ACH

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended September 30, 2001, for Owens & Minor, Inc. (O&M), a distributor of medical and surgical supplies. The filing includes unaudited consolidated financial statements for the three and nine months ended September 30, 2001, compared to the same periods in 2000. The company operates primarily through its subsidiaries and maintains a significant distribution agreement with Novation, LLC, representing approximately 52% of net sales for the first nine months of 2001.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 11% in the third quarter and 9% for the first nine months of 2001 compared to 2000, driven by new business and deeper penetration of existing accounts, particularly Novation.
• Profitability Decline: Net income for the third quarter turned to a loss of $5.4 million from a profit of $8.5 million in the prior year. For the nine-month period, net income dropped to $11.8 million from $23.3 million.
• Cash Flow Reversal: Operating cash flow swung from a positive $37.0 million in the first nine months of 2000 to a negative $39.0 million in 2001. This was primarily due to a significant increase in inventory purchases ($82.3 million outflow) to support sales growth and new customer service requirements.
• Debt Refinancing: In July 2001, the company issued $200 million in new 8.5% Senior Subordinated Notes (2011 Notes) to retire $150 million of higher-interest 2006 Notes. This resulted in an extraordinary loss of $7.1 million (net of tax) due to retirement premiums and write-offs.

Guidance, Outlook, Risks, and Unusual Items

Unusual Items and Adjustments

• Tax Provision: A $7.2 million provision was recorded in the third quarter for estimated tax liabilities and interest related to the IRS disallowance of deductions for corporate-owned life insurance (COLI) programs from 1995-1998. Management disputes this but deems the liability probable.
• Investment Impairment: A $1.1 million impairment charge was recorded for an equity investment in a healthcare e-commerce provider due to a significant decline in market value.
• Restructuring Credits: The company recorded a $1.5 million credit in the second quarter of 2001 due to a reduction in the restructuring reserve from a 1998 plan, as actual costs were lower than estimated.

Outlook and Risks

• Liquidity: Management expects available financing to be sufficient for working capital and growth. As of September 30, 2001, the company had $210.3 million of unused credit under its revolving facility and the ability to sell an additional $171.0 million of receivables.
• Margin Pressure: The company faces continued pressure on operating margins due to cost-control efforts in the medical industry. Gross margin percentage decreased slightly to 10.6%.
• Customer Concentration: Sales to Novation members represented over 50% of net sales. The loss of a major customer could significantly impact the business.
• Accounting Changes: The company will adopt SFAS 142 (Goodwill) in 2002, eliminating goodwill amortization. Management does not expect a transitional impairment loss.

Investor Verification Checklist

• COLI Tax Liability: Verify the status of the IRS appeal regarding the $7.2 million tax provision and the potential for further assessments.
• Inventory Levels: Assess the sustainability of the increased inventory levels ($395.1 million) and the impact on future working capital requirements.
• Debt Service: Confirm the impact of the new 8.5% debt structure on future interest expenses and cash flow coverage.
• Customer Concentration: Monitor the stability of the Novation contract, which accounts for the majority of revenue.
• Investment Recovery: Track the fair value of the impaired e-commerce investment to determine if further write-downs are necessary.