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IDEXX Laboratories (NASDAQ:IDXX)

Q3 2013 Earnings Call

October 22, 2013 8:30 am ET

Executives

Jonathan W. Ayers - Chairman, Chief Executive Officer and President

Willard R. Blanche - Interim Chief Financial Officer and Vice President of Finance

Analysts

Erin E. Wilson - BofA Merrill Lynch, Research Division

Ryan Daniels - William Blair & Company L.L.C., Research Division

Jonathan D. Block - Stifel, Nicolaus & Co., Inc., Research Division

David C. Clair - Piper Jaffray Companies, Research Division

Ross Taylor - CL King & Associates, Inc., Research Division

Nicholas Jansen - Raymond James & Associates, Inc., Research Division

Jeffrey Frelick - Canaccord Genuity, Research Division

Operator

Good morning, everyone, and welcome to the IDEXX Laboratories' Third Quarter 2013 Earnings Conference Call. As a reminder, today's conference is being recorded. Participating in the call this morning are Jon Ayers, Chief Executive Officer; Will Blanche, Interim Chief Financial Officer; and Ed Garber, 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. Investors should be aware that any forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those discussed here today. These risk factors are explained in detail in the company's filings with the Securities and Exchange Commission. Please refer to these filings for a more detailed discussion of forward-looking statements and the risks and uncertainties of such statements. All forward-looking statements are made as of today and except as required by law, the company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

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 measure is provided in our earnings release, which can be found on our website at www.idexx.com.

Finally, we plan to end today's call by 9:30 a.m. Eastern.

[Operator Instructions]

I would now like to turn the conference over to Jon Ayers. Please go ahead, Jon.

Jonathan W. Ayers

Okay. Thank you, Bonnie. With me is Will Blanche, our VP of Finance and Interim CFO; and also Ed Garber, our Director of Investor Relations. I'm going to turn the call over to Will now to take you through the numbers and I'll come back with some color commentary.

Willard R. Blanche

Thank you, Jon. Good morning, and thank for joining us for today's call. As reported in our press release, our third quarter revenues were $338.3 million, yielding organic growth of 7.4% versus 2012 and fully diluted earnings per share of $0.86, an increase of 13% versus the prior year period. Third quarter organic revenue growth was driven by a strong underlying performance across the annuity portions of our Companion Animal Group business, including lab services, Rapid Assays and instrument consumables, partially offset by reductions in revenue from interim placements. Earnings per share growth exceeded revenue growth due to an 80-basis-point expansion in gross margins, continued reductions in shares outstanding and a reduction in the tax rate. Currency had a $0.02 negative impact on EPS versus Q3 last year, slightly favorable to our expectations.

As a typical, we'll start with observations on the economy government and share what we see in the U.S. veterinary market based on data from approximately 700 of our Cornerstone customers. We are encouraged that during the quarter, patient visits were up 2.6% and practice revenues grew 6.1% versus the prior year. This is favorable to the numbers we reported in Q2 when we saw patient visits grow 0.7% and practice revenues grow 4.9%. Our guidance continues to reflect the cautious outlook on the impact, the economy may have on our growth rates given uncertainty, both domestically and abroad. In this regard, even with a relatively strong Q3 statistics, total year-to-date growth metrics were 1.1% per patient visits, and 4.7% for practice revenues versus the prior year.

VetLab instruments and consumable revenue of $108 million grew 8% organically versus Q3 2012. Instrument revenue of $19.1 million declined 10% organically. Analyzers placed through volume commitment reagent rental or other deferred revenue programs in Q3 of this year, negatively impacted our year-over-year instrument revenue growth by roughly 2%. Both chemistry and hematology placement declined versus Q3 last year and were different than our expectations for the quarter due to shortfalls in the U.S. However, the quality of our placement continues to be high and we are very encouraged by the positive dynamics we are seeing with our diagnostic sales force, which Jon will elaborate on in more detail. Our worldwide chemistry placement declined 5% year-over-year due to the decrease in Catalyst placement in the U.S. As I just mentioned, the quality of our placement remains very strong with 57% of our North American Catalyst placements and 49% of our worldwide Catalyst placements going to customers new to IDEXX. For the full year 2013, we expect chemistry placements to decline in the low-single digits versus our prior guidance of low-single digit growth compared to the prior year.

Our worldwide hematology placements declined 10% versus Q3 last year. Similar to Catalyst, we continue to a high percentage of ProCyte placements going to customers new to IDEXX, 45%, in fact, for Q3. For the full year 2013, we expect hematology placements to decline in the mid-single digits versus our prior guidance of flat year-over-year growth.

Instrument Consumables revenues of $75.8 million grew organically 13% versus the prior year period, or 15% when further normalized for changes in distributor inventory levels, which negatively impacted revenue growth by almost 5% and certain timing items that favorably impacted revenue growth by over 2%. This strong normalized growth, which is slightly above Q2 performance, is a result of a number of factors including: The quality of our placements; our increasing installed base; increased testing, as current IDEXX customers upgrade their in-house labs with Catalyst and ProCyte; and enhanced loyalty from our base of Catalyst customers who now account for 87% of our U.S. chemistry consumable revenues, exclusive of corporate accounts. With these continued strong fundamentals volume growth drivers, we are increasing the low-end of our guidance range and now project our full year 2013 Consumables growth to be 13% to 14% versus prior year.

Our third quarter Rapid Assay sales of $43 million, grew 10% organically versus the prior year, or 5% when further normalized for changes in distributor inventory levels, which favorably impacted growth by over 1% and certain timing items that benefited growth by another 4%. We continue to expect normalized growth to be 4% to 5% for the full year 2013 for Rapid Assay.

U.S. distributor inventories for instrument consumables and Rapid Assays averaged a little under 4 weeks at the end of the third quarter based on forward-looking demand, which is within their normal and customary range.

Our reference laboratory and consulting services business, with revenues of $110.3 million in the quarter, grew organically 9% versus the prior year. All geographies contributed to our solid third quarter performance and we benefited from acquisition of new accounts, improved customer retention and incremental testing from our customer base in part due to deleveraging the North American and diagnostic sales force model and VetConnect PLUS. We continue to expect organic revenue growth for labs and consulting services in the 8% to 9% range for full year 2013.

Our Practice Management and Digital Imaging Systems business, with revenues of $22.6 million, grew organically by 9% in the third quarter versus the prior year period, compared to a modest decline for the first half of the year. As mentioned last quarter, we had several new sales reps toward the end of last year and earlier this year. We did see improved placements in Q3 as compared to Q2 but Digital Imaging Systems placements were not quite to the level we'd assumed at the time of last quarter's call. And because of this, we are now expecting full year growth in the mid-single digits versus our prior high-single digit expectation.

Our Livestock, Poultry and Dairy revenues declined 2% organically to $25.1 million in the third quarter, in line with our expectations. The decline was driven by reduced testing in government programs in Europe, including BSE and in Latin America. We expect that Livestock, Poultry and Dairy organic growth for the full year will decline in the low-single digits, consistent with our prior guidance. Madasa, a distributor in Sao Paulo, Brazil, that we acquired on August 20, contributed just under $1 million of revenue in the quarter.

Our water business grew 5% organically versus the prior year period to $23.2 million in the third quarter, in line with our expectations. The increase was primarily due to continued gains in our core Colilert testing business in North America. We are maintaining our previous guidance of mid-single digit organic growth for the full year.

Moving to the rest of the P&L. Gross margin at 55%, as I mentioned, was 80 points favorable to the prior year, primarily due to price realization, favorable revenue mix, including high relative sales of instrument consumables, and continued service efficiencies in our reference labs line of business.

Operating expenses were 35.6% of revenue, and our effective tax rate at 29.1% was somewhat favorable to our expectations due to the release of reserves in conjunction with the completion of tax audits.

Turning to cash flow. Our free cash flow was $64.4 million or 141% of net income in Q3. The improvement compared to the first half of this year is primarily due to lower capital expenditures and the seasonal working capital improvements.

We repurchased 801,000 shares during the quarter, slightly higher than our thinking, when we provided guidance last quarter. Looking forward, we project full year 2013 revenues of approximately $1.370 billion to $1.372 billion, which implies a fourth quarter organic revenue growth rate in the range of 8.0% to 8.4%. This year's second half expected organic growth rate of approximately 8%, which is nearly double our first half organic growth of 4.4%. This second half 8% organic growth is different than the 10% growth expected at the time of our July call, and is driven primarily by anticipated revenue from capital placements, both VetLab and digital systems. These capital placement revenue expectations for the second half are lower for two primary reasons: the lower number of placements, as discussed previously; and higher amounts of deferred revenues as a result of marketing programs.

We expect full year 2013 gross margins to be about 55%, in line with our previous guidance. We expect operating expenses to be approximately 35% of revenue for the year, consistent with our previous guidance as well. 2013 operating margin is projected to be about 19.5% for the full year, which represents a year-to-year expansion of about 25 basis points when normalized for currency, and discrete items, consisting of the $3 million pharma milestone payment in 2012, and the $4 million Trendset loss reserve reported in the first quarter of this year. We expect the tax rate to be 29.0% to 29.5% for the 2013 full year, a half point reduction from our previous guidance, primarily due to the reserve adjustments made in Q3. Net interest expense is expected to be $3.5 million, up from our previous guidance of $2.5 million to $3 million due to higher volumes from our share repurchase activity. Weighted average share count, which is expected to be down 4% from full-year 2012 levels, an increase of 50 to 100 basis points from our previous range of 3.0% to 3.5%, reflecting our latest thinking on share repurchase.

Integration expenses, associated with the Madasa acquisition, negatively impacts EPS by approximately $0.01. This leads to updated full year 2013 earnings per share guidance of $3.44 to $3.48, which compares to our July guidance of $3.42 to $3.48. We expect free cash flow of 95% to 100% of net income and capital investments at $90 million, both consistent with our prior guidance.

As we look forward to 2014, we project revenues of $1.48 billion to $1.50 billion, a year-to-year increase of 8% to 9% in reported growth, and 7% to 8% in organic growth. Modest favorability from acquisitions and currency contributed approximately 1% to 2014 revenue growth. Fully diluted earnings per share are projected to be $3.76 to $3.86, a year-to-year increase of 8% to 11%, or 11% to 14% when normalized with 3 items: first, while currency is anticipated to have a minor favorable impact on revenue growth, our earnings per share guidance contemplates roughly $0.02 of headwind from currency due to 2013 foreign exchange hedge gains that are not projected to recur in 2014 based on 2014 hedges in place and FX rates assumed in our guidance. Second, the Trendset loss reserve reported in 2013 was $0.05; and last, the 2012 and 2013 R&D tax credits benefited 2013 by $0.10 and have not been assumed in our 2014 projections. We're still in the midst of our annual internal planning process and so we will provide more details on the components of our P&L, balance sheet and cash flow at the time of our earnings call in January.

With that, I'll turn it back to Jon for his comments.

Jonathan W. Ayers

Okay, nice work to Will. It was nice to see the revenue growth continuing to pick up in Q3. And as Will mentioned, our 7.4% organic revenue growth was driven by 8.7% Companion Animal Group growth, and Companion Animal Group growth is over 80% of our total revenue. That 7.4%, third quarter organic revenue growth was a nice pick up from the prior 2 quarters of 3.3% and 5.5%, Q1 and Q2 for IDEXX as a whole, and the 8.7% was a nice pick up for our Companion Animal Group from 3.6% and 6.8% in Q1 and Q2 of 2013, respectively. So this growth is reflective of the underlying strength we see in the business and it gives us confidence to guide the 7% to 8% organic revenue growth in 2014. Now Q3 was a very important quarter as it was the first full quarter of our CAG diagnostic sales organization in North America. An organization that is responsible for approximately 50% of IDEXX's revenues globally. I'm very pleased with the progress on the team's accomplishments, especially given the magnitude of the change. To remind investors, in April, an initial 20% of our North American sales organization for diagnostics moved to new roles and territories associated with our new customer coverage model. We called this first group, Wave 1. The new coverage model entails a single sales professional serving the customer for all IDEXX diagnostic modalities, including the instruments, SNAP and reference labs. Allowing for smaller more manageably size territories for each rep and more frequent and consistent customer contact. The remaining 80% of the field and what we call Wave 2 assumed their new roles in the new model in Q3. So this past quarter, clearly, has the highest risk for the 80% of North America in Wave 2 with all the associated changes in roles, in territories, in reporting relationships inherent in such a major shift in field sales strategy. The Wave 1 regions that were in their second quarter of the new model during this past quarter 2013 moved down the learning curve and performed better than both their first quarter this year and Q3 last year. Performance as IDEXX looks at it includes achieving goals across all 3 diagnostic modalities: Reference labs, Rapid Assays and instruments and consumables.

On the performance dimension of instrument placements, we were impressed to see Wave 1 region step up, with instrument placement growth year-over-year that reflects the productivity that comes from more time and position in territory and the additional number of reps in the field. As we extrapolate to Q4 and beyond, we anticipate that the second quarter in position learning curve benefits we saw for the Wave 1 regions will improve to the far larger number of Wave 2 regions.

A couple of other notes from our experience. Sales professional turnover remains at historically low levels, below even below Q2 level, we experienced. So in turn, tenure, and time and territories building in the field. We completed the quarter with 40% more customer calls per rep than the old model, which speaks to the benefit of the new coverage account model with smaller geographic territory, and that's far greater reach and frequency. We have 13% more sales professionals in the field in Q3, versus that the same quarter prior year and when you combine that with the 40%, more calls we actually achieved 58% total more customer calls in Q3 than prior quarters. And we enter Q4 with 16% more diagnostic sales professionals in the field than we had in Q4 of 2012. We saw increased loyalty, e.g. fewer loss accounts in Q3 in all 3 diagnostic modalities that at any time in the last couple of years for this important growth metric. Now high customer account loyalty is certainly an outcome of our new customer call -- customer-centric sales model, but also reflects our highly valued and differentiated diagnostic line including VetConnect PLUS, advanced and unique menus and the integration with practice management software, just to name a few.

Another point, Canada, which was part of Wave 2 performed above expectations in Q3, had strong year-over-year instrument placement metrics and executed a very successful launch of VetConnect PLUS in July. And finally, in other international markets, we had almost 10% growth in Europe, and 14% growth in Companion Animal Group, and 14% growth for the Companion Animal Group in Asia-Pacific. And chemistry placements grew year-over-year in both Europe and Asia-Pacific. So in summary, our Companion Animal business showed strong fundamentals with growth normalized -- with global normalized growth in the profitable annuity or recurring revenue aspects of our business. We've mentioned this 15% for instrument consumables, 9% for reference labs and 5% for Rapid Assay. In instrument revenues, while Q3 short falls have caused us to reduce our full year 2013 instrument revenue guidance, the quality of instrument placements continued to be as strong as measured by the percent that are going to new or competitive accounts. We are confident based on Wave 1 progress in Q3, that our North America sales professional productivity and diagnostics will continue to increase, and that assumption, along with the 16% larger sales presence in North America in Q4 over last year, is factored into our 2013 guidance, and of course, the foundation of our 2014 guidance.

We continue to innovate in the new product area. In Q4, we have launched a new catalyst single slide, single test for fructosamine which is a very exciting addition to our chemistry menu, allowing for the diagnosis and management of diabetes in a real-time care model. And diabetes is as important as a disease category, and dogs and cats as it is in humans. This new slide has been developed and has manufactured by IDEXX in our main facility and gives us demonstrated capability to further expand the catalyst slide menu with our internal R&D and manufacturing. While we don't expect the fructosamine in test revenues and itself to be significant, fructosamine is frequently used and highly valued by customers because they see a lot of diabetic patients. And thus, further differentiates our catalyst chemistry instrument from other chemistry platforms in its menu breadth and flexibility and thus, enhances all of the factors that drive our instrument consumable growth. Additionally, we introduced several new innovative products and reference labs, including an allergy screening test and our immunotherapy offering that complements our existing allergy product portfolio. We also introduced it in reference labs, a new canine and feline cardiac tests that significantly improves the customer workflow when assessing cardiac health. So in regards to our portfolio for test of cardiac disease, we recall that we will also be launching a new rapid test in early 2004, the SNAP Feline proBNP, a screening test for heart disease. Thus, the improved reference lab test that we just announced in this past quarter and the new point of care test significantly advances our cardiac testing franchise, leveraging the same proprietary biomarker technology across multiple complimentary modalities.

In fact, this management and digital imaging systems since our last call, we launched IDEXX IMAGEBANK, cloud-based image archive service. We also launched Pet Health Network 3D, a new subscription-based 3D animation product that supports veterinarians in communicating the value of their services to their patients -- to their pet owners and helps explain some of the conditions of the pet. It also -- Pet Health network 3D complements our Pet Health network Pro software-as-a-service offering.

Finally, we continued improve upon Pet Health Network Pro through new releases with key additional functionality for this cloud-based software service. We expect to start shippings SNAP Pro in Q1, as mentioned in the last call, and are taking orders this quarter. SNAP Pro is a mobile device that simplifies workflow associated with the Rapid Assay line, while pushing results to the cloud with VetConnect PLUS. Customer and distributor response has been extraordinarily strong. Our forecasted R&D investment in 2013 is about $88 million and we will build upon this base in 2014. While we don't want to be specific as to what else is in the pipeline, I do want to investors to know that our pipeline includes new instruments, test menu across all 3 modalities and advances in our Information Technology offerings, with many anticipated announcements in 2014. In August, we are very pleased to have acquired Madasa, as Will mentioned, in Brazil. Madasa is a long-time distributor of IDEXX's. This is very strong in entrepreneurial organization will help to serve to accelerate the adoption of our IDEXX Livestock, Poultry, Dairy and Companion Animal lines in this important growing Brazilian market for animal health.

Finally, as we announced last week, I'm absolutely delighted with the prospect of Brian McKeon joining our management team at the beginning of 2014 as our new EVP and Chief Financial Officer. We know Brian well from his decade of service as an IDEXX board member. He brings that tremendous track record and experience base to IDEXX, and thus, will become a key leader in helping to achieve our targets for growth, profitability and shareholder returns in the years to come.

And so, with those introductory remarks, I'd like to open it up to Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] We'll go to the line of Erin Wilson with Bank of America.

Erin E. Wilson - BofA Merrill Lynch, Research Division

I guess, can you speak to the Catalyst placement declines in the U.S. and how much of that do you think is associated with the sales force changes and the dynamics, I guess, behind the placement trends? And how we should think about that going into 2014?

Jonathan W. Ayers

Clearly, that was the sole reason for the decline in catalyst placements with U.S. and narrowing it more specifically, it was the Wave 2 regions, Canada actually did very well, we wanted well and internationally, we did well. But having said that, the quality of the placements was very strong as we've mentioned, in fact, if you just take the 3 quarters so far in 2013, we had almost a 20% increase in the number of competitive placements on an absolute basis. And competitive placements are new to IDEXX's, generating -- obviously, 100% new consumable growth. And I think, it's one of the underlying dynamics, along with strong loyalty of our customer base and the reason why we had the 15% adjusted for inventory factors and distributor inventory changes and other factors, 15% of consumable growth for our instrument line, globally.

Erin E. Wilson - BofA Merrill Lynch, Research Division

Okay. And just one on sales force transformation, how should we think about the incremental costs associated with the initiative is it running better than plan? And how should we think about that going into 2014? And you mentioned better loyalty or retention rates. Where did the retention rate stands now for the reference lab? And VetLab, where do you see that going over the next 12 months?

Jonathan W. Ayers

Yes. So the -- obviously, the cost of the 16% larger sales forces embedded in our operating expense metrics, we did have some one-time cost associated with the transformation that occurred over the first 3 quarters that we will not be recurring. We're basically through that now, and we are well into the model but, of course, the vast majority of our costs associated with providing a good economic experience for our reps, which is what allows them to build tenure and experience in the field, and I think a market-leading technology company.

Willard R. Blanche

Just quickly on that point, though, what I would add is that even though there was a one-time cost in the first part of the year, we have expanded our sales force. And so, we continue -- we've continued to expect that we will not have leverage on the operating...

Jonathan W. Ayers

Right. In general. There's different mixes, so the one-time costs are very small in relation to, of course, the expansion in the sales force. With regard to loyalty, it's very important metric. We're under -- we're over 98% year-over-year loyalty in the instrument consumables lines. I believe we are over 95% in the Rapid Assay line, loyalty and just under 95% in the reference lab line. And all those have been improving metrics over the course of the last, actually over the past 24 months. And we expect them to continue to improve because there's -- once people, I think, are using a highly differentiated line, they appreciate the value of the integrated and they're providing value to their clients and that's one of the benefits of working with IDEXX as a diagnostic partner.

Operator

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

Ryan Daniels - William Blair & Company L.L.C., Research Division

I wanted to do a quick follow-up on the sales force transformation. Jon, good data point that the initial waves saw a 20% increase in instrument placements. I wonder if you could go a little bit deeper and talk about how effective they were in other areas, meaning, was the instrument placements more of a focus for that group, or is that a benefit that accrued to the company, while other areas also outperformed?

Jonathan W. Ayers

Yes. It's a great question. In Wave 1 and Wave 2 they're really wasn't much of a learning curve. I mean, they did very well. For example, the sales force had several different performance metrics of which instrument placements is an important one, but by no means they are only one. We have reference lab and Rapid Assay and of course, those loyalty metrics are feed into all of at. And as a whole, the Wave 1 exceeded their performance and the Wave 2 essentially met the goals that we gave them. So obviously, there was some outperformance in some areas that made up for underperformance in other areas.

Ryan Daniels - William Blair & Company L.L.C., Research Division

Okay. That's helpful color. And then, one thing you didn't mention, I was hoping we could get one, a little bit of an update there on the number of practices that's had? And then number two, I know a lot of things going on with the transformation and the rollout of VetConnect PLUS. I'm curious if you've been able to parse out what kind of favorable impact that specifically has had on loyalty, utilization, cross-selling, any metrics you can offer?

Jonathan W. Ayers

Yes, in terms of the number of activations, we're a little over 10,000, 10,200 in North America. And of course, we launched it in Canada in July. And Canada had really a very successful launch. We have a very, very strong reference lab business in Canada and I think that team just looked at the U.S. experience and with them, the learning curve as they watch the U.S. experience and think at a much faster launch than we did in the U.S. And we have -- we anticipate towards the end of the year to launch that in one international market and then over the course of 2014, and other international markets, so it will be a global rollout. That the next challenge for us with VetConnect PLUS is utilization. One thing is to activate it and have it available and the next thing is to use it. While the large majority -- the majority of customers who are activated are using one of the things that our new customers centric sales model does, it helps with customers with the change management of moving from sample-centric, getting the result from 1 sample on a piece of paper to a patient-centric looking at the result in the context of the diagnostic history that you have in VetConnect PLUS. So the behavior changes, as we all know, in the veterinary world, it happens not as fast as you would like, but if once it happens, they never go back. And so we have a cadre of customers, of several thousand customers who are very active users of VetConnect PLUS, and that's growing. We measure that now every month. And one of the key roles of the sales organization. It is hard to parse out why is the loyalty growing as a result of VetConnect PLUS versus the sales model versus our more expanded set of test menu, much many of our proprietary test are unavailable other than through IDEXX or strong customer service model that we have. We think they're all contributing factors and the loyalty is really a key component of our strategy going forward.

Operator

Next, we'll go to the line of Jon Block with Stifel, Nicolaus.

Jonathan D. Block - Stifel, Nicolaus & Co., Inc., Research Division

Hey, Jon, I think the business model continues to sort of be two different worlds. I mean, the recurring is performing well, the equipment, you could argue poorly. If you can just help me, I'm wondering what changed in the last 2 months of the quarter. And by that, I mean, in the last call, I asked a pretty detailed questions. Just after 2 negative revisions to the top line if you felt guidance was where it needed to be. And now even after -- I think it was largely inline quarter, the implied 4Q number sort of moves from up, call it a 11% and maybe up 8 and change. So can you help us with what changed, I know you might reference the sales, what went on in the last maybe 8 weeks that's leading to the revision to 4Q?

Jonathan W. Ayers

Okay. Thank you. That's a great question. It is -- there are 2 -- you can count -- put our diagnostics business, which I mentioned as you know, about 82%, 83% of the company into 2 categories. You have 92% of that business or 93% of that business is what we call recurring revenues or annuity. That's really all of the diagnostic recurring revenue and then the recurring revenue in the Practice Management and Digital Systems business associated with customer support, the broken -- and Pet Health Network Pro which is description-based targets, all recurring revenue, right? So, 93% of the Companion Animal business. If you look at the recurring revenue growth over the last 3 quarters, Jon, and I'm just giving you kind of approximate numbers from 7.5%, this is for CAG, 7.5% in the first quarter to 9.5% in the second quarter, to nearly 11% in the third quarter. Now the instrument placements are negative. Part of that is marketing programs and part of that is the volume of placements. But what's happening is we're placing in good accounts and that's helping contribute -- the volume may be down but the quality of those placements is good, and that's helping to continue. But I think we would all would say nearly 11% recurring revenue of growth, being 93% of the Companion Animal business. That's a good result. And so -- we're -- and that's the ultimate objective how we measure ourself. Because that revenues is, of course, the more profitable revenue. I'll turn it over to Will in terms of some of the dynamics that have changed from our prior thinking.

Willard R. Blanche

Thanks, Jon. I think really important dynamics here and I think what's really driving some of that strong annuity growth is -- I go back to the quality of the instrument placements and so, while what is causing the decline in revenues in Q2 versus just a 8 weeks ago, is really the number of placements. The quality of those placements as really made up for it. I think we've mentioned on past calls that a competitive placement for us produces approximately 5x the value of a upgrade of one of our own customers. And the competitive placement do take a little bit more time and so we think that, that really has resulted in lower instrument revenues, but producing higher consumable revenues. And so it really is an instrument story. That lab instrument. And then I mentioned also digital placements. We did have some new reps. Our expectation was that they would come up the curve a little bit quicker than they have. But they've made really solid continuing improvements, which gives us more comfort with Q4, but not to the extent that we've had before. So those are really the 2 primary factors, Jon.

Jonathan W. Ayers

And then the other area that I would mention, would be the BioResearch business, which is a strong double-digit grower. But isn't achieving a very high growth rate that we had in our assumption. So that came down a little bit. And then finally, as Will mentioned in his up front comments, there is an increase in deferred revenues associated with capital placements that would apply to both, the digital, as well as -- actually all capital placement, digital instruments and Cornerstone placements, which is associated with our marketing programs and is a result of how those marketing programs are accounted for.

Jonathan D. Block - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And maybe, this might be part b in the question and you can just give it a simple yes, or no. So your new 2013 guidance sort of implies low 6% organic, by our calculations. And you could argue that 2013 benefited from the new rate with NWI and also the direct change in Nordic countries. So can you just talk to, what gives you the confidence to sort of layout the 7% to 8% organic next year? Is that just a function of everything that you just talked, your 3-year equipment comps? Where you are placing equipment is going into competitive accounts and therefore, you should see a modest reacceleration in '14 versus '13?

Jonathan W. Ayers

Yes. If that's a yes or no question, that's a yes. On the 7% to 8% organic growth for 2014, I think you've laid it out well. You did mention our Nordic go direct, that is really a very, very successful. We've had almost triple-digit growth in Nordics in Q3. And we've just been a very -- it's not a big number, so it's one of the contributing factors to the nearly 10% Europe CAG growth, 9.5% or so. But it's a -- it's been a very, very successful strategy for us. And now, we've essentially, in a little bit different way. We've done that in Brazil, acquired a very, very successful distributor for us in the Dairy and Livestock area, and we think they're a great platform. We don't really have a strong presence in Brazil in either LPD or the Companion Animal business. It's no one really does, it's an undeveloped market. It's a big animal health market. And so we are excited about that. We also actually acquired a distributor of ours in South Africa, which is going to give us a bit of a go direct benefit in South Africa, combined with a strong local team. So these are just elements of our global strategy of continuing to get that close to customers.

Jonathan D. Block - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And last one, if I could slip it in. Jon, looking back at your placement as to mature both chemistry and hematology, you started the year chemistry, you're thinking up low-single digits and hematology up low-teens . And now I think you mentioned both of those are sitting down mid single digits year-over-year. You went into the year, I believe, knowing that you're going to go ahead and sort of redo the sales force in certain ways. So can you just give us, from a high level, what are you seeing out there in terms of competitive -- competitiveness within placing instruments, and why was that -- why were you experiencing such a big delta. Where you'll end up from where you started the year?

Jonathan W. Ayers

Thank you, John. So the other thing we didn't expect is going to 55% plus competitive placements. I mean, that's a pretty -- that, that's the highest number we've achieved for Q2 was 45%. I mean, Q2 were 55% and 56%. So in competitive placement as a percentage of total, and the absolute number of competitive placements as I mentioned, up nearly 20%. For the first 3 quarters versus prior year was strong. So that was unexpected benefit to our model going forward. That's where the market opportunities, 87% of our -- of consumable or chemistry revenue comes from catalyst customers in North America right now, and they and there's still a lot of -- there are lot of -- they're still customers out there that we're upgrading every day. Obviously, that's makes the 44% of our placement. But I think we're getting better and better and more and more differentiated in talking to customers that are not currently using our technology and explaining some of the benefits, the clearly superior benefits that helps them grow their practicing as they move to certainly our inhouse platform, and combined with our reference lab platform giving them total diagnostic solution with the wraparound of VetConnect PLUS. We are getting better at that and there's a big opportunity out there, continuing opportunity, to grow the business. The other thing that's happening is we've got high loyalty. So once we get them, we keep them. And we're growing utilization of accounts, inspiring them with the importance of diagnostics as part of the practice of business model. And just -- finally, we're adding the tests. What we're adding in the reference lab is good, and we are very, very excited about the new test. It's probably I would call fructosamine the single most important individual test that we've launched in our chemistry platform in the last decade, because it is such an important disease, the diabetes. And just so if you understand, that this is equivalent to HB A1C in the human market. In other words, this measured glucose levels in the dog or cat over the past 2 to 3 weeks average. It's very, very hard to measure glucose, particularly in a cat. I know because I have a diabetic cat now. It's very hard to do so called glucose curves and so fructosamine is valued test and we're going to -- we're the only major platform that's got them on in-house now.

Willard R. Blanche

Just to add a little bit of color on the, what you're mentioning before about the instrument placement numbers. And certainly, they are very strong, just to go back to that, very strong competitive numbers. And so it really points to the VetTest upgrades. That's one thing that we really do believe that in the new diagnostic consultant model, that they are going to become partners with these practices, and that could result in us being able to accelerate the continued transition of our VetConnect prior VetTest customers up to catalyst customers. But even those prior VetTest customers, very loyal group of customers.

Jonathan W. Ayers

We like that customers as much as we like Catalyst customers. They give us good business, they have our in-house platform and it's being what they have showing in that VetTest to pick up the IVLS we've been selling since 2006. They can connect old model into VetConnect PLUS and that's a good customer for us. We'd like to inspire them, that's great. But in the meantime, it's good to have them as a customer in VetTest.

Operator

[Operator Instructions] We'll go to the line of David Clair with Piper Jaffray.

David C. Clair - Piper Jaffray Companies, Research Division

Some. I'm sure we don't want to get too deep into the details for your 2014 guidance, but I was hoping just to maybe get some details on your assumptions for instruments. And then, what are you assuming for the underlying economy?

Jonathan W. Ayers

Okay, thank you. Again, we're not really in, as you mentioned, in a position to get too detailed, but we do have -- I think it's fair to say, we're going to be, of course, having passed the comps of 2013 with the kinds of things that we've done that brought our instrument revenues down but of course, have done a nice job in growing the recuring revenue portion of the consumables. And so, we also expect that we're going to be really, in 2014, getting to a state of maturity with the new diagnostic model. We just went through the first quarter and the fourth quarter we're primed, we're ready to go. We've got people in position, fourth quarter is an important quarter. But by the time we get to 2014, we're going to have these reps who really know the customers. An average rep is 150, 160 customers really start getting to know them. And again, these are all relatively new territories. And we're going to really see the benefits of not only the expanded feet on the street but the productivity per rep that we think will be a good driver to 2014. With regard to the economy, I don't think we're expecting any great things that are -- I don't expect it to be much different than it was in 2013.

David C. Clair - Piper Jaffray Companies, Research Division

Okay. And then, it's been 3 quarters now since we saw the distribution change. I was just hoping, and I think you've mentioned in the past that MWI continued to see traction there. Any update that you can give us?

Jonathan W. Ayers

It's really the same story that has been all year. All of our distributors are performing well. The relative performance that the different distributors really haven't changed over the course of this year in comparison to prior years. I think we have very, very engaged distributor group, and it really -- there really isn't any change. Distributors are good partners for us. We also recognize that our sales organization are the primary ones in terms of placing instruments and growing diagnostic revenues. We've gotten really great response from distributors for SNAP Pro. They really get it, they see it as basically an iPhone for SNAP. And it's going to be fun to introduce that to the market. And our distributors have been strong partners with us and figuring out exactly how to do that.

Operator

Our next question comes from the line of Ross Taylor with CL King.

Ross Taylor - CL King & Associates, Inc., Research Division

A lot of my questions have been answered, but you gave out the statistic at about 87% of your consumable volume in the U.S. is coming from your Catalyst owner. I guess, intuitively, that you would imply that the VetTest that are still out there in North America are generating pretty low volumes of consumables. And my question is do these clinics you have enough revenue or enough in-house consumable volume to justify upgrading to Catalyst? And is it that you've challenged that maybe you've slowed some of your placements compared to expectations? And second part of this question would be, these clinics do upgrade to Catalyst. I mean, how much do their consumable volume have to increase to really justify the switch?

Jonathan W. Ayers

Well, the fact is they're consumable volume increased about 25%. So that's one of the things that happens. And what we're doing is we're really inspiring to use their in-house lab in a more client-centric way with Real-Time Care. And with this new coverage model, we're going to be back there after we place the instrument. We'll help them in learning how to utilize the instrument. And that's one of the nice things about this new model. You make a good point that we've got a relatively -- that the install base for chemistry is mostly a Catalyst now for our install base. But I have to tell you there is a tremendous opportunity out there. There is still opportunity for upgrades, although probably not as great as it was in a year ago but there's still an opportunity out there. But the big opportunity, which is no smaller today than it was in the past is the competitive switch, which is obviously, buybacks value creator for IDEXX shareholders. And of course, a good value creator for the customers too. And in addition, we do -- there's so much focus in the U.S. but we're doing really well outside the U.S. I mean, I'm very impressed with our teams around the world, whether it is in places like the U.K., or Germany, or Canada just did a great job with the transformation of the IDEXX diagnostics as a sales organization. Australia is doing very well. They were actually the original account coverage model. Japan is doing well. Other emerging markets. So these are all contributing factors to our, as I've mentioned, nearly 11% annuity growth that we saw in Q3 for the Companion Animal Group.

Ross Taylor - CL King & Associates, Inc., Research Division

Okay, that's helpful. And just one final question. I may have missed this in your prepared remarks, Jon, but I just wonder if you could explain what the difference is for the Pet Health Network Pro, 3D versus your base product that's been out there?

Jonathan W. Ayers

Right. So the base product is as you call base line in our pro description basis is a client -- is a software-as-service base client communication tool. So this is what allows you to send out an electronic minders as the Petly page which we've got tremendous response from both practices and pet owners. Where all were health informations online. It allows you to book appointments, integrated with Cornerstone. You can send out newsletters, it allows you to manage your reviews online. With Google and Yelp, this is turning to be a more and more important issue. So all a lot of different functionality in Pet Health Network Pro. And then Pet Health Network 3D is a -- you just have to see it and those of you who come to the North America veterinarian conference -- will is an imagining -- It gives you very clear illustrations, interactive images of different pet conditions. So you look inside the pet. And it helps the veterinarian primarily in the office explain what's going on with the pet. And then e-mail a link to the pet owner and other family members so they can see what is the condition that has been discovered, and what will be the treatment plan. So that's the difference between the two.

Willard R. Blanche

There will be work together. They're both -- they are separate subscriptions.

Operator

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

Nicholas Jansen - Raymond James & Associates, Inc., Research Division

A follow-up on Dave's question from earlier on in your relationships with your existing distributors, but how are those evolved this year with the new diagnostic model, are we expecting, kind of any changes for '14 and '15, and maybe you can remind us when your Patterson and Shine contracts are approval to?

Jonathan W. Ayers

We don't expect any changes. All of our contracts with the exception of the one with MWI, which was a 2-year associated with the change in the moving to nonexclusive in the lower margin. They are all annual, they've always been annual. We expect the annual renewal, we've good relationships with them, we continue to work closely with distributors to help them grow the IDEXX line. The IDEXX line is, it obviously, when you're looking at kind of consumable growth of 15% that they're distributing is an important line. That's a strategic line. So we really expect no change in the model in 2014 or even 2015 from where we are today.

Nicholas Jansen - Raymond James & Associates, Inc., Research Division

Okay. And then maybe just an update on your German lab venture kind of how where we are today in terms of country penetrated and how much benefit have you had from this rollout and kind of which we anticipate the next 2 years, maybe you better penetrate more countries there?

Jonathan W. Ayers

Yes. So that, we were talking about our Liepzig IDEXX direct lab, which is co-located with DHL in Liepzig Germany. It gives an improved -- it gives really that late pickup early-morning turnaround time that we're used to in the U.S. but is not of standard model in the vast majority of Europe. In key countries that's really helping us grow the lab services in Europe, would of course be Germany, but also Italy. And it's been one of the contributing factors to the success in the Nordic go direct. In fact, we had direct reps there for labs prior to 2013, but now we have the full coverage account model with in-house and lab and we've been very, very successful. But we're going to continue to roll that out to other countries that are supported by the DHL network. If you reflect back strategically, I think it was in 2008 when we opened the Memphis lab and is now the largest lab in North America, because of that very, very successful direct model using FedEx. And we really see long term strategically that Leipzig will -- could be that too in strong partnership with our core lab as really advanced testing capability that works closely with Leipzig in Ludwigsburg. But Leipzig is the fast turnaround overnight results the next morning model. And that's really bringing a completely different service level. So we're not only winning new customers, we are aggressively growing existing customers that are benefiting from that service model.

Willard R. Blanche

And in fact, John, for I think some of the experience, better service levels, we are actually seeing the customers that are of the Leipzig lab growing 30% faster, 30% versus 10% with our other customers. And so we're really seeing just very strong growth and customers are really liking the service that is being provided by the Leipzig lab.

Operator

Next, we'll go to the line of Jeff Frelick with Canaccord.

Jeffrey Frelick - Canaccord Genuity, Research Division

Jon, a quick question here on how you characterize the new customers to IDEXX. Are these more competitive instrument conversions or are you converting the send outs, moving those more to in-house? And how would you characterize the volumes of these new customers to IDEXX?

Jonathan W. Ayers

Yes. So they are -- I think they are primarily -- those who have another -- don't have IDEXX for their in-house but have an in-house analyzers and they switch to IDEXX. There's, another category of brand new practices. It's a small category but there's always new practices being formed. With regard to, I think over 90%, I would say 90% to 95% of customers already have chemistry analyzer. So it's not like exactly that we are converting people who weren't using in-house lab, they are using in-house lab, although we may be converting people from using their in-house lab to some degree to realizing the benefit of Real-Time Care. So the basic question is, why ask the customer to wait when you can run it now? Why ask the customer to come back? Why ask the customer to come a few days early to run the pre when you can run it the morning of the surgery? In this environment, people don't want to wait. They both want to drive to the practice more often than they had to, conveniences is the order of the day. And I think practices are understanding the convenience model. And our in-house instruments are uniquely designed to provide results within the practice -- within the appointment because of the fast turnaround time for both chemistry and hematology and certainly combined with VetConnect PLUS, we can have those results anytime, anywhere in the practice. So it really is uniquely designed for Real-Time Care scenario. So many times when we upgrade customer to IDEXX technology, they all are running more of their work in-house. I think we've seen a very, very slow -- we talked about this with you in the past. We are seeing a very, very slow shift of core chemistry and hematology from the reference lab to in-houses. Very slow, but it’s happening. These things can happen in slow motion, in the veterinary world. Our reference lab is doing well because we're back filling with new specialized tests and of course, growing that number of customers. So as we introduced a whole new category of cardiac disease, or allergy, or molecular diagnostics, these are -- these things are helping contribute to growth in the reference lab and these are technologies that are not available in the Real-Time Care modality.

Operator

And we have time for one final question. That will come from the line of Erin Wilson with Bank of America.

Erin E. Wilson - BofA Merrill Lynch, Research Division

Most of my questions are answered but on capital deployment, I know you didn't give any CapEx guidance, but do you anticipate any major capital expenditures out of the ordinary in 2014? For instance, is their data with your Brazil business or in South Africa that you mentioned?

Willard R. Blanche

No. I don't think so. I mean, we mentioned the CapEx guidance for the current year of around $90 million, but for next year, no. There's nothing that we're expecting.

Jonathan W. Ayers

It's just normal, capital expansion associated with volumes. But that's normal run rate stuff. One of the things that we did complete in 2013 was our expansion here of our facility in May. So we're not going to have to do that again. But there's always growing. When you grow consumable by 15%, you need to continue to invest in production. But that's all in the normal ordinary course of business. We haven't given specific items but I don't see anything unusual in 2014.

Erin E. Wilson - BofA Merrill Lynch, Research Division

And where does the cornerstone adoption stand? Is that growing meaningfully?

Jonathan W. Ayers

We're really pleased with the success with Cornerstone. We've seen -- we had some rep transition issues in our Cornerstone business, kind of like we had in our Digital business that hurts a little bit in the first and second quarter, but we'll talk about taking a little bit longer to get the new digital reps up to speed. We haven't had that issue on Cornerstone. We had a very strong Cornerstone placement. And of course, I think that goes -- it works very, very well with Pethelp network to products. We just remind investors that client communications is really being recognized more and more, a key capability of the practice, and we are the only partner who can provide a client communications tool that is fully integrated with the practice management. And that turns out to be really important because if you want to share exam results, you've got to be integrated. If you want the pet owner to be able to book an appointment with -- through their Petly page, it's going to integrated with the practice management software. And so, I think we're really pleased with the success we had in a moment and we had in both those related product lines, we've got that established in Q3. Thank you for your questionnaire.

Operator

With that, speakers, I'd like to turn it back over to you for any closing comments.

Jonathan W. Ayers

Okay. I want to thank everybody for being on the call. And I certainly want to -- a huge congratulations to our North American sales and marketing organization. They've really stepped up and it was a lot of change and we're through that period now and we're settled down and we're learning new model and it's been a tremendous accomplishment. But we've also had what I would say is extraordinary performance with our regions around the world. So I just want to -- I do want to thank everybody and again, we're going to be looking forward to updating you on the full year performance in January and giving more details on the 2014 outlook. And that concludes the call.

Operator

Thank you. And ladies and gentlemen, that does conclude our 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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