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VCA Antech, Inc. (NASDAQ:WOOF)

Q3 2010 Earnings Conference Call

October 21, 2010 4:30 PM ET

Executives

Tom Fuller – CFO and VP

Bob Antin – Chairman, President and CEO

Analysts

Dawn Brock – Kaufman Brothers

Ryan Daniels – William Blair & Company

Mark Arnold – Piper Jaffray

Bob Willoughby – Bank of America-Merrill Lynch

Stan Manny – Manny Family Investments

Rob Mains – Morgan Keegan

Maggie Lovatt – SunTrust Robinson

Carter Dunlap – Dunlap Equity Management

Operator

Good day, ladies and gentlemen, and welcome to the VCA Antech Third Quarter 2010 Conference Call. All participants are currently in a listen-only mode and following the prepared remarks, we will take question. This conference is being recorded. Before we commence the discussion, I would like to preface the comments made today with a statement regarding forward-looking information.

The information contained in this presentation includes forward-looking statements that involve risks and uncertainties. Such statements appear in a number of places in this presentation and include statements regarding our intent, our belief or current expectations with respect to our revenues and operating results in future periods, our expansion plans and our business strategy and ability to successfully execute on that strategy.

We caution you not to place undue reliance on such forward-looking statements. Such statements are not guarantees of our future performance, and involve risks and uncertainties. Our actual results may differ materially from those projected in this presentation for the reasons among others discussed in our filings with the Securities and Exchange Commission. The information in this presentation concerning our forecast for future periods represents only our outlook only as of today’s date, October 21, 2010, and we undertake no obligation to update or revise any forward-looking statements, whether as a result of new developments or otherwise.

Listeners should also be aware that today’s discussion includes reference to non-GAAP financial measures, which management believes are useful to an understanding of our business. A reconciliation of these non-GAAP measures to the most comparable GAAP measure will be included with our earnings release and posted on our website at investor.vcaantech.com. Our earnings and guidance releases are available on our website at investor.vcaantech.com. In addition, an audio file of this conference call will be available on our website for a period of three months.

I would now like to introduce our host for today, Mr. Bob Antin, CEO and Tom Fuller, CFO. Mr. Fuller, please go ahead.

Tom Fuller

Thank you, Karen and good afternoon and welcome to the third quarter 2010 WOOF earnings call. Today, we reported diluted earnings per share of $0.32 per share and adjusted diluted earnings per share of $0.37 per share. During the quarter, we had a couple of unusual expenses that we added back to our adjusted diluted earnings per share. First is we missed our refinancing in July of this year. We’ve refinancing cost of which we expensed $2.5 million in the quarter pretax.

We also settled a tax on it for prior year’s state taxes for $5.4 million pretax adding these back to the reported earnings per share. We arrived at $0.37 of adjusted diluted earnings per share which compares to $0.42 of diluted earnings per share in the prior year. I’m not surprised, you know, given the shape of the economy, we’ll continue to see pressure on an internal growth rate in the hospital same-store for the quarter was down 4%. And laboratory internal growth for the quarter was down 9%, which compares to a negative 2% in the second quarter for the hospitals and negative 5% internal growth in the second quarter for the Laboratory division.

So a little bit of deterioration in our growth rates. And as in the past, it’s a high-tech cost business. These revenue decline puts pressure on our earnings and hence, our operating income and our net income. On a consolidated basis, our third quarter revenue increase 5.9% to $358 million. And our operating income decrease 11.3% and operating margins decrease to 310 basis points to 16.2%.

The decrease in the operating income and margins came mostly in our lab and hospital segment. As we continue to see deleveraging, our hospital margins were down 290 basis points. And our laboratory margins were down 280 basis points. So on the $7.4 million decrease in operating income, we partially offset by a million dollar decrease in interest expense resulting in adjusted net income and adjusted diluted earnings per share down 12% to the $0.37 per share from $0.42 from the prior year quarter.

Our Antech Diagnostics, revenue up 0.8% to $77 million. Internal growth for the quarter was negative 0.9% and operating income was down 7.9%, operating margins down 280 basis points to 36.1% and 80 basis points. That decline is due to incremental R&D spending. On an adjusted basis, down roughly 200 basis points year-over-year due to deleveraging and increase our transportation cost that continue to build out in industrial and infrastructure and laboratory network.

Now, the components of the growth, requisitions were down 3%, 3,232,000 requisitions in the same store base and our average requisition was up 2.2% to $23.89 for a negative 9% of our combined growth. Total requisitions for the quarter of $3,235,000. We added one lab domestically for the quarter so we started with 48 labs and ended with 49 labs, 45 in the U.S. and four in Canada.

So in the Laboratory division, our continued decision of deleveraging as the revenue growth rates aren’t coming back and we continue industrial infrastructure and R&D and still looking towards growth in the future. All right, the Household division, revenue increase 7.5% to $277 million, all from acquisitions. Same-store revenue was down 4% as I mentioned earlier. Gross profit increased 9% or, excuse me, decrease 9% and gross margins were down 310 basis points to 16.8%.

Most of that decline is due to same-store margins which were down 270 basis points down from 20.0 last year to 17.3 in the current year period. Household margins were also impacted by the Pet DRX, Pet Doctors acquisition in July 1 you recall on an annual basis. Pet Doctors has roughly $6 million of revenue, putting into the quarter – Pet Doctors revenue represent roughly 5% of our hospital’s revenues. And as expected, their margins were lower than our hospital margins, roughly 500 basis points which is typical of the large change we’ve acquired in the past four year.

And as in the past, we expect the sales margin increase and approach our margins over the next year or so. All in all, Pet Doctors are going very, very well. The results were pretty much as expected. And as I mentioned, we do expect improvement in results over the next two to three quarters. Also I point out that the quarter included $1.2 million or almost a penny a share of one-time transaction integration cost related to Pet Doctors, bringing in the total transaction cost for today of $2.1 million.

And we expect another half a million dollars in the fourth quarter. Your call from prior quarters, we’ve been suggesting that there are limits to our ability to cut expenses. I think we’re going to teach each other of holding and cutting. Dollars, as each quarter goes by, becomes more and more difficult. So we saw continued deleveraging in the third quarter as the growth rates continue show impact with the economy.

Same-store hospital average order was at 1% to $153.69. The number of orders was down 5% to 1, 596,000 orders. We did see positive trends through the first quarter of this year and you recall in the second quarter, we saw some stabilization in growth rates. And accordingly, we revise our guidance from the last quarter, reflecting, I believe, the rate of the term growth rates have stabilized.

Unfortunately, that was clearly not the case in the third quarter. The growth rates have deteriorated. And as I said, a negative 4% in the hospital division compared to 2% down in the preceding quarter. So we do continue to see a little bit of weakness there. The good news is these acquisitions came in very, very strong to the quarter, six hospitals acquired for a total revenue of $21 million because I think there’s roughly the, not we, acquired the first two quarters of the year.

So a very strong quarter for acquisition. Plus we did the Pet Doctors acquisition 23 hospitals with annual revenues of around $16 million. So year-to-date, we’ve acquired roughly 99, I’m sorry, a hundred million dollars in revenue in the fourth quarter. Pipeline was very, very strong. So we do continue to invest in Hospital division. We started the quarter with 496 hospitals. We acquired nine including the 23 Pet Doctors hospitals and we closed, merged two hospitals.

We ended the quarter with 523 hospitals. Medical technology continues to be on a roll of revenue increased almost 31% to $17.4 million. And that is all internal growth as we have anniversary treat the Eklin acquisition which we did on July 1 of 2009. On that 30% increase in revenue, gross profit increased 29% and gross profit margins were down slightly basically flat down 40 basis points or 30.2%.

The great news is is the G&A percentage is significantly down 680 basis points to 21.4% in revenues which was ultimately a very big increase, 630 basis points increase in our operating margins to 8.7%. So in a tough, tough market obviously for the economy, tough for equipment purchases, medical technology continues to do very, very well. Balance sheets continue to be strong, $132 million in cash which is down $62 million from $194 million at the end of June.

Now we use cash for the Pet Doctors the acquisitions is going to also use cash. It’s part of our refinancing in July. Long-term debt, $500 million which is our new senior credit facility, made a terrific job, a very successful refinancing. Our current rate is LIBOR plus 225 basis points and we have no swaps in place. And that’s a five-year term on that. So I think the balance sheet is now strong, the accessibility to and thus, the company continue on our acquisition pipeline strategy.

All right, in terms of the guidance, clearly, we continue to really impacting the economy and our growth rates. And we also continue to see very poor visibility in our growth rates that you’ve talked about in the past, continue to go up, up one quarter, up one down quarter, monthly, weekly, very volatile. Unfortunately, that non-visibility has led us to revise our guidance for the quarter. So based on what we experienced in the third quarter, we’re revising our assumptions for the fourth quarter.

Now we are assuming similar growth rates in the fourth quarter that we experienced in the third quarter. So accordingly, our revised guidance through the rest of the year, annual guidance, diluted earnings per share of a dollar thirty to a dollar forty cents per share which implies fourth quarter diluted earnings per share of $0.20 to $0.22 per share. Now obviously in the past, we said it before, that becoming incredibly difficult to predict our demand and to predict revenues.

I think we do a good job of controlling expenses. And because of the variations in revenue, our results in the future could materially differ from expectations.

And now we’ll go to Bob for more comments.

Bob Antin

Thank you Tom. As Tom said in quite a bit of detail, we were disappointed with the revenue in the third quarter. We had been hopeful that the economy and the effects on the veterinary industry had leveled off by the end of the second quarter. And that has clearly not been the case. We still feel the impact of the economy across all line of business and across all parts of the country.

We’re experiencing it as our own intelligence and our industry contacts have provided the softness that we’re feeling is not just within VCA but it’s within the industry itself. And we have felt it across the board. Having said that we still remain very focused on growing the company with very positive initiatives. We pay close attention to the expense side. We continue to build a franchise because we know when the economy does change, which we have seen a little strengthening in the first few weeks of the fourth quarter.

However you can be confident that that’s going to stay the way the economy has been, but we continue to invest in the franchise, and acquisitions have been very plentiful for us and very strong throughout the country. So I will open it up to questions now.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question comes from the line of Dawn Brock of the Kaufman Brothers.

Dawn Brock – Kaufman Brothers

Good afternoon guys. Just wanted to start maybe with talking a little bit about the lab business and maybe could you characterize for us the mix of tasks you’re seeing and maybe just from a physician perspective whether you’re seeing more weakness in volume or more weakness on the pricing side or is it a mix of the two?

Bob Antin

I believe it’s clearly a mix of the two. I think it starts off with a number of people that are walking into hospitals. So we’re seeing weakness to begin in the process. The pricing sensitivity has been there but our average price per acquisition has actually gone up 2%. So I think that’s relatively stable. I think it basically comes from the weakness and the softness of consumers being a little bit more sensitive right now in ordering tests. So I think that’s the crux of it.

We’re very active. Has everyone else in the industry in educating and supporting the clients, the doctors, veterinarians and they’re continuing education of the clients but I think withstanding all of those it’s really the full traffic that’s going into the hospitals right now that’s making a little bit more difficult. Having said that, I think we’re doing a very, very good job and in the lab division, in a competitive environment in holding our own in the markets. And I think that’s a very positive aspect of it.

Dawn Brock – Kaufman Brothers

So I mean is it fair to say Bob that you’re not necessarily seeing some sort of competitive pricing environment on the lab side, and then on the hospital side, we know that over the last probably two years it’s been difficult to connect or drive the communication between the vets and the consumer. Are you getting pushback from your doctors, not necessarily the guys that are driving your lab volume per se, but what are you feeling from your vet as far as their feel for being able to educate the consumer and actually have a positive reaction?

Bob Antin

Let me answer the first one. We do live in a competitive world on the lab side and I think we have done a very good job on that side. We compete with a very good company and I don’t think that’s the core issue right now. I think the core issue is back to the doctor. Including in our own hospitals because we don’t tell the doctors how to practice. They’re confronting pet owners every single day. And they can feel, our doctors are no different. No different than the independent doctor. They feel the pressures of the economy, the difficulties whether it’s in Florida, where real estate is crashing, unemployment is very high or in Michigan or in San Bernardino in Las Vegas. They can feel it from their clients.

We experience something little different our own reference laboratory sales within our hospitals are actually up a little bit while our in-hospital diagnostics is still trending down. So our doctors will tend to rely more on reference lab but nonetheless they still the pressure of a consumer. And I’m not sure it’s an issue of connecting because with lower volume inside the hospitals, you certainly have more opportunity to talk to consumers and pet owners. And to getting educated more so than in the past. But I think it’s just a hesitancy for the extra test because it is on the market.

As Tom said the requisitions are not very much but you’re not getting those extra tests in that little bit growth that that’s needed.

Dawn Brock – Kaufman Brothers

Okay, that makes sense. My last question is probably more from a consolidated perspective when it comes to headcount. Are you at the point now where that is a question and possibly reducing the headcount is on the table, or are you optimistic enough that you still think you can make it work with your current employee base?

Bob Antin

I think the operating management, I think the operating management both certainly in the lab and the hospital division has always been very focused on compensation. And in fact, the compensation in the hospitals up until this last quarter has actually trended down. So the hospital management team has done a phenomenal job in managing compensation as a percentage of revenue. So I don’t see that in a large way.

There were certainly some opportunities in some areas to pay attention to but I think as a culture, they’re always very closely aligned to it. And to remind you which I think you know is veterinarians are as a whole are compensated based on revenue. So they too are feeling the pain as revenue declines they feel it. On the lab side, it just happens to be an incredibly leverageable business. So it has high fixed overhead. So with the drop-in in a little bit of volume which is why we’ve had a little run off in March and its about 300 basis points, half of which came from R&D.

I think they’ve been very attentive to it. So I don’t see a major headcount reduction. I think we’re pretty tightly managed company. I think Tom has indicated in the past, that we need a little bit of revenue growth because it is distributed company. So I think our expenses can be cut in some places but I do not see a large headcount reduction.

Dawn Brock – Kaufman Brothers

Okay. And Antin, I have one more question. Just we’re through this, the third quarter 2Q and 3Q are typically the seasonally stronger quarters for heartworm. Can you just characterize how this season went in here and whether or not you were seeing kind of a major drop off whether or not the clients that you’ve had for years actually came in on time and whether or not you’re seeing any shift on the pharma side? Thank you.

Bob Antin

Well there is a tiny, there is a tiny shift on it where clients will be prescribed six medications on heartworm medication done. They made by one. They made by two and could fill the entire script. So we’ve seen that. But pet owners are pretty attentive to heartworm. It’s not something that’s very pleasant, most dog owners know it. So I don’t see that. I do think on the pharma said as you will know there are alternate distributions for pharmacy items which we are going to address and I’ll addressing it by creating and have created along private label line of products.

But there is a small shift in distribution which we’ve seen which I know you’re aware of, the market is aware of and its occurred. But we don’t see a tremendous change in that.

Dawn Brock – Kaufman Brothers

Okay. Thank you very much.

Operator

Thank you. Our next question comes from the line of Ryan Daniels of William Blair.

Ryan Daniels – William Blair & Company

Yes, good afternoon guys. A quick question on the guidance, Tom its really one of the numbers there. I just want to make sure I had it correct. The $1.38 to $1.40, does that include the add back in the third quarter of the roughly I guess $0.05 for the onetime charges.

Tom Fuller

That’s an adjusted dividend range per share. Right, so we include the add backs.

Ryan Daniels – William Blair & Company

Okay, it does include the add backs. And then if we think of the kind of balance sheet, if you guys considers hedging in or locking in some of the rates given where LIBOR is and the fact that you don’t have any swamps in place today?

Tom Fuller

The answer is yes, we’ve considered at this point we’re pretty happy where we are with no swamps, I mean the spreads are still (inaudible) spreads are still pretty big. So I think we’re now just going to watch it for a while.

Ryan Daniels – William Blair & Company

Okay. And then you mentioned that the M&A pipeline, I guess is one of the silver lines in the quarter, that’s very, very strong. Can you give us a little bit more color on that, I assume a lot of its probably just people potentially trying to sell facilities and practices ahead of capital gains rate tax changes. IS that a fair assumption and then maybe any other color about the pipeline size or characteristic of those facilities.

Tom Fuller

I think tax rate is a motivator but I don’t think it’s the only one. I think people are genuinely tired, hospital owners tired of managing to the metrics that are out there. And if you, as you will know we’re not the only one facing the pressure that’s out there. We may handle it little differently, a little better than others on the individual hospital site. So I think that’s created opportunity as well.

Ryan Daniels – William Blair & Company

And if you think about the size of that, I mean could this be – how big I guess would you allow the M&A pipeline to get in a given quarter without stressing kind of operational?

Tom Fuller

I’m not sure that that I could answer a specific question but if you think about the hospitals, some of the hospitals now are larger than the average $1.5 million, $2 million hospital. And depending on the mix of the hospitals and the location, I mean we have the capacity to take on quite a few hospitals. So I don’t think its constrained by the capacity. So long it’s not on one area. Pet doctors as an example which is quite a task, the hall was located in California and because there were some broken facilities and issues in operating. It takes quite a bit of management to do that. But that’s the exception, that’s not the rule. So we have plenty of capacity for acquisitions.

Ryan Daniels – William Blair & Company

Okay, fair enough. And then I guess, final question Bob, just given the refinancing is taken place, I know you’re still sitting on the $130 million in cash, you have a revolver. You guys draw off a great amount of free cash flow even in this environment. Has there been more consideration to a share repurchase authorization going forward with the board or is that something you’ll consider entertaining going forward.

Bob Antin

We’ll consider entertaining it as we go forward but I will tell you, as you know we were a little surprised by the impact of the economy. And the first thing you do is you look whether or not it’s something systemic to VCA and we are pretty confident that it’s not. So we were taken back a little bit by the economy in the quarter. So I would say that it’s a certainly consider, but I think we wanted to get through the earnings release and their estimate pet doctors as well.

Ryan Daniels – William Blair & Company

Okay, fair enough. Thanks guys.

Operator

Thank you sir. And our next question comes from the line of Mark Arnold of Piper Jaffray.

Mark Arnold – Piper Jaffray

Good afternoon. I guess just a start and Tom mentioned a little bit about this in his guidance comment, but are you guys seeing any less volatility in an individual clinic results on a week-to-week or month-to-month basis or does it continue to just be all over the board.

Bob Antin

All over the board. And I wish, industry looks (ph) confident and everyone that we speak to inside the industry unfortunately has a same comment to make that it is, it’s just up and down, up and down.

Mark Arnold – Piper Jaffray

Okay. And then our channel checks have kind of suggested that clinic operators are a bit less optimistic looking forward today versus earlier in the year? Is that consistent with what you’re seeing as well?

Bob Antin

Well what saw in the third quarter, what we experienced in the third quarter was certainly less optimistic than when we released the second quarter results. Her actuals were certainly different than what our forecast was which I know the rest of the industry has felt the same.

The only thing we can tell you is that the beginning is which we don’t normally comment on. The beginning of the fourth quarter is a little bit stronger than how we finished the third quarter but I offer no confidence at all that that’s a continuous trend for the same reason that you brought up is that they are up and down. It’s a very unpredictable. Elections are probably going to have an impact, positive and negative, depending on where you are. So I wouldn’t want to comment that it portrays anything ongoing. But there is choppiness throughout.

Mark Arnold – Piper Jaffray

Tom, the pet doctors comments, I think you made a comment in your earlier remarks that you can get that view expect to get the 500 basis points of margin improvement there. How should we think about that over the next year? Can you get there without significant clinic revenue growth if some of that just come from opportunities to consolidate facilities or do other things in those markets. Can you just maybe just give a little bit more commentary on that.

Tom Fuller

I go back to the three previous acquisition before this one when we started with as much as 900 basis points down as much as 300 basis points down and our goal is always been to get them not necessarily add-on margins because there is a systemic differences that would make it impossible for more as to add our margins but they’ll approach our margin, it really takes a year I mean if we’ve done in less than a year.

Clearly with the pressure on revenue that’s going to be a little bit harder but there are some key differences in expense lines that we will continue to work and that should improve the margins. .But I think if we can cut the delta into half or then two, three quarter probably a good call but it’s in development maybe it would been last year.

Mark Arnold – Piper Jaffray

Okay, one last question. It’s kind of a follow-up on something asked earlier about just the acquisition pipeline and your acquisition activity. If we think forward over the next year, are there other opportunities like pet doctors which I don’t want to call the stressed per se but I’m more strategic in nature where our acquisition is more likely to be single facility transaction.

Bob Antin

We focus on the single facility acquisition. I don’t think we plan for other company acquisitions. I think they’re basically dictated by where they are and their capital process, how far they’ve come, what walls they’ve hit and whether or not they feel internally the combination makes sense to them for the continuation of their own practices.

We don’t forecast them. They have to – those elements have to come together as they have in every other one of them and it’s probably more than anything driven by their own capital needs.

Mark Arnold – Piper Jaffray

Great, thank you guys.

Operator

Thank you sir.

Tom Fuller

We missed a quick follow-up on acquisition. There is lot of focus on this quarter and next quarter in 2010 with potential packs on, but I think the real plan for us is longer term, whether it’s a big fourth quarter than it is slower first quarter of next year. Longer term we are in a fantastic position to make acquisitions. The business is consolidating below as so we’re one man shots we’re going away which makes sense with real estate costs and lifestyles.

So we’re seeing bigger and bigger hospitals. There is still not a lot of for sales and there is still not a lot of cap room in the profession, all those small companies that do buy hospitals don’t have nearly a five power rehab with a big bank account and 100 plus endorsed in free cash flow per year. So I think the next five, six years are very, very positive for us. And whether it’s a huge fourth quarter or not, it’s really long term as we’re focused on, I think we’re in a great position in the industry.

Operator

Thank you sir. Our next question in queue comes from the line of Bob Willoughby of Bank of America-Merrill Lynch.

Bob Willoughby – Bank of America-Merrill Lynch

Hi Tom, you may have just spoken to it here but I guess, if you look Bob we’ve had sort of the same quarter here for a while now much of what there and you certainly out of your control with the economy. At what point or do you conduct a strategic review here and say maybe putting to get the capital to work on the hospitals while things are down and out. Maybe that’s not the right answer, maybe there is a third or fourth or fifth leg at the table, we could add over the next few years by putting the capital to work elsewhere or win this maybe splitting things up make some sense. Is there any thought strategic review at some point down the line?

Bob Antin

I would say there is no special moment or engagement, but I think you know that we’re always looking for opportunities in different areas. So I would say the door is wide open.

Bob Willoughby – Bank of America-Merrill Lynch

Okay, and that’s more towards the building, is there any sense of splitting off a higher value lab business or?

Bob Antin

I think the – I mean various folks, people for the shareholders, I’ll say that first. The second part of it is I think there is an amazing amount of synergies that exist between the two. So right now, we don’t consider that an opportunity.

Bob Willoughby – Bank of America-Merrill Lynch

Okay, thank you.

Operator

Thank you sir. And our next question in the queue comes from the line of Stan Manny with Manny Family Investments.

Stan Manny – Manny Family Investments

Gentlemen, the question I thought had been asked but Bob how do you look at the cash on hand that you have. You feel strongly that it should be used for building through acquisition or do you have a negative bias towards share buyback or et cetera or use of cash for the stockholders?

Bob Antin

Well, I think right now we think the franchise we have is great and I think there is a tremendous opportunity to continue to build the franchise. We have 525 hospitals. I think we’ve done an incredibly reputable job inside the profession. We’ve gained the respect of the veterinary schools or the professionals. We’ve taken our capital and we’ve created the largest post graduate in teaching programs in the world and I think we’ve been investing steadily at building the franchise. So I think we’re going to continue to do that.

A share buyback is certainly something we’ve considered. We just came through debt financing and I think that was our primary goal as we stated in other calls and then we took on pet doctors so it’s there. I mean the opportunity is there, but it’s – I would say to you that it is not our number one priority right now. Right now it’s continuing to grow the franchise.

Stan Manny – Manny Family Investments

Okay. So you don’t personally or the Board doesn’t personally feel that buyback even at these, what I think is going to be even better levels, low level of value of the equity is advantageous at this time?

Bob Antin

I’m not going to reflect what the Board doesn’t. I mean the Board is a thoughtful experience group and from time-to-time they do consider it. I believe that the franchise right now in terms of capital there is plenty of opportunities, but that’s not to totally dismiss the share buyback.

Stan Manny – Manny Family Investments

Okay. My last question Bob is, looking at your capacity of the assets you have at the hospitals, could you grow incrementally 10%, 20%, 30% without any major capital or people investment? I don’t think any of us have appealed for that. So, how much leverage have we got once this economy starts picking up and people have a little more cash flow – available cash flow for pets and doing things?

Bob Antin

It’s enormous. There may be some facilities which we have a normal capital expenditure program of rebuilding, expanding and refurbishing. But our capacity in the hospitals as a rule – the hospital is very underutilized. We have an awful lot of opportunity for leverage in the hospital.

Stan Manny – Manny Family Investments

Is it 20%, 30%? Just give us a –

Bob Antin

It’s a hard one but I could say that I believe the numbers are easily in that range.

Stan Manny – Manny Family Investments

Is it 20% to 30% range?

Bob Antin

I think they’re high. It’s hard to answer the question, but I think there is tremendous opportunity for the hospitals to leverage.

Stan Manny – Manny Family Investments

So you have gigantic upside leverage available.

Bob Antin

If we had the client volume, the answer is an absolute yes.

Stan Manny – Manny Family Investments

It is. And there are no promotional methods available to increase a business?

Bob Antin

It’s a great question. And I would almost turn it back to you if you’re a pet own. We do have a very talented marketing department in the company and in the industry and we are accessing the Internet. We do work with humane societies, we do provide new clients with offers of free exams and discount services. Fundamental issue is whether or not you can encourage a pet owner to come into the veterinary and just based on a monitory offer and that still – that question still remains unsolved, but we are certainly probing and trying. But there isn’t an absolute answer to the question.

Stan Manny – Manny Family Investments

Okay. So you basically feel that the economy turns, you’re going to turn, and your leverage on the upside is gigantic tremendous.

Bob Antin

Well, I think when the economy turns, I sure hope we turn. I’ve given up on prognosticating, but I’m also somebody hard to paint into a corner. But I think when the economy turns, yes I do think you see more feed in, I think you certainly see more diagnostics. We experienced that for years the percentage of people who do diagnostics based on traffic in the hospital is a meaningful one. We’ve seen the growth only inhibited throughout the industry by foot traffic. So yes, the answer is if foot traffic picks up and the economy eases off a little bit, I do think we will see it.

Stan Manny – Manny Family Investments

Thank you.

Bob Antin

Thank you very much.

Operator

Thank you, sir. And our next question in the queue comes from the line of Rob Mains of Morgan Keegan.

Rob Mains – Morgan Keegan

Yes thanks. Question on the lab margins; I understand that you wouldn’t – if you get a sort of negative leverage with the volumes that you have, but if I look at the absolute revenue number in the third quarter, it wasn’t a whole lot different from what it was in the first quarter either this year or in ‘09, yet both the Red Cross and GNA are up in the neighborhood of a million from what they were in those first quarter. Is there any – and Tom, you’ve laid out a couple of things going on. But is there anything else that’s going on in the expense structure for the labs at the level of business that we’re seeing now, the prior margins are unsustainable?

Tom Fuller

As I mentioned, we did have incremental increase in R&D spending. We’ve also been investing in our transportation network to improve service levels in several markets that we are currently in. So I think those expense levels are probably built in now and it would be leverageable when revenue grows. But I don’t see substantial – continual increases, I think it’s probably going to level off at this point.

Rob Mains – Morgan Keegan

And are those embedded on direct cost, G&A, or you split between them?

Tom Fuller

Split between them.

Rob Mains – Morgan Keegan

Okay. And they’re of that order of magnitude like about 2 million in total.

Tom Fuller

Yes in that range potentially.

Rob Mains – Morgan Keegan

Okay. And then the other question is on the medical technology business, pretty nice increase that you saw at a time when everything else seems to be pretty challenging. What do you view as working in that business at this point?

Bob Antin

I think it’s a large part, not exclusively, I think to a large part is veterinarians investing in their own business, independent veterinarians wanting to upgrade technology, because they’ve lived through this long enough, and they anticipate at some point the economy has an upbeat to it. So I think veterinarians are investing in their own capabilities.

And, on top of it, you still have an issue where you have better trained vets, more specialists, more doctors coming out of internship program, so want the technology. So by digitizing image you have the ability to access more specialists by moving images to neurologists, internists, radiologist, oncologists, so I think that’s part of continuing the building of the infrastructure.

Rob Mains – Morgan Keegan

Okay, thanks. And then last question on the competitive environment. On the lab business, do you have a sense as to – I understand that part of it is just decreased volume. But could you speak a little bit to moving lab volume either to competitors or to lab share either to competitors or to veterinarians doing tests in-house?

Bob Antin

Competition is stiff on the outside. I think our loss of clients has declined. In part as I said before, competitor does a good job as we do for them. They’ve entered in markets where they have taken some share, where they previously weren’t strong and we’ve seen a decline in that. And I think that’s – I think that’s a leveled off a little bit for all concerned.

I think on the inside, inside lab business, I can speak from our hospitals and those that I have – we have close relationships. Our revenue from internal lab capabilities because we do have technology in every one of our hospitals has declined greater than 5% for no other reason than the amount of elective procedures that are being done in the hospitals in one of the areas where hospitals are feeling it and that’s where you typically would do most of your – at least in our hospitals we would do most of it. So I don’t see any major shift, I see competition continuing on the outside and I think we coexist with the inside capabilities.

Rob Mains – Morgan Keegan

Okay. So just to make sure I understand what you said about the inside. So the decline that you’re seeing both external and internal lab, referencing and in-house is kind of same order of magnitude?

Bob Antin

For us as an animal hospital owner, our decline is greater on in-house laboratory work than on outside. Our revenue in our hospital division through our hospital division our revenue has declined a little bit more on in-house testing and has actually grown a little bit on reference lab testing based on the number of tests that are being done.

Rob Mains – Morgan Keegan

Okay I understand that now.

Bob Antin

Okay.

Rob Mains – Morgan Keegan

That’s great, thank you.

Operator

Thank you, sir. And the next question we have in queue comes from the line of Jonathan Block of SunTrust Robinson.

Maggie Lovatt – SunTrust Robinson

Hi guys, this is Maggie Lovatt in for Jonathan Block. Just had a quick question for you Tom. Could we get the total number of orders on the hospital side?

Tom Fuller

The total orders – you’re correct, I’ll just find it.

Maggie Lovatt – SunTrust Robinson

And maybe if I could –

Tom Fuller

You know what I don’t have that number, sorry. I can get back to you.

Maggie Lovatt – SunTrust Robinson

Great. And I –

Bob Antin

$1,596,000 for the quarter.

Tom Fuller

That’s same-store orders. Do you want total orders?

Bob Antin

Total orders.

Maggie Lovatt – SunTrust Robinson

I was looking for total. That’s all right.

Tom Fuller

Actually I may have it, but you keep talking.

Maggie Lovatt – SunTrust Robinson

Okay. Question for Bob –

Tom Fuller

Got it. Great, great, great work, we got it.

Maggie Lovatt – SunTrust Robinson

Go ahead.

Tom Fuller

$1, 803,000.

Maggie Lovatt – SunTrust Robinson

$1,803,000 great.

Tom Fuller

Yes.

Maggie Lovatt – SunTrust Robinson

And I have a question I think just longer term if we look out say three years to five years just wondering what your thoughts were on the market, what kind of top line growth you could see in 2005, 2007, I think hospitals were maybe in the mid-single digits; lab was low double digits, can we get back to those levels or kind of what’s your view on the sustainable growth?

Bob Antin

It’s a hard – it’s an impossible one to answer. I’m hopeful that it gets back there. I’d love to get back up to even right now I got to be honest with you. But I do think – and I think in the long term, pets still occupy a wonderful place in our families. I think 3% to 5% was always a sustainable number except for a couple of events. One was the pet food scare, which drove up a little bit on a temporary basis, and the other is the economy that has actually taken it down. So I look forward on a long-term basis with 3% to 5% internal growth.

Maggie Lovatt – SunTrust Robinson

Great, that’s very helpful. And then I mean just as frustrating as it maybe, is the bottom line where we’re going to have a hard time getting even up to even on the hospital side until employment in the economy turns around? I mean there’s not much more you can do in terms of like marketing –

Bob Antin

We certainly don’t give up. And I think that is a – I think it is a challenge. And I don’t think we’ve comped off of as others double-digit drops, so the comps are realistic. I think we do need some help in the economy. We’re trying, we’re not giving up in terms of programs, but I do think we hit a headwind with the economy. And we can see it in the markets that we’re in, we’re high in employment and employment is going higher, some correcting and we see it.

Maggie Lovatt – SunTrust Robinson

Okay, great. And then last one just on R&D, you said it cuts you about 80 bps on the lab side, should we expect that to continue and then when do you think we could see some of that benefit I guess in order numbers.

Bob Antin

Well, I think it’s – and the margin is probably stable in terms of spending and I don’t want to forecast when R&D actually comes to fruition. We have as you saw, we worked PCR to market. But we’re working diligently at some other technologies to add testing capability to our menu, so we really can’t say.

Maggie Lovatt – SunTrust Robinson

All right. Thanks for taking my questions.

Bob Antin

Thanks Maggie.

Operator

Thank you. And we have one more question in queue at this time from the line of Carter Dunlap of Dunlap Equity Management.

Carter Dunlap – Dunlap Equity Management

Hi, earlier you spoke of your private label initiative in the product line business.

Bob Antin

Yes.

Carter Dunlap – Dunlap Equity Management

I’m not familiar with that. Can you speak to what in the breadth of it and what you hope it to become?

Bob Antin

Well we’ve seen – one of the earlier questions it might have been from Don – we’ve seen channel changes in veterinarians who have traditionally supported pharma companies and they then changed the channels and move them out moving them to a more retail environment, and pet owners rely heavily on their veterinarians for integrity of product and reference in selling.

So we made a decision that in some of the product categories – I don’t want to go into all of them – that we would begin to private label our own line and work with selected manufacturers for private labeling and have a line of both ethical and OTC products that we hope will over the course of a period of time will become a full offering to our clientele, so will help them bond a little bit more to our hospitals under our brand with extremely high-quality products that they can count on some stability that we also hope to be able to home deliver to them as well.

Carter Dunlap – Dunlap Equity Management

I mean I know you don’t want to explain, which one.

Bob Antin

No it’s –

Carter Dunlap – Dunlap Equity Management

No, where are we in the rollout, are they in the hospitals yet?

Bob Antin

No I would expect that by the end of the year or the begin of the year, we will start rolling out one or two of the products.

Carter Dunlap – Dunlap Equity Management

Okay great, thank you very much.

Operator

Thank you, sir. And we have no further questions in the queue at this time.

Bob Antin

I’d like to thank you. I know that it’s a roughed point in many businesses. I’d like to remind everybody that we still have a phenomenal franchise. Our animal hospital business is considered probably among the tops in the world. Our name is recognized, our performances has had a great history, we are definitely having an issue of dealing with the economy, and I think that our future is strong that we have capital structure, the resources available to continue to grow, and I think we will look back on this time as a challenging one. But having said that we still have a great, great cash flow from our businesses. So I’d like to thank everybody and I appreciate the time, bye.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may now disconnect. Everyone have a great day.

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