerous tax jurisdictions.  These deferred tax assets are subject to periodic assessment as to recoverability and if it is determined that it is more likely than not that the benefits will not be realized, valuation allowances are recognized.  In evaluating whether it is more likely than not that we would recover these deferred tax assets, future taxable income, the reversal of existing temporary differences and tax planning strategies are considered.

We believe that our estimates for the valuation allowances recorded against deferred tax assets are appropriate based on current facts and circumstances.  Entering the fiscal year we had $28.5 million of valuation allowances on deferred tax assets, on a tax-effected basis, primarily related to foreign operating loss carryforwards and other tax attributes.  It is possible that sustainable improvements in foreign earnings could result in a reconsideration of the need for these valuation allowances, resulting in the accelerated recognition of all or some portion of the previously unrecognized tax benefits.

We account for uncertain income tax positions using a threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  The difference between the tax benefit recognized in the financial statements for an uncertain income tax position and the tax benefit claimed in the tax return is referred to as an unrecognized tax benefit.

Recently Issued Accounting Standards

There have been no significant changes to our assessment of the impact of recently issued accounting standards included in Note 1 of Notes to Consolidated Financial Statements in our 2010 Form 10-K except as noted below:

On October 1, 2010, we adopted the Financial Accounting Standard Board’s (“FASB”) revised authoritative guidance requiring entities to provide more information about sales of securitized financial assets and similar transactions, particularly if the seller retains some risk with respect to the assets.  Our adoption of this guidance was prospective and did not have a material impact on our Condensed Consolidated Financial Statements.

On October 1, 2010, we adopted the FASB’s revised authoritative guidance to improve financial reporting for companies involved with variable interest entities to provide more relevant and reliable information to users of financial statements.  Our adoption of this guidance was prospective and did not have a material impact on our Condensed Consolidated Financial Statements.

In May 2011, the FASB issued an amendment to the authoritative guidance on fair value measurements.  The amendment requires companies to include expanded disclosures for their recurring Level 3 fair value measurements.  In addition, companies must report the level in the fair value hierarchy of assets and liabilities not recorded at fair value but where fair value is disclosed. The amendment will be applied prospectively and will be effective for our quarter ending March 31, 2012, with early adoption prohibited. Our adoption of this amendment is not expected to have a material effect, but may require additional disclosure on our available-for-sale marketable securities, which are classified and disclosed as Level 3 fair value measurements.

In June 2011, the FASB issued an amendment to the authoritative guidance on comprehensive income.  The amendment eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity or include the components in the Notes to the Condensed Consolidated Financial Statements and instead requires the presentation of comprehensive income in either (1) a continuous statement of comprehensive income or (2) two separate but consecutive statements.  The amendment will be effective for our quarter ending December 31, 2012.  The adoption of this amendment is not expected to have a material effect on our Condensed Consolidated Financial Statements, but will require a change in the presentation of comprehensive income from the notes of our Condensed Consolidated Financial Statements, where it is currently disclosed, to the face of our Condensed Consolidated Financial Statements.

 

 

3.  Acquisitions

On November 9, 2009, we entered into a joint venture with Encompass Group, LLC (“Encompass Group”), to form Encompass TSS, LLC (“Encompass”), of which we ultimately owned 60 percent.  For our 60 percent ownership interest we paid $7.5 million to Encompass Group, contributed cash and entered into license and distribution agreements with Encompass.  On November 30, 2010, we purchased the remaining 40 percent of Encompass for $10.6 million, plus a variable earn-out with a minimum of $1.2 million and a maximum of $1.6 million per year over five years.  We have a total of $5.5 million accrued in other current liabilities and other long-term liabilities on our Condensed Consolidated Balance Sheet at June 30, 2011 related to the earn-out.

If the Encompass joint venture had been consummated at the beginning of our 2010 fiscal year or wholly-owned, the impact to revenues and net income on an unaudited pro forma basis would not have been material to our financial results in any of the periods presented.

 

4.  Financing Agreements

Total debt consists of the following:

 

 

We have trade finance credit lines and uncommitted letter of credit facilities.  These lines are associated with the normal course of business and are not currently, nor have they historically, been of material size to the overall business.

 

Unsecured debentures outstanding at June 30, 2011 have fixed rates of interest.  We have deferred gains included in the preceding table from the termination of previous interest rate swap agreements, and those deferred gains amounted to $1.3 million at June 30, 2011 and $2.1 million at September 30, 2010.  The deferred gains are being amortized and recognized as a reduction of interest expense over the remaining term of the related debt through 2011 and 2024, and as a result, the effective interest rates on that debt have been and will continue to be lower than the stated interest rates.

We have a $500.0 million senior revolving credit facility, which expires on March 28, 2013 (subject to extension upon satisfaction of certain conditions set forth in the credit facility).  Borrowings under the credit facility bear interest at variable rates, and the availability of borrowings is subject to our ability at the time of borrowing to meet certain specified conditions, including compliance with covenants contained in the credit agreement governing the facility.  The credit agreement contains covenants that, among other matters, require us to maintain a ratio of consolidated indebtedness to consolidated EBITDA (each as defined in the credit agreement) of not more than 3.5:1.0 and a ratio of consolidated EBITDA to interest expense of not less than 3.5:1.0.  The proceeds of the five-year facility shall be used, as needed: (i) for working capital, capital expenditures, and other lawful corporate purposes; and (ii) to finance acquisitions.

As of June 30, 2011, we had outstanding borrowings of $45.0 million and undrawn letters of credit of $5.8 million under the five-year facility, leaving $449.2 million of borrowing capacity available under the facility.

The fair value of our debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to us for debt of the same remaining maturities.  The book values of our short-term debt instruments approximate fair value.  The estimated fair values of our long-term debt instruments were $51.2 and $95.7 million at June 30, 2011 and September 30, 2010.

 

5.  Retirement and Postretirement Plans

We sponsor four defined benefit plans: a master defined benefit retirement plan, a nonqualified supplemental executive defined benefit retirement plan and two defined benefit retirement plans covering employees in Germany and France.  Benefits for such plans are based primarily on years of service and the employee’s level of compensation during specific periods of employment.  We contribute funds to trusts as necessary to provide for current service and for any unfunded projected future benefit obligation over a reasonable period of time.  All of our plans have a September 30th measurement date.  The following table includes the components of net pension expense for our defined benefit plans.

We also sponsor a domestic postretirement health care plan that provides health care benefits to qualified retirees and dependents until eligible for Medicare.  Annual costs related to the domestic postretirement health care plan are not significant.

Fair value measurements are classified and disclosed in one of the following three categories:

·

Level 1:  Financial instruments with unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets and liabilities.

·

Level 2:  Financial instruments with observable inputs other than those included in Level 1 such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

 

·

Level 3:  Financial instruments with unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.  Unobservable inputs reflect our own assumptions that market participants would use in pricing the asset or liability (including assumptions about risk).  Unobservable inputs are developed based on the best information available in the circumstances, which might include our own data.

The following table summarizes our financial assets measured at fair value on a recurring basis included in our Condensed Consolidated Balance Sheet, as of June 30, 2011:

 

At June 30, 2011, we had $11.3 million of AAA rated student loan ARS.  While we continue to earn interest on the ARS at the contractual rate, these investments are not currently being bought and sold in an active market and therefore do not have readily determinable market values.  At June 30, 2011, our investment advisors provided a valuation based on unobservable inputs for the ARS.  The investment advisors utilized a discounted cash flow approach (an “income approach”) to arrive at this valuation, which was corroborated by separate and comparable discounted cash flow analysis prepared by us.  The assumptions used in preparing the discounted cash flow model include estimates of interest rates, timing and amount of cash flows, credit spread related yield and illiquidity premiums and expected holding periods of the ARS.  These assumptions are volatile and subject to change as the underlying sources of these assumptions and market conditions change.  Activity related to our ARS was not significant during the first nine months of fiscal 2011.

The net-of-tax effect of unrealized gains or losses on: our available-for-sale securities, foreign currency translation adjustments, pension (or other defined benefit postretirement plans) actuarial gains or losses, prior service costs or credits are required to be included in comprehensive income.

The composition of comprehensive income is as follows:

 

 

8.  Special Charges

Over the past several years, we have placed a focus on improving our cost structure and business processes through various means including consolidation of certain manufacturing and select back office operations, customer rationalizations and various other organizational changes.  Activity related to these actions during fiscal 2011 was as follows:

 

During the second quarter of fiscal 2011, we recorded an additional special charge of $2.6 million related to our fiscal 2010 fourth quarter action.  The majority of the charge related to additional severance and other benefits provided to affected employees of that action as well as a write-down of assets held for sale.   During the third quarter of fiscal 2011, we recorded a benefit of $1.2 million primarily related to the net reversal of severance recorded in relation to our fourth quarter of fiscal 2010 restructuring action, partially offset by an additional write-down of assets held for sale.  The above table excludes the write-down of our assets.

 

 

 

Basic earnings per share are calculated based upon the weighted average number of outstanding common shares for the period, plus the effect of deferred vested shares.  Diluted earnings per share are calculated consistent with the basic earnings per share calculation plus the effect of dilutive unissued common shares related to stock-based employee compensation programs.  For all periods presented, anti-dilutive stock options were excluded from the calculation of diluted earnings per share.  Cumulative treasury stock acquired, less cumulative shares reissued, have been excluded in determining the average number of shares outstanding.

Earnings per share are calculated as follows (share information in thousands):

 

11.  Common Stock

Share Repurchases

We repurchased 0.6 and 1.5 million shares of our common stock during the three- and nine-month periods ended June 30, 2011 for $27.3 and $64.7 million.  In May 2011, our Board of Directors approved an expansion of our share repurchase authorization by 3.0 million shares.  Share repurchases may be made through the open market or private transactions and as of June 30, 2011, a cumulative total of 25.2 million shares had been repurchased by us at market trading prices, leaving 3.5 million shares remaining for purchase under the Board’s authorization.  The Board’s approval has no expiration date and currently there are no plans to terminate this program in the future.

Stock Based Compensation

The stock based compensation cost that was charged against income, net of tax, for all plans was $1.6 and $5.9 million for the three- and nine-month periods ended June 30, 2011, and $1.1 and $5.7 million for the comparable periods of fiscal 2010.

12.  Guarantees

We routinely grant limited warranties on our products with respect to defects in material and workmanship.  The terms of these warranties are generally one year, however, certain components and products have substantially longer warranty periods.  We recognize a reserve with respect to these obligations at the time of product sale, with subsequent warranty claims recorded directly against the reserve.  The amount of the warranty reserve is determined based on historical trend experience for the covered products.  For more significant warranty-related matters which might require a broad-based correction, separate reserves are established when such events are identified and the cost of correction can be reasonably estimated.

A reconciliation of changes in the warranty reserve for the periods covered in this report is as follows:

 

 

In the normal course of business we enter into various other guarantees and indemnities in our relationships with suppliers, service providers, customers, business partners and others.  Examples of these arrangements would include guarantees of product performance, indemnifications to service providers and indemnifications of our actions to business partners.  These guarantees and indemnifications have not historically nor do we expect them to have a material impact on our financial condition or results of operations, although indemnifications associated with our actions generally have no dollar limitations.

In conjunction with our acquisition and divestiture activities, we have entered into select guarantees and indemnifications of performance with respect to the fulfillment of commitments under applicable purchase and sale agreements.  The arrangements generally indemnify the buyer or seller for damages associated with breach of contract, inaccuracies in representations and warranties surviving the closing date and satisfaction of liabilities and commitments retained under the applicable contract.  With respect to sale transactions, we also routinely enter into non-competition agreements for varying periods of time.  Guarantees and indemnifications with respect to acquisition and divestiture activities, if triggered, could have a materially adverse impact on our financial condition and results of operations.

13.  Segment Reporting

We disclose segment information that is consistent with the way in which management operates and views the business.  During the first quarter of fiscal 2011, we changed our segment reporting to reflect changes in our organizational structure and management’s view of the business.  We moved our surgical reporting unit from the International and Surgical segment (now referred to as the International segment) to the North America Acute Care segment.  In addition, manufacturing and research and development costs were fully allocated to our three segments.  We have also assigned additional direct functional costs to the segments as well as an allocation of certain corporate functional expenses that can be attributed to the segments.  The prior year segment information included in this Note has been updated to reflect these changes.  Our new operating structure contains the following reporting segments:

·

North America Acute Care - sells and rents our hospital patient support and near-patient technologies, as well as our health information technology solutions and surgical accessories, to acute care facilities .

 

·

North America Post-Acute Care - sells and rents a variety of products outside of the hospital setting including long-term acute care, extended care and home care and our respiratory care products in all settings .

 

·

International - sells and rents similar products as our North America businesses to Europe and the rest of the world.

Our performance under the new operating structure continues to be measured on a divisional income basis before litigation and special charges.  Divisional income generally represents the division’s standard gross profit less its direct operating costs along with an allocation of manufacturing and distribution costs, research and development and corporate functional expenses.

Corporate expenses, while not considered a segment, are presented separately to aid in the reconciliation of segment information to consolidated financial information.  These costs include corporate costs that support the entire organization such as administration, finance, legal and human resources.