NOTE 1 — GENERAL

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the results of operations, financial position and cash flows of MWI Veterinary Supply, Inc. and its wholly-owned subsidiaries (collectively referred to as “we,” “us,” and “our” throughout this Form 10-Q). All intercompany balances have been eliminated.

In the opinion of our management, the accompanying unaudited condensed consolidated financial statements include all adjustments necessary to present fairly, in all material respects, our results for the periods presented. These condensed consolidated financial statements have been prepared by us pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and accompanying notes included in our 2011 Annual Report on Form 10-K filed with the SEC on November 28, 2011. The results of operations for the three months ended months ended December 31, 2011 are not necessarily indicative of results to be expected for the entire fiscal year.

Our unaudited condensed consolidated balance sheet as of September 30, 2011 has been derived from the audited consolidated balance sheet as of that date.

Use of Estimates

The accompanying unaudited condensed consolidated financial statements have been prepared on the accrual basis of accounting using accounting principles generally accepted in the United States. In preparing financial information, we use certain estimates and assumptions that may affect the reported amounts and disclosures. Some of these estimates require difficult, subjective and complex judgments about matters that are inherently uncertain. As a result, actual results could differ materially from these estimates. Estimates are used when accounting for, among other items, sales returns, allowance for doubtful accounts, customer incentives, vendor rebates, inventories, goodwill and intangible assets, income taxes, impairment of long-lived assets, depreciation and amortization, employee benefits, unearned income and contingencies. The estimates of fair value of assets and liabilities and the disclosure of contingent assets and liabilities as of the balance sheet date and reported amounts of revenue and expenses for the periods are based on assumptions that we believe to be reasonable.

Revenue Recognition

We sell products we source from 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 the vendor. When a customer places an order with us, we pick, pack, ship and invoice the customer for the order. We recognize revenue from “buy/sell” transactions as product sales when the product is delivered to the customer. We accept product returns from our customers. We estimate returns based on historical experience and recognize these estimated returns as a reduction of product sales. Product returns have historically not been significant to our financial statements. We record revenues net of sales tax. In an agency relationship, we generally do not purchase and take inventory of products from vendors. We receive an order from a customer, then transmit the order to the vendor, who picks, packs and ships the order to the customer. In some cases, the vendor invoices and collects payment from the customer, while in other cases we invoice and collect payment from the customer on behalf of the vendor. We receive a commission payment for soliciting the order from the customer and for providing other customer service activities. Commissions are recognized when the services upon which the commissions are based are complete. Gross billings from agency contracts were $68,031 and $70,565 for the three months ended December 31, 2011 and 2010, respectively, and generated commission revenue of $3,746 and $3,714, respectively.

Customer incentives are accrued based on the terms of the contracts with each customer. These incentive programs provide that the customer receive an incentive based on their product purchases or attainment of performance goals. Incentives are estimated based on the specific terms in each agreement, historical experience and product growth rates. Incentives are recognized as a reduction to product sales.

Cost of Product Sales and Vendor Rebates

Cost of product sales consist of our inventory product cost, including shipping and delivery costs to and from our distribution centers. Vendor rebates are recorded based on the terms of the contracts or programs with each vendor. Many of our vendors' rebate programs are based on a calendar year. We may receive quarterly, semi-annual or annual performance-based rebates from third-party vendors based upon attainment of certain sales and/or purchase goals. Sales rebates are classified in the 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 classified as a reduction of inventory until the product is sold. When the inventory is sold and purchase measures are achieved, purchase rebates are recognized as a reduction to cost of product sales.

Historically, actual results have not significantly deviated from those determined using the estimates described above. We expect that our estimates in the future will continue to be reasonable as our rebates are based on specific vendor program goals and are principally recorded upon achievement of sales or purchase performance measures. Vendors may change or eliminate rebate programs from year to year.

In May 2011, the FASB issued guidance to provide a consistent definition of fair value and ensure that the fair value measurement and disclosure requirements are similar between generally accepted accounting principles in the United States and International Financial Reporting Standards. The guidance changes certain fair value measurement principles and enhances the disclosure requirements, particularly for Level 3 fair value measurements. The guidance is effective for our fiscal year beginning October 1, 2012. We do not believe that the adoption of this guidance will have a material impact on our consolidated financial statements.

In June 2011, the FASB issued guidance on the presentation of comprehensive income in an entity's financial statements. The guidance requires that comprehensive income be presented either in one continuous statement or in two separate but consecutive statements presenting the components of net income and its total, the components of other comprehensive income and its total, and total comprehensive income. The guidance also requires that reclassification adjustments from other comprehensive income to net income be presented in both the components of net income and the components of other comprehensive income. The guidance is effective for our fiscal year beginning October 1, 2012. We do not believe that the adoption of this guidance will have a material impact on our consolidated financial statements.

On March 21, 2011, MWI Veterinary Supply Co. (“MWI Co.”) purchased substantially all of the assets of Nelson Laboratories Limited Partnership (“Nelson”) for $7,000 in cash. Nelson was a distributor of animal health products to over 1,100 veterinary practices, primarily in the Midwestern United States. This acquisition allows us to better serve our customers in this region of the United States. An intangible asset representing customer relationships acquired in the acquisition has an estimated useful life of 10 years. The amount recorded in goodwill is expected to be deductible for tax purposes over 15 years.

On October 31, 2011, MWI Co. purchased substantially all of the assets of Micro Beef Technologies, Ltd. (“Micro”) for $60,880, including $53,400 in cash and 94,359 shares of common stock valued at $7,158, which is the fair value as of the date of acquisition and an estimated working capital adjustment of $322. The purchase price remains subject to a post-closing working capital and debt adjustment. Micro was 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. Micro also was a leading innovator of proprietary, computerized management systems for the production animal market. The intangible assets acquired in the acquisition include customer relationships, covenant not to compete, technology and trade name. The useful life of the amortizing intangible assets ranges from 5 years to 17 years. Trade name is a non-amortizing intangible asset. The amount recorded in goodwill is expected to be deductible for tax purposes over 15 years.

The following table summarizes the fair values of the assets acquired and liabilities assumed at the date of acquisition, which may be adjusted during the allocation period as defined in Accounting Standards Codification (“ASC”) 280. These purchase price allocations are based on a combination of valuations and analyses.

The following table presents information for Micro that is included in our consolidated statements of income from the acquisition date of October 31, 2011 through the end of the quarter ended December 31, 2011:

The following table presents supplemental pro forma information as if the acquisition of Micro had occurred on October 1, 2011 for the three months ended December 31, 2011 and on October 1, 2010 for the three months ended December 31, 2010 (unaudited):

The unaudited pro forma consolidated results are not necessarily indicative of what our consolidated results of operations would have been had we completed the acquisition on October 1, 2011 or 2010. Additionally, the unaudited pro forma consolidated results do not purport to project the future results of operations of the combined company.

Product sales resulting from transactions with Banfield, The Pet Hospital (“Banfield”) were approximately 6% of total product sales during the three months ended December 31, 2011 and 2010, respectively. Approximately 7% and 8% of our trade receivables resulted from transactions with Banfield as of December 31, 2011 and September 30, 2011, respectively.

Depreciation expense was $1,458 and $1,085 for the three months ended December 31, 2011 and 2010, respectively.

The changes in the carrying value of goodwill are as follows:

Balances of intangibles are as follows:

Amortization expense was $738 and $407 for the three months ended December 31, 2011 and 2010, respectively. Estimated future annual amortization expense related to intangible assets as of December 31, 2011 is as follows:

The above projection of amortization expense includes preliminary estimates of intangible assets and lives associated with the acquisition of Micro. These amounts may be adjusted during the allocation period as defined in ASC 805.

The following table presents the outstanding debt and capital lease obligations as of December 31, 2011 and September 30, 2011:

Revolving Credit Facility — On November 1, 2011, MWI Co. as borrower, entered into a Third Amendment to Credit Agreement (the “Third Amendment”) with MWI Veterinary Supply, Inc. and Memorial Pet Care, Inc., as guarantors, and Bank of America, N.A. and Wells Fargo Bank, N.A. as lenders (collectively, the “Lenders”), amending the Credit Agreement dated December 13, 2006, and as amended from time to time, by and among Supply Co., MWI Veterinary Supply, Inc., Memorial Pet Care, Inc. and the Lenders (the “Credit Agreement”). The Third Amendment increased the aggregate revolving commitment of the Lenders under the Credit Agreement from $100,000 to $150,000 and extended the maturity date of the Credit Agreement from March 1, 2013 to November 1, 2016. Under the Third Amendment, the margin on variable interest rate borrowings now ranges from 0.95% to 1.50%. The margin previously ranged from 1.50% to 2.25% under the Second Amendment. The Third Amendment also reduced the commitment fee from a range of 0.2% to 0.35% to a range of 0.15% to 0.25% depending on the funded debt to EBITDA ratio. The Credit Agreement contains financial covenants, including a fixed charge ratio and a funded debt to EBITDA ratio. We were in compliance with all of the covenants as of December 31, 2011 and September 30, 2011.

Sterling revolving credit facility— On November 5, 2010, Centaur Services Limited (“Centaur”) entered into a £12,500 unsecured revolving line of credit facility (the “sterling revolving credit facility”) with Wells Fargo Bank, N.A. London Branch (“Wells Fargo”). The sterling revolving credit facility is for a three year term with interest paid at the end of the applicable one month, three month or six month interest period. Interest is based on LIBOR for the applicable interest period plus an applicable margin of 1.05% to 1.90%. The facility contains financial covenants requiring Centaur to maintain a minimum tangible net worth of £3,000. As of December 31, 2011 and September 30, 2011, Centaur was in compliance with the covenant.

Current fair value accounting guidance includes a hierarchy that is intended to increase consistency and comparability in fair value measurements and disclosures. This hierarchy prioritizes inputs to valuation techniques based on observable and unobservable data. The guidance categorizes these inputs used in measuring fair value into three levels which include the following:

• Level 1 – observable inputs such as quoted prices in active markets;
• Level 2 – inputs, other than quoted prices, that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active; and
• Level 3 – unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

As of December 31, 2011 and September 30, 2011, financial instruments include cash and cash equivalents, receivables and accounts payable, and the fair values approximate book values due to their short maturities.

In November 2011, we amended our revolving credit facility in the United States and in November 2010, we amended our sterling revolving credit facility in the United Kingdom. Because these amendments were done relatively recently and include interest rates based on current market conditions, we believe that the estimated fair value of our debt was materially the same as our carrying value.

2002 Stock Plan

We have a 2002 Stock Plan (the “2002 Plan”) to provide our directors, executives and other key employees with additional incentives by allowing them to acquire an ownership interest in us and, as a result, encouraging them to contribute to our success. As of December 31, 2011 and September 30, 2011, we had 64,032 and 67,032 shares, respectively, of our common stock available for issuance under the 2002 Plan. The options granted under the 2002 Plan are nonqualified stock options that have an exercise price per share equal to fair market value of the common stock at the time of grant. The term of each option is determined by our board of directors or by a designated committee of the board. The term of any option may not exceed ten years from the date of grant. As of December 31, 2011, 3,592 options to purchase common stock were outstanding with a weighted average exercise price of $0.18 per share and expiring through June 2012.

2005 Stock Plan

We have a 2005 Stock-Based Award and Incentive Compensation Plan (the “2005 Plan”), under which we may offer restricted and unrestricted shares of our common stock and grant options to purchase shares of our common stock to selected employees and non-employee directors. The purpose of the 2005 Plan is to promote our long-term financial success by attracting, retaining and rewarding eligible participants. As of December 31, 2011 and September 30, 2011, we had 929,707 and 932,438 shares, respectively, of our common stock available for issuance under the 2005 Plan. As of December 31, 2011, 30,361 options to purchase common stock were outstanding with a weighted average exercise price of $17.85 per share and expiring through September 2015.

The 2005 Plan permits us to grant stock options (both incentive stock options and non-qualified stock options), restricted and unrestricted stock and deferred stock. The compensation committee will determine the number and type of stock-based awards to each participant, the exercise price of each award, the duration of the award (not to exceed ten years), vesting provisions and all other terms and conditions of such award in individual award agreements. The 2005 Plan provides that upon termination of employment with us, unless determined otherwise by the compensation committee at the time options are granted, the exercise period for vested awards will generally be limited, provided that vested awards will be canceled immediately upon a termination for cause or voluntary termination. The 2005 Plan provides for the cancellation of all unvested awards upon termination of employment with us, unless determined otherwise by the compensation committee at the time awards are granted.

We did not grant common stock options during each of the three months ended December 31, 2011 and 2010. During the three months ended December 31, 2011 and 2010, we issued 3,500 and 300 shares of restricted stock under the 2005 Plan. During the three months ended December 31, 2011 and 2010, we recognized $432 and $247 of compensation expense related to stock grants, respectively.

We also have an employee stock purchase plan (“ESPP”) that allows substantially all employees to purchase shares of our common stock at 95% of the fair market value on the date of purchase. The purchase date is the last trading date of the purchase periods, which begin in March, June, September and December. Employees accumulate amounts through payroll deductions during the purchase period of between 1% and 10% but no more than $20 annually. An employee is allowed to purchase a maximum of 200 shares per purchase period. During the three months ended December 31, 2011 and 2010, we issued 2,113 and 1,734 shares, respectively, of our common stock under the ESPP.

Our effective tax rate for each of the three months ended December 31, 2011 and 2010 was 38.6% and 38.3%, respectively. The increase in the effective tax rate is primarily attributable to greater domestic pre-tax income.

As of December 31, 2011, we had $23 of unrecognized tax benefits, of which $15 would impact our effective rate if recognized. Our policy for classifying interest and penalties associated with unrecognized tax benefits is to include such items in income tax expense. The amount of interest and penalties recognized during the three months ended December 31, 2011 and 2010 was not material.

With few exceptions, we are no longer subject to income tax examination for years before 2007 in the U.S. and significant state and local jurisdictions. We are no longer subject to income tax examination for years before 2009 in significant foreign jurisdictions.

(In thousands, except per share data)

MWI Co. holds a 50.0% membership interest in Feeders' Advantage LLC (“Feeders' Advantage”). MWI Co. charged Feeders' Advantage for certain operating and administrative services in the amounts of $263 and $241 for the three months ended December 31, 2011 and 2010, respectively. Sales of products to Feeders' Advantage were $15,558 and $14,723, which represented 3% and 4% of total product sales for each of the three months ended December 31, 2011 and 2010, respectively.

MWI Co. provides Feeders' Advantage with a line-of-credit to finance its day-to-day operations. This line-of-credit bears interest at the prime rate. The interest due on the line-of-credit is calculated and charged to Feeders' Advantage on the last day of each month. Conversely, to the extent MWI Co. has a payable balance due to Feeders' Advantage, the payable balance accrues interest in favor of Feeders' Advantage at the average federal funds rates in effect for that month. MWI Co. had a payable balance to Feeders' Advantage of $1,141 as of December 31, 2011 and a receivable balance from Feeders' Advantage of $756 as of September 30, 2011.

From time to time, in the normal course of business, we may become a party to legal proceedings that may have an adverse effect on our financial position, results of operations and cash flows. At December 31, 2011, we were not a party to any material pending legal proceedings and were not aware of any claims that could have a material adverse effect on our financial position, results of operations or cash flows.

The components of comprehensive income were as follows:

Revenue Recognition

We sell products we source from 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 the vendor. When a customer places an order with us, we pick, pack, ship and invoice the customer for the order. We recognize revenue from “buy/sell” transactions as product sales when the product is delivered to the customer. We accept product returns from our customers. We estimate returns based on historical experience and recognize these estimated returns as a reduction of product sales. Product returns have historically not been significant to our financial statements. We record revenues net of sales tax. In an agency relationship, we generally do not purchase and take inventory of products from vendors. We receive an order from a customer, then transmit the order to the vendor, who picks, packs and ships the order to the customer. In some cases, the vendor invoices and collects payment from the customer, while in other cases we invoice and collect payment from the customer on behalf of the vendor. We receive a commission payment for soliciting the order from the customer and for providing other customer service activities. Commissions are recognized when the services upon which the commissions are based are complete. Gross billings from agency contracts were $68,031 and $70,565 for the three months ended December 31, 2011 and 2010, respectively, and generated commission revenue of $3,746 and $3,714, respectively.

Customer incentives are accrued based on the terms of the contracts with each customer. These incentive programs provide that the customer receive an incentive based on their product purchases or attainment of performance goals. Incentives are estimated based on the specific terms in each agreement, historical experience and product growth rates. Incentives are recognized as a reduction to product sales.

Cost of Product Sales and Vendor Rebates

Cost of product sales consist of our inventory product cost, including shipping and delivery costs to and from our distribution centers. Vendor rebates are recorded based on the terms of the contracts or programs with each vendor. Many of our vendors' rebate programs are based on a calendar year. We may receive quarterly, semi-annual or annual performance-based rebates from third-party vendors based upon attainment of certain sales and/or purchase goals. Sales rebates are classified in the 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 classified as a reduction of inventory until the product is sold. When the inventory is sold and purchase measures are achieved, purchase rebates are recognized as a reduction to cost of product sales.

Historically, actual results have not significantly deviated from those determined using the estimates described above. We expect that our estimates in the future will continue to be reasonable as our rebates are based on specific vendor program goals and are principally recorded upon achievement of sales or purchase performance measures. Vendors may change or eliminate rebate programs from year to year.

In May 2011, the FASB issued guidance to provide a consistent definition of fair value and ensure that the fair value measurement and disclosure requirements are similar between generally accepted accounting principles in the United States and International Financial Reporting Standards. The guidance changes certain fair value measurement principles and enhances the disclosure requirements, particularly for Level 3 fair value measurements. The guidance is effective for our fiscal year beginning October 1, 2012. We do not believe that the adoption of this guidance will have a material impact on our consolidated financial statements.

In June 2011, the FASB issued guidance on the presentation of comprehensive income in an entity's financial statements. The guidance requires that comprehensive income be presented either in one continuous statement or in two separate but consecutive statements presenting the components of net income and its total, the components of other comprehensive income and its total, and total comprehensive income. The guidance also requires that reclassification adjustments from other comprehensive income to net income be presented in both the components of net income and the components of other comprehensive income. The guidance is effective for our fiscal year beginning October 1, 2012. We do not believe that the adoption of this guidance will have a material impact on our consolidated financial statements.