News Column

MWI VETERINARY SUPPLY, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

February 6, 2014

All dollar amounts are presented in thousands, except for per share amounts.

Overview

We are a leading distributor of animal health products in the United States and the United Kingdom. We sell our products primarily to veterinarians in both the companion and production animal markets. Our growth has primarily been from internal growth initiatives and, to a lesser extent, selective acquisitions, including the following transactions:

· On November 1, 2013, we acquired substantially all of the assets of IVESCO, a

value-added distributor of animal health and related products to veterinarians,

food animal producers and dealers in the United States.

· In December 2012, we purchased substantially all of the assets of PCI Animal

Health, a distributor of companion animal health products primarily in the

Northeastern United States.

· In October 2011, we acquired substantially all of the assets of Micro Beef

Technologies, Ltd. ("Micro"), a value-added distributor to the production

animal market, including the distribution of micro feed ingredients,

pharmaceuticals, vaccines, parasiticides, supplies, and other animal health

products. In addition, as a result of the Micro transaction, we now offer

proprietary, computerized management systems for the production animal

market.



We estimate that in the United States approximately 59% of our total revenues have been generated from sales to the companion animal market and 41% from sales to the production animal market during fiscal year 2013. Including the gross billings from agency commissions which are excluded from our total revenues in order to comply with generally accepted accounting principles, we estimate that in the United States approximately 64% of our total revenues have been generated from sales to the companion animal market and 36% from sales to the production animal market during fiscal year 2013. We estimate that approximately two-thirds of our total revenues have been generated from sales to the companion animal market and one-third from sales to the production animal market in the United Kingdom during fiscal year 2013. The state of the overall economy in both the United States and United Kingdom and consumer spending have impacted both the companion animal and production animal markets, with tightening credit markets, volatile commodity prices such as milk, grains, livestock and poultry, and changes in weather patterns (e.g. droughts or seasons of higher precipitation) also affecting demand in the production animal market. Both the companion animal and production animal markets have been integral to our financial results and we intend to continue supporting both markets.

Industry



We believe that the companion animal market in both the United States and United Kingdom has slowed as a result of a decrease in consumer spending, but has shown signs of a recovery in 2012 and 2013. Historically, growth in the companion animal market has been due to the increasing number of households with companion animals, increased expenditures on animal health and preventative care, an aging pet population, advancements in pharmaceuticals and diagnostic testing and extensive marketing programs sponsored by companion animal nutrition and pharmaceutical companies. While the average order size for companion animal health products is often smaller than production animal health products, companion animal health products typically have higher margins. We intend to continue to penetrate this market through internal growth initiatives and selective acquisitions. We believe that some of our customers in this market have experienced liquidity issues as a result of the tightening credit markets.

Product sales in the production animal market in both the United States and United Kingdom are impacted by volatility in commodity prices such as milk, grains, livestock and poultry, changes in weather patterns (e.g. droughts or seasons of higher precipitation that determine how long cattle will graze and consequently the number of days an animal is on feed during a finishing phase) or a change in the general economy, which can shift the number of animals treated, the timing of when animals are treated, to what extent they are treated and with which products they are treated. This could also create cash-flow challenges for these customers and in turn, could impact the time it takes for us to collect our outstanding accounts receivable from these customers as well as affect the overall collectability of these accounts. However, we still believe that it is important to our business to service this market and we intend to continue to support production animal veterinarians with a broad range of products and value­added services. Historically, sales in this market have been largely driven by spending on animal health products to improve productivity, weight gain and disease prevention, as well as a growing focus on food safety.

We generally extend some level of credit to our customers without requiring collateral, which exposes us to credit risk. If customers' cash flow or operating and financial performance deteriorates, or if they are unable to make scheduled payments or obtain other sources of credit, they may not be able to pay or may delay payment to us, or in some cases may

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return products to us. In the United Kingdom, our business relies on a smaller number of relatively larger customers than does our business in the United States. Our customers in the United Kingdom accounted for an aggregate of 12.7% and 14.5% of our consolidated accounts receivable balance as of December 31, 2013 and September 30, 2013, respectively, and one significant customer accounted for 2.4% and 2.6% of our consolidated accounts receivable balance as of December 31, 2013 and September 30, 2013, respectively. We continually assess our customers' ability to pay us and adjust our allowance for doubtful accounts, as necessary.

Our quarterly sales and operating results have varied significantly in the past, and will likely continue to do so in the future. Historically, our total revenues have typically been higher during the spring and fall months due to increased sales of production animal products. Product use cycles for production animal products are directly related to medical procedures performed by veterinarians on production animals during the spring and fall months. These buying patterns can also be affected by the marketing programs or price increase announcements of vendors and distributors, which can cause veterinarians to purchase production animal health products earlier than those products are needed. This kind of early purchasing may reduce our sales in the months these purchases would have otherwise been made.

Sales



We sell products that we source from our vendors to our customers through either a "buy/sell" transaction or an agency relationship with our vendors. In a "buy/sell" transaction, we purchase or take inventory of products from our vendors. When a customer places an order with us, we pick, pack, ship and invoice the customer for the order. We record sales from "buy/sell" transactions, which account for the vast majority of our business, as revenues in conformity with generally accepted accounting principles in the United States. In an agency relationship, we generally do not purchase and take inventory of products from our vendors. When we receive an order from our customer, we transmit the order to our vendor, who picks, packs and ships the order to our customer. In some cases, our vendor invoices and collects payment from our customer, while in other cases we invoice and collect payment from our customer on behalf of our vendor. We receive a commission payment for soliciting the order from our customer and for providing other customer service activities. The aggregate revenues we receive in agency transactions constitute the "commissions" line item on our condensed consolidated statements of income and are recorded in conformity with accounting principles generally accepted in the United States. Our vendors determine the method we use to sell our products. Historically, vendors have occasionally switched between the "buy/sell" and agency models for particular products in response to market conditions related to that particular product. A switch between models can impact our revenues and our operating income. We cannot know in advance when a vendor will switch between the "buy/sell" and agency models or what impact, if any, such a change may have. A switch can occur even with vendors with whom we have written agreements, because most of our agreements with vendors have relatively short terms and are terminable with or without cause on short notice, normally 30 to 90 days. The impact of any individual change from a "buy/sell" to an agency model depends on the costs and expenses associated with a particular product, and can have either a positive or a negative effect on our profitability.

We typically renegotiate vendor contracts annually. These vendor contracts may include terms defining margins, rebates, commissions, exclusivity requirements and the manner in which we go to market. For example, vendors could require us to distribute their products on an exclusive basis, which could cause us to forego distributing competing products which may also be profitable. Conversely, competitors could obtain exclusive rights to market particular products, which we would be unable to market. If we lose the right to distribute products under such exclusive agreements, we may lose access to certain products and lose a competitive advantage. Exclusivity agreements could allow potential competitors to sell products that we cannot offer and erode our market share. In addition, vendors have the ability to expand the distributors that they use which could have a material adverse effect on our business.

Some of our current and future vendors may decide to compete with us in the future by pursuing or increasing their efforts in direct marketing and sales of their products. These vendors could sell their products at lower prices and maintain a higher gross margin on their product sales than we can. In this event, veterinarians or animal owners may elect to purchase animal health products directly from these vendors.

Many of our vendors' rebate programs are based on a calendar year. Historically, the three months ended December 31 has been our most significant quarter for recognition of rebates. Vendor rebates based on sales are classified in our accompanying condensed consolidated statements of income as a reduction to cost of product sales at the time the sales performance measures are achieved. Purchase rebates are measured against inventory purchases from the vendors and are a reduction of inventory until the product is sold. When the inventory is sold, purchase rebates are recognized as a reduction to cost of product sales.

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Vendor Consolidation



Our ten largest vendors supplied products that accounted for approximately 69% of our revenues during each of the three months ended December 31, 2013 and 2012, respectively, and 70% of our revenues for the fiscal year ended September 30, 2013. Zoetis supplied products that accounted for approximately 22% and 21% of our revenues during the three months ended December 31, 2013 and 2012, respectively, and 20% of our revenues for our fiscal year ended September 30, 2013. Of the Zoetis supplied products, production animal products under a livestock agreement accounted for approximately 11% and 12% of our revenues for the three months ended December 31, 2013 and 2012, respectively, and approximately 10% of our revenues for our fiscal year ended September 30, 2013. Elanco supplied products that accounted for approximately 11% of our revenues during the three months ended December 31, 2013 and 10% of our revenues for our fiscal year ended September 30, 2013 and the three months ended December 31, 2012. Merck supplied products that accounted for approximately 10% and 15% of our revenues during the three months ended December 31, 2013 and 2012, respectively, and 14% of our revenues for our fiscal year ended September 30, 2013. Merial, a subsidiary of Sanofi-Aventis, supplies the majority of their products to us under an agency relationship. Commission revenue generated from Merial products accounted for approximately 26% and 53% of total commission revenues during the three months ended December 31, 2013 and 2012, respectively, and 50% of total commission revenues for our fiscal year ended September 30, 2013.

For more information on our business, see our Annual Report on Form 10-K filed with the SEC on November 27, 2013.

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Results of Operations The following table summarizes our results of operations for the three months ended December 31, 2013 and 2012, in dollars and as a percentage of total revenues. Three Months Ended December 31, 2013 % 2012 % Revenues: Product sales $ 662,741 96.4 % $ 549,487 95.9 % Product sales to related party 20,700 3.0 % 19,006 3.3 % Commissions 3,818 0.6 % 4,355 0.8 % Total revenues 687,259 100.0 % 572,848 100.0 % Cost of product sales 598,171 87.0 % 495,919 86.6 % Gross profit 89,088 13.0 % 76,929 13.4 % SG&A expenses 56,073 8.2 % 47,460 8.3 % Depreciation and amortization 2,809 0.4 % 2,392 0.4 % Operating income 30,206 4.4 % 27,077 4.7 % Other income (expense): Interest expense (239) - % (203) - % Earnings of equity method investees 104 - % 93 - % Other 197 - % 204 - % Total other income (expense) 62 - % 94 - % Income before taxes 30,268 4.4 % 27,171 4.7 % Income tax expense (11,829) (1.7) % (10,420) (1.8) % Net income $ 18,439 2.7 % $ 16,751 2.9 % Earnings per common share: Basic $ 1.45$ 1.32 Diluted $ 1.45$ 1.32 Weighted average common shares outstanding (in thousands): Basic 12,707 12,665 Diluted 12,743 12,695 20



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Three Months Ended December 31, 2013 Compared to Three Months Ended December 31, 2012

Total Revenues. Total revenues increased 20.0% to $687,259 for the three months ended December 31, 2013, from $572,848 for the three months ended December 31, 2012. Revenues from the IVESCO business were $75.1 million for the two months during the quarter ended December 31, 2013, which is a seasonally strong time of the year for IVESCO. Excluding the impact of IVESCO revenues, revenue growth in the United States was 9.6% for the three months ended December 31, 2013, compared to the same period in the prior fiscal year. Revenues in the United Kingdom decreased 8.3% from the same period in the prior fiscal year, as a result of a 9.0% organic decrease offset in part by a 0.7% increase related to foreign currency translation.

Revenue growth in the United States benefited from new diagnostic lines, which represented approximately 2.1% of the growth. Growth in flea, tick and heartworm products represented 1.2% of the revenue growth in the United States for the three months ended December 31, 2013. Additional new customers from the acquisition of the PCI Animal Health business represented approximately 0.3% of the growth in the United States, and the growth from existing customers that were also customers of the PCI Animal Health business was approximately 1.1% of the growth.

Product sales to related party increased by 8.9% to $20,700 for the three months ended December 31, 2013, from $19,006 for the three months ended December 31, 2012. Commissions decreased 12.3% to $3,818 for the three months ended December 31, 2013, from $4,355 for the three months ended December 31, 2012. Gross agency billings decreased to $67,514 from $67,661 for the three months ended December 31, 2013 and 2012, respectively. The decrease in commissions was due primarily to veterinarians transitioning to products we sell under buy/sell relationships rather than agency relationships. As a result, an agency incentive that was received during the quarter ended December 31, 2012 was not received during the current quarter.

Gross Profit. Gross profit increased by 15.8% to $89,088 for the three months ended December 31, 2013, from $76,929 for the three months ended December 31, 2012. The change in gross profit is primarily a result of increased total revenues as discussed above. Gross profit as a percentage of total revenues decreased to 13.0% for the three months ended December 31, 2013 from 13.4% for the three months ended December 31, 2012. Product margin as a percentage of total revenues decreased due to the addition of the IVESCO business during the quarter. The product margin on the IVESCO business is generally lower than our overall product margin. This serves to reduce the overall product margin of the consolidated company when compared to our results for the same period in the prior fiscal year. Vendor rebates for the three months ended December 31, 2013 increased by approximately $2,560 compared to the three months ended December 31, 2012.

Selling, General and Administrative ("SG&A"). SG&A expenses increased 18.1% to $56,073 for the three months ended December 31, 2013, from $47,460 for the three months ended December 31, 2012. The increase in SG&A expenses was primarily due to the addition of the IVESCO business during the quarter. SG&A expenses as a percentage of total revenues were 8.2% for the three months ended December 31, 2013 compared to 8.3% for the three months ended December 31, 2012. We incurred $817 of integration and acquisition related costs during the quarter in connection with the acquisition of substantially all of the assets of IVESCO on November 1, 2013.

Depreciation and Amortization. Depreciation and amortization increased 17.4% to $2,809 for the three months ended December 31, 2013, from $2,392 for the three months ended December 31, 2012. The increase was primarily due to amortization for assets acquired from IVESCO.

Income Tax Expense. Our effective tax rate for the three months ended December 31, 2013 and 2012 was 39.1% and 38.3%, respectively. The increase was primarily due to higher estimated state income taxes.

Critical Accounting Policies

The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. The accompanying condensed consolidated financial statements are prepared using the same critical accounting policies discussed in our Annual Report on Form 10-K filed with the SEC on November 27, 2013.

Liquidity and Capital Resources

Our principal sources of liquidity are cash flows generated from operations and borrowings on our credit facilities. We use capital primarily to fund day-to-day operations and to maintain sufficient inventory levels in order to promptly fulfill customer orders and to expand our operations and sales growth. We believe our capital resources, including our ability to borrow funds from our credit facilities, will be sufficient to meet our anticipated cash needs for at least the next twelve months.

We generally extend some level of credit to our customers without requiring collateral, which exposes us to credit risk. If customers' cash flow or operating and financial performance deteriorates, or if they are unable to make scheduled

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payments or obtain other sources of credit, they may not be able to pay or may delay payment to us, or in some cases may return products to us. Any inability of current and/or potential customers to pay us for our products and/or services due to their deteriorating financial condition or otherwise may adversely affect our results of operations and financial condition. Volatility in commodity prices, such as milk, grains, livestock and poultry, and deteriorating economic conditions can have a significant impact on the financial results of our customers. In the United Kingdom, we rely on a smaller number of relatively larger customers than does our business in the United States. Our customers in the United Kingdom accounted for an aggregate of 12.7% and 14.5% of our consolidated accounts receivable balance as of December 31, 2013 and September 30, 2013, respectively, and one significant customer accounted for 2.4% and 2.6% of our consolidated accounts receivable balance as of December 31, 2013 and September 30, 2013, respectively. We continually assess our customers' ability to pay us and adjust our allowance for doubtful accounts, as necessary.

Capital Resources. MWI Co. as borrower, is party to the Credit Agreement, by and among MWI Co., MWI, and Memorial and the Lenders. The Credit Agreement allows for an aggregate revolving commitment of the Lenders of $150,000 and a maturity date of November 1, 2016. Under the Credit Agreement, the margin on variable interest rate borrowings ranges from 0.95% to 1.50%. The commitment fee under the Credit Agreement ranges from 0.15% to 0.25% depending on the funded debt to EBITDA ratio. The variable interest rate is equal to the Daily LIBOR Floating Rate or the LIBOR 1-month, 2-month, 3-month or 6-month fixed rate (at MWI Co.'s option) plus the margin. The facility contains financial covenants, including a fixed charge ratio and a funded debt to EBITDA calculation. We were in compliance with all of the financial covenants as of December 31, 2013 and September 30, 2013. Our outstanding balance on the Credit Agreement at December 31, 2013 was $109,500, and the interest rate was 1.03% as of December 31, 2013.

On February 3, 2014, MWI Co., as borrower, entered into a Fifth Amendment to Credit Agreement (the "Fifth Amendment") among MWI Co., MWI, Memorial and the Lenders. The Fifth Amendment allows for an aggregate revolving commitment of the Lenders under the Credit Agreement of $200,000. All other provisions under the Credit Agreement, as discussed above, remain unchanged.

On March 15, 2013, Centaur entered into the Amendment to the Sterling Revolving Credit Facility dated November 5, 2010 with Wells Fargo Bank, N.A.London Branch. The Amendment increases the maximum loan amount of the Sterling Revolving Credit Facility to £20,000, an increase of £7,500, and extends the term of the facility to November 1, 2016. Interest is based on LIBOR for the applicable interest period plus an applicable margin of 0.95% to 1.50%, and the commitment fee ranges from 0.15% to 0.25%, depending on our funded debt to EBITDA ratio. The facility contains a financial covenant requiring Centaur to maintain a minimum tangible net worth of £5,000. As of December 30, 2013 and September 30, 2013, Centaur was in compliance with the covenant. No balance was outstanding on the Sterling Revolving Credit Facility at December 31, 2013.

Also on March 15, 2013, Centaur entered into the Overdraft Facility with Wells Fargo. The Overdraft Facility allows Centaur to borrow an additional £10,000 to fund short term normal trading cycle fluctuations. The Overdraft Facility will expire on November 1, 2016. Interest on the borrowing under the Overdraft Facility is the same as the terms under the Amendment.

MWI Co. guarantees the obligations of Centaur under the Sterling Revolving Credit Facility and the Overdraft Facility.

Operating Activities. For the three months ended December 31, 2013, cash used by operations was $10,673 and was primarily attributable to a decrease in accounts payable of $61,112. This amount was partially offset by net income of $18,439 and a decrease in receivables of $30,530. The decrease in accounts payable was primarily due to the timing of payments for the strategic inventory purchases made during the fiscal year ended September 30, 2013. The increase in net income is a result of the factors discussed above in "Results of Operations." The decrease in receivables was primarily due to the collections of receivables with extended payment terms, which came due during the quarter.

Investing Activities. For the three months ended December 31, 2013, net cash used in investing activities was $80,806. We acquired substantially all of the assets of IVESCO for $77,360, net of cash acquired of $1,387. Additionally, we paid for capital expenditures of $3,468 which related primarily to technology and equipment purchases.

Financing Activities. For the three months ended December 31, 2013, net cash provided by financing activities was $90,875, which was primarily due to net borrowings of $90,706 on our revolving credit facilities. Our revolving credit facilities are used to fund strategic acquisitions, capital expenditures and meet our working capital requirements.

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Contractual Obligations and Guarantees

For information on our contractual obligations and guarantees, see our Annual Report on Form 10-K filed on November 27, 2013 with the SEC. At December 31, 2013, the only material change to our contractual obligations from those disclosed in our 2013 Form 10-K are due to net borrowings under our Credit Agreement.

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