ITEM 1. BUSINESS
OVERVIEW
SteriGenics International, Inc. ("SteriGenics" or the "Company") is a provider of high quality contract sterilization and radiation processing services, with over 19 years of experience in the operation, design and development of Gamma irradiation ("Gamma") facilities. The Company operates 12 Gamma facilities and one electron beam radiation ("E-Beam") facility nationwide serving over 1,000 customers, primarily in the medical products market. SteriGenics has expanded its presence in the medical products sterilization market through the opening and acquisition of new facilities, addition of new customers and conversion of products of new and existing customers from ethylene oxide gas ("EtO") sterilization to Gamma sterilization. In recent years, the Company has expanded into various advanced application markets. The Company recently expanded its technology base into E-Beam with the acquisition in December 1997 of certain assets of the Nicolet Electron Services Division of ThermoSpectra Corporation (the "Nicolet Acquisition"). The Company's objective is to be the leading provider of high quality contract sterilization and radiation processing services for manufacturers of medical and advanced applications products.
THE STERILIZATION AND RADIATION PROCESSING MARKET
The sterilization and radiation processing market consists of independent suppliers of sterilization and radiation processing services and certain large manufacturers that have in-house sterilization capabilities. Although there are no published industry statistics and precise numbers are difficult to determine, the Company estimates that the U.S. market for contract sterilization and radiation processing services (including Gamma, EtO and E-Beam) was approximately $170 million in 1996 and that a similar volume of product was processed by captive processors. Of the U.S. contract sterilization market, the Company estimates that in 1996 approximately 40% to 45% was Gamma, 50% to 55% was EtO and 5% was E-Beam. There is also a significant market for sterilization and radiation processing services outside of the U.S. In the international market, EtO maintains a significantly larger share of the market than Gamma.
In determining the total cost of various sterilization services, manufacturers must consider not only the cost of the actual sterilization services, but also the cost of transportation and cost of processing time. As a result, manufacturers typically do not send product for sterilization beyond a 300-mile radius since the cost of transportation would likely exceed the cost of sterilization, which typically ranges from 0.1% to 3.0% of unit manufacturing cost for medical products. Because of these limitations, contract sterilizers have needed to strategically locate their facilities in close proximity to their customer base. In contrast, with respect to the radiation processing market, manufacturers of materials such as certain industrial compounds, semiconductors and gemstones are often willing to ship products longer distances for processing since the cost of transportation and processing account for a smaller percentage of the unit manufacturing cost.
The Company believes there are a number of manufacturing trends that may have a significant impact on contract providers of Gamma sterilization services. The first trend is closer coordination between manufacturers and their suppliers in order to reduce inventory exposure, improve the manufacturer's level of service to its customers and to facilitate new product launches. By closely coordinating the sterilization process with the manufacturing process, the planning of production is simplified and the number of days of raw materials and finished goods inventory can be reduced. As a result, manufacturers are increasingly demanding shorter turn-around times for sterilization services. The second of such trends is the "outsourcing" of non-core elements of the manufacturing process where services can be obtained from third party providers on a more cost-effective basis. While several large corporations continue to perform either all or a portion of their sterilization in-house, the trend has been away from building in-house sterilization capacity due to cost, safety, flexibility and regulatory issues associated with maintaining an in-house irradiator or EtO chamber. Finally, an emerging concept is "in-house outsourcing," utilizing third party contractors to provide services within a manufacturer's own facility. This emerging concept has the potential to provide the cost advantages and core-business focus of outsourcing, while also providing benefits such as reduction of finished goods inventory, elimination of transportation costs and greater control associated with a captive facility.
MEDICAL PRODUCTS STERILIZATION MARKET
The medical portion of the sterilization market includes manufacturers of single-use medical products. The types of products sterilized include items such as syringes, needles, scalpels, dental implants, hospital packs, gloves, gowns, bandages, cotton balls, cotton swabs, cotton gauze, cotton towels, surgical drapes, surgical kits, suture staples, specimen bottles, intravenous tubes and bottles, blood collection devices, drug packaging materials, orthopedic implants, petri dishes, contact lenses, and eyecare solutions. Based upon industry sources, the Company estimates that the U.S. market for contract sterilization of these types of medical products was approximately $130 million in 1996.
ADVANCED APPLICATIONS PRODUCTS STERILIZATION MARKETS
The market for sterilization and radiation processing of advanced applications products includes a diverse group of products. Growth in these markets is primarily being driven by concerns over health risks and potential product liability as well as economic considerations such as losses due to infestation and spoilage. In addition, concerns over foodborne illnesses have contributed to an increased awareness of the need for sterilization. While the vast majority of the processing of advanced applications products is currently done with EtO, the percentage being processed using Gamma or E-Beam sterilization has increased in recent years. A number of manufacturers have converted to Gamma sterilization for their products since Gamma does not leave any chemical residues and is better able to penetrate products such as spices and cosmetics which are often processed in bulk. The following are the primary non-medical products being processed using all of the various methods:
Spices and Herbs. Spices and herbs constitute the largest portion of the current advanced applications sterilization market. According to The American Spice Trade Association, of the approximately 850 million pounds of spices sold in the U.S. in 1995, approximately 300 million pounds were processed using Gamma or EtO to extend shelf-life and/or reduce microorganisms. Examples include black pepper, garlic, nutmeg, mustard seed, paprika and cinnamon.
Cosmetics. Cosmetics often require processing to reduce microorganisms in either finished goods or certain cosmetic ingredients that have naturally high microbial content. Examples include shampoo, eye make-up remover, mascara and compounds used in lipstick.
Food Packaging Products. As the market for prepackaged foods has grown, increasing the shelf-life of these products has become a critical economic issue. By reducing the microbial count in the packaging material, producers are able to reduce the risk that microorganisms contained in the packaging material will come into contact with the food product and reduce its shelf-life. Examples include milk cartons and meat packaging materials.
MATERIALS PROCESSING MARKET
The materials processing market is comprised of a large number of distinct segments which can be addressed using E-Beam or Gamma technology. Due to the fragmented nature of the market, and the large number of existing and potential applications, market size is difficult to estimate. Current markets include the processing of various industrial compounds, cross-linking of polymers and the breakdown of teflon. In addition, E-Beam radiation is used to process certain semiconductor wafers and to colorize various gemstones.
POTENTIAL MARKETS
In recent years there has been increased interest in evaluating food irradiation in light of the heightened public concern over outbreaks of E. coli, salmonella and other foodborne pathogens. As a consequence, the Company believes that there are a number of large potential markets for the sterilization of food products. The FDA has approved radiation as a safe and effective means of processing a variety of foods including pork, poultry, fresh fruits and vegetables. In addition, the FDA has recently approved the radiation of red meat, meat byproducts and meat food products in order to eliminate E. coli and other harmful pathogens. However, before irradiated red meat, meat byproducts and meat food products can be sold commercially, the United States Department of Agriculture (the "USDA") must amend its regulations to authorize the use of irradiation and subsequently establish the applicable manufacturing practices that must be followed when using such irradiation. The USDA is currently reviewing the issue and is expected to set regulatory standards later in 1998, although there can be no assurance it will do so. Current FDA regulations also require any retail foods that have been irradiated to be labeled.
While the Company is closely monitoring developments related to the potential market for irradiated red meat, the development of this potential market is subject to consumer acceptance of irradiated foods and the willingness of consumers to pay the higher prices likely to be charged for such products. In addition, if these markets do develop, facilities will have to be built or modified to address the specific requirements of the red meat market. These modifications would include the addition of refrigeration facilities, changes in material handling equipment and alterations in processing techniques to accommodate higher volumes of low dosage products. In addition, new facilities would have to be constructed in close proximity to customers' facilities to accommodate the perishable nature of red meat.
SERVICES
SteriGenics offers a number of services to its customers including its standard processing services, time-based services and value-added services such as validation and testing. In addition, the Company is seeking to lease its MiniCells to large medical products manufacturers or other customers with high product volumes for installation in such customers' facilities.
STANDARD GAMMA SERVICE
SteriGenics' standard Gamma service is a five working day turn-around time on the product, which is an industry standard. The processing time of any particular product is dependent upon several factors, including the dose required, the density of the product and the number of curies of Cobalt 60 present in the cell. In general, a higher dose requirement or density of material has the effect of increasing the amount of time the product needs to be exposed to Gamma radiation. Once these elements are determined, the Company determines the processing time for the specified product. It is the responsibility of the Company's customers to determine the level of microorganisms or other contamination that exists in their respective products, as well as the dose of Gamma radiation that will reduce such microorganisms or contamination to the required levels. After performing sterilization services, dosimeter readings are taken and documented to verify that the customer's dose requirements were attained. The Company then issues a certification that the product received the specified dosage. The fee charged for this service is dependent primarily upon the required dose of Gamma radiation, density of the product, permissible dose range and the volume of product to be processed.
GAMMASTAT I AND II SERVICES
GammaSTAT I and II are premium gamma sterilization services that guarantee a turn-around time of 23 or 48 hours, respectively. The Company does not limit the volume or type of product to be processed. Pricing for both GammaSTAT services is at a premium to standard service and is based upon the time (23 hours or 48 hours) in which the customer requires the product to be processed and available for shipment. GammaSTAT was introduced in fiscal 1996 and revenues resulting from GammaSTAT increased significantly in fiscal years 1997 and 1998.
GAMMARESERVE SERVICES
GammaReserve is a premium gamma sterilization service that utilizes proprietary software to allow customers to reserve processing time on a specific day. The customer is then charged for the reserved processing time whether or not it is used. The Company began offering GammaReserve in April 1997.
EXCELL SERVICES
The ExCell is an automated precision dose irradiator. SteriGenics has an ExCell in operation in both Charlotte, North Carolina and Corona, California. The ExCell service can be used for several different purposes, including production services for finished goods that require a very limited dose range, dosage auditing to allow customers to verify their dosage requirements, validation work and materials testing. ExCell services are offered at a premium price based upon the nature of the service being provided.
STANDARD E-BEAM SERVICE
SteriGenics' standard E-Beam service for conveyer processing is a one to two working day turn-around time on the product, which is an industry standard. Turn-around times for gemstones are typically two weeks. The processing time of any particular product is dependent upon several factors, including the density of the product, the dose requirement and the energy level of the E-Beam. In general, a higher dose requirement or density of material has the effect of increasing the amount of time the product needs to be exposed to E-Beam radiation. Based upon these factors, the Company determines the processing time for the specified product. It is the responsibility of the Company's customers to determine the dose of E-Beam radiation that will achieve the desired results. The Company uses a calorimeter dosimeter to verify that the customer's dosage requirements were attained. The Company then issues a certification that the product received the specified dosage. The fee charged for this service is dependent primarily upon the dose of E-Beam radiation, density of the product, packaging compatibility with the Company's size specifications and the volume of the product to be processed.
MINICELL LEASING
The Company plans to lease MiniCells to larger medical products manufacturers for installation in their existing facilities. SteriGenics is offering the MiniCells pursuant to an operating lease which would include Cobalt 60 replenishment, dosimetry management and maintenance. If the customer so desires, SteriGenics will provide operating personnel, as well as a radiation safety officer, relieving the customer of many regulatory burdens. The Cobalt 60 will be disposed of through the Company's existing agreements with its suppliers providing for the disposal of "spent" Cobalt 60. The monthly lease payment will be based upon the level of service and the curies of Cobalt 60 required. To date, no MiniCells have been leased.
MARKETS AND CUSTOMERS
MEDICAL PRODUCTS MARKET
The medical products market is comprised of manufacturers of healthcare and single-use medical products. The medical products division of the Company had over 800 customers in fiscal 1998, including many of the largest manufacturers of single-use medical products. Sales to medical products customers accounted for the majority of the Company's revenues in fiscal 1998. One customer, Baxter International Inc.
("Baxter"), accounted for approximately 13% of revenues during fiscal year 1996. No customer accounted for more than 10% of revenues during fiscal years 1997 or 1998.
ADVANCED APPLICATIONS MARKET
The advanced applications division of the Company provides services through both its Gamma and E-Beam facilities to over 200 customers producing a variety of products, including spices and herbs, cosmetics, food ingredients, semiconductors, gemstones, fruit and vegetable products, food packaging, consumer products and industrial compounds. The Company expects that sales to advanced applications customers as a percentage of overall revenues will increase in the future. See "Risk Factors -- Uncertainty of Expansion in Advanced Applications Markets."
CUSTOMER AGREEMENTS
The Company does not have a standard form of agreement for customer contracts. The Company's agreements with customers vary from purchase order arrangements to multiple year contracts. Certain of these contracts provide pricing terms based upon volume or product line commitments from its customers. In addition, the Company enters into contracts providing for guaranteed turn-around times and special services.
SALES AND MARKETING
The Company has separate sales and marketing groups servicing the medical products and advanced applications markets. In addition, the Company maintains a separate sales and marketing group for its E-Beam business. The Company's services are sold primarily by its direct sales force, based throughout the country. Facilities managers and other personnel at the Company's facilities also take an active role. SteriGenics maintains a customer service and support operation within each of its facilities.
The Company's marketing of its Gamma services emphasizes technical assistance to customers in all aspects of the sterilization process, including product conversion from other sterilization methods and material compatibility studies and participation by facility and corporate staff members on technical committees responsible for the implementation of industry standards pertaining to the sterilization of products and materials. The Company's salespersons and senior management draw upon their backgrounds in radiation, engineering, microbiology, packaging, material compatibility and regulatory compliance to provide customers a full range of services. SteriGenics' promotional activities consist of printed media advertising (primarily trade journals), participation in trade shows, mailing campaigns to selected territories, addressing industry organizations and sponsoring promotional events. In addition, as part of its efforts to expand its potential markets, the Company has sponsored and supported FDA petitions related to the sterilization of various products and product labeling.
In 1996, the Company introduced a new program to further encourage the conversion of medical products from EtO to Gamma. Through this program the Company provides technical assistance to customers and potential customers who are interested in converting their products to Gamma. These technical assistance services are provided at no charge to the customer. The conversion program has been successful both with customers who have in-house EtO sterilization facilities and with those using an EtO contract sterilizer. During fiscal 1997, the first year of the program, SteriGenics converted slightly over 2 million cubic feet of product to Gamma sterilization.
RESEARCH, DEVELOPMENT AND ENGINEERING
The Company believes its future competitive position will depend, in part, on its ability to develop and introduce process and design innovations in its radiation systems. The Company intends to continue to make significant investments in research, development and engineering for the foreseeable future. Although the Company maintains an active research, development and engineering program to improve its process and design technology, there can be no assurance such efforts will be successful or the Company's process and design innovations will enable it to offer new services that will achieve customer acceptance. Failure to
develop, or introduce on a timely basis, such new process and design technology could adversely affect the Company's business, financial condition and results of operations. See "Risk Factors -- Competition."
QUALITY ASSURANCE AND SAFETY
The Company has quality assurance departments at both the corporate and facility levels. The corporate quality assurance group has the primary responsibility for structuring the Company's quality system, developing quality assurance policies, operating procedures and work instructions and ensuring that such policies, procedures and work instructions are in compliance with national and international standards, federal, state and local regulations, as well as customer requirements. The department is also responsible for monitoring quality related activities at all locations, changes in the federal, state and local regulatory environment, each facility's compliance with the quality system, national standards working groups and technical assistance to customers. At the facility level, quality assurance personnel are given the authority and responsibility to ensure compliance within that facility with SteriGenics' quality policies, procedures, work instructions and customer specifications.
Ten of SteriGenics' facilities are certified to International Standards Organization ("ISO") 9002, Quality System -- Model for Quality Assurance in Production, Installation and Servicing. Certification to the ISO 9002 standard demonstrates that the Company has implemented the essential elements necessary for an effective quality control system. The Company received its initial certification in 1993 from Det Norske Veritas ("DNV"), an approved Notified Body, and is subject to quality system surveillance audits every six months by DNV. Additionally, ten of the Company's facilities have recently received EN46002/EN552 certification from the DNV. This certification expedites the ability of certain of the Company's medical device customers to obtain the CE Mark which is required to sell their products in Europe. The Company has scheduled ISO 9002 and EN46002/EN552 certification audits for the Rockaway and Salem facilities during 1998. See "Properties"
The Company has implemented a number of safety procedures for its workers. Each Gamma and E-Beam cell has a separate safety system designed to ensure that no individual is exposed to the radiation. The Company believes it has redundant safety precautions that meet or exceed all applicable safety regulations imposed by federal regulations. Safety backup precautions also exist in the event of power outages and natural disasters. In the event of a failure of electric power in a Gamma facility, the Cobalt 60 source racks are automatically lowered into the pool on a gravity feed basis. There can be no assurance that such safety precautions will prove effective under normal operating conditions or in the event of a power outage or natural disaster. A failure in safety precautions would have a material adverse effect on the Company's business, financial condition and results of operations. See "Risk Factors -- Risks of Operating Facilities Using Radioactive Material."
COMPETITION
The market for sterilization and radiation processing services is intensely competitive and is characterized by significant price competition. The Company's market is fragmented as a result of geographical limitations on the transportation of products for sterilization, multiple technologies and the mix of captive and contract facilities. In particular, the Company currently faces competition from other providers of contract Gamma sterilization services, the most significant of which is Isomedix, Inc., a subsidiary of Steris Corporation ("Isomedix"), and other providers of contract E-Beam sterilization services including The Titan Corporation, E-Beam Services Inc. and Iotron Industries Canada Inc. In addition, many products that can be sterilized using Gamma or E-Beam can also be sterilized using EtO. As a result, the Company also competes with companies that process products using EtO technology including Cosmed Group, Inc., Griffith Micro Science, Inc. and Isomedix. Certain of the Company's competitors and potential competitors have substantially greater financial, marketing, distribution, technical and other resources than the Company or offer a broader range of sterilization technologies, which may enable them to address more of the sterilization requirements of individual customers. In addition, the Company competes with manufacturers that have or are considering establishing in-house sterilization capabilities. The Company may also in the future face competition from suppliers of Cobalt 60 radioisotope, particularly MDS Nordion, Inc. ("Nordion"), as well as foreign providers
of sterilization services. In addition, Isomedix has announced its intention to enter the California market for sterilization services, which would increase competition in that market. To the extent that the Company expands into international markets it will also be faced with competition from existing providers of sterilization in those markets.
In recent years, price competition in the sterilization services industry has intensified. The Company may in the future face increased competition from companies that employ new or improved technologies or that offer sterilization services that are more effective or less costly than those developed and marketed by the Company. To the extent such increased competition were to occur the Company may explore alternative sterilization technologies as necessary to enhance its competitive position. Such competition could have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that the Company will be able to continue to compete effectively or that the competitive pressures faced by the Company will not have a material adverse effect on the Company's business, financial condition and results of operations.
The Company believes that price, processing time, quality of services and sterilization method are the primary factors upon which it competes. The Company believes that it compares favorably on all of these factors. In order to be successful in the future, the Company must continue to respond promptly and effectively to the challenges of technical change and competitors' innovations. Performance in these areas will, in turn, depend upon the Company's ability to attract and retain highly qualified technical and sales personnel. See "Risk Factors -- Competition."
REGULATORY AND ENVIRONMENTAL MATTERS
The design, construction, use and operation of commercial Gamma facilities such as those operated by the Company, and byproduct materials used in such facilities, are extensively regulated by the United States Nuclear Regulatory Commission (the "NRC"), or in some cases by various state regulatory agencies and authorities that undertake a comparable regulatory function from the NRC (the "Agreement States"). While E-Beam is not regulated by the NRC, the Company's E-Beam facility is subject to regulation by the California Department of Health Services (the "CDHS"). The Company is currently operating its E-Beam facility under a CDHS license held by ThermoSpectra Corporation pending the approval of its application for a new radioactive material license. The Company is also subject to various local zoning and permit rules in the construction of its facilities. The Company's facilities are subject to regulation by additional regulatory bodies at the federal, state and local levels, depending upon the type of product that is being irradiated. The Company's facilities are subject to the requirements of the FDA when irradiating medical devices, foods, cosmetics or food and drug packaging materials. In addition, if the Company were to begin processing meat or poultry products, it would become subject to the requirements of the Food Safety and Inspection Service of the USDA, which would require preapproval of the irradiation process for meat and poultry. The Company is also subject to the requirements of other federal agencies, such as the United States Occupational Safety and Health Administration and the United States Environmental Protection Agency (the "EPA"). In addition, the Company is subject to the regulatory requirements of the state and local agencies in the jurisdictions where the various irradiation facilities are located.
In addition to extensive regulation by various governmental bodies and agencies, the Company is subject to standards, guidelines and requirements established by industry organizations and other non-governmental bodies, such as ISO and the Association for the Advancement of Medical Instrumentation.
Changes in, or reinterpretations of, existing requirements or adoption of new requirements beyond those described below or the failure at any time to comply with any applicable material regulations and standards could have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that the Company will not incur significant costs to comply with laws, regulations and other requirements in the future or that such laws, regulations and other requirements will not have a material adverse effect upon the Company's business, financial condition and results of operations.
NRC REGULATION OF IRRADIATION FACILITIES
The receipt, acquisition, ownership, transfer, possession, use, transportation and disposal of nuclear byproduct material, as well as the construction, operation, transfer, closure and decommissioning of commercial Gamma irradiation facilities such as those operated by the Company, are subject to extensive and rigorous government regulation by the NRC or, in some cases, by the Agreement States.
The Company believes it has received all licenses and permits necessary for the conduct of its business. Commercial irradiation facilities, such as those owned or operated by the Company are subject to both regularly scheduled and unannounced inspections by the NRC or the Agreement States, with regard to all aspects of their operation, recordkeeping, compliance with health and safety regulations and all aspects of the utilization, storage, transfer, possession and transportation of regulated byproduct materials. Noncompliance with the health and safety regulations of the NRC and most Agreement States are generally ranked according to levels of severity. Since 1993, the Company has received notices of violation from the NRC and the Agreement States concerning items of noncompliance at five of its facilities, which were not in such categories considered to be of "significant regulatory concern." The Company believes that it has taken appropriate corrective actions in response to each such notice. In addition, the regulatory history of the former RTI facilities, as operated by RTI, involved very significant regulatory compliance problems, which involved among other things, the payment of civil and criminal penalties by RTI, as well as a facility license suspension for a period of approximately 80 days. As a consequence of this regulatory history, there can be no assurance that the former RTI facilities will not be subject to heightened regulatory scrutiny and inspections for an extended period of time. Such heightened regulatory scrutiny and a failure by the Company to address concerns raised from such scrutiny and inspection could result in civil penalties or the suspension or termination of operations at one or more of the Company's facilities or could otherwise have a material adverse effect on the Company's business, financial condition and results of operations. The Company has no knowledge of any circumstances which would constitute a present significant violation of any applicable state or federal laws or regulations. However, there can be no assurance that the Company will not in the future be determined to be in violation of any such laws or regulations.
The terms and conditions of the Company's licenses may be amended, revised or modified by reason of changes in the applicable laws, rules, regulations, or agency orders. Any such action may have a material adverse effect on the Company's business, financial condition and results of operations.
Violations of or noncompliance with applicable governmental requirements may result in an enforcement action including, among other things, a notice of violation, imposition of civil penalties, suspension, modification or revocation of any applicable license, criminal prosecution, or withholding or recall of the nuclear byproduct material held by the Company. Any such action would have material adverse effect on the Company's business, financial condition and results of operations.
FDA REGULATION OF IRRADIATION FACILITIES
The Company's irradiation facilities are subject to the requirements of the FDA when irradiating medical devices, foods, cosmetics and food or drug packaging materials. The FDA implements the Federal Food, Drug, and Cosmetic Act ("FFDCA"), which establishes premarket approval requirements for certain drugs and medical devices and for all food additives. In addition, the Company is subject to inspection by the FDA for compliance with the FDA's Good Manufacturing Practices ("GMP") and other applicable FDA requirements. The FFDCA also prohibits the introduction into interstate commerce of adulterated or misbranded drugs, medical devices, foods and cosmetics. Products are deemed adulterated if, for example, they are manufactured or processed in facilities that fail to comply with GMP requirements.
Failure by the Company at any time to comply with applicable FDA requirements could lead the FDA to institute materially adverse enforcement actions against the Company and/or its customers, including, among other things, warning letters, recall or seizure of products, fines, injunctions, civil penalties, total or partial suspension of sterilization operations and criminal prosecution. Such enforcement actions would also harm the Company's business reputation and could cause the Company to lose customers to competitors with better records of regulatory compliance.
Medical Device Regulation. The Company's contract sterilization of medical devices is subject to pervasive and continuing regulation by the FDA. The FFDCA defines a medical device, in part, as including an instrument, apparatus, implement, machine, contrivance, implant or other similar or related article that is intended for use in the mitigation, treatment, or prevention of disease in man or other animals. The Company sterilizes finished devices made by other manufacturers, who commercially distribute them.
The Company's contract sterilization activities render it a device manufacturer for purposes of the FDA's Quality System Regulation ("QSR"), which sets forth detailed GMP requirements. As a result, the Company is required to adhere to the requirements of the QSR that apply to its contract sterilization activities. The QSR revises the previous GMP regulation (which also applied to the Company's activities) and imposes certain enhanced requirements that are likely to increase the cost of compliance. There can be no assurance that the FDA would find that the Company is in compliance with applicable GMP requirements or that the Company will be found in compliance at all times in the future. The Company may also be subject to other FDA requirements such as the medical device reporting requirements.
Drug Regulation. Contract sterilizers used by manufacturers of aseptic filled drug products are subject to applicable provisions of the FDA's drug GMPs. There can be no assurance that the FDA would find that a contract sterilizer is in compliance with applicable GMP requirements now or at any time in the future.
Food Regulation. The FFDCA requires premarket approval for food additives. Irradiation is regulated by the FDA and is considered to be a food additive. Irradiation may only be used on foods and food packaging materials in accordance with the requirements established in the food additive regulations. The existing food additive regulations only approve the use of irradiation for a limited variety of foods and food packaging materials that are used during the irradiation of foods. Food packaging materials that are irradiated prior to filling are exempt from the premarket approval requirements, provided that the irradiated food packaging material is still suitable for use and complies with the applicable indirect food additive regulations. Before the Company could expand its sterilization services to certain foods or food packaging materials, the food additive regulations would have to be amended to include the irradiation of foods or food packaging materials not covered by the existing regulations. There can be no assurance that the FDA would amend the food additive regulations or that such regulations would be amended in a timely manner. Irradiation currently is approved for use on a limited number of foods and for disinfection of a variety of food packaging materials. Any use of food irradiation outside of that covered in an existing food additive regulation is prohibited.
The irradiation of foods must be conducted in accordance with the general GMP requirements for foods. In addition, special labeling is required to appear on foods that have been irradiated. The label and labeling of retail packages of the irradiated food must bear an irradiated logo and a statement such as "treated with radiation." No special labeling is required, however, on the label of foods that contain irradiated food ingredients. For example, if a spice is being irradiated, the irradiation logo and statement would need to appear on the label of the spice when it is sold directly to the consumer, but no special labeling would be required on the label of a pasta sauce that uses the irradiated spice ingredient.
The Food Safety and Inspection Service (the "FSIS") of the USDA is responsible for establishing additional requirements for the irradiation of meat and poultry products. In addition to issuing a regulation that specifically authorizes the use of irradiation, FSIS has established manufacturing practices that must be followed when irradiating products. Although FDA recently approved the use of irradiation for purposes of controlling foodborne pathogens and extending shelf life of red meat, meat byproducts and meat food products, FSIS has not yet amended its regulations to authorize this use of irradiation or established the applicable manufacturing practices that must be followed when using such irradiation. FSIS is in the process of issuing proposed rules and final rules are anticipated before the end of 1998.
Cosmetics Regulation. Cosmetics are defined under the FFDCA as including articles intended to be rubbed, poured, sprinkled, or sprayed on, introduced into, or otherwise applied to the human body or part thereof for cleansing, beautifying, promoting attractiveness, or altering the appearance. There currently are no statutory or regulatory provisions, other than the general adulteration and misbranding provisions, that limit the use of radiation in the processing or labeling of cosmetics.
ENVIRONMENTAL AND RELATED MATTERS
The Company's operations are subject to regulation by the EPA as well as state and local governmental agencies. Although there can be no assurance, the Company believes it currently maintains all licenses and permits necessary to conduct its current business and that it is in material compliance with applicable environmental, health and safety laws and regulations. The loss of any of the Company's licenses or permits could force the Company to suspend or terminate operations at one or more of its facilities or could otherwise have a material adverse effect on the Company's business, financial condition and results of operations.
Pursuant to an Asset Acquisition Agreement effective August 8, 1996 (the "Asset Agreement"), the Company purchased certain assets of RTI, including property located in Haw River, North Carolina and leasehold interests in property located in Salem, New Jersey and Rockaway, New Jersey (the "Rockaway Property"). The Rockaway Property was previously owned and operated by Thiokol Chemical Corporation ("Thiokol"), and is listed on the Superfund National Priorities List ("NPL"). In 1992, RTI and Thiokol entered into an Administrative Consent Order ("ACO") with the New Jersey Department of Environmental Protection (the "NJDEP") requiring, among other things, implementation of a groundwater remedy estimated to exceed $2.0 million in costs.
Under the Asset Agreement, RTI retained ownership of the Rockaway Property and all associated environmental liabilities as of the closing date. RTI agreed to indemnify and hold the Company harmless from and against any and all claims which may arise directly or indirectly from any use or release of hazardous substances on or under the leased premises as of the closing date. In addition, the Company obtained a letter from the NJDEP stating that the NJDEP will not institute either judicial or administrative civil proceedings against the Company for any discharge, deposit, release or disposal of hazardous substances or pollutants existing at the Rockaway Property, emanating therefrom, or occurring before the closing. However, the Company is required by the NJDEP to maintain a standby letter of credit in the amount of $500,000, contingent upon the continued clean up efforts required of RTI. The required amount of the letter of credit decreases over the life of the leasehold interest, and/or as the NJDEP requires. The Company believes, based on present information available to it, including the indemnification from RTI, the ACO among RTI, Thiokol and the NJDEP, and the NJDEP's letter stating that it will not seek recovery or remediation costs from the Company for contamination that predates the purchase of RTI's assets, that it does not face any significant environmental liability with respect to the Rockaway Property. However, there can be no assurance that the Company will not be subject to environmental liability relating to the remediation of the Rockaway Property or liability for losses suffered by adjacent property owners or other third parties, and such liability could have a material adverse effect on its business, financial condition and results of operations.
EMPLOYEES
At March 31, 1998, the Company had 321 employees. The Company considers its relations with its employees to be good. See "Risk Factors -- Dependence on Key Personnel."
RISK FACTORS
In addition to the other information in this Report, the following risk factors should be considered carefully in evaluating the Company and its business.
UNPREDICTABILITY OF FUTURE OPERATING RESULTS; LIKELY FLUCTUATIONS IN QUARTERLY OPERATING RESULTS
The Company has experienced, and expects to continue to experience, significant fluctuations in revenues and operating results from quarter to quarter. As a result, the Company believes that period-to-period comparisons of its operating results are not necessarily meaningful, and that such comparisons cannot be relied upon as indicators of future performance. In addition, there can be no assurance that the Company's revenues will grow or be sustained in future periods or that the Company will maintain its current profitability in the future. A significant component of such quarterly fluctuations results from fluctuations in the demand by the Company's customers for sterilization and radiation processing services due to varying manufacturing cycles, changes in demand for customers' products and seasonality related to growth cycles for spices and herbs and
decreased demand during the third fiscal quarter and the first part of the fourth fiscal quarter due to the holiday season. Other factors that could cause the Company's operating results to vary significantly from period to period include volatility in the market for medical devices; the ability of the Company to deliver services in a timely and cost effective manner; the ability of the Company to expand successfully in the advanced applications sterilization and radiation processing market; the ability to effectively integrate and successfully expand its recently acquired E-Beam business; the timing and size of orders from the Company's customer base; the ability of the Company to obtain supplies of Cobalt 60 on a timely basis and at a reasonable cost; fluctuations in currency exchange rates because payments under certain of the Company's Cobalt 60 operating leases are payable in Canadian dollars; fluctuations in the costs of electricity for the Company's E-Beam business; loss of processing time due to maintenance; the costs associated with customer product being damaged as a consequence of overdosing and other factors; changes in interest rates; regulatory matters; and litigation, acquisitions and other extraordinary events.
The Company's results of operations are also influenced by competitive factors, including the pricing and availability of the Company's and competing sterilization and radiation processing services; the acceptance of Gamma and E-Beam radiation as a means of sterilizing and processing products as opposed to other technologies; the ability of the Company's competitors to obtain orders from the Company's customers; the establishment of in-house sterilization capabilities by the Company's customers; the acquisition of the Company's customers by entities that do not use the Company's services; the timing of new service or technology announcements and releases by the Company and its competitors; and the entry of new competitors into the market for sterilization and radiation processing services. A large portion of the Company's expenses are fixed and difficult to reduce in a short period of time. If revenues do not meet the Company's expectations, the Company's fixed expenses would exacerbate the adverse effect of such a shortfall on net income.
Additional factors that have a significant impact on the Company's results of operations are the timing of construction and commencement of operations of new facilities. Building new facilities requires significant capital investments in construction and equipment and, for Gamma facilities, in Cobalt 60. In addition to incurring costs associated with building and equipping such facilities, the Company also incurs costs related to Cobalt 60 and higher personnel costs in the months preceding initial operation. As a result of their own internal procedures, customers often delay qualification and use of new facilities until they have been operational for a specified period of time of up to 12 months. As a result, in the past, the Company has failed to realize a portion of anticipated revenues for the facility pending such qualification, while incurring significant start-up costs, both of which adversely affected the Company's results of operations.
Due to these factors, as well as other unanticipated factors, it is likely that in some future quarter the Company's operating results will be below the expectations of public market analysts or investors. In such event, the price of the Company's Common Stock would be materially adversely affected.
DEPENDENCE ON MEDICAL PRODUCTS CUSTOMERS
The Company derives a substantial portion of its revenues from the sale of sterilization services to manufacturers of medical devices, labware and eyecare products ("medical products"), and the Company expects that the sterilization of medical products will continue to account for a significant portion of the Company's revenues for the foreseeable future. The Company thus depends to a considerable extent upon the continued growth of the market for medical products. In particular, a significant aspect of the Company's medical products business is the sterilization of single-use medical devices. As a result, the Company is dependent in part on continued growth in the market for single-use medical devices. There has recently been an increasing focus on reusable medical devices and, therefore, there can be no assurance that use of reusable medical devices will not increase. Any significant increase in the use of reusable medical devices would decrease the use of single use devices of the type sterilized by the Company, which could have a material adverse effect on the Company's business, financial condition and results of operations. The Company believes that continued growth in the use of medical products depends on a number of factors, including the impact of health reform proposals. The Company believes that government and private insurance company efforts to contain or reduce health care costs are likely to continue. These trends may lead to fewer medical procedures
being performed or the increased use of reusable medical devices, either of which could negatively impact the demand for the Company's services. In addition, the Company is dependent on the ongoing conversion of products from EtO to Gamma or E-Beam sterilization and there can be no assurance that such conversion will continue at the rate currently anticipated by the Company. Loss of significant business from medical products manufacturers, including reductions caused by large customers establishing captive facilities, changes in such customers' competitive position or a decision to purchase contract sterilization services from other suppliers, a downturn in the medical products market, or a failure of the conversion of products from EtO to Gamma at the anticipated rate could have a material adverse effect on the Company's business, financial condition and results of operations.
COMPETITION
The market for sterilization and radiation processing services is intensely competitive and is characterized by significant price competition. The Company's market is fragmented as a result of geographical limitations on the transportation of products for sterilization, multiple technologies and the mix of captive and contract facilities. In particular, the Company currently faces competition from other providers of contract Gamma sterilization services, the most significant of which is Isomedix, Inc., a subsidiary of Steris Corporation ("Isomedix"), and other providers of contract E-Beam sterilization services including The Titan Corporation, E-Beam Services Inc. and Iotron Industries Canada Inc. In addition, many products that can be sterilized using Gamma or E-Beam can also be sterilized using EtO. As a result, the Company also competes with companies that process products using EtO technology, including Cosmed Group, Inc., Griffith Micro Science, Inc. and Isomedix. Certain of the Company's competitors and potential competitors have substantially greater financial, marketing, distribution, technical and other resources than the Company or offer a broader range of sterilization technologies, which may enable them to address more of the sterilization requirements of individual customers. In addition, the Company competes with manufacturers that have or are considering establishing in-house sterilization capabilities. The Company may also in the future face competition from suppliers of Cobalt 60 radioisotope, particularly Nordion, as well as foreign providers of sterilization services. In addition, Isomedix has announced its intention to enter the California market for sterilization services, which would increase competition in that market. To the extent that the Company expands into international markets it will also be faced with competition from existing providers of sterilization and radiation processing services in those markets.
In recent years, price competition in the sterilization and radiation processing services industry has intensified. The Company may in the future face increased competition from companies that employ new or improved technologies or that offer sterilization services that are more effective or less costly than those developed and marketed by the Company. To the extent such increase in competition were to occur, the Company may explore alternative sterilization technologies as necessary to enhance its competitive position. Such competition could have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that the Company will be able to continue to compete effectively or that the competitive pressures faced by the Company will not have a material adverse effect on the Company's business, financial condition and results of operations.
UNCERTAINTY OF EXPANSION IN ADVANCED APPLICATION MARKETS
While the Company has traditionally focused primarily on the medical products market, it has recently increased its efforts in the advanced application contract sterilization and radiation processing market. The Company currently sterilizes a wide range of food ingredients and consumer products, including cosmetics, spices and herbs. The Company also processes various industrial compounds and other materials using both Gamma and E-Beam technologies. In addition, as a result of the Company's recently acquired E-Beam business, the Company has begun to process other advanced application products such as semiconductors and gemstones. These services accounted for approximately 20% of the Company's revenues in fiscal 1997. Many of the advanced application markets for Gamma sterilization and processing are new and emerging, and there can be no assurance that any of these markets will develop at the anticipated rate, if at all.
Approval for the irradiation of food products is regulated by the FDA and the USDA. While the FDA has approved radiation for the processing of a variety of foods, including pork, poultry and fresh fruits and vegetables, only limited commercial sales of irradiated food have taken place. The FDA has recently approved the radiation of red meat, meat byproducts and food products in order to eliminate E. coli and other harmful foodborne pathogens. However, before irradiated red meat can be sold commercially, the USDA must set certain minimum standards for processors to follow. The USDA is currently reviewing the issue and is expected to set such standards later in 1998, although there can be no assurance it will do so. In addition, current FDA rules and regulations require the labeling of any retail food product that is irradiated, and to date, there has been significant consumer resistance to irradiated food. The radiation of red meat could also result in an increase in the cost of such products to a level which may be unacceptable to most consumers. As a result, there can be no assurance that sterilization of fresh food products will gain public acceptance or will ultimately prove commercially feasible in the United States or that the Company would undertake to expand its irradiation activities to include red meat. To the extent that the Company seeks to take advantage of future opportunities in this market, such activities would require significant changes in the Company's processing techniques, including the redesign of facilities and the addition of refrigeration capabilities. Furthermore, to accommodate the perishable nature of red meat and the high processing volume that may result from the commercial irradiation of red meat, the Company could be required to expend significant capital to build specially equipped processing facilities near customer facilities.
RISKS RELATED TO GEOGRAPHIC EXPANSION USING THE MINICELL; RISKS RELATED TO INTERNATIONAL OPERATIONS
A key element of the Company's strategy is to expand geographically into smaller regional markets and internationally using the MiniCell. There can be no assurance that manufacturers in these markets will use the Company's facilities, that such manufacturers will pay higher sterilization prices in exchange for lower transportation costs and a decrease in turn-around time or that the Company will receive enough volume of product to operate such facilities on a profitable basis. In addition, many manufacturers in these smaller markets currently use EtO to sterilize their products and would need to convert their products to Gamma. Failure of the Company to successfully introduce and operate MiniCells in these new markets could materially adversely affect the Company's business, financial condition and results of operations.
If the Company is successful in expanding into international markets either through the use of the MiniCell or otherwise, it will be subject to a number of risks related to foreign operations, including fluctuations in currency exchange rates, political and economic conditions in various jurisdictions, unexpected changes in regulatory requirements, tariffs and other trade barriers, difficulties in staffing and managing foreign operations, longer accounts receivable payment cycles and potentially adverse tax consequences. There can be no assurance that such factors will not have a material adverse effect on the Company's future operations outside the U.S.
UNCERTAINTIES RELATED TO MINICELL LEASING
The Company's ability to successfully lease its MiniCell will depend upon the acceptance of the Company's technology and the concept of "in-house outsourcing" (utilizing third party contractors to provide services within a manufacturer's own facility) by manufacturers with high volume sterilization needs, as well as upon the Company's ability to enter into favorable leasing terms with potential customers. The Company has not yet leased a MiniCell, and there can be no assurance that manufacturers will elect to lease a MiniCell in lieu of relying on traditional in-house sterilization operations and contract sterilization providers or that any such leases will be on terms favorable to the Company. In addition, the leasing of the MiniCell will involve a significant commitment of management attention and resources by prospective customers and may require input from and approval at multiple levels of a customer's organization. Accordingly, the Company anticipates that the MiniCell leasing process will be subject to long sales cycles typically associated with significant capital expenditures. Delay in or the failure to lease the MiniCell could have a material adverse effect on the Company's business, financial condition and results of operations.
DEPENDENCE ON GAMMA TECHNOLOGY
Historically, the Company has performed all of its sterilization and radiation processing services using Gamma radiation. Because of its reliance on Gamma technology, a decline in the demand for, or the pricing of, Gamma services would have a material adverse effect on the Company's business, financial condition and results of operations. To remain competitive, the Company may also need to respond quickly to technological changes and innovations in the sterilization and radiation processing market, including changes in the technologies used to perform sterilization or radiation processing services that could render Gamma obsolete or noncompetitive. The Company is also dependent upon continued consumer acceptance of the Gamma sterilization of medical products and the ongoing conversion of products from EtO to Gamma sterilization. There can be no assurance that such conversion will occur at the rate anticipated by the Company. Failure by the Company to quickly and effectively respond to changes in the sterilization and radiation processing market, including the development of new technologies, or a significant increase in consumer resistance to products sterilized by Gamma, could have a material adverse effect on the Company's business, financial condition and results of operations. See "--Competition" and "-- Risks Associated With Entry Into E-Beam Business."
RISKS ASSOCIATED WITH ENTRY INTO E-BEAM BUSINESS
On December 31, 1997, the Company expanded into E-Beam technology as a result of the Nicolet Acquisition. The Company's senior management has no experience operating an E-Beam facility or marketing E-Beam services and there can be no assurance that the Company will successfully operate the E-Beam business. Achieving the anticipated benefits of the Nicolet Acquisition will depend in part upon whether the integration of the Gamma and E-Beam businesses is accomplished in an efficient and effective manner. There can be no assurance that the Company will be able to effectively integrate the operations, systems, technology and personnel of the E-Beam business. The failure to do so could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, any significant diversion of management resources required in connection with the operation or integration of the E-Beam business could have a material adverse effect upon the Company's business, financial condition and results of operations.
SUBSTANTIAL DEBT
As of March 31, 1998, the Company's total consolidated liabilities were $61.0 million, of which $42.6 million represented long-term debt (including current portion), its total consolidated assets were $130.7 million and its total stockholders' equity was $69.7 million. The Company's substantial level of debt presents the risk that the Company might not generate sufficient cash to service the Company's indebtedness, including its Industrial Revenue Bonds ("IRBs"), or that its debt level could limit its ability to finance an acquisition and develop additional projects, to compete effectively or to operate successfully under adverse economic conditions. As of March 31, 1998, the Company had $36.5 million of tax-free IRBs outstanding with variable interest rates as of March 31, 1998 of either 3.7% or 3.9%. Under federal regulations, the maximum aggregate amount of tax-free IRBs that the Company may issue is $40.0 million. Once the Company has issued the maximum amount of tax-free IRBs, it will be required to obtain any additional financing through higher cost funding sources. Each of the Company's IRBs is collateralized by certain assets of the Company. The Company is also required, under certain IRB agreements, to maintain cash reserves in the amount of the bond interest payments due within one year. As a result, such cash is not available to the Company for working capital or other purposes. See Note 3 of Notes to the Consolidated Financial Statements.
RISKS RELATED TO GOVERNMENT REGULATION AND STANDARDS COMPLIANCE
The Company's business is subject to various federal, state and local laws, regulations, agency actions and court decisions. Although the Company believes it has received all licenses and permits necessary to conduct its current sterilization business, there can be no assurance that the Company will not be found in violation of applicable requirements or that governmental bodies will not seek to impose regulatory requirements not now anticipated on the Company and its business. In addition, the long-term course of regulatory policy cannot be predicted and, there can be no assurance that laws and regulations will not be applied in a manner that adversely affects the Company. The imposition of such regulatory requirements could force the Company to alter or cease operations of its facilities and could otherwise have a material adverse effect on the Company's business, financial condition and results of operations.
The design, construction, use and operation of commercial Gamma facilities such as those operated by the Company, and byproduct materials used in such facilities, are extensively regulated by the United States Nuclear Regulatory Commission (the "NRC"), or in some cases by various state regulatory agencies and authorities that undertake comparable regulatory functions from the NRC (the "Agreement States"). While E-Beam is not regulated by the NRC, the Company's E-Beam facility is subject to regulation by the California Department of Health Services. The Company is currently operating its E-Beam facility under a California Department of Health Services license held by ThermoSpectra Corporation pending the approval of its application for a new radioactive material license. The Company is also subject to various local zoning and permit rules in the construction of its facilities. The Company's facilities are subject to regulation by additional regulatory bodies at the federal, state and local levels, depending upon the type of product that is being irradiated. The Company's facilities are subject to the requirements of the FDA when irradiating medical devices, foods, cosmetics or food or drug packaging materials. In addition, if the Company were to begin processing meat or poultry products, it would become subject to the requirements of the Food Safety and Inspection Service of the USDA, which would require the amendment of its regulations to authorize this use of irradiation as well as the establishment of the applicable manufacturing practices that must be followed when using such irradiation. The Company is also subject to the requirements of other federal agencies, such as the United States Occupational Safety and Health Administration and the United States Environmental Protection Agency (the "EPA"). In addition, the Company is subject to the regulatory requirements of the state and local agencies in the jurisdictions where the various irradiation facilities are located.
In addition to extensive regulation by various governmental bodies and agencies, the Company is subject to standards, guidelines and requirements established by industry organizations and other non-governmental bodies, such as the International Standards Organization ("ISO") and the Association for the Advancement of Medical Instrumentation ("AAMI"). The ISO 9002 Standard is an international quality standard that requires the Company to implement and document an effective quality assurance program which is subject to quality systems surveillance audits every six months.
Changes in, or reinterpretations of, existing requirements and standards or adoption of new requirements beyond those described below or the failure at any time to comply with any applicable material regulations and standards could have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that the Company will not incur significant costs to comply with laws, regulations and other requirements in the future or that such laws, regulations and other requirements will not have a material adverse effect upon the Company's business, financial condition and results of operations.
Violations of or noncompliance with applicable governmental requirements may result in an enforcement action including, among other things, a notice of violation, imposition of civil penalties, suspension, modification or revocation of any applicable license, criminal prosecution, or withholding or recall of the nuclear byproduct material held by the Company. Any such action would have a material adverse effect on the Company's business, financial condition and results of operations.
RISKS OF OPERATING FACILITIES USING RADIOACTIVE MATERIAL
The operation of the Company's Gamma and E-Beam facilities involves special safety risks, potential liabilities related to exposure to radioactive material, and specific regulatory, radiological health and safety and environmental requirements and may raise concerns with respect to both worker safety and community reaction. Should an incident involving exposure of workers or others beyond regulatory limits to radioactive materials occur at any of the Company's facilities, the resultant liability could be substantial. Such an incident would also result in adverse community reaction, which could impact the Company's ability to continue to operate any facility involved in such an incident, as well as similar facilities. In the event any losses or liabilities related to such an incident are underinsured or exceed accumulated funds, or adequate recovery is not possible, the Company's business, financial condition and results of operations would be materially adversely affected.
In addition, the Company may encounter resistance from those in the communities where it seeks to build additional facilities or be subject to protests or other actions in areas where it has facilities based on perceived risk of exposure to radiation on the part of those living in the communities surrounding the
Company's facilities. Any actual or perceived exposure to radiation as a result of the Company's activities or a failure related to the Company's safety procedures could have a material adverse effect on the Company's business, financial condition and results of operations. See "-- Environmental and Related Risks."
The Cobalt 60 stored in water shielding pools at each of the Company's facilities is double encapsulated in stainless steel. There can be no assurance that these stainless steel capsules will not corrode. In 1995, the Company encountered minor corrosion in the outer encapsulation of certain of its Cobalt 60 rods, requiring their replacement. Since the quantity of Cobalt 60 in a facility is the key determinant of the amount of product that can be processed, any significant delay in the replacement of such Cobalt 60 could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, if the Company is determined to be responsible for the corrosion, it could be required to bear the costs of transportation and reencapsulation of the Cobalt 60. Furthermore, such corrosion, if undetected, could result in radioactive material being released into the water shielding pool, which could cause contamination of the pool and potentially the related facility. Any contamination resulting from such release and the related decontamination process would have a material adverse effect on the Company's business, financial condition and results of operations. See "-- Risks Related to Government Regulation and Standards Compliance."
Due to the high energy levels emitted from the electron accelerator in the Company's E-Beam facility, some residual radiation remains in the cell after the accelerator is turned off and items that are in the direct path of the beam, such as equipment and portions of the concrete, may become radioactive for some period of time. Therefore, although the Company complies with federal and state regulations with regard to worker safety, workers who enter the E-Beam cell are exposed to low levels of radiation. Furthermore, the Company may be required to incur costs in connection with disposal of radioactive material in connection with the replacement of equipment or upgrading or decommissioning of its E-Beam facility.
ENVIRONMENTAL AND RELATED RISKS
The Company's operations are subject to regulation by the EPA as well as state and local governmental agencies. Although there can be no assurance, the Company believes it currently maintains all licenses and permits necessary to conduct its current business and that it is in material compliance with applicable environmental, health and safety laws and regulations. The loss of any of the Company's licenses or permits could force the Company to suspend or terminate operations at one or more of its facilities or could otherwise have a material adverse effect on the Company's business, financial condition and results of operations.
Pursuant to an Asset Acquisition Agreement effective August 8, 1996 (the "Asset Agreement"), the Company purchased certain assets of RTI, Inc. ("RTI"), including property located in Haw River, North Carolina and leasehold interests in property located in Salem, New Jersey and Rockaway, New Jersey (the "Rockaway Property"). The Rockaway Property was previously owned and operated by Thiokol Chemical Corporation ("Thiokol"), and is listed on the Superfund National Priorities List ("NPL"). In 1992, RTI and Thiokol entered into an Administrative Consent Order ("ACO") with the New Jersey Department of Environmental Protection (the "NJDEP") requiring, among other things, implementation of a groundwater remedy estimated to exceed $2.0 million in costs.
Under the Asset Agreement, RTI retained ownership of the Rockaway Property and all associated environmental liabilities as of the closing date. RTI agreed to indemnify and hold the Company harmless from and against any and all claims which may arise directly or indirectly from any use or release of hazardous substances on or under the leased premises as of the closing date. In addition, the Company obtained a letter from the NJDEP stating that the NJDEP will not institute either judicial or administrative civil proceedings against the Company for any discharge, deposit, release or disposal of hazardous substances or pollutants existing at the Rockaway Property, emanating therefrom, or occurring before the closing. However, the Company is required by the NJDEP to maintain a standby letter of credit in the amount of $500,000, contingent upon the continued clean up efforts required of RTI. The required amount of the letter of credit decreases over the life of the leasehold interest, and/or as the NJDEP requires. The Company believes, based on present information available to it, including the indemnification from RTI, the ACO among RTI, Thiokol and the NJDEP, and the NJDEP's letter stating that it will not seek recovery or remediation costs from the Company for contamination that predates the purchase of RTI's assets, that it does not face any significant environmental liability with respect to the Rockaway Property. However, there can be no assurance that the
Company will not be subject to environmental liability relating to the remediation of the Rockaway Property or liability for losses suffered by adjacent property owners or other third parties, and such liability could have a material adverse effect on its business, financial condition or results of operations.
In the spring of 1985, the Company leased over 400 stainless steel capsules of radioactive Cesium from the United States Department of Energy (the "DOE") for use at the Company's Decatur, Georgia and Westerville, Ohio irradiation facilities. On June 6, 1988, the Company discovered one or more of DOE's Cesium capsules had leaked radioactive Cesium, which is water soluble, contaminating the Company's Decatur, Georgia facility. As a result of the contamination, the Company's Decatur irradiation facility was completely shut down from June 6, 1988 until July 1996, when the Company leased the facility to a third party for a different purpose. The decontamination activities were conducted by the DOE and its contractors, and the Company filed an administrative claim with the DOE for damages the Company incurred as a result of the Cesium contamination. The DOE did not pay or deny the Company's claim within the required six month period. As a result, the Company filed suit against the U.S. government in June 1991. Although the DOE had orally offered to fund the costs of the cleanup, the government subsequently asserted a substantial counterclaim against the Company alleging that the Company had been negligent in its handling and use of the Cesium capsules. A settlement was reached between the parties to this litigation on April 9, 1997, following a trial and notice of appeals filed by both SteriGenics, the U.S. government and two of its contractors. The presiding court entered a stipulation of dismissal effective May 9, 1997. While the litigation resulted in significant expenses and was a significant diversion of management attention, the Company is not aware of any ongoing environmental or other legal liabilities associated with the Cesium incident. However, there can be no assurance that unspecified third parties, including former employees or persons owning or occupying nearby properties, would not, in the future, assert claims against the Company in connection with the contamination of the Decatur facility. In January 1993, after the decontamination activities were completed, final survey reports were prepared by both a contractor for DOE and by a third party consultant on behalf of the Georgia Department of Human Resources, which regulates such matters in Georgia, to allow for the unrestricted use of the Decatur facility consistent with the requirements of the Georgia Department of Human Resources. The documentation and data prepared by such third party indicated that any residual radioactivity at the Decatur facility was beneath that of regulatory concern to the applicable regulatory authority. While the Company no longer uses Cesium in any of its facilities, there can be no assurance that it will not experience any incidents of radioactive contamination resulting from its use of Cobalt 60. Incidents involving radioactive contamination from use of Cobalt 60 would likely differ from incidents involving Cesium contamination in a number of respects. Cesium is a salt and water soluble, in contrast to Cobalt 60, which is a metal and not water soluble. As a result, when Cesium contamination occurs, the evaporation of contaminated water can result in Cesium being spread to a greater extent than would be the case with substances that are not water soluble, such as Cobalt 60. However, since Cobalt 60 is a metal and therefore any released amount would remain in a more concentrated form, direct exposure could potentially be more dangerous. See "-- Risks of Operating Facilities Using Radioactive Material."
RISKS RELATED TO COBALT 60 SUPPLY
To date, the Company has obtained its supply of the Cobalt 60 radioactive isotope from three sources. The Company's primary sources of Cobalt 60 are Nordion, a Canadian company and the world's principal source of Cobalt 60, and REVISS Services (UK) Limited ("REVISS"), a United Kingdom company and formerly a division of Amersham International plc. In addition, the Company has purchased smaller amounts of its Cobalt 60 requirements from Neutron Products Inc., a Maryland corporation. While the Company has not experienced any shortages in Cobalt 60 supply since the mid-1980s and has various supply contracts in place, there can be no assurance that it will be able to obtain sufficient supplies of Cobalt 60 from Nordion, REVISS or other suppliers on acceptable terms or that it will be able to identify and qualify alternative sources. In addition, there is no assurance that Nordion will not in the future become a competitor of the Company in the delivery of sterilization services, which could result in a decrease in the availability of Cobalt 60 from Nordion. In July 1997, Nordion announced a joint venture with Griffith Micro Science, Inc. to provide sterilization services in Mexico. If interruptions in the supply or increases in the price of Cobalt 60 were to occur for any reason, including a decision by any of the Company's suppliers to decrease or discontinue supplies of Cobalt 60 to the Company, trade restrictions with Canada or the United Kingdom,
political unrest, labor disputes or other factors, the Company's business, financial condition and results of operations would be materially adversely affected. Since the Company pays for Cobalt 60 primarily in Canadian dollars, and the Canadian dollar is currently trading at levels significantly lower than it has in recent years, the Company's results of operations may be adversely affected by fluctuations in currency exchange rates. In addition, the availability and price of Cobalt 60 to the Company and its suppliers is dependent in part on the political situation in countries with large deposits of Cobalt 59 (the material that is processed into Cobalt 60), such as the Democratic Republic of Congo and the republics of the former Soviet Union. Such countries have recently experienced political unrest. In addition, since mined Cobalt 59 must be converted into Cobalt 60 in nuclear reactors, the supply of Cobalt 60 to the Company's suppliers is dependent upon the availability of nuclear reactors to convert Cobalt 59 to Cobalt 60. An interruption in the Company's supply of Cobalt 60 or significant increase in the price the Company is required to pay for Cobalt 60 would have a material adverse effect on the Company's business, financial condition and results of operations.
RISKS OF BUSINESS INTERRUPTION
Any prolonged disruption in the operations at any of the Company's facilities, whether due to technical or labor difficulties, equipment malfunction, regulatory action, destruction of or damage to any facility or other reasons, would have a material adverse effect on the Company's business, financial condition and results of operations. This risk is increased since customers generally seek to have their products sterilized within a 300 mile radius of their production or distribution facilities and, therefore, it is often not feasible to transfer products to other facilities in the event of a prolonged disruption in any facility. The Company is also susceptible to natural disasters, including earthquakes, hurricanes and tornadoes, as well as other catastrophic events such as fire. Furthermore, if additional capacity is required as a result of unplanned increases in demand for the Company's services, the Company may suffer delays and increased costs in establishing other facilities or increasing production at existing facilities that could adversely affect customer relationships, cause a loss of market opportunities and have a material adverse effect on the Company's business, financial condition and results of operations. In addition, the failure to effectively implement any design or process changes could disrupt the sterilization process, which could also adversely affect customer relationships, cause a loss of market opportunities and have a material adverse effect on the Company's business, financial condition and results of operations.
MANAGING GROWTH; RECENT AND POTENTIAL ACQUISITIONS
The Company has recently experienced a period of revenue growth and an expansion in the number of its employees, the scope of its operating and financial systems and the geographic area of its operations. In addition, the Company has recently entered the E-Beam business through the Nicolet Acquisition. This growth and expansion has resulted in and may continue to result in new and increased responsibilities for management personnel and has placed additional demands upon the Company's management, operating and financial systems and resources. In order to successfully integrate its expanded operations and to manage future growth, if any, the Company will be required to implement new and expanded business and financial systems, procedures and controls, and to upgrade its accounting and other internal management systems. There can be no assurance that the Company's systems, procedures, controls and staffing will be successfully managed or will be adequate to successfully support the Company's operations. Failure to manage any future growth properly would have a material adverse effect on the Company's business, financial condition and results of operations.
The Company may in the future undertake acquisitions that could present challenges to the Company's management, such as integrating and incorporating new operations, technologies and personnel. If the Company's management is unable to effectively manage these challenges, the Company's business, financial condition and results of operations could be materially adversely affected. Furthermore, there can be no assurance that any acquisitions will result in increased revenue or positively impact the Company's profitability. Moreover, any new acquisition, depending on its size, could result in the use of a significant portion of the Company's available cash or the acquisition of additional debt or, if such acquisition is made utilizing the Company's securities, could result in significant dilution to the Company's stockholders. The Company does not currently have any understandings, commitments or agreements with respect to any potential acquisition or corporate partnering arrangements. While it is an element of the Company's strategy to pursue strategic acquisitions, the Company believes that the number of potential acquisition candidates in
the domestic market is limited. Therefore, there can be no assurance that the Company will successfully complete any such transaction.
DEPENDENCE ON KEY PERSONNEL
The Company's progress to date has been highly dependent upon the skills of its key technical and management personnel, many of whom would be difficult to replace. To reach its future business objectives, the Company will need to hire additional qualified personnel in the areas of sales, engineering and management. There can be no assurance that the Company will be able to hire such personnel, as the Company must compete with other companies, academic institutions, government entities and other agencies. The number of persons with experience in Gamma sterilization and E-Beam technology is limited, and as a result, competition for such personnel is intense. There can be no assurance that the Company can retain such personnel or that it can attract or retain other highly qualified personnel in the future. The Company maintains $2.0 million of key person life insurance on James F. Clouser, the Company's Chief Executive Officer and President. The loss of any of the Company's senior management, facilities managers or other key research, regulatory, technical or sales and marketing personnel, particularly if lost to competitors, or the failure of any key employee to perform well in his or her current position, could have a material adverse effect on the Company's business, financial condition and results of operations. In particular, the loss of James F. Clouser could have a material adverse effect on the Company's business, financial condition and results of operations.
FINANCIAL EXPOSURE TO PRODUCT LIABILITY CLAIMS
The Company faces the risk of financial exposure to product liability claims alleging that the Company's failure to adequately perform its services resulted in adverse effects. While the Company's customers are responsible for determining the appropriate dosage of radiation their products should receive, the Company is required to certify that such dose level was achieved. There can be no assurance that the Company will not be held liable for damages that are alleged to result from improper dosing or incorrect dosage instructions received from a customer. The Company currently maintains product liability insurance with a claims limit of $5.0 million per claim and $5.0 million in the aggregate. However, there can be no assurance that the Company will avoid significant product liability claims and attendant adverse publicity. Furthermore, there can be no assurance that the Company's product liability insurance is adequate or that such insurance coverage will remain available at acceptable costs. A successful claim brought against the Company in excess of its insurance coverage could have a material adverse effect on the Company's business, financial condition and results of operations. Additionally, adverse product liability actions could negatively affect market acceptance of the Company's services and the Company's ability to obtain and maintain regulatory approval for its products.
NEED FOR ADDITIONAL CAPITAL
The Company requires substantial working capital to fund its business, particularly for capital expenditures, including the construction of its facilities and acquisition of Cobalt 60. There can be no assurance that as a result of acquisitions, lower than anticipated cash flows or other unforeseen events the Company will not require additional debt or equity financing. Further, there can be no assurance that additional financing, if required, will be available to the Company on acceptable terms, if at all. If adequate funds are not available, the Company may be required to delay, scale back or eliminate its planned expansion, acquisitions or research, development and engineering programs. Accordingly, the inability to obtain or difficulty in obtaining such financing could have a material adverse effect on the Company's business, financial condition and results of operations.
PROPRIETARY TECHNOLOGY AND INTELLECTUAL PROPERTY
The Company relies on a combination of copyright and trade secret protection and nondisclosure agreements to protect its proprietary rights. In addition, the Company has a U.S. patent application pending on its MiniCell. There can be no assurance, however, that patent and copyright law and trade secret protection will be adequate to deter misappropriation of its technology, that any patents issued to the Company will not be challenged, invalidated or circumvented, that the rights granted thereunder will provide competitive advantages to the Company, or that the claims under any patent application will be allowed. Furthermore, there can be no assurance that others will not independently develop similar processes or designs, duplicate the Company's processes or design around any patents issued to the Company. The Company may be subject to or
may initiate interference proceedings in the United States Patent and Trademark Office, which can demand significant financial and management resources. The process of seeking patent protection can be time consuming and expensive and there can be no assurance that patents will be issued from currently pending or future applications or that any new patents that may be issued will be sufficient in scope or strength to provide meaningful protection or any commercial advantage to the Company.
The Company has received an inquiry from the Software Publishers Association (the "SPA") regarding an alleged failure to obtain proper licenses for certain third party software. The Company is in discussions with the SPA and, while there can be no assurance, the Company does not believe that the resolution of this matter will have a material adverse effect on its financial condition or operating results.
The Company may in the future receive communications from third parties asserting that the Company is infringing certain patents and other intellectual property rights of others or seeking indemnification against such alleged infringement. No assurance can be given that any of these claims will not result in protracted and costly litigation, that damages for infringement will not be assessed or that should it be necessary or desirable to obtain a license relating to one or more of the Company's services or current or future technologies, the Company will be able to do so on commercially reasonable terms or at all.
POTENTIAL VOLATILITY OF STOCK PRICE
The market price of the Company's Common Stock has fluctuated and may continue to be subject to significant fluctuations in the future. Factors such as variations in the Company's financial results, comments by securities analysts, changes in earnings estimates by securities analysts, fluctuations in the stock prices of the Company's competitors, the Company's ability to successfully sell its services in the U.S. and overseas, any loss of key management, adverse regulatory actions or decisions, evidence regarding the safety or efficacy of Gamma or E-Beam sterilization activities, announcements of extraordinary events such as litigation or acquisitions, announcements of technical innovations or changes in pricing policies by the Company or its competitors, the development of in-house sterilization capabilities by manufacturers, changing government regulations or industry standards and developments with respect to FDA, NRC or other government regulations, developments with respect to patents or other proprietary rights or public concern as to the safety of sterilization services performed by the Company, as well as changes in the market for medical products and general economic, political and market conditions, may have a significant effect on the market price of the Company's Common Stock. In addition, stock markets have experienced extreme price and volume trading volatility in recent years. This volatility has had a substantial effect on the market prices of securities of many companies for reasons frequently unrelated or disproportionate to the operating performance of the specific companies. These broad market fluctuations may adversely affect the market price of the Company's Common Stock.
ANTI-TAKEOVER EFFECT OF CERTAIN CHARTER AND BYLAW PROVISIONS
Certain provisions of the Company's Certificate of Incorporation may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire control of the Company. The Company's Certificate of Incorporation allows the Board of Directors to issue and determine the rights, powers and preferences of Preferred Stock without any vote or further action by the stockholders, and certain provisions of the Company's Certificate of Incorporation and Bylaws eliminate the right of stockholders to act by written consent without a meeting, and specify procedures for director nominations by stockholders and submission of other proposals for consideration at stockholder meetings. Certain provisions of Delaware law could also delay or make more difficult a merger, tender offer or proxy contest involving the Company, including Section 203 of the Delaware General Corporation Law, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless certain conditions are met. The possible issuance of Preferred Stock, the procedures required for director nominations and stockholder proposals and Delaware law could have the effect of delaying, deferring or preventing a change in control of the Company, including without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of the Company's Common Stock. These provisions could also limit the price that investors might be willing to pay in the future for shares of the Company's Common Stock.
ITEM 2.
ITEM 2. PROPERTIES
The Company has a network of 12 Gamma facilities and one E-Beam facility. Eight of the Gamma facilities perform sterilization services primarily for the medical products market. The remaining four Gamma facilities provide services primarily to advanced applications customers. The Company processes its advanced applications products primarily in its advanced applications facilities since certain medical products customers prefer that their products be segregated from advanced applications products such as herbs and spices. The 12 Gamma facilities have an aggregate design capacity of 101 million curies of Cobalt 60. The Company's E-Beam facility performs sterilization and radiation processing services for both the advanced applications and medical customers.
The following table sets forth information regarding the Company's facilities as of March 31, 1998:
- ---------------
(1) Financed through the issuance of Industrial Revenue Bonds. See -- "Risk Factors -- Substantial Debt" and Note 3 of Notes to the Consolidated Financial Statements.
(2) ISO-9002 Certified and EN46002/EN552 Certified facilities.
(3) ISO-9002 Certified and EN46002 Certified facility.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not currently subject to any material legal proceedings.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company did not submit any matters to a vote of security holders during the fourth quarter of the fiscal year ended March 31, 1998.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is listed for trading on the Nasdaq National Market under the symbol "STER". On March 31, 1998, there were approximately 58 holders of record of the Common Stock.
The table below sets forth the high and low sales prices per share as reported on the NASDAQ National Market System since the Company's initial public offering on August 14, 1997. The Company's initial public offering price was $12.00 per share.
- --------------- (1) Trading of the Company's Common Stock commenced on August 14, 1997.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
- --------------- (1) See Note 1 of Notes to Consolidated Financial Statements included herein for a description of the computation of pro forma basic and diluted net income per share.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
Since its inception, SteriGenics International, Inc. (the "Company") has engaged primarily in the business of operating, designing and developing Gamma facilities to provide contract sterilization and radiation processing services to manufacturers of medical and advanced application (non-medical) products. The Company currently operates 12 Gamma facilities nationwide. In fiscal 1998, the Company began operation of its first MiniCell facility in Hayward, California and opened its second Fort Worth, Texas facility. With the addition of these facilities, the Company's maximum Cobalt 60 capacity has increased from 32 million curies at the end of fiscal 1994 to a current capacity of 101 million curies.
On December 31, 1997, the Company acquired certain assets of the Nicolet Electron Services Division of ThermoSpectra Corporation ("Nicolet") for approximately $5.0 million cash and 109,307 shares of the Company's Common Stock. As a result of the acquisition, the Company currently operates one electron beam technology ("E-Beam") facility, located in San Diego, California. E-Beam involves exposing products to a high-energy electron beam. The acquisition was accounted for as a purchase.
In order to more effectively address its customer base, the Company has divided its operations into two divisions: medical and advanced application products. While the Company's primary market continues to be the sterilization of medical products, the Company has increased its focus on the sterilization and processing of advanced application products. The Company has dedicated four of its Gamma facilities to processing primarily advanced application products. In addition, a significant portion of the Company's revenues from its E-Beam facility is generated from the processing of advanced application products.
The Company's revenues have increased significantly from fiscal 1996 to fiscal 1998 as the Company has opened and acquired additional facilities, increased its loaded curies of Cobalt 60 and expanded its customer base. In addition, in recent years the Company has generated incremental revenues by offering its customers premium services such as ExCell, precision dosing and validation services, and GammaSTAT, a guaranteed variable time-based service. Revenues are recognized upon completion of the sterilization or processing services.
The Company's cost of revenues is comprised primarily of: the depreciation of Cobalt 60, facilities and equipment; direct labor costs; facilities rental; and costs associated with facility quality assurance personnel. Since Cobalt 60 represents a significant portion of the Company's cost of revenues, Cobalt 60 efficiency and utilization are key determinants of the Company's gross margin. Cobalt 60 is amortized using an accelerated method (approximately 12.3% of net book value per year), which corresponds to its natural decay rate. As the Company periodically increases its installed capacity of Cobalt 60 in existing facilities, or when it opens a new facility, it typically has excess capacity for some period of time, which can adversely affect gross margin. Correspondingly, once a facility reaches its break-even point for a given amount of Cobalt 60, there are relatively low costs associated with incremental revenues until such time as the amount of Cobalt 60 is increased. The Company's gross margin is also affected by the mix of standard services and higher margin premium services such as ExCell and GammaSTAT.
From time to time, the Company has built or expanded facilities. The cost of construction of a facility is reflected as construction-in-progress until start-up of the facility, at which time depreciation commences. Building new facilities requires significant capital investments in building construction, equipment and, for Gamma facilities, in Cobalt 60. In addition to incurring costs associated with Cobalt 60, the Company also incurs incremental personnel costs in the months preceding initial operation, and typically incurs substantial personnel and other operating expenses during the first several months of operation. These costs have historically exceeded revenues during the initial months of operation.
As a result of their own internal procedures, customers often delay qualification and use of a new facility until it has been operational for periods of up to 12 months. As a result, in the past, the Company failed to realize a portion of anticipated revenues for the facility pending such qualification. Qualification generally requires the completion of various audit procedures by a customer's quality assurance personnel. Customers' decisions on timing of qualification of new facilities are based on various issues including internal policies and
procedures, work load of internal quality assurance audit personnel and the need for amendments of certain FDA approvals. Certain customers will qualify a new facility shortly after opening, while others may delay for three, six, nine or twelve months depending on various internal issues. The Company generally does not have the ability to expedite this qualification process as the decisions are made independently by the individual customers.
RESULTS OF OPERATIONS
The following table provides a breakdown of the Company's consolidated statements of operations on a percentage of revenues basis for the periods indicated:
FISCAL YEARS ENDED MARCH 31, 1998, 1997 AND 1996
REVENUES
Revenues increased in fiscal 1998 to $47.0 million, or 24.7%, compared to $37.7 million in fiscal 1997, and 24.6% from $30.2 million in fiscal 1996. The increase in revenues in fiscal 1998 is primarily due to a full year of operations for the Company's facilities in Gurnee, Illinois; Hayward, California; Salem, New Jersey; Haw River, North Carolina; and Rockaway, New Jersey, and the addition of a second Fort Worth, Texas facility during the fiscal year, as well as the addition of the Company's first E-Beam facility in San Diego, California. Salem, Haw River and Rockaway are the former RTI, Inc. facilities acquired by the Company in August 1996. Revenues in fiscal 1997 increased primarily as a result of the addition of the Salem, Haw River and Rockaway facilities, and the Gurnee facility. The increase in revenue year over year to fiscal 1998 from fiscal 1996 is also attributable to the increased installed base of Cobalt 60 in its existing facilities, which enabled the Company to process higher volumes of product, and the continued expansion of the Company's advanced applications business, as well as continued growth in revenue from premium services. Growth in revenues attributable to premium services contributes to the Company's ability to maintain its revenue per installed Cobalt 60 curie despite opening new facilities, which generally incur higher costs related to Cobalt 60, as well as higher personnel costs in the months preceding initial operation.
COST OF REVENUES
Cost of revenues increased to $24.2 million in fiscal 1998 from $20.4 million in fiscal 1997 and $17.0 million in fiscal 1996. Gross margin increased to 48.4% in fiscal 1998 from 45.8% in fiscal 1997 and
43.9% in fiscal 1996. The increase in gross margin in fiscal 1998 was primarily attributable to greater utilization of the Company's existing facilities which enabled the Company to leverage the fixed costs associated with such facilities, a higher percentage of revenue attributable to premium services, and the acquisition of the San Diego E-Beam facility, offset in part by the impact of the opening of the Hayward and Fort Worth II facilities. The increase in gross margin in fiscal 1997 was primarily attributable to greater utilization of the Company's existing facilities and a higher percentage of revenue attributable to premium services, offset in part by the impact of the opening of the Gurnee facility and transition of the former RTI, Inc. facilities. The Company expects gross margin to fluctuate in future periods, and that it may be negatively impacted to the extent the Company adds facilities and continues to expand its installed capacity of Cobalt 60. The Company's cost of revenues is subject to fluctuations based upon changes in currency exchange rates between the U.S. dollar and the Canadian dollar because payments under certain of the Company's Cobalt 60 operating leases are payable in Canadian dollars (approximately $1.6 million remaining at March 31, 1998 at then current exchange rates).
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased 23.7% to $7.8 million in fiscal 1998 from $6.3 million in fiscal 1997, and 21.7% from $5.2 million in fiscal 1996. The increase in absolute dollars in fiscal 1998 was attributable to increases in corporate overhead, including the additional costs of becoming a public company, as well as increased headcount at the facility level attributable to the addition of three new facilities (including the former Nicolet E-Beam facility) during the fiscal year. The increase in absolute dollars in fiscal 1997 was primarily attributable to an increased headcount at the facility level as four new facilities (including the three former RTI, Inc. facilities) were added during the fiscal year and, to a lesser extent, related increases in corporate overhead. As a percentage of revenues, these expenses decreased to 16.7% from 16.8% and 17.2% in fiscal 1998, 1997 and 1996, respectively. The decrease in general and administrative expenses as a percentage of revenue in fiscal 1998 from fiscal 1997 and fiscal 1996 was primarily due to economies of scale achieved as the Company's revenues increased. The Company expects general and administrative expenses will continue to increase in absolute dollars as the Company adds facilities and corresponding plant administration, and incurs additional costs related to being a public company.
MARKETING AND SELLING
Marketing and selling expenses increased 40.9% to $3.5 million in fiscal 1998, from $2.5 million in fiscal 1997, and 40.9% from $1.8 million in fiscal 1996. As a percentage of revenues, these expenses increased to 7.5% from 6.6% and 5.8% in fiscal 1998, 1997 and 1996, respectively. The increase in fiscal 1998 was primarily attributable to the addition of sales and marketing personnel at the corporate level in 1998 in the newly organized Advanced Applications division and, to a lesser extent, increased sales and marketing personnel at the facility level, and higher travel and advertising expenses. The increase in fiscal 1997 was primarily attributable to increased sales and marketing personnel at the facility and corporate level and, to a lesser extent, higher travel and advertising expenses. Additional headcount at the corporate level enabled the Company to focus on large national customers as well as new advanced application markets. The Company expects marketing and selling expenses will continue to increase in absolute dollars and as a percentage of revenue as the Company continues to move into new advanced application markets.
RESEARCH, DEVELOPMENT AND ENGINEERING
Research, development and engineering expenses decreased 11.0% to $1.2 million in fiscal 1998, from $1.4 million in fiscal 1997, and increased 55.2% from $890,000 in fiscal 1996. As a percentage of revenues, these expenses decreased to 2.6% from 3.7% and 3.0% in fiscal 1998, 1997 and 1996, respectively. The decrease in fiscal 1998 was primarily attributable to decreased travel, rent and research expenses associated with fewer new system installations in the year. The increase in fiscal 1997 was primarily attributable to the addition of engineering personnel and, to a lesser extent, increased travel expenses related to the installation of new systems. The Company expects research, development and engineering expenses will continue to increase in absolute dollars as it intends to design and develop new facilities and systems during fiscal 1999.
INTEREST INCOME
Interest income increased 143.4% to $835,000 in fiscal 1998, from $343,000 in fiscal 1997, and 200.9% from $114,000 in fiscal 1996. The increase in fiscal 1998 is attributable to the earnings on invested proceeds from the Company's initial public offering in August 1997 and to a lesser extent, earnings on invested proceeds from the issuance of a tax-free Industrial Revenue Bond ("IRB") in July 1997. The increase in fiscal 1997 is primarily attributable to earnings on invested proceeds from the issuance of a tax-free IRB in April 1996, as well as earnings on cash reserves. As a percentage of revenues, interest income increased to 1.8% from 0.9% and 0.4% in fiscal 1998, 1997 and 1996, respectively.
INTEREST EXPENSE
Interest expense increased 6.3% to $2.3 million in fiscal 1998, from $2.2 million in fiscal 1997, and 11.2%, from $2.0 million in fiscal 1996. Interest expense increased in fiscal 1998 primarily due to higher levels of borrowings of tax-free IRB financing offset by a reduction in bank financing, which was repaid during the year with a portion of the proceeds from the Company's initial public offering, and the reduction in the Company's outstanding capital lease debt. Interest expense increased in fiscal 1997 as higher levels of borrowings were partially offset by lower interest rates on tax-free IRB financing which replaced higher rate bank financing and other debt. As a percentage of revenue, interest expense decreased to 4.9% from 5.8% and 6.5% in fiscal 1998, 1997 and 1996, respectively. The maximum aggregate amount of tax-free IRBs that the Company may issue is $40.0 million. Once the Company has issued the maximum amount of tax-free IRBs, it will be required to obtain any additional financing through higher cost funding sources. The Company's interest expense fluctuated with changes in currency exchange rates between the U.S. dollar and the Canadian dollar because payments under certain of the Company's Cobalt 60 capital leases were payable in Canadian dollars (all such amounts had been paid at March 31, 1997). To date, the effect of currency fluctuations has not been material to the Company. The Company does not currently engage in hedging transactions to mitigate this risk. The Company expects interest expense to remain relatively unchanged in absolute dollars and to decrease as a percentage of revenue.
PROVISION FOR INCOME TAXES
In fiscal 1998, 1997 and fiscal 1996, the total provision for income taxes differs from the statutory rate primarily due to state income taxes. The Company's net deferred tax liabilities in fiscal years 1998, 1997 and 1996 relate primarily to tax depreciation taken in excess of book depreciation.
LIQUIDITY AND CAPITAL RESOURCES
In August 1997, the Company completed its initial public offering of Common Stock, raising approximately $21.4 million, net of expenses. Additionally, the Company completed a follow-on offering of Common Stock in February 1998, raising approximately $8.8 million, net of expenses. Prior to the initial and follow-on public offerings, the Company had financed its operations with cash from operations, capital leases, IRB and bank financing, and the private placement of equity securities. At March 1998, the Company had $12.7 million in cash and cash equivalents and $29.8 million in working capital.
Net cash provided by operating activities was $13.3 million, $12.2 million and $11.0 million in fiscal 1998, 1997 and 1996 respectively. Net cash provided by operating activities in fiscal 1998, fiscal 1997 and fiscal 1996 was primarily attributable to net income, depreciation, and deferred tax liability.
Net cash used in investing activities was $33.5 million, $19.1 million and $7.6 million in fiscal 1998, 1997 and 1996, respectively, primarily attributable to the purchase of property, plant and equipment (including Cobalt 60) and, for fiscal 1998, the assets acquired in the Nicolet acquisition, as well as the purchase of short term investments.
Net cash provided by (used in) financing activities was $30.8 million, $(1.0) million and $4.7 million in fiscal 1998, 1997 and 1996 respectively. Net cash provided by financing activities in fiscal 1998 was primarily attributable to net proceeds of $21.4 million from the Company's initial public offering in August 1997, the net
proceeds of $8.8 million from the Company's follow-on public offering in February 1998, and an increase in IRB financing, offset in part by the repayment of bank, IRB and Cobalt 60 financing, and to a lesser extent, the redemption of Preferred Stock. Net cash used in financing activities in fiscal 1997 was primarily attributable to repayment of a term loan and Cobalt 60 financing, offset in part primarily by increases in IRB financing. Net cash provided by financing activities in fiscal 1996 was generated primarily from an increase in IRB financing offset in part by the repayment of bank and Cobalt 60 financing.
Noncash financing activities included the issuance of Common Stock, totaling $2.1 million, in connection with the acquisition of Nicolet in fiscal year 1998 and the acquisition of Cobalt 60 through capital leases totaling $2.5 million and $2.4 million in fiscal years 1997 and 1996, respectively. These leases have terms of 15 years.
The Company has a $3.5 million revolving line of credit with a bank that carries a variable interest rate (8.5% at March 31, 1998), collateralized by certain assets of the Company. The line of credit is payable on demand, and at March 31, 1998, no amount was outstanding under this line of credit. The payment of cash dividends on the Company's Common Stock is limited by the terms of the Company's revolving line of credit.
At March 31, 1998, the Company had $36.5 million in IRB financing which bears interest at market rates (either 3.9% or 3.7% at March 31, 1998). The IRBs are collateralized by certain assets of the Company at March 31, 1998 and by letters of credit with a bank. The Company is able to issue only $3.5 million of additional tax-free IRBs until it reaches the maximum aggregate tax-free IRB limit of $40.0 million. Thereafter, the Company will be required to obtain any additional financing through higher cost funding sources.
The Company had capital expenditures of $7.3 million, $18.6 million and $7.2 million in fiscal 1998, 1997 and 1996, respectively. The Company currently expects to make capital expenditures of approximately $18.0 million during fiscal 1999. These expenditures will include, but are not limited to, the purchase of additional Cobalt 60, new facilities and renovations to existing facilities.
SteriGenics believes that existing cash balances, including the net proceeds of its two public offerings of Common Stock, cash expected to be generated from operations and available credit facilities will be sufficient to fund the Company's anticipated capital expenditures, operations and repayment of debt, at least through the end of fiscal 1999. There can be no assurance that adequate sources of capital will be available in the future or, if available, will be on terms acceptable to the Company.
The Company believes that success in its industry requires substantial capital in order to maintain the flexibility to take advantage of opportunities as they may arise. The Company may, from time to time, invest in or acquire complementary businesses, products or technologies. The Company may attempt to utilize additional equity or debt financing to fund such activities. The sale of additional equity or convertible debt could result in additional dilution to the Company's stockholders.
YEAR 2000 COMPLIANCE
The Company is aware of the issues associated with the programming code in existing computer systems as the year 2000 approaches. The "year 2000 problem" is pervasive and complex as virtually every computer operation will be affected in some way by the rollover of the two digit year value to 00. The issue is whether computer systems will properly recognize date sensitive information when the year changes to 2000. Systems that do not properly recognize such information could generate erroneous data or cause a system to fail. Management is in the process of working with its software vendors to assure that the Company is prepared for the year 2000. Management does not anticipate that the Company will incur significant operating expenses or be required to invest heavily in computer systems improvements to be year 2000 compliant. However, significant uncertainty exists concerning the potential costs and effects associated with any year 2000 compliance. The Company is currently implementing an upgrade to its management information system that the Company believes is year 2000 compliant. Any year 2000 compliance problem of either the Company or its suppliers or customers could materially adversely affect the Company's business, results of operations, financial condition and prospects.
ADOPTION OF NEW ACCOUNTING STANDARDS
In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("FAS 128"), which was adopted by the Company on December 31, 1997. Upon adoption, the Company changed the method used to compute earnings per share and restated all prior periods.
In June 1997, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("FAS 130") and No. 131, "Disclosures About Segments of an Enterprise and Related Information" ("FAS 131"). FAS 130 establishes rules for reporting and displaying comprehensive income. FAS 131 will require the Company to use the "management approach" in disclosing segment information. Both statements are effective for the Company during fiscal 1999. The Company believes that the adoption of either FAS 130 or FAS 131 will not have a material impact on its results of operations, cash flows, financial position or prospects.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
FINANCIAL SECTION
STERIGENICS INTERNATIONAL, INC.
CONSOLIDATED BALANCE SHEETS
ASSETS
See accompanying notes.
STERIGENICS INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes.
STERIGENICS INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See accompanying notes.
STERIGENICS INTERNATIONAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
STERIGENICS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization
SteriGenics International, Inc. (the "Company") was incorporated in the state of California in 1978. In July 1997, the Company was reincorporated in the state of Delaware. The Company performs contract sterilization and radiation processing services using gamma radiation ("Gamma") and electron beam radiation ("E-Beam"). The Company operates 12 Gamma facilities in several states and one E-Beam facility in San Diego, California.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, SteriGenics East Corporation, SteriGenics International Holding Corporation and RSI Leasing, Inc. SteriGenics East Corporation includes three facilities located along the eastern seaboard of the United States (see Note 11). SteriGenics International Holding Corporation holds investments in the Company's joint venture in Taiwan (see Note 10). RSI Leasing, Inc. leases Cobalt 60 to the Company and includes a facility located in San Diego acquired pursuant to the acquisition of the Nicolet Electron Services Division of ThermoSpectra Corporation (the "Nicolet Acquisition") (see Note 11). All significant intercompany accounts and transactions have been eliminated.
Certain prior year balance sheet amounts have been reclassified to conform with the current year's presentation.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates, and such differences may be material to the financial statements.
Revenue Recognition
Revenue from contract manufacturing is recognized upon the completion of sterilization. No customer accounted for more than 10% of revenues during fiscal 1998 or 1997. One customer accounted for approximately 13% of revenues during fiscal 1996.
Advertising Costs
Advertising costs are recorded as an expense when incurred. Advertising costs were approximately $348,000, $289,000 and $191,000 for the years ended March 31, 1998, 1997 and 1996, respectively. The Company does not incur any direct response advertising costs.
Cash and Cash Equivalents
The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Cash equivalents are carried at cost, which approximates fair value. The Company is exposed to credit risk in the event of default by the financial institutions or issuers of the investments to the extent of the amounts recorded on the balance sheet.
STERIGENICS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Short-Term Investments
The Company invests its excess cash in high-quality commercial paper with maturity less than one year. At March 31, 1998, all short-term investments are designated as available for sale. Interest and dividends on the investments are included in interest income. There were no realized gains or losses on the Company's investments during fiscal 1998 as all investments were held to maturity during the year. At March 31, 1998, the fair value of short-term investments approximates cost.
Financial Instruments
The estimated fair values of financial instruments approximate the carrying values at March 31, 1998 and 1997 using available market information and appropriate valuation methodologies. The fair value of long-term debt is estimated using discounted cash flow analysis and the Company's current incremental borrowing rate.
Risks, Uncertainties, and Significant Concentrations
The Company's trade receivables consist principally of amounts due from its customers in the sterilization industry. The Company's trade customers are primarily in the United States. Management believes any concentration of credit risk is substantially alleviated by the Company's credit evaluation and collection practices. The Company generally requires no collateral. Bad debt experience and expenses have been insignificant.
The Company's operations are dependent on its ability to obtain Cobalt 60 isotope or an equivalent radioactive material. Cobalt 60 isotope is a controlled substance, supplied only by a limited number of vendors. If the Company is unable to obtain adequate supplies of Cobalt 60 isotope at commercially reasonable terms, its operations may be materially adversely affected.
Depreciation and Amortization
Cobalt 60 isotope is amortized using an accelerated method (approximately 12.3% of net book value per year) which relates to the natural decay of the isotope. For all other property, plant and equipment, depreciation is computed using the straight-line method over estimated useful lives of three to thirty years. Amortization is included with depreciation expense in the accompanying consolidated financial statements.
Construction-in-Progress
From time to time, the Company builds or expands facilities. The cost of construction of these facilities is reflected as construction-in-progress until start-up of the facility, at which time the costs are reclassified to the appropriate fixed asset category.
Goodwill
Goodwill represents the excess of the purchase price paid over the estimated fair values of tangible and intangible net assets acquired. Goodwill is amortized on a straight-line basis over the estimated useful life of the assets acquired.
Stock-Based Compensation
In fiscal 1997, the Company implemented the disclosure requirements of Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"). As permitted under FAS 123, the Company continues to account for its employee stock option plans in accordance with the provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB Opinion No. 25") and will provide pro forma disclosures of net income and earnings per share as if the
STERIGENICS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
fair value basis method prescribed by FAS 123 had been applied in measuring employee compensation expense (see Note 5.)
Net Income Per Share
In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("FAS 128"), which was adopted on December 31, 1997. In accordance with the provisions of FAS 128, all prior period net income per share amounts have been restated to reflect basic and diluted per share amounts.
Except as noted below, basic net income per share is computed using the weighted average number of shares of Common Stock outstanding. Pro forma basic net income per share is calculated as for basic net income per share, but assumes conversion of all convertible Preferred Stock which converted automatically in the initial public offering, even if antidilutive. Diluted net income per share includes potential common shares, when dilutive, from stock options (using the treasury stock method) and from convertible Preferred Stock (using the if-converted method).
The following table sets forth the computation of basic, pro forma basic and diluted net income per share:
Options to purchase 88,250 shares of Common Stock were outstanding in the year ended March 31, 1998 but were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of the common shares and, therefore, the effect would be antidilutive.
New Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued Statement No. 130, "Reporting Comprehensive Income" ("FAS 130") and Statement No. 131, "Disclosures About Segments of an Enterprise and Related Information" ("FAS 131"). FAS 130 establishes rules for reporting and displaying comprehensive income. FAS 131 will require the Company to use the "management approach" in disclosing segment information. Both statements are effective for the Company during fiscal 1999. The Company believes that the adoption of either FAS 130 or FAS 131 will not have a material impact on the Company's results of operations, cash flows or financial position.
STERIGENICS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. BALANCE SHEET COMPONENTS
Property, Plant and Equipment
Property, plant and equipment consist of the following:
Other Assets
Other assets consist of the following:
Accrued Liabilities
Accrued liabilities consist of the following:
STERIGENICS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. BORROWING ARRANGEMENTS
Long-term debt consists of:
Industrial revenue bonds are collateralized by certain assets of the Company and by letter of credit agreements with a bank. The Company is required under certain industrial revenue bond agreements to maintain cash reserves in the amount of the bond interest payments due within one year. At March 31, 1998 and 1997, there were approximately $969,000 and $885,000 recorded, respectively, as restricted cash associated with the outstanding industrial revenue bonds.
The Company has a $3,500,000 revolving line of credit with a bank, payable on demand, with a variable interest rate of 8.5% at March 31, 1998 and 1997, collateralized by certain assets of the Company. At March 31, 1998 and 1997, no amount was outstanding under this line of credit.
Payments of principal due on long-term debt for the five-year period from March 31, 1998 and thereafter are:
Cash payments for interest in fiscal 1998, 1997 and 1996 were approximately $1,664,000, $1,875,000 and $996,000, respectively.
STERIGENICS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
On July 30, 1997, the Company issued an industrial revenue bond in the amount of $5.0 million which bears a variable interest rate. The interest rate was 3.9% at issuance, and on March 31, 1998.
4. REDEEMABLE PREFERRED STOCK
In August 1997, the Company completed its initial public offering of 2,000,000 shares of its Common Stock at a price of $12.00 per share, raising net proceeds of $21.4 million. The shares of Series A Redeemable Preferred Stock were redeemed for $1,500,000 from the proceeds of the initial public offering.
Series A Redeemable Preferred Stock was not convertible and had no voting rights. In the event of liquidation, Series A stockholders were entitled to receive $100.00 per share plus all declared but unpaid dividends prior to any distribution to the common stockholders.
5. STOCKHOLDERS' EQUITY
Convertible Preferred
Each share of the Company's outstanding convertible Preferred Stock was automatically converted to a share of Common Stock during the initial public offering in August 1997.
Each share of Series B Preferred Stock was convertible into one share of the Company's Common Stock, had voting rights, had a liquidation preference of $5.00 per share, was subordinate to the Series A Preferred Stock, and permitted noncumulative dividends to be declared at the discretion of the Board of Directors. In any fiscal year, dividends of $0.50 per share for Series B Preferred Stock must be paid before any dividends on Common Stock.
Each share of Series C Preferred Stock was convertible into one share of the Company's Common Stock, had voting rights, had a liquidation preference of $11.00 per share, was subordinate to the Series A and B Preferred Stock, and permitted noncumulative dividends to be declared at the discretion of the Board of Directors. In any fiscal year, dividends of $1.10 per share for Series C Preferred Stock must be paid before any dividends on Common Stock.
No dividends have been declared to date by the Board of Directors on any of the outstanding Preferred Stock.
Stock Option Plans
Under the 1985 Incentive Stock Option Plan and the Second Amended and Restated 1986 Stock Option Plans, the Board of Directors were able to grant options to key employees to purchase up to 1,210,000 shares of Common Stock at not less than fair value on the date of grant, as determined by the Board of Directors. The options generally vest with respect to 24% of the shares one year after the options' grant date and with respect to 2% of the shares on a monthly basis for the next 38 months. The option term is ten years, and options expire at the end of the term.
In July, 1997, the stockholders approved the adoption of the 1997 Equity Incentive Plan, as amended, and the 1997 Stock Plan, under which a total of 1,025,000 shares and 175,000 shares, respectively, of the Company's authorized but unissued Common Stock have been reserved for issuance thereunder. Subsequently, the remaining available shares under the 1986 Stock Plan and the 1997 Stock Plan became available for issuance under the 1997 Equity Incentive Plan.
STERIGENICS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Activity under the option plans was as follows:
During fiscal 1996, the Company offered all optionees the right to amend the terms of their outstanding options to lower the exercise price to the then fair value of $4.90 per share, and to reset the vesting schedule. Included above are options to purchase 172,564 shares of Common Stock canceled and regranted during fiscal 1996 with the amended terms.
At March 31, 1998, options outstanding under the stock option plans were as follows:
At March 31, 1997, options to purchase 487,014 shares of Common Stock were exercisable at an average exercise price of $5.01 per share. At March 31, 1996, options to purchase 433,095 shares of Common Stock were exercisable at an average exercise price of $5.02 per share. At March 31, 1998, 764,686 shares were available for future grant under the plans.
The Company has elected to follow APB Opinion No. 25 and related interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS 123), requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB Opinion No. 25, when the exercise price of the Company's employee stock options equals the fair value of the underlying stock on the date of grant, no compensation expense is recognized.
Pro forma information regarding net income and earnings per share is required by FAS 123 and has been determined as if the Company had accounted for its employee stock options under the fair value method of
STERIGENICS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FAS 123. For options granted prior to the initial public offering, the fair value for these options was estimated at the date of grant using the minimum value option pricing method. For options granted subsequent to the initial public offering, the fair value for these options was estimated at the date of grant using the Black-Scholes option pricing model. The following weighted average assumptions were used for the years ended March 31:
The Minimum Value option valuation method may be used by non-public companies to value an award. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected option life. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
Had compensation cost for the Company's stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans consistent with a method prescribed in FAS 123, the Company's net income and net income per share would have been decreased to the pro forma amounts indicated below:
The weighted average fair value of options granted in fiscal 1998 and 1997 was $5.97 and $1.10 per share, respectively.
Because FAS 123 is applicable only to options granted subsequent to March 31, 1995, its pro forma effect will not be fully reflected until the year ending March 31, 2000.
Employee Stock Purchase Plan
In June 1997, the Company adopted the 1997 Employee Stock Purchase Plan ("the Purchase Plan"). The Company has reserved 400,000 shares of Common Stock for issuance thereunder. Under the Purchase Plan, qualified employees are entitled to purchase shares through payroll deductions at 85% of the fair market value at the beginning or end of the offering period, whichever is lower. As of December 31, 1997, shares issued under the Purchase Plan totaled 32,111.
Notes Receivable from Sale of Common Stock to Employees
At March 31, 1998, the Company had notes receivable in the amount of $49,000 arising from the sale of Common Stock to employees. Such notes bear interest at 7% to 9%, are collateralized by the related stock of the Company and are due between April 1998 and August 2000. In April 1998, repayments of $38,000 were received by the Company.
STERIGENICS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. TAXES ON INCOME
The provision for income taxes for the years ended March 31 consists of the following:
The tax benefits associated with disqualifying dispositions of stock options or employee stock purchase plan shares reduced taxes currently payable as shown by $93,084 for 1998. Such benefits are credited to paid-in-capital when realized. The total provision for income taxes differs from the amount computed by applying the statutory federal income tax to income before taxes as follows:
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the deferred tax assets and liabilities at March 31, 1998 and 1997 are as follows:
At March 31, 1998, the Company had federal and state alternative minimum tax credit carryforwards of approximately $1,860,000 and $162,000, respectively, which do not expire, and other carryforwards of approximately $70,000 expiring in fiscal 2005. Utilization of the carryforwards may be subject to a substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986 and similar state provisions.
Cash payments made for income taxes, net of refunds received, were $1,696,000, $805,000 and $11,000 during fiscal 1998, 1997 and 1996, respectively.
STERIGENICS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. EMPLOYEE BENEFIT PLAN
Effective February 1, 1990, the Company established a defined contribution retirement plan, the SteriGenics 401(k) plan, which covers all employees, age 21 or older, with at least six months of service. Employees may make contributions by a percentage reduction in their salaries of up to a statutory limit of $10,000 for calendar year 1998. Company contributions consist of matching funds equal to 50% of the first 5% of employee eligible earnings contributed, as well as discretionary profit sharing amounts. Effective April 1, 1996, the Company increased the matching contribution percentage from 25% to 50%. Company contributions were $176,000, $122,000 and $44,000 for fiscal 1998, 1997 and 1996, respectively. Administrative expenses related to the plan are not significant.
8. COMMITMENTS AND CONTINGENCIES
The Company leases a portion of its Cobalt 60 isotope under capital leases having terms of 15 years. Assets acquired by the Company under such lease arrangements are included on the consolidated balance sheet as follows:
The Company leases certain facilities and a portion of its Cobalt 60 isotope under noncancelable operating leases. At March 31, 1998, future minimum lease payments under operating leases and capital leases are as follows (including approximately $1.6 million under operating leases, at then current exchange rates, payable in Canadian dollars):
In conjunction with the RTI, Inc. ("RTI") Asset Acquisition Agreement (see Note 11) the Company leases a facility in Rockaway, New Jersey and is required by the New Jersey Department of Environmental Protection ("NJDEP") to maintain a standby letter of credit in the amount of $500,000, contingent upon the continued environmental clean up efforts required of the property owners, RTI. The required amount of the letter of credit decreases over the life of the building lease, and/or as the NJDEP deems required.
Additionally, RTI has the option to require the Company to purchase the Rockaway land and buildings on the sixth anniversary of the lease commencement date for a purchase price equal to $138,376. RTI may only exercise the option upon receipt of proof that environmental remediation of the property was complete to
STERIGENICS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
the extent that the Company would not have any material liability for further environmental remediation and the property has been removed from the national priorities list.
In the normal course of the Company's operations, it is subject to various claims and litigation, the outcomes of which, in the opinion of management, will not have a material adverse effect on the Company's financial position or results of operations.
Total rent expense for fiscal 1998, 1997 and 1996 was $1,167,000, $1,318,000 and $1,246,000, respectively.
9. TRANSACTIONS WITH RELATED PARTIES AND MINORITY STOCKHOLDERS
In June 1997, the Company entered into operating leases with its chairman on the two sterilization facilities previously rented on a month to month basis. The leases have 60 month terms which expire in June 2002 with annual rent expense of approximately $419,000.
Rent expense attributable to these related party leases was approximately $407,000 in the fiscal year ended March 31, 1998, and $472,000 in fiscal 1997 and 1996. The Company also leases one facility and its corporate offices from a publicly traded real estate investment trust of which its chairman is a minority shareholder, but is neither a director nor an officer.
Included in costs and expenses are approximately $1,168,000, $2,116,000 and $1,189,000 for fiscal 1998, 1997 and 1996, respectively, relating to payments to a minority stockholder for administrative, maintenance and engineering services.
10. INVESTMENTS IN JOINT VENTURES
In January 1997, the Company sold the majority of its holdings in a joint venture in a sterilization facility in Taiwan for $1,249,000. This investment was accounted for under the equity method. No gain or loss was recorded related to this transaction. The carrying value of the remaining investment was $1,000 at March 31, 1998 and 1997.
11. ACQUISITIONS
On February 26, 1996, the Company, through its subsidiary SteriGenics East Corporation, entered into an agreement to acquire certain assets and liabilities of RTI, Inc., a New York corporation, and its subsidiaries that operated three irradiation facilities along the eastern seaboard of the United States. At March 31, 1996, the Company had an initial investment of $236,000 in RTI. The acquisition was finalized in August 1996 with a net purchase price of approximately $4,872,000, and was accounted for as a purchase. The initial investment was applied toward the purchase price upon completion of the acquisition. The consolidated statements of operations include the results of operations of RTI subsequent to the acquisition date. The Company recorded approximately $580,000 of goodwill which is being amortized over a fifteen-year period. Accumulated amortization of goodwill, related to this acquisition, was approximately $58,000 at March 31, 1998.
On December 31, 1997, the Company acquired certain assets of the Nicolet Electron Services Division of ThermoSpectra Corporation ("Nicolet") for a net purchase price of approximately $7 million, $5 million in cash and 109,307 shares of the Company's Common Stock valued at approximately $2 million. The consolidated statements of operations include the results of operations of Nicolet from the date of acquisition. The Company recorded approximately $3.8 million of goodwill in connection with the acquisition, which is being amortized over a twenty-year period. Accumulated amortization of goodwill, related to this acquisition, was approximately $47,000 at March 31, 1998. Under the asset acquisition agreement, ThermoSpectra Corporation may under certain circumstances be entitled to receive up to an additional 21,861 shares of Common Stock of the Company.
STERIGENICS INTERNATIONAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The following unaudited pro forma summary represents the Company's consolidated results of operations for the periods presented on the following basis: (i) as if the acquisition of RTI had occurred on April 1, 1995 and is therefore included in all periods presented and (ii) as if the acquisition of Nicolet had occurred on April 1, 1996 and is therefore included in the year ended March 31, 1998 and 1997. Such pro forma results do not purport to be indicative of what would have occurred had the acquisitions been made as of those dates or the results which may occur in the future.
12. SUBSEQUENT EVENTS (UNAUDITED)
The following events occurred subsequent to March 31, 1998.
During April 1998, the Company received $38,000 in repayments of notes receivable from the sale of stock to employees.
On June 4, 1998, the Company entered into an operating lease on a building with a total lease commitment of approximately $4.3 million and a term of 10 years.
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders SteriGenics International, Inc.
We have audited the accompanying consolidated balance sheets of SteriGenics International, Inc. as of March 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended March 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of SteriGenics International, Inc. at March 31, 1998 and 1997, and the consolidated results of its operations and its cash flows for each of the three years in the period ended March 31, 1998, in conformity with generally accepted accounting principles.
ERNST & YOUNG LLP
Palo Alto, California May 1, 1998
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The directors and executive officers of the Company as of March 31, 1998 are as follows:
- --------------- (1) Member of Audit Committee and Compensation Committee.
All directors hold office until the next annual meeting of the stockholders and until their successors have been duly elected and qualified. Officers are elected by and serve at the direction of the Board of Directors. There are no family relationships among the directors or officers of the Company.
James F. Clouser joined SteriGenics in June 1988 as President and Chief Executive Officer. Previously, from 1984 to 1988 he served as Chief Operating Officer of Attain, Inc., a high technology start-up manufacturer of automatic test equipment for semiconductor devices. Mr. Clouser has a Bachelor of Science degree in Electrical Engineering from Pennsylvania State University, a Masters of Business Administration degree in Finance from Wayne State University, and a Masters of Science degree in Accounting from Rochester Institute of Technology.
D. Patterson Adams joined SteriGenics in January 1998 as Vice President and General Manager of the Non-Medical Division. Prior to joining SteriGenics, Mr. Adams served as a consultant to health care providers and medical manufacturers as President of VestCorp, an investment holding company, from July 1995 to January 1998. Mr. Adams served as Chief Operating Officer of Progressive Capital Investment Corporation from July 1993 to June 1995. From June 1988 to June 1993, Mr. Adams was Vice President of EtO Operations for Isomedix, Inc. Mr. Adams earned his Bachelor of Science Degree in Biology from the University of Memphis.
Eric W. Beers joined SteriGenics in February 1994 as Senior Vice President of Engineering. Prior to joining SteriGenics and since 1980, Mr. Beers held several engineering and managerial positions with Nordion, a supplier of Cobalt 60 and irradiation equipment, the most recent of which was as Manager of the Industrial Irradiation Engineering Department. Mr. Beers has a degree in Mechanical/Aeronautical Engineering from Carleton University in Canada and is a Member of the Association of Professional Engineers of Ontario, Canada.
Donald A. Currie joined SteriGenics in March 1991 as General Manager of the Westerville facility. In August 1994, Mr. Currie became Director of Operations overseeing the Westerville and Schaumburg facilities and was promoted to Vice President of Operations, Non-Medical in November 1996. In January 1998,
Mr. Currie became Vice President of Operations, Eastern Region. Mr. Currie has a Bachelor of Arts degree in Materials and Operations Management from Michigan State University.
Eugene C. Davis joined SteriGenics in April 1994 as Vice President of Quality Assurance and Regulatory Affairs. In January 1996, he became Vice President of Sales and Marketing, and in July 1997, he became the Vice President of Operations for the Western Region. From 1979 to 1993 Mr. Davis held various positions with the Opthalmic Surgical Products Division of Optical Radiation Corporation, an opthalmic surgical products company, the most recent of which was Vice President of Quality Assurance. Mr. Davis has a Bachelor of Arts degree from California State Polytechnic University at Pomona.
Lisa C. Foster joined SteriGenics in January 1989 as Quality Assurance Manager at the Decatur facility. In February 1990, Ms. Foster transferred to the Schaumburg facility as Quality Assurance Manager. Later that year she joined the Corporate staff, assuming the responsibility of Corporate Quality Assurance Manager. In April 1992, Ms. Foster was promoted to Director of Corporate Quality Assurance and in June 1997 was promoted to Vice President of Quality Assurance. Ms. Foster has a Bachelor of Science degree in Food and Nutrition from Mississippi University for Women and a Masters of Science degree in Food Chemistry from Mississippi State University.
David E. Meyer joined SteriGenics in November 1989 as General Manager of the Schaumburg facility and in May 1991 was promoted to Senior Vice President of Operations. In July 1997, Mr. Meyer was promoted to President of Medical Products Division. From 1976 to 1989, Mr. Meyer held various positions with the Barber-Greene Company, a producer of road construction equipment, most recently that of Manufacturing Manager. Mr. Meyer has a Bachelor of Science degree in Business Administration from Valparaiso University and a Masters of Science degree in Management from Aurora University.
Charles W. King, Jr., a founder of the Company, has been Chairman of the Board of SteriGenics since its inception. Mr. King is a private investor and real estate developer and has been a Managing Partner in Charles King & Associates since 1965.
Walter G. Kortschak became a director of the Company in September 1993. Mr. Kortschak is a General Partner of Summit Partners, L.P., where he has been employed since June 1989. Summit Partners and its affiliates manage a number of venture capital funds, including Summit Ventures III, L.P. and Summit Investors II, L.P., which are principal stockholders of the Company. Mr. Kortschak also serves as a director of Diamond Multimedia Systems, Inc., HMT Technology Corporation, and Simulation Sciences Inc. Mr. Kortschak formerly served as a director of McAfee Associates, Inc.
Thomas F. Stephenson became a director of the Company in September 1993. Mr. Stephenson is a General Partner of Sequoia Capital, where he has been employed since 1988. Sequoia Capital and its affiliates manage a number of venture capital funds, including Sequoia Capital Growth Fund and Sequoia Technology Partners III, which are principal stockholders of the Company.
James R. Yarter became a director of the Company in January 1998. Mr. Yarter has been a consultant to medical device manufacturers since April 1996. From October 1995 to April 1996, Mr. Yarter served as President and Chief Executive Officer of U.S. Medical, a medical device company. From February 1994 to October 1995, Mr. Yarter was President and Chief Executive Officer of BLOCK Medical, a medical device company. Mr. Yarter provided private consulting services to medical device manufacturers from 1990 to February 1994. Previously, Mr. Yarter served as a corporate officer at C.R. Bard, a medical equipment and supplies manufacturer.
Director Nominee
Frederick J. Ruegsegger has been the Senior Vice President, Finance and Corporate Development and Chief Financial Officer of AXYS Pharmaceuticals, Inc. since January 1998. Prior to that he served as Vice President, Finance and Administration and Chief Financial Officer of Arris Pharmaceutical Corporation from December 1996 until January 1998. From 1993 to 1996, he was President and Chief Executive Officer of EyeSys Technologies, Inc., a medical instrument and software company. Mr. Ruegsegger received a B.S. degree in Economics from the University of Illinois and a Master of Management from Northwestern University's Kellogg Graduate School of Management.
Information regarding compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, (the "Exchange Act") is incorporated herein by reference from the section entitled "Compliance with Section 16(a) of the Exchange Act" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act in connection with the registrant's Annual Meeting of Stockholders to be held on August 5, 1998 (the "Proxy Statement"). The Proxy Statement is anticipated to be filed within 120 days after the end of the registrant's fiscal year ended March 31, 1998.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information regarding executive compensation is incorporated herein by reference from the section entitled "Executive Compensation and Related Information" of the Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information regarding security ownership of certain beneficial owners and management is incorporated herein by reference from the section entitled "Stock Ownership of Certain Beneficial Owners and Management" of the Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding certain relationships and related transactions is incorporated herein by reference from the section entitled "Certain Relationships and Related Transactions" of the Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
- ---------------
++ Incorporated by reference from the exhibit of the same number in the Registrant's Registration Statement on Form S-1 (Registration No. 333-30047) as filed with the SEC on June 24, 1997.
* Incorporated by reference from Exhibit 4.1 of the Registrant's SEC Filing on Form 8-K as filed with the SEC on January 14, 1998.
** Incorporated by reference from Exhibit 2.1 of the Registrant's SEC filing on Form 8-K as filed with the SEC on January 14, 1998.
(b) Reports on Form 8-K
On January 14, 1998 the Company filed a Report on Form 8-K with the Securities and Exchange Commission relating to the acquisition of certain assets and liabilities of the Nicolet Electron Services Division of ThermoSpectra Corporation. The Company did not file any financial statements in connection with such filing.
(c) Exhibits
See (a)(3) above.
(d) Valuation and Qualifying Accounts Years Ended March 31, 1996, 1997 and
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
STERIGENICS INTERNATIONAL, INC.
By: /s/ JAMES F. CLOUSER -------------------------------------- James F. Clouser President, Chief Executive Officer and Director (Principal Executive and Financial Officer)
Date: June 25, 1998
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the dates indicated.
STERIGENICS INTERNATIONAL, INC. SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS MARCH 31, 1998 (IN THOUSANDS)
- ------------------------
(1) Uncollectible accounts written off, net of recoveries.
INDEX TO EXHIBITS
- ---------------
++ Incorporated by reference from the exhibit of the same number in the Registrant's Registration Statement on Form S-1 (Registration No. 333-30047) as filed with the SEC on June 24, 1997.
* Incorporated by reference from Exhibit 4.1 of the Registrant's SEC Filing on Form 8-K as filed with the SEC on January 14, 1998.
** Incorporated by reference from Exhibit 2.1 of the Registrant's SEC filing on Form 8-K as filed with the SEC on January 14, 1998.