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IDEXX Laboratories Inc. (NASDAQ:IDXX)

Q4 2008 Earnings Call

January 30, 2009 9:00 am ET

Executives

Bonnie Reid - IR

Jon Ayers - CEO

Merilee Raines - CFO

Analysts

David Clair - Piper Jaffray

Ryan Daniels - William Blair & Company

Jonathan Block - SunTrust Robinson Humphrey

Ross Taylor - C.L. King & Associates

Daniel Owczarski - Avondale Partners

Operator

Ladies and gentlemen, thank you for standing by and welcome to the IDEXX Laboratories fourth quarter 2008 Earnings Call. (Operator Instructions).

We will now begin the conference.

Bonnie Reid

Good morning, everyone, and welcome to the IDEXX Laboratories fourth quarter 2008 earnings conference call. Just a reminder, today's conference is being recorded.

Participating in the call this morning are Jon Ayers, Chief Executive Officer; Merilee Raines, Chief Financial Officer; and Susan Astro, Director of 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 Management's future expectations and plans and IDEXX's future prospects constitute forward-looking statements for purposes of the Private Securities Litigation Reform Act of 1995. Such statements include, but are not limited to statements regarding Management's expectations for financial results for future periods and the timing of new product introductions.

Listeners are reminded that actual results could differ materially from Management's expectations. 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, 2008 and Form 10-K for the year ended December 31, 2007 in the section captioned Risk Factors, which are on file with the SEC, and also available on IDEXX's website, idexx.com.

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 estimates as of any subsequent date. The company disclaims any obligation to update or revise any forward-looking statements in the future, even if its estimates or expectations change.

At this time, I would like to turn the conference over to Merilee Raines. Please go ahead.

Merilee Raines

Thank you, Bonnie. Good morning and thank you for joining us today. In our press release this morning, we reported fourth quarter revenue of $243 million and diluted earnings per share of $0.39.

As anticipated at the time of our last earnings call, we completed the sale of certain of our pharmaceutical product lines in the fourth quarter, and the transaction and related restructuring cost reduced earnings per share by $0.06.

As we had indicated at the end of October, the updated 2008 EPS guidance we gave at that time was exclusive of this discrete item. Fourth quarter EPS of $0.44 as adjusted for the transaction grew 10% year-to-year.

Full year earnings per share adjusted for discrete items were $90, an increase of 20% over 2007 earnings of a $58, as similarly adjusted for discrete items. Please refer to the table in our earnings press release for full detail on the discrete items in both years.

Adjusted earnings were a $0.01 above the high end of the guidance we gave in the third quarter call, as the impact of slightly lower than anticipated revenues was more than offset by careful control of operating expenses.

Before I further discuss operating results, I would like to briefly discuss our pharmaceutical transaction.

The financial details of the product line divestiture have been highlighted in our press release. The net loss of $3.6 million, or $0.06 a share, consists of two components. The first is a pre-tax loss of $1.5 million that is inclusive of all transaction-related fees, severance and restructuring costs. The second is the tax provision of $2.1 million, which results from the tax bases of that divested assets, being less than the book basis and consequently producing a taxable gain.

Although the impact to earnings from these transactions is negative, from a cash perspective, the transaction yields $9.7 million, a positive cash flow, consisting of the net proceeds of $5.5 million and the realization of a tax deduction of approximately $4.2 million for the disposition of the nitazoxanide inventory we wrote-off for book purposes in 2007.

There is also the possibility for future cash flows from this transaction, if and when the feline insulin product, currently in the regulatory approval process, becomes commercialized.

Additionally, as previously announced, we entered into an agreement with the top-tier animal pharmaceutical company to out-license one of our promising pipeline product.

We received a $250,000 payment at the time of signing in the fourth quarter and the agreement provides for development milestone payments and revenue-based royalty payments, once the product is commercialized.

We do not anticipate any follow-on payments from either the insulin product or the out-licensed agreement to be significant in 2009.

Now on to fourth quarter operating results. Fourth quarter revenues grew organically 6.5% after adjusting for currency and the divestiture and discontinuance of pharmaceutical products. This growth of 6.5% compares to 10% for the third quarter and 11% for the first half.

The third quarter growth just sided is normalized for the acceleration of PZI VET insulin product sale from the second half of 2008 into the second quarter. The first half growth is further normalized for the impact of the pet food recall that occurred in the first half of 2007.

Isolating the impact of the economy on our revenues is a not a precise science and it varies by product and service category and geography.

As we have noted in past quarters, the products and services most impacted by the recession are those in our Companion Animal Group related to routine wellness testing and more discretionary treatments. These would be our instrument consumables, lab services and to a lesser extent infectious disease rapid assays. The geographies most impacted are North America and Europe.

We have attempted to estimate the recession impact by isolating all other known factors influencing growth and try angulating that information with what we can discern about what is happening with activity in that clinic, based on aggregate data we are able to obtain from our customers, who utilize our practice management software, external surveys and information we hear from the field.

We estimate the economic situation flow the growth for the company overall by 3% to 4%, as compared to approximately 2% in the third quarter. I will speak more about this in a moment. Sales of instruments in our IDEXX VetLab suite were solid in the fourth quarter. At $23 million, they grew organically 26% over a strong fourth quarter last year.

We placed just over 500 Catalyst but aim the installed base to 750, and we entered the first quarter of 2009 with over 200 orders in-hand. SNAPshot Dx placement also ramped and the installed base is just over 800. Our controlled launch of Catalyst is progressing well and the placements in the fourth quarter more than doubled those of the third quarter.

Given this performance, we feel we are on track to place about 200 or about 2000 instruments in 2009. As we have stated, since the launch began, our first priority is to have satisfied customers. And so, we will continue to control our placements in early 2009 to ensure that we are providing the after-sales support that our customers expect and value.

Accordingly, we expect to place about 300 instruments in the first quarter and placements will ramp over the course of the year. We continue to see demand for both Catalyst and SNAPshot Dx to be very strong, and the goal for us is to improve the scalability of the manufacturing process and reduce cost.

As mentioned, the economy has impacted recurring revenue streams from instrument consumables, laboratory services and rapid assays to a somewhat greater extent in the fourth quarter than the third quarter.

In combination with lower pets [owners attending] clinics, we are observing some purchasing patterns that some clinics are also reducing levels of supplies on-hand in order to improve cash flow.

This supply reduction effect is relevant to our instrument consumable and rapid assay product lines.

We estimated that the fourth quarter economic impact was 5% to 6% overall across these three product and service lines in North America and Europe, as compared to approximately 3% in the third quarter.

As these revenues account for approximately 60% of total company revenues, this is how we derive the 3% to 4% negative impact of the economy on total company growth.

Instrument consumable sales are $50.5 million, grew organically 1% in the fourth quarter.

To remind investors, in the fourth quarter of last year, we had a change in distribution in Japan for instrument consumables and rapid assays and the resulting initial stocking order in conjunction with year-to-year changes in U.S. distributor inventory levels, negatively impacted instrument consumable growth by 2 points.

So growth normalized for changes in distributor inventories was 3% in the fourth quarter, as compared to a similarly adjusted growth number of 9% for the third quarter.

Our rapid assay sales of $30.2 million down 2% organically year-to-year, but up 5% when further adjusted for the fourth quarter 2007 Japan stocking order and year-to-year changes in U.S. distributor inventory. This 5% compares to 14% in Q3 and 12% for the first half, as those periods organic growth rates are also normalized for distributor inventory changes.

In addition to the economy, our rapid assay product line growth is also being negatively impacted by a couple of pricing dynamics. The first being a slowing in the rate of conversion from canine heartworm-only testing to our multi-parasite disease panels, as we further penetrate the relevant market. 3 and 4Dx test panels now account for 70% of the testing volume.

In addition, we are seeing relatively higher growth from larger multi-practice accounts and shelters, who received more favorable volume-based pricing and lapping a price increases in certain customer segments.

We achieved the full commercial launch in December of our Feline Triple test, which includes heartworm-only in addition to FeLV and FIV. The early interest is strong as it supports best medical practice cited by key opinion leaders to screen test for heartworm infection and also provides the new source of revenue to practices.

We also received USDA approval this month for our SNAP Feline Combo test to be read on SNAPshot Dx. SNAP Feline Combo and our canine pancreatitis test will both be available on SNAPshot Dx in the second quarter. We have other SNAP tests in the regulatory process and expect 4Dx as the next approval in the first half.

U.S. distributor inventory levels for instrument consumables and rapid assays averaged just over four weeks at the end of the quarter based on forward looking demand. Our laboratory and consulting services with revenues of $65.3 million had organic growth of 8% as compared to 10% in the third quarter. Though this business does appear to experience the similar trends in economic impact on same store testing volumes, as we see in our in-clinic test products, there is no clinic supply reduction impact on the service business.

Additionally, we are seeing reflected in the growth rate, the benefits of our efforts to continually enhance service levels, expand our proprietary test offering and integrate our lab offering with our in-house test and crack this information management system.

Our practice information management and digital radiography systems, with fourth quarter revenues of $18.9 million grew 15% organically. As noted in the third quarter, we entered the fourth quarter with a healthy backlog, and with continued strong demand, particularly in the US; we also entered the first quarter, with a meaningful order book.

As we have noted, our development efforts over the past few years in the areas of connectivity and information management are being appreciated by our customers now more than ever, as they look to increase practice efficiency and ensure that they capture the revenue for all the services they perform. Our practice management systems and digital product lines are prominent components of the movement to more efficient paperless practices.

Production analyst service sales are $20.3 million, had a 2% decline in organic growth in the fourth quarter, similar to what we experienced in the third quarter. In addition to the impact that the price erosion in BSE testing has had on this business in 2008, we also believe there is a modest impact on the business from the global economic slowdown, as governments in some instances delay or redo act to other programs funding for surveillance testing and disease eradication.

To remind you, we anticipate a further decline in BSE test sales in 2009 of approximately $6 million due primarily to a change in European regulations to raise the mandatory testing age of cattle to 48 months from 30 months.

Our Water business had another strong quarter with revenues of $17.2 million and organic growth of 7%. The collaboration with Invitrogen which added six points to growth over the first three quarter of 2008 anniversaried in the third quarter and this is the reason for the step down in growth rates from previous quarters.

This business does not appear to be impacted to any real degree by the economy and we see continued growth opportunity primarily from further geographic expansion.

Looking at the rest of the P&L, gross margin at 49.5% was on par with our thinking. Operating expenses at 34.2% of revenue were about a point below our expectations. This is reflective of our continued vigilance to control spending in these times of slower top line growth.

The organization has done a great job in this regard throughout 2008 and we are prepared to continue these efforts in 2009. Our fourth quarter tax rate of 33% was impacted favorably by the recording of the full year federal R&D credit and negatively impacted by the gain on the pharma product sales. The full year effective rate net of the first quarter discrete items, and the pharma sales was 31% right inline with our thinking.

As for the balance sheet and cash flow, we ended the year with $79 million of cash and $151 million of debt for a net debt position of $72 million. Our free cash flow was $9 million for the quarter and full year free cash flow of $60 million was 50% of net income as adjusted to exclude the pharma product sales.

In looking forward to this year, we now project revenues of $1.02 to $1.04 billion. This is down from the first guidance we gave back in October of $1.05 to $1.07 billion due impart to additional unfavorable impacted currency and more significantly due to greater caution about the impact of the economy on growth rates given what we have experienced in the fourth quarter.

This range would reflect reported growth that is flat to 2% and organic growth of 7% to 9%, as we adjust for the 5% anticipated negative impact of currency year-to-year and the 2% negative impact of the divested pharmaceutical products. This compares to the 6.5% organic growth we experienced in the fourth quarter.

Catalyst and SNAPshot DX are anticipated to contribute roughly 2% to growth. We expect reported growth rates to ramp gradually in the second half and we will see low single-digit declines in revenues year-to-year in the first half. As a reminder, PZI VET sales in the first half of 2008 exacerbate the reported growth profile for 2009.

We expect the full year gross margin to be about on par with that achieved in 2008. This is the net result of a revenue mix shift toward relatively lower margin instruments offset by productivity improvements in our lab operations and instrument and kit manufacturing.

Margins are expected to be highest in the second quarter as in previous years, given the somewhat seasonal revenue profile for rapid assay business.

Our production learning curve for Catalyst will continue to be an important factor in our ability to achieve our anticipated gross margin performance over the year.

Operating expenses should average out to 35% to 36% of revenues for the full year, translating to a full year operating margin of approximately 16% of revenues. We expect the first quarter margin to be lowest at approximately 13.5% due to the timing of commercial activities, such as tradeshows.

As indicated at the time of our third quarter call, we are not expecting margin expansion in 2009 from 2008, given the increased prominence of our new instrument offerings in our 2009 financial profile. We view them as near-term investments in our longer-term strategy to ensure a profitable proprietary consumable stream and to increase our market share, not only for in clinic instrumentation but also for other offerings in our Companion Animal portfolio.

While we are committed to make any appropriate investments to support Catalyst and other new product and service offerings, we are at the same time committed to continuing our close monitoring and control of expenses to achieve our earnings objective. We have demonstrated our discipline to do this in 2008.

We expect the tax rate to be approximately 31% for the full year. Net interest expense to be $2 million to $2.5 million and the full year share count to decline approximately 3% from the full year 2008 level. All of this leads us to modestly tighten our full year EPS projection to $1.84 to $1.90 from the previous range of $1.82 to $1.92 that we cited in October.

Before I mention the balance sheet and cash flow, I would like to update on currency. Our primary currency exposures are in the euro, the pound, and the Canadian dollar. Our guidance given today assumes the euro at a $1.30, the pound at $1.40 and the Canadian dollar at $0.80.

We did complete an additional round of financial hedges in the fourth quarter, while still being cautious with our purchases for the second half of 2009, so that we would not risk over hedging our exposure. Our revised sensitivity is every 1% strengthening of the U.S. dollar vis-à-vis our basket of currencies yields approximately $4 million of lower revenues and approximately $750,000 of lower operating profit on an annual basis.

As for the balance sheet, we project DSO to remain at approximately 40 days, inventories to turn down from $115 million to $110 million and capital expenditures to be approximately $55 million, down from $89 million in 2008. We project free cash flow to be approximately 100% of net income.

Now on to John for further comments on the business.

Jon Ayers

Thank you, Merilee, for the overview and supporting detail of our financial and business result for the quarter and year. Given the very challenging economic environment that the world faced in Q4, and the consequent pressures on our customers, I am very satisfied with these results, both on the top line and the bottom. IDEXX continues to respond effectively to market conditions with the appropriate focus on cost efficiency and execution against objectives.

I am also pleased that the pharmaceutical divestiture and out licensing deals were completed in the fourth quarter in a timely fashion, which allows us to focus on our core diagnostics and information technology strategies. I would like to note that with the reporting of the 2008 fourth quarter and full year revenues; we can confirm that our 11% annual revenue growth propelled us over the $1 billion threshold.

The $1 billion mark was the company goal established a little over three years ago when we developed a strategic plan we call the blueprint to a $1 billion. Since that time, we built out this blueprint by investing and growing our core businesses and by making a few selected acquisitions that strengthened this quarter.

I would like to take this opportunity to congratulate the employees of IDEXX on the hard work, innovation and customer focus that achieved this accomplishment. Our blueprint to a $1 billion called, in part, for investment in new product and service innovation that brings value to our customers.

And as a result of the sustained level of investment over several years, we continued to introduce new offerings. For example, in a large tradeshow for the North American veterinary market held just last week, we introduced several new products and services and highlighted others that were launched in the fourth quarter for total of over a dozen announcements.

Let me update you on a few. Catalyst Dx, our next generation Chemistry Analyzer that is the flagship of our point-to-care laboratory instrument suite has added new menu capability, including electrolytes and automated urine protein analysis, while also adding automated dilution capability.

In the fourth quarter we placed over 500 catalyst units with customers while building the backlog for Q1 of over 200 units. As with any major instrument launch, we continue to keep a close eye on insuring a great customer experience and thus we will continue a controlled launch phase into the first half of 2009, by constraining placements in order to ensure a high level of customer satisfaction.

Customers especially appreciate a higher throughput and efficiency of Catalyst Dx. For example, four patients can be run through the system with a pre anesthetic protocol in just 16 minutes. And in just eight minutes a technician can run a complete chemistry panel of 22 parameters with left hands on time, then it would take to prepare that blood work to send to the outside lab. This throughput, ease of use and comprehensive meaning capability is unmatched by any other bench top analyzer.

We're also made important progress with SNAPshot Dx, the other analyzer that we introduced in parallel to Catalyst, by announcing that we will be adding two SNAP Test kits to the capability of the instrument in the next few months as mentioned by Merilee.

By adding SNAP capabilities the SNAPshot DX, we are bringing the electronic medical record to the traditionally manually read test kits segments. This capability creates further synergies between two significant IDEXX lines of business, a ubiquitous SNAP family of test kits and instruments allowing us a tremendous cost selling opportunity.

Speaking of SNAP, we also introduced the full launched of Feline Triple, the next generation in Feline disease testing by adding heartworm to our highly popular SNAP Feline combo. Feline heartworm has received broad recognition by the profession in the last year.

In addition, some of the large animal health pharmaceutical companies have been educating the profession on the importance of Feline heartworm prevention. Early customer response Feline Triple has been greater than we anticipated, and the demand has outpaced our manufacturing capabilities.

Our IDEXX sales force and third party distributors in the US, who together encompass over 800 reps in the field, are very excited about having a next generation Feline SNAP to sale. One which could have higher volume screening applications with practices who are located in heartworm endemic areas.

And, our customers are excited to have a new reason Feline heartworm testing to encourage their Feline Pet owners to come in for their annual exams, thus bolstering cat visits in this economy. We will see where it all goes and any new idea takes time to spread across the veterinarian community as we all know, but early feedback is very, very positive.

In the lambs business, we are introducing yet another new and proprietary test offerings, a cardiac monitoring for dogs and cats. Cardiac disease is a big topic in veterinary medicine, just as it is in human medicine, although the specific pathologies are bit different in both the canine and feline species.

This test offering was featured early this year on Good Morning America, as one of the top five new pet products of the year and there was only one or two medical products. Both the veterinarian and the pet owner appreciate a simple blood test to help rule in or rule out cardiac disease.

In fact, this test can save a pet owner from significant veterinarian deals with more expensive procedures, such as echocardiograph, which could be avoided in the case of the dog, if cardiac disease can be ruled out early on. We expect this test called Cardiopet proBNP to begin to be offered in a convenient form throughout our North American Lab network starting in March and on our other international labs in the ensuing months. Cardiopet proBNP as to our growing menu of next generation diagnostics offered exclusively by IDEXX Reference labs.

As investors know, we have built a strategy over the last couple of years of enabling our customers to more easily transition to electronic medical records, a big topic recently in human medicine. Some refer to this as the paperless practice or at least a paper light approach.

By automating the information transfer between the software that runs the practice and our diagnostic solutions, including both the in-house and the Reference lab, as well as digital radiography, we increased technician productivity and satisfaction, enable a consolidated electronic medical record reach patient and importantly ensure that no fees or loss from services provided. We call this two way information communication, SmartLink, and in the current economic environment when practitioners are facing slow or no growth, or even revenue declines in some cases, many customers have become more interested in our SmartLink solutions.

All of our Companion Animal Group offering is now SmartLink if you will, which provides opportunities for cross selling and even total solutions selling. In fact, we can create the market by demand, by showing the customer, the medical, productivity, and economic benefit that come from an investment in IDEXX. By way of example, we believe it is one of the factors behind our success in the digital radiography business in the fourth quarter, where we had an outstanding performance in placements and orders.

We thus seem to have developed a timely solution that is particularly attractive in these economic times. Indeed, anecdotal evidence to suggest that customers who use our Cornerstone software and other elements of the IDEXX integrated practice, such as SmartLink, are on average holding up better in this economy.

IDEXX some markets unaffected by the economy. Our water microbiology test kit business, which generated 18% of our operating profit in 2008, continues its track record of 5% to 7% core organic revenue growth, by continuing the strategy of brining its technology to markets around the world and gaining regulatory approvals. Most recently, we were excited to introduce a special version of our Colilert product line in China and initial sales have been very encouraging.

Moving on to staffing, I was delighted to announce in December the addition of a new executive to the management team. Bill Brown with 25 years of experience at Abbott Diagnostics, most recently as the head of R&D in that division, has joined IDEXX as the officer supporting our instrument business and as the eventual successor to our Chief Scientific Officer, Bill Wallen in 2010. Please join me in welcoming Bill Brown.

There is no question that our major end market, veterinary healthcare for the family pet, is challenged by the global recession, particularly as the recession impacts the consumer and the pet owner. We are further challenged by the strength of the dollar as Merilee has enumerated. This will likely make for a low growth outlook for IDEXX in 2009. At the same time at IDEXX, like most companies in the current environment, we remain vigilant in controlling operating expenses, a [goal embracing] supported across our entire organization.

On the other hand, our strategy of innovation and a focus on solutions for the customer, such as Catalyst Dx, SNAPshot Dx, digital radiography, SmartLink solutions and new test introduction such as Feline Triple, Cardiopet proBNP and Chinese Colilert will help us achieve our organic growth targets.

At this point, Cynthia, I'd like to open it up to questions for Merilee and myself.

Question-and-Answer Session

Operator

(Operator Instructions) We'll first go to the line of David Clair of Piper Jaffray. Please go ahead.

David Clair - Piper Jaffray

Good morning.

Merilee Raines

Good morning.

David Clair - Piper Jaffray

Just a quick question on guidance. You grew 6.5% organically this quarter. Your guidance was 7% to 9% in fiscal '09. Just, if you can kind of walk us through there. I mean, it seems like the economy continues to be a drag year. I am just curious how you get into the 7% to 9%?

Merilee Raines

David, I think that nobody can really predict where the economy is going to go and so all that we can do is really with our projections is, kind of presume that what we saw in the fourth quarter continues into 2009, so we kind of looked at that. That is being the impact of the economy.

And then, as John and I both mentioned, we do have some growth that's coming from new products. Our instrument launches will contribute a couple of percentage to the organic growth next year. And so, we just looked at everything all in the mix economy and then factoring growth of and contribution from new products is delivering the 7% to 9%.

David Clair - Piper Jaffray

Okay. And you kind of hit on this on the commentary, but can you give us any clarity on pricing and volume impacts on the consumables and the rapid assay businesses? I mean if you can just kind of split impact on each of those?

Jon Ayers

Do you mean the impact in Q4?

David Clair - Piper Jaffray

Yes.

Merilee Raines

Well, in comparison to what prior periods?

David Clair - Piper Jaffray

Well, year-over-year, I mean, was pricing up 2% and volume down 2% or how?

Merilee Raines

In rapid assay, in particular, looking year-over-over and the quarter, pricing was a little bit under 2% and the rest was volume and this is on the growth of 5%, that's adjusted for distributor inventories.

David Clair - Piper Jaffray

Okay.

Merilee Raines

So pricing a little bit under 2% and then volume therefore a bit above 3% or closer to 4% for the total of 5%.

David Clair - Piper Jaffray

Okay, great. And well I think that's it for me. Thank you.

Jon Ayers

Thank you.

Operator

Thank you. And our next question comes from Ryan Daniels from William Blair. Please go ahead.

Ryan Daniels - William Blair & Company

Yeah, good morning, Jon and Merilee. A couple of more detailed questions on the outlook. If we thing of the share repurchases, I know you guys have been averaging about 3% from the last, I don't know three to five years, it sounds like you expect that again.

Have you considered taking that up given where the stock is and given the fact that your free cash flow should be so strong next year? Is that an option that we might see that tick up a little bit or maybe provide a little cushion at the bottom line as the year goes on, any thoughts there?

Jon Ayers

Ryan, yes, I think that's our base assumption that we gave you. We continue to be very excited about IDEXX's longer-term outlook. We think at the current price, the share is an attractive investment opportunity for us. We're going to have a strong free cash flow in this environment. We're going to be balancing our share repurchase against other things that we could do with that cash flow, but we do feel very good about in investment in IDEXX stock at this point.

Ryan Daniels - William Blair & Company

Okay. That's helpful color. And, then if we think of the R&D, I know that that's run about 7% historically maybe a $70 million plus or minus run rate. Does that change it all with the divestiture of the pharma business? I don't know, what type R&D spend was related to that but I'm curios looking out to '09, '010 what we might see on the R&D front?

Merilee Raines

It is somewhat impacted by the divestiture of the pharma business. But, we had been keeping very controlled investment in R&D there in limiting to products that were very near term. So, I think that we might see, I mean -- basically the percentage will hover around 7% and it might be a little bit less than that as a percent of revenues for this year.

Ryan Daniels - William Blair & Company

Okay. And then, you mentioned I know last quarter specifically about $3 million in pharma sales for '09. Is that still a good metric to be thinking about? I know Navigator, you're not producing anymore, does that change of assumptions in the pharma side?

Merilee Raines

Yeah. The revenues for 2009 will be slightly less than $3 million.

Jon Ayers

And, while they were part of the pharma segment, there basically some licensing fees and actually an equine diagnostic that just happened to be in the pharma group because of the Equine Pharmaceuticals.

Ryan Daniels - William Blair & Company

Okay.

Jon Ayers

From a strategy point of view it is -- our focus is on diagnostic technology and information technology and so that 3 -- little bit less than $3 million is more of a assay of some other things.

Ryan Daniels - William Blair & Company

Sure. Okay, that's helpful. And, then there's been a little bit of noise, obviously some new competition in the rapid assay market and based on all our channel checks. It sounds like really to compete with some of your 3Dx, 4Dx that Lyme disease is pretty critical to have a multi-analyte test.

I was wondering, if you could talk a little bit about your patent protection around that is that something you guys are pretty comfortable with? It's going to be hard replicate or just any color you might have there I think would be helpful.

Jon Ayers

Thank you for that question, Ryan. Our 3Dx and 4Dx of course tests for several tick borne diseases the most, probably the one that investors understand the most is Lyme disease, but there are a couple of other tick borne diseases Ehrlichia canis and anaplasmosis, they are also kind of treacherous diseases to test for. We have a variety of intellectual property positions against 3Dx and 4Dx. Some of them are associated with the platform, the ability to do multi-analyte on the same platform. The ability to our SNAP bidirectional ELISA on a test kit is patented.

I think what you are also referring to is the technology that we used for Lyme disease, which is the gold standard in both human and companion animal Lyme disease testing. It's called C6 technology. I don't want to get too technical here, but it's actually very difficult to test for Lyme disease, because it doesn't really – Lyme disease itself doesn't float around in the blood. It migrates to the tissues. And so what you can only test for is antibodies and that is much trickier and our C6 is a very clever technology. That technology, we've licensed of course exclusively worldwide for the life of the patent that goes through 2019.

Ryan Daniels - William Blair & Company

2019. Okay, great. And then last question, I'll jump off here. I know to date, you guys have really just been putting Catalyst and I think SNAPshot to its existing customers. You purposely have not gone after market share shifts. Can we -- looking into 2009 expect that to be part of the strategy too? Obviously, the curiosity here stems because of the consumable sales or probably incrementally better when you upgrade the Catalyst that would markedly better if you are actually changing share. So I don't know if you want put right color there, but anything would be helpful. Thanks.

Jon Ayers

Yeah, Ryan, we have been taken care of our friends and family as we call it, our existing customers with Catalyst, so far through the launch the vast majority of the catalyst that we have placed are with existing VetLab customers, who had the Vet test and upgraded. They have been waiting for high throughput ease of use

some platform such as Catalyst, and we felt important to take care of the customers. We are going to continue with that strategy through probably good part of the first half of this year. But catalyst is an extraordinarily efficient instrument for any high volume practice and when we are talking about high volume here, let's not -- let's understand what that means.

That means, it could be 5, 10, 15 test a day. That would be very high volume in a veterinary practice, but that's good business. And so, I think catalyst will be a very attractive option, whether it happens to be an IDEXX customer or somebody who is not currently using IDEXX equipment, and so we are going to be migrating as the year progresses to target the segment that is most appropriate for catalyst and we'll be moving beyond the friends and family, as we get into the second quarter and of course more into the second half of the year.

Ryan Daniels - William Blair & Company

Okay, great. Thanks.

Operator

Thank you. Next we'll go to the line of Jonathan Block from SunTrust Robinson. Please go ahead.

Jonathan Block - SunTrust Robinson Humphrey

Thanks and good morning, guys.

Jon Ayers

Good morning

Jonathan Block - SunTrust Robinson Humphrey

First question, Jon, just the gross margins for both of Water and the PAS business were up very nicely year-over-year. And so sort of two part question, one what drove that and then to how should we view the mature margins in both of those businesses?

Merilee Raines

Jon, it's Merilee, I'll take that one. Actually both of those businesses, because they have a high percentage of international revenues, actually benefitted quite nicely from our hedging practices. So they had gains related to the financial hedges that we put in. And we also have seen for some of the areas that there's been a little bit of a favorable price mix, that's been going on.

Jon Ayers

And, we also have some licensing fees in the water business that are falling away.

Jonathan Block - SunTrust Robinson Humphrey

Okay. So Merilee, I mean, is there a way to just try to quantify approximately what do you think the hedges may have added on the bottom line?

Merilee Raines

I, Jon, I wouldn't have that for you.

Jon Ayers

If you look at over the course of 2008, we have obviously very favorable currency environment for half or then more than half of the year and then the hedges when they play to factor there. They are just to the extent that those businesses benefit from volume that's manufactured in the U.S. and exported which is basically all the water international business and a portion of the PAS international business then.

Merilee Raines

Well, and another thing to think about. Just looking at year-over-year comparisons, we also last year in the PAS business had done an acquisition in Europe and so there were some of the integration fees were reflected in gross margin percentage. So, yes, there are just a number of factors that are going on there.

Jon Ayers

Those are generally very, very good gross margin and operating margin businesses for us.

Jonathan Block - SunTrust Robinson Humphrey

Okay, great. And then maybe just a move on. Thoughts on the Catalyst, I think previously it was thought the control launch would last through the end of the year and then sort of glows off scenario and that I thinks' to be, maybe just push back a little bit.

So Jon, when do you think you are going to go after those market share gains if you want sort of a question little bit ask differently than Ryan? And then, if you can just address the deal what I believe it was IRIS International, what does that give you guys or you didn't have before, does that alleviate any of the quality control issues?

Jon Ayers

Yes. Thank you. Let me address the second question first, it's relatively easy. We have a long-standing relationship with IRIS and really what that deal allowed us to do was to move to a high volume manufacturer of consumables to support the volume growth that we would anticipate.

What they helped us design was the whole blood separator, which is the little plastic piece that you put the blood in and allows you to run whole blood on Catalyst. And so, we're moving that from manufacturers to a supplier with high volume medical plastic manufacturing as the core competency.

So it's a pretty strict forward evolution of the supply base and we continue to enjoy very good relationship with IRIS. They make the centrifuges and an important centrifuges component for Catalyst Dx.

More generally, we are very excited by having now launched some of the remaining capability for Catalyst as I mentioned in my opening remarks with electrolytes, which gives the ability to a full Chem-22 panel in eight minutes and also some important ease-of-used features on automated dilution and automated something we call urine protein/cretonne ratio made it far easier to now analyze urine on the analyzer.

And so, as we've launched these and as we're taking care of friends and family which we continue to need to do in the first quarter, we're going to be opening it up to competitive, what we call competitive or [IONEX] places, starting a little bit in the second quarter and certainly more as the year progresses and that those are factored into our plans and our placement numbers.

Jonathan Block - SunTrust Robinson Humphrey

Okay. And, then just moving on to your guidance, I mean simply you got a little bit more conservative on the organic growth. But just curious implicit in the guidance Jon early, are there any assumptions about share losses in your rapid assay market, you have got a new competitive today, you have got 90% of this market. Within your '09, do you assuming that you exit, beginning the exit in the 90% share?

Jon Ayers

I think it's important to state that we feel we have a really strong position in the rapid assay business strategically. A vast majority of our products are protected by a variety of patterns or even in both the platforms and the reagents.

The area that has traditionally not been the case and there's nothing new about that is the straight heartworm-only testing segment. That's been an open field since the middle to late 90s. And, there have been lateral flow competitors in that segment since that time.

What we have been doing has been migrating heartworm-only testing to 3Dx and 4Dx as people appreciated the importance of parasitic disease screening. But, we have always competed in that segment, now relatively small portion of our rapid assay business and obviously becoming small as we continue that migration.

But even then, we think we have a superior platform, a product that would third-party clinical data has higher sensitivity and specificity, a strong sales and distribution network and as we put that on SNAPshot Dx and integrate that into the instrument suite is our additional values that we are going to be bringing to our rapid assay business.

Now, having said all that, more because of the economy, we have a very conservative assumption for rapid assay revenues built into our 2009 guidance. Just because of -- it's kind of a trend that we've seen in the fourth quarter.

Jonathan Block - SunTrust Robinson Humphrey

Okay. And just last one and then I'll just jump back in the queue. But past two our three quarters revenue has decelerated again. You are pointing to 7% and 9%. I think what you had in '08 and I think I am correct here, you had a little bit of tail and maybe 200 bps from a couple of lab wins that you'll lap in '09. So Jon, is it safe to say, again and pushing this guidance do you think that we shake out of this thing in the back half of the year. That's sort of the general thoughts on how you still get to that 7% to 9%?

Jon Ayers

Well, we are kind of assuming status quo. I bet -- if things improve, that would be good. If things deteriorate, that would not be good. We are assuming status quo. Now what happens of course is as you get to the fourth quarter, you anniversary the recession. So your comps become easier in the fourth quarter of 2009. But, I think what we are seeing with our 7% to 9% organic growth is that we feel very good about the markets we are going to create with our new products introductions. Catalyst Dx, we have a very, very strong digital radiography offering and digital radiography is an area of investment by our customers that saves them money and gives them higher productivity and gives them higher revenue capture.

So we are right at the most attractive point for substitution from film, to digital in that trend as is demonstrated in for quarter seems to be a strong enough trend because of its economic inspects, not to be effected by the economy. Just in those two categories, Catalyst and Digital that's been generally close to half of our -- if you take 10% of the number, it's being close to half of the 7% of the organic growth alone.

So you take the rest of the assumptions there are pretty conservative. The other thing I would say is we reported the 6.5% organic growth in the fourth quarter. We do that consistently throughout, but if you listen to Merilee's comments, we don't make an adjustment for changes in distributor inventories, but we felt very good about the quality of that underlying organic growth of 6.5% in the fourth quarter which gives us confidence with regard to our trends ended 2009.

Jonathan Block - SunTrust Robinson Humphrey

Okay, great. Thanks very much guys.

Operator

Thank you. And next we'll go to the line of Ross Taylor with C.L. King. Please go ahead.

Ross Taylor - C.L. King & Associates

Hi, I might start by just kind of continuing that same thought on distributor inventories. I think Merilee maybe answered this question with some other number she gave. But, if you exclude the distributor in Japan, can you estimate I mean how much inventory reduction on the part of distributors and maybe also that that's reduced your instrument consumable growth and rapid assay growth in the quarter?

Merilee Raines

The numbers that I gave included the distributor impact from both Japan and the US, so they were only numbers, so for instrument consumables it was a 2% impact to growth and on rapid assay that was a 7% impact from those two categories on growth.

Ross Taylor - C.L. King & Associates

Okay.

Jon Ayers

And then with regard to what happened inside the practices, this is really, we of course don't measure inventory inside the practices. I wish we could, one of the problems, reason why we don't do it because the practice themselves don't measure the inventory. Inside their practice is very well. [Weigh it all] and they consider supply side inventories, when they bought it they have spent the money and then -- they don't think about when they have used it. So, the economic concept in inventory is not something they think about.

However, as we look at the ordering patterns in the fourth quarter, and we compare them to the ordering patterns of the prior fourth quarter, we noticed a little bit tick up in the frequency, and a little bit tick down in the size for order. And so one could speculate that, that might have had a small impact, 1%, maybe 2% impact on the growth rate that they were buying less than they were selling, they were using in comparison to the compared quarters of 2007.

Ross Taylor - C.L. King & Associates

Okay. That's helpful. I am sure they did very, very dramatically byproduct line. But what would you consider to be a normalized, kind of day sales inventory that distributor add of that might have in their clinic?

Jon Ayers

Well, distributor is, very typically, it's three to four weeks. It's been that way for us, as that US, outside the US might be a little bit more or less, depends on the distributor. Well, inside the clinic it's probably also weeks, I would say, that would be our guess, it would be weeks, not months.

Ross Taylor - C.L. King & Associates

Okay, all right. And just maybe two other questions…

Jon Ayers

And as you say, it varies by product line too. Sometimes they, like they buy up for the season on parasitic disease screening, for example, and with instrument consumables is probably more steady state.

Ross Taylor - C.L. King & Associates

Okay. And then maybe two others questions. But can you all make any estimates as to what might actually be happening at the average clinic level in terms of revenues, I mean are there average practice, I mean do you think their revenues are up down flat, can you make any estimates there?

Jon Ayers

That's a great question. And we get reports from our customers, our big customers, our little customers. We also are able to analyze some data, some sample data that comes from our Cornerstone customers and as part of the service that we provide them to help them understand what their business is doing.

And as we put all this together, it looks like the clinic growth, if you will, in the fourth quarter in the U.S. was somewhere between a zero and 1% or 2%. But that's very anecdotal. We're trying it like the three or four ways, and unfortunately the data is just not, there is no way that get this in a way would give you a lot of confident around those numbers, but it's the ballpark.

Ross Taylor - C.L. King & Associates

Okay. That's actually helpful. And maybe the water business is some times hard for at least me to analyze, but the Colilert product in China, I mean do you think that has much potential to accelerate your organic growth within that business?

Jon Ayers

I think it will allow us to continue our organic growth in that business. We've talked about a 5% to 7% organic growth and that organic growth really comes from as we introduced the product into new geographies, we get new approvals and we get tick up in those geographies over time. And China is one of those geographies that we have not yet really penetrated until relatively recently.

We were delighted to be the technology that was used in the Beijing Olympics for the potable water in the village. And I think that gave us some visibility inside the country and what we've introduced in there is not just to scare it, but it's actually a very similar product, but it's all in Chinese. So they can understand that and use a little bit different marketing and distribution approach and that seems to be a very effective early returns.

Ross Taylor - C.L. King & Associates

Okay. And, last question, I want to make sure I understood something that I think Merilee said, but did you mention that the Feline Combo test can now be performed on Catalyst or is that you read by SNAPshot?

Merilee Raines

If I said Catalyst, I meant SNAPshot Dx and that got approval in this month in January and so we expect then it will be out on the market in the second quarter.

Jon Ayers

As we introduce the software in SNAPshot Dx. So, two products SNAP cPL, which is pancreatitis test that we use and which do not require USDA approval and Feline Combo which did. We'll be introducing that capability on SNAPshot as the first off our plan to rule out the entire SNAP line on SNAPshot Dx.

And we've got a lot of excitement from customers. We've done some field trials and basic productivity with their technicians. They see charge capture. They see information capture in the electronic medical record. It's funny. They don't actually fully appreciate until they start using it and then they really see the benefit.

And, so we think that's always been a little bit of a sleeper opportunity. But as we actually show the customers it and they actually see it, see how it works, they get pretty excited.

Ross Taylor - C.L. King & Associates

Okay. That's great. That's all I have. Thanks very much.

Merilee Raines

Thanks, Ross.

Jon Ayers

Thanks you, Ross.

Operator

Thank you. And, we have time for one final question and that will come from the line of Daniel Owczarski from Avondale Partners. Please go ahead.

Daniel Owczarski - Avondale Partners

Yes, thanks and good morning. Just I had one question on the digital radiography side. You had talked about still having a meaningful order book. Are you seeing your backlog increasing or decreasing? I was just curious as to even customer response. Are you seeing cancellations or delays?

And then finally, can you explain again like in this line who are you competing with? Is it older technology or you selling into clinics that don't have any of that capability whatsoever?

Jon Ayers

Thank you. Those are great questions. We are very happy with our digital radiography line. There are actually a two different price points that we sell. One is called computer radiography and one is called direct digital radiography. Computer radiography might be a $40,000 to $50,000 system. The direct digital might be double that, $85,000 to $90,000 system. The only difference between the two is, you get the image in the direct digital in five to ten seconds and in computer radiography, it takes you 60 seconds to create the image.

The image quality is indistinguishable between the two as is stated by third-party radiologists. So we have outstanding image quality across our product line. We used the same software. It's a very, very software-intensive business because you got to not only take the images, you got to have software that allows you to read them, store them and manipulate them.

And then the other aspect of our offering which I think is unique is it's ability to integrate with Cornerstone. And as we roll out over the course of 2009 third-party software, this high level of two-way integration that we call SmartLink and so people are appreciating that. It's not so easy, if you just order a digital radiography system, you're going to have like a whole different medical record system then anything else if its not integrated, and they would rather have one medical records then multiple line in different systems.

We compete against a wide -- there are a lot of people who are getting into digital radiography, I think they will probably be few of them. A year from now, that they are now, somebody counted something like 15 different companies in the trade show that we just came back from. We believe, we have a very strong, if not leadership position, it was result of our success over the second half of 2008 in digital radiography, most of the volume is coming from practices who are converting from film to digital, so that that's the bulk of the revenue as conversion.

There are some who are adding a second system or third system and some cases they have a very old technology that they are upgrading, but that's really not as, not very big part of the market at this stage.

Daniel Owczarski - Avondale Partners

Okay. But if that price point you are not saying, or are you saying delays or cancellations?

Jon Ayers

Not anything out of the ordinary, we had a very strong fourth quarter, we went into the fourth quarter with a strong order book. We delivered against that order book. We had good year-over-year growth. We developed orders in the fourth quarter, that where gave us a backlog that went into the first quarter and so at this point the market looks very good.

Daniel Owczarski - Avondale Partners

Thank you.

Operator

Thank you, and with that Jon and Merilee, I'd like to turn it back over to you for any closing remark.

Jonathan Ayers

Well, I'd just like to thank everybody that came on the call. We remain very excited about our business and our market despite the challenges that all those who are facing with the economy. And again, I'd like to congratulate all the employees of IDEXX to have cross the billion dollar threshold and reach our blue print $2 billion like, actually earlier than we originally anticipated. And we look forward to updating investors on our progress at our first quarter conference call in April. Thank you and that concludes the call.

Operator

Thank you. And ladies and gentlemen that does concludes your conference call for today. Thank you for your participation and for using AT&T executive teleconference service. You may now disconnect.

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Source: IDEXX Laboratories Inc. Q4 2008 Earnings Call Transcript
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