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IDEXX Laboratories, Inc. (NASDAQ:IDXX)

Q4 2012 Earnings Call

January 29, 2013 9:00 AM ET


Jonathan Ayers - Chairman, President and Chief Executive Officer

Merilee Raines - Executive Vice President, Chief Financial Officer, Treasurer and Assistant Secretary

Pete Levine - Director, Investor Relations


David Clair - Piper Jaffray

Kristina Blaschek - William Blair

Erin Wilson - Bank of America

Ross Taylor - CL King

Jonathan Block - Stifel Nicolaus

Nicholas Jansen - Raymond James & Associates

Ben Haynor - Feltl and Company

Jeff Frelick - Canaccord


Good morning everyone and welcome to the IDEXX Laboratories' fourth quarter 2012 earnings conference call. Participating in the call this morning are Jon Ayers, Chief Executive Officer; Merilee Raines, Chief Financial Officer; and Pete Levine, Director, Investor Relations.

IDEXX would like to preface the discussion today with a caution regarding forward-looking statements. Listeners are reminded that statements that members of IDEXX management may make on this call regarding IDEXX's future expectations, plans and prospects constitute forward-looking statements for purposes of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements can be identified by the use of words such as expects, may, anticipates, intends, would, will, plans, believes, estimates, should, and similar words and expressions. Such statements include but are not limited to statements regarding management's expectations for financial results for future periods. Actual results could differ materially from those indicated by such forward-looking statements. Factors that could cause or contribute to such differences are described in IDEXX's quarterly report on Form 10-Q for the quarter ended September 30, 2012, in the section captioned Risk Factors, which is on file with the SEC and also available on IDEXX's website,

In addition, any forward-looking statements represent IDEXX's estimates only as of today and should not be relied upon as representing the company's expectations as of any subsequent date. The company specifically disclaims any obligation to update or revise any forward-looking statements in the future even if its expectations change.

Also during this call we will be discussing certain financial measures not prepared in accordance with generally accepted accounting principles or GAAP. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP measures is provided in our earnings release which can be found on our website,

Finally, we plan to end today's call by 10:00 AM Eastern. In order to allow broad participation in the Q&A, we ask that each participant limit his or her questions to one with one follow-up as necessary. We do appreciate you may have additional questions, so please feel free to get back into the queue, and if time permits, we will be more than happy to take your additional questions. I would now like to turn the conference over to Merilee Raines.

Merilee Raines

Good morning and thanks for joining us today, as we discuss our fourth quarter 2012 results and outlook for 2013. As we reported this morning, our fourth quarter revenues were $319.5 million, yielding organic growth of 4% and diluted earnings per share were $0.78, a year-to-year increase of 16%. Organic revenue growth was a couple of points shy of our expectation at the time of our third quarter call, with the primarily shortfalls coming from revenue associated with capital placements and our reference labs and consulting services.

As I will explain in further detail momentarily, there were some transitory factors that impacted results such as weather, most notably Hurricane Sandy as well as the timing of the Christmas and New Year holidays. We estimate that their combined impact reduced topline growth by nearly one point.

And looking at the components of overall growth, the metrics for the fundamental growth and value drivers in our principal companion animal businesses, which are chemistry and hematology instrument placements, instrument consumable growth, reference laboratory and rapid assay growth are all very sound and portend well in our view for accelerating growth in 2013.

Earnings per share exclusive of the third and final milestone payment of $3.5 million or $0.04 related to the sale in late 2008 of our feline diabetes therapeutics were a couple of pennies above our thinking, due primarily to efficiencies achieved in operating expenses. Currency had an immaterial impact on EPS versus our expectations.

Before discussing our fourth quarter performance, as we customarily do, I want to share what we are seeing in the U.S. veterinary market based on data from a subset of our Cornerstone Practice Management customers. In the fourth quarter patient visits grew by about 3% and practice revenues grew by 5%. Growth in patient visits in October was roughly a point lower than the average for the quarter and based on the geographic trends, we attribute this largely to the effects of Hurricane Sandy.

Normalizing for Sandy's impact, we project patient visit growth for the quarter would have been about 3.5%, very much in line with the second and third quarter metrics. Quite consistently throughout the year, we have seen practice revenue growth a couple of points higher than patient visit growth, which we believe indicates that practices are achieving some modest price realization.

In Europe overall, our Companion Animal Group businesses grew organically at just over 4%, about a point step-down from the growth rate for the first nine months. Though, Spain remains troubled and we saw a slight deterioration in growth in France, performance in Italy improved and Germany remains solid and steady.

We were pleased with a nice acceleration and growth in the U.K. and emerging markets in Eastern Europe. Q4 was a quarter of readying for our transition towards direction companion animal sales force in the Nordic region and we expect that to be a growth contributor in 2013.

Organic growth in Asia-Pacific across our total portfolio of businesses was mid teens for the quarter and just shy at 20% for the year. In sound, as we enter 2013, we continue to expect a little contribution from the macro environments in the U.S. and Europe to our topline growth. However, the continued development of earlier stage markets combined with our rollout of new product and service innovations internationally will be an important growth factor for 2013 and beyond.

Let me now give some further detail on the revenue performance of our Companion Animal Group. VetLab instruments and consumable revenue of $109.5 million grew 7% organically. Instrument revenue at $24.6 million declined 14% organically year-to-year. As we have noted on several occasions, the success of our protocol-based rebate program that was introduced in the third quarter of 2011 in North America makes for difficult comparison in the second half of 2012.

Additionally, instrument revenue growth was negatively impacted by roughly 8 points and total company topline growth by about 0.75 point with the launch of a reagent rental program in the fourth quarter. Under this type of program, revenue on instrument placement and its related cost are not recorded at the time of instillation, but are instead recognized as consumables are purchased over the term of the arrangement, which is typically five years.

We have seen this program resonate with larger clinics that have relatively higher consumable usage and the consumable annuity stream and associated economics for us are also particularly compelling. In part, due to the success of this program and with impressive performance internationally, we had solid chemistry performance in the fourth quarter that translated to 3% unit growth for the year in line with expectations we shared at the time of our third quarter call.

Commercial focus on new and competitive accounts, armed with our medical information and workflow advantages as well as program tools such as protocol-based rebates and reagent rental contributed to high quality of placements in the fourth quarter. The percentage of new to IDEXX's chemistry accounts, including both Catalyst and VetTest was in excess of 60% for the fourth quarter.

Focusing on Catalyst alone, nearly 50% of our placements, which are customers new to IDEXX compared to 40% for the first three quarters of the year and 30% in the second half of 2011. This metric was consistent across all geographies. We noted last quarter, the overall value to IDEXX of a new Catalyst customer is four to five times that of an upgrade of a VetTest customer, based on gross profit of the instrument and the five year consumable streams for an average placement.

For Hematology, we continue to see strong performance for the quarter in our ProCyte placements. For the year ProCyte placements grew 20% on a worldwide basis, the major driver of 11% growth in hematology placements overall. As with Catalyst, we saw an increase in the percentage of ProCyte placements to new accounts, climbing to about 40% in the quarter. Also in Q4 and for the year, roughly 80% of ProCyte were sold to Catalyst customers with approximately 60% of that subset being to temporaneous purchase of both instruments, evidence of the important role that the dual plays in enabling real-time care.

For 2013, we expect chemistry placement growth to be low-single digit, about on par with what we experienced in 2012. For hematology, we expect low-teen growth, aided by the recent launch of LaserCyte DX and continued strong international performance, based on the success of the reagent rental program with large accounts, both existing VetTest customers and competitive accounts. We will likely continue with a similar program in 2013.

While the accounting treatment for such a program results in muted instrument revenue growth in the near term that is reflected in our overall guidance, the annuity benefit to consumable growth is very compelling from both the revenue and an operating profit perspective. Consumable revenues, up $72.4 million, grew organically 16% or 13% when further normalized for changes in distributor inventory levels. This strong result, our highest growth quarter for the year, brought our full year 2012 normalized organic growth to 10%.

Our growth continues to be a function of our increasing installed base and the quality of those placements. Increased testing, as current IDEXX customer upgrade their in-house lab with Catalyst and ProCyte, and enhanced loyalty from our base of Catalyst customers who now account for more than 80% of our U.S. chemistry consumable sales volumes, exclusive of corporate accounts. For 2013, we expect the fundamental trends driving consumable volume growth to continue.

In addition, we expect revenue growth will be further enhanced by price realization, due to changes in our sales channels both with the MWI margin in the U.S., and from the move from distribution to a direct sales model in Scandinavia as well as a lower unfavorable price impact from protocol-based rebate program that have reached more of a steady state. All of this translates to an expectation of 11% to 13% normalized organic growth for instrument consumables for 2013.

In the fourth quarter, our rapid assay sales of $33.7 million declined organically by 5%. When normalized for changes and distributor inventory levels, revenues were flat for the quarter and grew by 5.5% for the full year, which was in line with our expectations of 4% to 6%. To remind, we had anticipated a step-down in normalized organic growth from the 7% experienced through the first three quarters of the year. About half of the step-down in growth reflects the impact of a smaller price increase in October of 2012 versus the prior year.

Additionally, based on geographic revenue data we received from distribution, we believe there was a modest impact of approximately 1.5 point to rapid assay growth related to Hurricane Sandy. The remainder of the step-down is primarily related to the timing of marketing programs within the second half of the year.

Our expectation for 2013 is to see normalized organic growth rates in the range of 46% for the rapid assay business on par with 2012. Growth will come primarily from further expansion of our Canine Vector-borne disease testing in North America, as fostered by 4Dx Plus. Recall that 4Dx Plus was launched in 2012, as the Vector-borne disease testing season was winding down. In 2013, it will be available for the full testing season.

Additionally, continued ramp on specialty test in Europe and the anticipated launch of other enhancements to the product line as well as some price realization from distribution margin changes in both the U.S. and Japan, and list price increases, all contribute to rapid assay growth expectations. U.S. distributor inventory for instrument consumables and rapid assays average to a little over four weeks at the end of the fourth quarter based on forward-looking demand, which is within their normal and customary range.

Our reference laboratory and consulting services business with revenues of $97.7 million grew organically 6% in the fourth quarter. Based on daily testing volume trend data, we estimate that our growth rate was impacted by both the midweek timing of the holidays in 2012 versus prior year as well as Hurricane Sandy.

When combined, we believe these transitory factors reduced lab and consulting services revenue growth by approximately 2% in the quarter. Normalizing for these events, labs and consulting services growth was approximately 8% for both the quarter and the year, and the sequential normalized growth marked a continued modest acceleration from the growth rates experienced in Q2 and Q3.

As we stated in our third quarter call, in October we opened our new core lab in Germany, which will serve as a centralized hub for testing samples picked up by our European logistics partners, DHL. We believe this lab will enable us to replicate in Europe the successful strategy we have employed in the U.S. in our Memphis lab, greatly enhancing our reach and service levels across Europe. It will also enable scale economies and other operating efficiencies.

We were in a controlled launch in the fourth quarter to ensure smooth operations and a superior customer experience. Our operational quality and customer service expectations were achieved in the fourth quarter, and as a result we have now moved into full launch in the first quarter, accepting and processing samples from a number of countries across Europe. This is one of several key initiatives in 2012 that strengthened our lab business and positions us well for 2013 and beyond.

For 2013, we are projecting organic growth of 8% to 10% for labs and consulting services. This acceleration in growth will be driven by a step-up in growth from both volume and price. Volume growth will come from continued focus on our core strategies.

First, coverage; that is increasing our footprint, including the ramp in volume from the four labs added to our network in 2012. Second, content; which encompasses expanding our specialty test menu and continued penetration of recent introductions such as allergy. And third, connectivity; as enabled by VetConnect and VetConnect PLUS, to both, gain new customers and enhance loyalty of existing customers.

We expect improved price realization as we move forward the timing of annual list price increases and anniversary the ramp in late 2011 and early 2012 of instrument lab bundle marketing programs, with their associated accounting treatment that negatively impacted lab revenue. Our Practice Management and Digital Imaging systems business with revenues of $22.7 million grew 4% organically in the fourth quarter to yield full year growth of 11%.

Performance was a bit light from our expectation at the time of our third quarter call of low-to-mid teen organic growth, primarily from lower digital systems placement due to timing of orders within the quarter. We had a strong book of orders in December, but the lead time for installation are longer in this business, and so we are entering 2013 with a healthy backlog and good momentum and some newer sales reps come down the learning curve. Our Practice Management Systems business continues to grow in the mid-teens driven by Cornerstone, which was the latest software released is fully integrated with VetConnect PLUS and Pet Health Network Pro.

Looking to 2013, we expect to achieve mid-teen organic growth for the year in this business. Factors contributing to this accelerated growth include the recent launch of Cornerstone 8.3, the full commercial launch of Pet Health Network Pro in the first quarter and our partnership with the American Animal Hospital Association announced late in November to advance the Client-centric Animal Hospital with tools that includes Cornerstone and Pet Health Network Pro. In addition, the recent acquisition of DVMAX Practice Management Software will provide cross-selling opportunities for the loyal base of approximately 1,200 practice subscribers.

Livestock and Poultry Diagnostic revenues of $22.6 million declined organically 4% in the fourth quarter and for the full year, pretty much in line with our expectations at the time of our third quarter call. To remind, the principal drive for this performance is lower testing of cattle in Europe due to reductions in government spending, as some highly successful eradication programs come to end of life.

Secondary contributors are lower swine testing in the U.S. due to drought, and new products ramping up a bit more slowly than originally anticipated. Beginning in 2013, we will be combining our dairy line of business, which represents about 2% of our total company revenues with our livestock and poultry line of business. We are combining the management of these businesses, because of market synergies between the product lines as well as operational efficiencies we achieve.

Through 2012, our dairy financial results were included in this segment labeled other, along with our Opti Medical human point-of-care diagnostics and our remaining pharmaceutical products and out licensing arrangements. For 2013, we expect revenues for the combined livestock, poultry and dairy business to decline organically in the low-to-mid single digits with flat to slightly negative growth for the livestock and poultry lines as we have reported historically.

For livestock and poultry, we anticipate further declines in government testing programs that will be partially offset by higher growth from new products as they continue their adoption ramp. Dairy is expected to decline roughly 10% due to a difficult comparison to high testing in early 2012 in China for milk packs and operate that subsided over the course of the year.

Our water business had sales of $20.9 million for the quarter or 5% organic growth reflecting contributions from our core Colilert testing business, particularly in the Americas. We expect growth for water in 2013 to again be in the mid-single digit range, driven by continued market penetration from recently launched products as well as geographic expansion from regulatory approvals.

Turning to the rest of the P&L. Gross margin at 53% was largely consistent with our expectations. Operating expenses at 33% of revenue or somewhat below our thinking in October, reflecting the $3.5 million milestone payment, which is netted against operating expenses on the G&A line as well as somewhat lower spending. Operating expenses normalized from the milestone payment were 34% of revenues.

Our effective tax rate of 31.3% was in line with our expectations. As I will touch on further momentarily, the benefit of the reinstatement of the federal R&D tax credit for 2012 will be recognized in 2013, as the measure was approved in 2013.

Turning to the balance sheet and cash flow. We ended the quarter with $224 million of cash and $215 million of debt, for a net cash position of $9 million. Our inventory balance of $141 million was $6 million lower than at the end of the third quarter as anticipated, the results of solid instrument placements. DSO at 40 days remains very consistent and healthy metric. Our free cash flow was $59 million or 136% of net income. Free cash flow for the year was 104% of net income.

Now as we look forward to 2013, we project revenues to be approximately $1.405 billion to $1.42 billion. Our revenue guidance implies reported growth of approximately 8.5% to 9.5%, which translates to organic growth of 8% to 9%, as favorable impacts of currency and acquisitions together contribute approximately 50 basis points.

Organic growth of 8% to 9% compared to 7% achieved in 2012. I'd discuss growth progress by business area, but to summarize at a total company levels, growth acceleration can be categorized by two primary themes. First, price realization; from changes in distributor margins in the U.S. and internationally, moving to a direct sales model in the Nordic countries, reduced headwind from marketing programs that have reached steady state, and timing and impact of list price increases.

Second, growth from recent commercial investments and product, and service innovations, including Pet Health Network Pro, VetConnect PLUS, the core lab in Germany and expanded reach into the bioresearch market. Bioresearch revenue growth is anticipated from both, expanding geographically and augmenting our operating to address not only send-out testing performed at the reference lab, but also the market point of care needs with our vet lab platform. We expect organic growth to accelerate sequentially throughout 2013, as commercial initiatives and product and service innovations gain increasing traction.

Additionally, the first quarter faces a difficult comparison for livestock, poultry and dairy as I just described, as well as for companion animal product and service lines, given the mild winter last year that manifested in relatively higher clinic traffic. Accordingly, we anticipate first quarter organic revenue growth to be in the mid-single digit. We expect full year growth margins to be approximately 54%, roughly in line with our full year 2012 rate.

While targeted initiatives in our two largest businesses, VetLab and reference laboratories will continue to generate margin expansion. The impact of these initiatives will be muted by headwind to the tune of about 50 basis points from 2012 currency hedge gains that are not projected to recur in 2013.

Operating expenses should average out to be in the range of 34% with a quarterly profile that is highest as a percentage of revenue in the first quarter due to commercial activities such as tradeshows and sales meetings. We expect operating margin to be between 19.5% and 20%, which would yield operating margin expansion of roughly 50 basis points when you normalize for the pharma milestone payment in 2012 and impacts of FX. As I just stated, this margin expansion is occurring at the gross margin line.

We expect the tax rate to be between 30% and 30.5% for the full year. The decrease in the tax rate relative to 2012 is the result of the recent expansion of the federal R&D tax credit for 2012 and 2013, which we expect to lower our 2013 tax rate by almost 200 basis points. The full effect of the extension for both years will be recognized in 2013, with the 2012 credit recognized in total in the first quarter and the 2013 benefit recognized ratably over the year.

Net interest expense is expected to be about $2.5 million and weighted average share count is expected to be down 2% to 2.5% from full year 2012 levels. All of this leads us to raise our full year earnings per share guidance to $3.47 to $3.57, up $0.10 from $3.37 to $3.47 that we guided to in our October call, primarily due to the benefit of the R&D tax credit, which is expected to be $0.04 to $0.05 for each of 2012 and 2013 for a total impact of $0.08 to $0.10.

We are also increasing the low end of our range by a couple of pennies to reflect our increased confidence in the dynamics of the business. Earnings per share growth for 2013 when normalized for hedge gains and pharma payments in 2012 and the 2012 R&D tax credit recognized in 2013 is projected to be 10% to 13%.

And now, I'd like to turn it over to John for further comments on the business.

Jonathan Ayers

Thank you, Merilee. As you can tell, we're very pleased with the fundamentals of the business and the growth rate of the core annuity revenue streams ensuring most of our profit. I want to touch lightly on a couple of things before we open it up to Q&A.

First, I'd comment on the VetLab instrument and reagent business performance, which investors know as a razor and blade business model. While we realized lower instrument revenues than expected in Q4, the number in quality placements was strong, specifically considering the increase in competitive Catalyst placements from 40% to nearly 50% and the size of accounts that we upgraded.

In addition, we're seeing even higher growth in consumable usage from customers who upgrade from VetTest to Catalyst than we have seen in the past. Our more recent placement show increased testing in the neighborhood to 20% to 25%, as current IDEXX customers upgrade their in-clinic lab with Catalyst and ProCyte, 5 points higher than what we saw for customers upgrading in prior years.

Clearly, real-time care works for our customers and for IDEXX, as they are running more in-house diagnostics for IDEXX's new product. This is because in part our instruments, both Catalyst and our hematology units are designed for just this goal, as they have superior workflow, a more complete test menu and much shorter turnaround time than anything else from the market.

We continue to see impressive loyalty of our Catalyst customers, greater than 99% in 2012. In fact, even with a significantly higher installed base, we have roughly half the number of catalyst losses in 2012 to 2011. Once a customer experiences our in-house lab, including a Catalyst and our hematology offerings, they don't ever want to go backwards.

I'll remind investors that our two hematology offerings consisting of ProCyte Dx and the new LaserCyte Dx remain in a class of their own. Even after 10 years, no other company has managed to introduce the gold standard of laser flow cytometry and a benchtop hematology offering. The only technology that gives complete results and yet we provided a choice of two systems to customers.

The net result of our instrument placements and this extraordinary loyalty is accelerating consumable growth in 2012 over 2011 as well as over the course of 2012. Q4 had 13% instrument consumables growth normalized for U.S. distributor inventory changes, up from the 9% in the first three quarters. Importantly, this 10% revenue growth for all of 2012 was driven more than entirely by consumable unit and volume growth, which is offset by a small amount of negative unit price realization.

We believe this double-digit unit growth for the year bodes well for our outlook in 2013 of 11% to 13% consumable revenue growth in the following way: we expect to realize unit volume growth similar to 2012, i.e., greater than 10% for all the reasons we said so in 2012 and have very modest price realization in 2013 as a result to the evolution of our pricing strategies.

As investors know, a sustainable on growing the annuity of consumables is the important profit driver in the instrument and consumables business, and unit volume growth is the most strategic goal. This unit volume growth is also a core validation effect that our customers are using our instruments to deliver increased diagnostic testing real time, solely increasing the percentage of chemistry and hematology run at the point of care.

In 2013, we expect to further extend our transformation of the veterinarian's diagnostic experience through the continued customer adoption of VetConnect PLUS, our cloud-based service that allows the veterinarian to view results in a completely new insightful, interactive and intuitive way.

We are moving from paper to mobile with all the attendant benefits. You might consider what is happening to the print media industry as a good analogy for this transformation that we are bringing to diagnostic information.

As of today, we've reached 4,500 VetConnect PLUS activations in the U.S., almost double the number we had three months ago. In addition, our sales organization is wanting more and more, how to use this transformational service, which comes free as part of our IDEXX diagnostic offerings to win new accounts for both in-house equipment placements and reference lab services.

Note that, at this time, more of our customers use only one of the two-halves of our diagnostic offering, that is in-house instruments and reference labs, and not including our rapid assay offering, then use both together. So the opportunity for cross-selling IDEXX's diagnostics with VetConnect PLUS is high.

One interesting result of VetConnect PLUS is the increasing customer loyalty in our reference lab that comes from practices, who have activated the new service. As you know, we launched VetConnect PLUS back in July. We are accumulating data on the impact of customer loyalty. And while there is still very early days, we see a clear trend that customers on VetConnect PLUS seem to me more loyal than those not on it, enough to increase customer retention somewhere in the range of 2% to 4%. All other things being equal, that would result in a 2% to 4% increase in the revenue growth from the cohort of practices that have adopted this service.

Of course, we're still somewhat early in the adoption phase with our reference lab customer base, even with 4,500 practices, note, some of which only use our in-house equipment right now, but we have plans to approach a 100% adoption in the U.S. in 2013. This increased loyalty trend helps provide us confidence in our outlook for 8% to 10% growth in the global reference lab line of diagnostics in 2013.

Our goal in 2013 for our North American sales and distribution organization is to continue to grow our effectiveness and communicating the transformational value of VetConnect PLUS to all of our customers, both those who use in-house reference lab or both, both in terms of advanced medical insight and as a tool to demonstrate value to the pet owner.

Ultimately, this value will help vets appropriately increase their use of diagnostic testing with sick pets, those with chronic conditions and in a growing category of preventive care. We also plan to launch VetConnect PLUS to some important international markets in 2013.

We are also pleased to be able to launch the commercial marketing of Pet Health Network Pro at the recent North American Veterinary Conference. This is our cloud based subscription service that helps practices engage clients before, during, and after the visit, to increase the veterinarians' relevance in the pet owner's life and to increase visits and income per visit.

So far we have had hundreds of customers signed up. The large majority are actively using the system as an advance data, before we go to full production later this quarter. We are pleased to see the extraordinary response to the North American Veterinary Conference with crowds around the booth during most of the show.

Pet Health Network Pro benefits IDEXX in multiple ways. First, it generates a revenue stream from subscriptions and consumables, such as reminder cards sent by traditional mail. Second, it will grow visits and the usage of diagnostics as it shares information back and forth with IDEXX's other software products such as Cornerstone and VetConnect PLUS. Third, it gives us yet another cross-selling opportunity across the entire IDEXX product offering by the Companion Animal Group.

In summary, we have a clear roadmap for organic growth of 8% to 9% in 2013 and consequent bottomline growth, in the way that position us well for the years beyond 2013.

So at this point in time, I'd like to open up the call for questions and answers.

Question-and-Answer Session


(Operator Instructions) Our first question will come from the line of David Clair with Piper Jaffray.

David Clair - Piper Jaffray

The first one from me, I was just curious on the reagent rental program, is that just for Catalyst Dx? And then secondly, do you expect the counts with the reagent rental agreements to generate higher consumables compared to accounts buying instruments?

Jonathan Ayers

Yes, that's exactly right. They're really for higher volume accounts.

Merilee Raines

And I would say that that also is true for the first part of your question, David, that generally the reagent rental programs work that from both the customer perspective and our perspective, when there are higher consumable usage accounts. So whether that would be high VetTest or Catalyst that would be the case, but primarily we are seeing success with this with Catalyst.

David Clair - Piper Jaffray

I guess what I'm trying to ask is, are you setting the bar a little bit higher in terms of the consumable agreement with these accounts, so that they're expected to actually use a little bit more?

Jonathan Ayers

Yes, exactly. You are exactly right, David.

David Clair - Piper Jaffray

And then for the 8% to 10% reference lab growth target, what are your expectations from volume versus price in there? And should we expect additional lab openings during the year?

Merilee Raines

The breakout between price and volume is probably about, 70% of that growth would be due to volume and about 30% for price.

Jonathan Ayers

And we have a couple of lab openings, but I think the primary growth driver is going to be leveraging our whole network of 60 plus labs and the hub. And the other driver of growth is a growth in our, specialty testing, which generally speaking new categories of testing that that can't be run in-house and uniquely accrue to the benefit of the reference lab.


Next, we'll go to the line of Ryan Daniels from William Blair.

Kristina Blaschek - William Blair

It's Kristina Blaschek for Ryan today. To start, on the change in distributor margin from MWI, have you thought about how that will be reinvested. I assume some of it will be OUS with the Scandinavian opportunities, anything domestic though that you thought about specifically?

Jonathan Ayers

I'll tell you, it's kind of hard to allocate here or there. We continue with an appropriate and aggressive investment in our commercial organizations, whether they'd be at sales, support. We have couple of dozen people who supports specifically our distribution, as well as other elements of the marketing mix. So I think we're very comfortable with that mix. And it was really a modest change.

Referring to the Scandinavian situation, what we're doing there is going directly. Obviously, we have a number of customers who use our equipment today. The distributor that we had wasn't very effective in placing new instruments and we think that's a very attractive market. And so with direct, we think we'll be in a much better position to place our instruments, which are well designed for the Scandinavian markets. It's an excellent match. But of course, we get the up lift from going from distribution in 2012 to direct in 2013.

So yes we are investing in commercial resources in Scandinavia to go direct, although we're already leveraging our warehouse and distribution network because we're direct in the other countries and Europe. But that is in essence, being more than paid for by the pickup in the margin in those same countries.

Kristina Blaschek - William Blair

And then I guess, staying under distributor topic, at NAVC this year, it seemed like the two large exclusive distributors were more engaged than in the past, with Henry Schein even commenting, they were much more active in attempting to place IDEXX analyzers OUS. Can you share with us your view on how these relationships have improved since going through this distribution few last years?

Jonathan Ayers

We're really pleased with the relationships that we have with our U.S. distribution and I think one of the hallmarks of IDEXX is that over two decades of having work with distribution we're continuing to learn how to make that partnership stronger and stronger.

And so we're pleased with the engagement of our exclusive distributors that you mentioned in an increase level of engagement. And we're also pleased with the continued high level of engagement of MWI, which remains an important partner for us. So distribution is an important element that supplements, of course, our direct sales organization.

In the U.S. market, they work hand in glove. And we're very pleased with where things are as we move to 2013. And the ability of this entire, our commercial organization to communicate the benefits of the transformation of value of that our diagnostics provide. And as I mentioned in the call, I think it's kind of important, when people make that transition, they just realize they never want to go back, because, they've kind of asked us, so who should've been doing this all along.

And so our challenge is really to bring people to that point across the market. And with our direct sales and our distribution engagement that we have now and they're pretty excited about things like VetConnect PLUS and the product line. We're thinking we're in a good position to do so.


Next, we will go to line of Erin Wilson from Bank of America.

Erin Wilson - Bank of America

I guess, can you just speak to what you're seeing as far as the competitive dynamics on the reference laboratory front, and I guess domestic market? But also, can you speak to the dynamics internationally?

Jonathan Ayers

In the competitive situation in the U.S. is different than international. And every country is a little bit different. We are really not seeing any change, and what I would characterize is historically been a very competitive market that we participate in U.S. and indeed all of North America. It's really the same level of competition.

I think what we're excited about as we're bringing a new wave of innovation, on top of things like the specialized testing and the expansion of our coverage, of our lab network in North America, this new way of innovation really driven by VetConnect PLUS. And just as, I said a different way to see the value, and have much higher value in the usage of diagnostic information in the clinics, so that's really the biggest change we're seeing is what we're brining to the market.

None of our competitor's in North America are competitors. Outside of North America, it's usually a country-specific competitors, in rare cases may move across a couple of countries. For example, we're really only reference lab network in Europe that's across the continent level, and then in the U.K. and of course, leveraging our global scale and capability. And the same is true in Australia, and in Japan, just a very different local competitive environment.

So we're excited about it, because we can bring innovations that really come out of our global investment reference lab. And they might be in specialized testing, in advanced lab technologies and LIMS, which is our new Laboratory Information Management System that we're over the course of several years rolling out through the global lab business, internally developed system that we put over $10 million investment in.

And very pleased by the way to be able to say that we've launched our first lab in the U.S. under LIMS after having successfully rolled linked out to our four labs in the U.K., and our four labs in Australia. So that rollout will continue and the U.S. of course is a pretty big opportunity to get a significant ROI in the LIMS investment. So we can bring those types of scale benefits internationally, and we're dealing really with local competition.

Erin Wilson - Bank of America

And then how do you expect, I guess, VetConnect PLUS to ultimately impact reference laboratory retention longer-term? And I guess I understand how VetConnect PLUS links to equipment and the reference lab results, but what happens when for instance its rapid assay test when it's not used with the SNAPshot reader. I mean, it seems like maybe that would be a little bit more vulnerable to competition.

Jonathan Ayers

First of all, we really do think that VetConnect PLUS will be transformational in the way that diagnostic results are viewed and used. It's kind of the move to digital media from print media would be the analogy there. Right now, of course, it applies quite relevantly to the reference lab offering and to the in-house instrument offering. We do have a couple of different ways that rapid assay results can be entered into VetConnect Plus through SNAPshot as you mentioned or also directly through IDEXX VetLab station.

One of the benefits of doing so is now VetConnect PLUS has what we call client-friendly reports, and in the case of our rapid assay business, preventative screening used in 4Dx for parasitic disease screening, the VetConnect PLUS can generate report that congratulate the customer on having protected their pet from vector-borne diseases, which gives a lot more of value to that 4Dx comprehensive test.

I'm just saying there wasn't any negative result. And that's all integrated into VetConnect PLUS. As one of the benefits, but clearly as we look forward, we're going to be looking for ways to continue to leverage VetConnect PLUS as a way of communicating and disseminating diagnostic information and rapid assay included, Erin.


We'll go the line of Ross Taylor from CL King.

Ross Taylor - CL King

Wanted to go back to the instruments and the reagent rental program, what factors led you to adopt that program now? And I guess related to that intuitively I would think that larger clinics, you will be better able to afford than just an outright purchase of the instrument. I mean, why is that you're proving to be popular with the larger clinics at this point? Is Catalyst is just getting more mature or fully penetrated since been in the marketplace for about five years now?

Jonathan Ayers

Well, I think we've been very successful in placing Catalyst in larger accounts since we launched it in 2008. And as you know we had launch, what we called the in-house protocol agreement, the IPA, about year and a half ago. And so we're continuing to find ways to move these larger accounts to the IDEXX diagnostic advantage, and with in-house equipment.

And I think what we found was that every accounts will differ, they all will have different needs, they all will have different way of thinking. Many accounts do want to purchase the equipment. And there are programs that are beneficial to them, that place equipment, and there are other accounts that are more interested in this type of arrangement.

The economics are actually not different, although the revenue recognition will be little bit different, but the economics and the cash flow, isn't really that different between different types of programs. But we just found that there is a segment of the market that this works.

And of course, we really see that any account, certainly a large account, but any account, when they move to Catalyst and ProCyte and they are integrated with the complete solution and VetConnect PLUS, they realize that they just never want to go backward again. And so we're just finding ways to be able to bring them to that solution. We found that for a segment of customers, a minority of customers that this happens to be an effective tool.

Ross Taylor - CL King

And if I can just squeeze in a second question, the 2% impact you mentioned for the reference labs of Hurricane Sandy and the holidays. Can you quantify how much you might be due to each one of those?

Merilee Raines

About maybe 0.5% was due to Sandy and about a 1.5% would be due to the timing of the holidays.

Ross Taylor - CL King

With Christmas, and New Years falling on a Tuesday that's the toughest calendarization of the calendar cycle?

Merilee Raines

Going from a weekend to the middle of the week, basically it's a challenge.


Our next question comes from the line of Jonathan Block from Stifel Nicolaus.

Jonathan Block - Stifel Nicolaus

Maybe the first one just on the instrument placement, I think Merilee you said about 3% for the year for 2012 and expectations for low single digits in 2013. It seems like you lowered the bar a little bit by the consumable reagent program. So can you talk to just market share?

And I know John, you're going to say, well, it's about where the box goes and I realize that but your chief competitor on the point-of-care side has been placing instruments closer to about 7% to 9%. You guys have decelerated and instilled steady it about 2% to 3%. Can you just talk to the dynamics of box placements with market share going forward?

Jonathan Ayers

We are a global business. So there a lot of moving parts there, John, but the purpose of placing the box is to generate the consumables. And that's where the profit driver is, and razor and blade of business model. And our objective is to find the ways to grow. And in fact accelerate, as we've seen that consumable revenue. And we're very pleased with what we're seeing over the course of 2012 with the accelerating volume.

And as I mentioned, unit volumes is even higher than the revenue. In 2012, we think that will equalize volume and revenue in 2013, which will help to drive to 11% to 13% growth. So I mean, if you look at the 11% to 13% growth in the profit driver, which is three quarters of the business, we think that compares favorably with the market growth.

Jonathan Block - Stifel Nicolaus

Maybe just one or two more, if I can fit it in. The first one, Merilee, you mentioned a lot of areas where you might be able to realize price in '13. John, you just alluded to the consumables, the Scandinavian going market going directs, some price at the lab, but your gross margin guidance, I think of 54% would be flat in '13, flat versus '12. So can you talk to sort of where you're giving back in the COGS, if you're able realize a lot more price in '13 than '12?

Merilee Raines

We again, currency and the impact of hedge gains this year that we do not project would reoccur in 2013, create quite a bit of headwind. In fact, gross margin expansion that would be about 50 basis points, if you were to normalize for that. So we are expecting gross margin expansion and some price as a piece of that, as well as manufacturing efficiencies, and just really volume leverage and other things that we've been driving, and again, primarily our reference lab and our VetLab business. So those kind of recurring things we still see that manifesting, and we expect to see that manifesting continued margin expansion in 2013.

Jonathan Ayers

And that's a little bit offset by some of the areas that we're investing and that will generate attractive revenue streams in the future of such as Pet Health Network Pro and the expansion of bioresearch with our point-of-care of instruments and associated consumables. Those are going to be little bit negative, and those will be unfavorable to the gross margin in terms of mix as they pick up in the near term, but attractive in the long-term.

Jonathan Block - Stifel Nicolaus

Maybe one last one, wasn't able to ask in 3Q '12, so I was trying to pull-in forward. Just here we are on the first month of the year and distribution has changed, John, and I understand NWI is still a very important partner. But anything you've seen in the first 30 days, now that we're in sort of the new regime or different dynamic that you can speak to? And I'm guessing, you really don't expect much of any impact, because if you isolate your rapid assay growth of 4% to 6% for '13, that's the line, I don't know, might be most vulnerable? So do you really expect little to no noise in the distribution front?

Jonathan Ayers

I'll tell you, we're very pleased with our engagement. And just returning to the rapid assay business, these are very unique, valuable combination assays. The 4Dx Plus, which of course, by far, the largest product line in the rapid assay business test for six different vector-borne diseases that are prevalent in test. And it's the gold standard. We have a lot of benefits. We can easily distinguish, in many cases, between a vaccinated animal and an infected animal, which is unique to that assay. And it's easy-to-use, people know it.

And there is just nothing else that compares on the market. So I think the strength of our products, which particularly in the rapid assay side, speaks well for our position. And of course, we're continuing to innovate in the rapid assay line. And have a pipeline in the rapid assay line, as we do in our other lines. So we're never standing still.


Our next question comes from the line of Nicholas Jansen from Raymond James and Associates.

Nicholas Jansen - Raymond James & Associates

On the rental reagent agreements, did you get higher margins on the consumables under the new relative to, let's say, if they were associated under the old methodology?

Merilee Raines

I really think this is more about the utilization. It's not so much about a higher margin. What we really have found is that with particularly, as we've now focused on customers' that are new to IDEXX and that's been an increasing focus for us, we found that there are plenty of high-test users out there.

And because they are very confident about their consumable usage that this type of program, they feel very comfortable with it because they are already very confident about their consumable usage, so this is about high-volume users and really appealing. And, again, different things appeal to different customers, but this particularly resonates in some cases with some of these higher volume clinics.

Nicholas Jansen - Raymond James & Associates

Then speaking of Pet Health Network Pro, what do you guys have embedded in terms of your expectations for '13 for revenue growth? Certainly it's falling more of a longer-term revenue opportunity, but just trying to sense of how many customers do you think you could add on this year, vis-à-vis competition or on your market growth?

Jonathan Ayers

We do have very specific plans in that area. For competitive reasons, won't go into much detail, but it is a contributor to our accelerated revenue growth. And I would mention with the Pet Health Network Pro, that these are annuity revenues. It's different than the instrument business where in the good majority of the cases. Even with the reagent rental program, you get the instrument revenue upfront and then you get the consumables after this. This is just the consumables business.

So in other words, annuity business that comes from the subscription and the usage of traditional mail, which generates incremental revenue. So it's growing, I think it will be a new revenue stream in 2013. And it will be one which we'll build nicely in an annuity fashion in the years to come.

We're very excited with the market response to Pet Health Network Pro. And really just had an unbelievable show at the North American Veterinary Conference, and of course, we're very pleased that the American Animal Hospital Association, which has tremendous credibility with 5,000 more sophisticated practices gave the exclusive endorsement for Pet Health Network Pro combined with Cornerstone as the way to take it to the next step in practice management. So we think we're well positioned to achieve our objectives in 2013 with Pet Health Network Pro.

Nicholas Jansen - Raymond James & Associates

And Merilee, if I can may, just maybe the 1Q tax rate, considering it's going to include the 2012 R&D portion, I know you gave us the full year but 1Q would be helpful?

Merilee Raines

Let's say, that probably more talking about something in the neighborhood of 27% or something by nature.

Nicholas Jansen - Raymond James & Associates

Tax rate?

Merilee Raines

Tax rate.


Our next question comes from the line of Ben Haynor with Feltl and Company.

Ben Haynor - Feltl and Company

You mentioned the instrument organic growth was impacted by about 8% due to the reagent rental program. Could you quantify the impact to the consumable organic growth during Q4?

Jonathan Ayers

I would say it really didn't have much of an impact, because generally those instruments are placed over the course of the quarter. Usually, it's a little bit more towards the end of the quarter. So not really, I would think any noticeable material impact in Q4. Really the impact will be in the quarters to come.

Ben Haynor - Feltl and Company

And then, do you expect differential reference lab growth rates outside the U.S. versus inside the U.S. in 2013?

Jonathan Ayers

Yes. We're expecting a growth in all of our reference labs in every single country market or region that we participate in, and they all will contribute to the growth. There are very different economies and different situations in each economy, and we generally don't go through each one, one-by-one. But for instance, in Europe, we have a new (licensing) opening which will really help the continental Europe.

We have good momentum in our other markets, whether it would be U.K., Canada, Australia, or Japan, and of course, we're really excited about the U.S. because U.S. is the first beneficiary, the benefits of VetConnect PLUS in terms of the transformational way to experience and use diagnostics in practice. So all the regions will contribute to growth.


We'll go to the line of Jeff Frelick with Canaccord.

Jeff Frelick - Canaccord

Did you say the reagent rental program you are able to combine hematology with chemistry? And then should we also assume in general, the reagent renal program, the business should be little bit more sticky, given the five-year contracts that you're engaged?

Merilee Raines

The program is really mostly geared towards chemistry. I don't know, there may have been a hematology or two, that was placed along with that but it primarily is geared at the chemistry market.

Jonathan Ayers

I wouldn't say just to the answer of stickiness, it's hard to get stickier than plus 99%. And so I think our instrument line is already amazingly sticky. And so this is not going to really change that, I don't think. I think it will continue to be amazingly sticky, not just because of the regional rental but because of the value that people see in these instruments and bring in to their practice. And the capabilities that once they start using, they appreciate and that are unique to the IDEXX offering.

And that really runs across so many different dimensions, whether it's the speed of the instruments and being able to deliver the results inside an appointment, to the far more complete menu to the menu-flexibility, to the ease-of-use, to integration and to practice management software, and of course the benefits of VetConnect PLUS. So the list goes on. And I think people once they experience that they really don't want to lose any of that. And that's why these are so sticky.

Jeff Frelick - Canaccord

Just a quick follow-up to that then, John, the success you had with the Catalyst and you had said about I guess an excess of 60% had been into competitive accounts. What was the practice doing previously for chemistry, were they using a competitive in-house instrument or they're sending out to reference labs?

Jonathan Ayers

In terms of Catalyst placements, I think we said a nearly 50%.

Merilee Raines

That was the combined Catalyst and VetTest with 60% to new accounts, just to clarify.

Jonathan Ayers

So with the VetTest, we're are still placing a lot of VetTest in emerging markets, and even some markets you would consider established markets or emerging markets from a veterinary perspective. And so a lot of that is new instruments, where the practice is adding the instrument for the first time. But you know, with regard to Catalyst placement nearly 50% which is up from the 40% in the first three quarters of the year, and 30% really last year, so nice tickup.

That's really going into accounts that have existing mostly, accounts that have some kind of existing analyzer that doesn't provide the same capability Catalyst, that's why they upgrade the Catalyst. And in minority cases its new practices. There are some practices out there, it's true. Not too many, but some of that that don't have in-house instrumentation. But that's more rare than customers who are using exclusively or primarily another analyzer not from IDEXX. And they decide to upgrade to the IDEXX diagnostic advantage.


Thank you. And with that Mr. Ayers, I'd like to turn it back over to you for any closing comments.

Jonathan Ayers

Well, thank you very much everybody for listening in the call. And I want to congratulate the IDEXX team for all of our successes in 2012 and the momentum that we've established going into 2013. And we look forward to updating investors at our first quarter call as we continue to achieve our strategic objectives over the course of 2013. Thank you.


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