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Heska Corporation (NASDAQ:HSKA)

Q2 2014 Results Earnings Conference Call

July 30, 2014, 11:00 AM ET

Executives

Brett Maas - Managing Partner, Hayden IR

Robert B. Grieve - Executive Chair

Kevin S. Wilson - CEO and President

Jason A. Napolitano - EVP, CFO and Secretary

Analysts

Joseph Munda - Sidoti & Company

Nicholas Jansen - Raymond James & Associates

Ben Haynor - Feltl and Company

Operator

Good day and welcome to the Heska Corporation Second Quarter 2014 Earnings Conference Call. Today's presentation is being recorded. At this time I would like to turn the call over to Brett Maas. Please go ahead, sir.

Brett Maas

Thank you all for joining us today on our conference call. On the call today with us are Kevin Wilson, Heska's President and Chief Executive Officer; Jason Napolitano, Heska's Chief Financial Officer and Bob Grieve, Heska Corporation's Executive Chair.

We appreciate having the opportunity to review the results for the second quarter of 2014 and provide an update on the company's progress.

Prior to discussing our results I'd like to remind you that during the course of this call we may make certain forward-looking statements regarding future results, events or future financial performance of the company. We need to caution you that any such forward-looking statements are based on our current beliefs and expectations and involve known and unknown risks and uncertainties, which may cause actual results and performance to be materially different than what is expressed or implied by those forward-looking statements.

Factors that could cause or contribute to such differences are detailed in our press releases or in our annual, quarterly or other filings with the SEC. These forward-looking statements speak only as of today and except as otherwise required by law, Heska does not intend to update any forward-looking statements to reflect events that occur after today's call.

I'd like to now turn the call over to Kevin Wilson, Heska's President and Chief Executive Officer to provide opening remarks. Kevin the floor is yours.

Kevin S. Wilson

Thanks Brett. I would like to thank everybody for joining the call today. By now most of you have seen our release this morning. Heska had a strong quarter and our team did a fantastic job. Compared to the last year in the same period we grew top line sales by 25%. We increased gross margins by 12.1% and we decreased operating expenses by 5%. Basically we sold more at higher margins while spending less. The result was a net income attributable to Heska of $1.1 million for the second quarter, a positive swing of $0.56 in earnings per share over last year's loss of $0.38 per share. I am really pleased with the progress and enthusiasm of our whole team.

We had a few good quarters now and we look forward to building on this momentum. While there are literally hundreds of recent improvements at Heska, in our limited time today I would like to highlight three areas that have contributed to our recent momentum.

First we worked very hard to make our products best in class. Couple of examples; for our Element DC chemistry unit we have launched a new EWrap and a fixed slide pre-surgical and closed slide comprehensive package. While customers can still perform single slide studies which they love, with an EWrap they can also load multi-slide pre-packaged panels. In the second quarter we have done a limited release of the new EWrap to a select group of customers. It's gone extremely well and we anticipate broad satisfaction and slide usage increases as we make EWrap generally available in the fourth quarter.

In the handheld blood gas electrolyte metabolite and basic chemistry space our Element POC continues to gain traction as it enters its third full quarter of availability. While the rate has slowed in Q2 of 2014 we continue to upgrade competitor analyzers to the new Element POC. In imaging we have completed the launch of three major new Digital Radiography acquisition products. [3 point] veterinary and the Slate 4 for and the [Bruno 4 portable products] are fully released. And for companion animal hospitals the new cloud DRHD which is the industry's first ultra-high definition Digital Radiography solution is also now fully released and shipping. The quality of these products appears to be stimulating an upgrade cycle.

In Cloud software services at the end of the second quarter we went live on our new cloud based image and data management archive called Cloud Bank 2.0. Along with an all new cloud base viewing and sharing platform called View Cloud 2.0. And finally in allergy we have launched the all new advanced [inaudible] test for substantially higher level of sensitivity and specificity. And even we as made the test better we have reduced our test pricing to make it more accessible which has resulted in increased ongoing allergy immunotherapy treatment sales. The advanced allergy test and treat model continues to gain traction.

With each new product launch comes the opportunity to approach existing and new customer clinics with a compelling conversation starter which leads to more sales of our products. We anticipate more product releases in the second half of this year.

The second area that we are focused on is our sales people and product line bundling. We have completely revamped our inside and outside sales management structure and compensation plans. We have invested heavily in recruiting and training the best people. Over this past year we got to a core of the highest quality Heska team and then we built around that core with new fresh people and new intense training. Roughly 40% of the sales and marketing team in Q2 of this year is new compared to Q2 of last year.

And finally we’ve accelerated the integration of our imaging and blood analyzer teams for increased opportunities, cross selling best practices and bundling. On this last point of bundling it's early and we have more work to do to integrate imaging more closely into the broader Heska line. That said we are seeing many of our best Heska blood analyzer customers opting for new Digital Radiography Ultrasound and Cloud-based data solutions. We are now also seeing early ramp up of our Digital Radiography and Ultrasound customers upgrading to Heska blood analyzers. Both trends are encouraging.

The third area of focus, we have made Heska so helpful that customers choose Heska and perhaps more importantly they stay. We have launched a membership advantage program for current customers whereby they receive substantial savings on test and return for yearly and multi-yearly partnerships with Heska. We have also launched the Reset program aimed at new analyzer customers in chemistry hematology and blood gases. With Reset customers get Heska analyzer and full warranty and service for five years along with test pricing that is often 30% below their current solution.

And in imaging we have expanded our Digital Radiography Rent or Own programs whereby customers can rent our new Digital Radiography and archival solutions for 24 months. At the end of the 24 months they have three options. They can renew, they can apply a 100% of their prior payments to price and purchase the installed system or they can return the solution. With early rentals having begun two years ago the first indications are good of customers using the purchase or the renewal. This model has proven to be unique in the imaging space.

While the imaging rental program the blood analyzer reset and membership advantage programs may have dampened revenues in the near term and may continue to do so, the benefits of sustained revenue market share and momentum are beginning to show on our numbers. For example sales of our analyzer consumables were up 20% year-over-year approximately which is encouraging and important.

We have accomplished a lot at Heska in a short time, but there is still more to do. While it's not possible to detail each initiative in our brief call today I am thankful for the time to share with you some of our recent work. And now I will turn the call over to Jason for his review on our most recent results.

Jason A. Napolitano

Thank you, Kevin. Second quarter of 2014 was another solid quarter for Heska. Revenues for the quarter were $22.9 million compared to $18.3 million in the year ago quarter, an increase of 25.5%. Core Companion Animal Health revenue was $17.5 million, including $3.2 million in Heska imaging, an increase of 10.3% compared to $15.9 million including $2.7 million from Heska imaging in the prior year period. Key factors in the increase were greater revenue from our instrument consumables, domestic sales of our canine heartworm preventive and our digital imaging products. These were somewhat offset by lower revenue from international and domestic sales of our heartworm diagnostic tests.

Revenue in our Other Vaccines, Pharmaceuticals and Product Segment or OVP was $5.4 million in the second quarter of 2014, an increase of 125% from $2.4 million in the prior year period. The largest factor in the increase was greater revenue from the contract Elanco Animal Health received from AgriLabs last year. For the six months ended June 30 2014 revenue was $43.7 million including $5.3 million from Heska Imaging an increase of 17% as compared to $37.2 million including $4.6 million from Heska Imaging in the year ago period.

We generated $9.1 million in gross profit in the second quarter of 2014, an increase of 81% compared to $5 million in the prior year period. Gross margin was 39.6% in the second quarter of 2014 compared to 27.5% in the year-ago period. In the second quarter of 2013 we recognized the reserve which I will refer to as the Roche reserve related to an agreement with Roche Diagnostics Corporation under which we would be released for any minimum purchase obligations for our previous blood gas analyzer as well as a reserve related to inventory of our previous chemistry analyzer. These items did not recur in the second quarter of 2014 and were a large factor in the lower gross margin in the prior year period.

In the second quarter of 2014 total operating expenses were $8.2 million including $1.5 million from Heska Imaging. This represents a 5% decline from $8.6 million in the second quarter of 2013 including $1.2 million from Heska Imaging. Lower expense in the 2014 period due to the Roche reserves, lower severance cost and lower advertising and promotional expenses were key factors in the decline. These were somewhat offset by increased non-cash compensation expense, primarily related to new employment agreements for our Chief Executive Officer and Executive Chair.

Total operating expenses for the six months ended June 30, 2014 were $16.5 million, a decline of 3% as compared to $17.1 million in the prior year period. Depreciation and amortization was $1.6 million in the first half of 2014, as compared to $1.1 million in the prior year period. Factors in the change include increase depreciation and amortization from Heska Imaging in the 2014 period, and increased depreciation from blood testing instrument rentals in the 2014 period.

Stock-based compensation increased to $586,000 in the first half of 2014 from $231,000 in the prior year period. The largest factor in the change is related to the previously mentioned CEO and Executive Chair employment agreements.

Operating income was $917,000 in the second quarter of 2014 compared to an operating loss of $3.6 million in the prior year period. We had operating income of $816,000 in the first six months of 2014 as opposed to an operating loss of $4.3 million in the first half of 2013. In the second quarter of 2014 we generated net income attributable to Heska Corporation of $1.1 million, as compared to a net loss attributed to Heska Corporation of $2.2 million in the prior year period. We had net income attributable to Heska Corporation of $1.3 million in the first half 2014, as compared to a net loss attributable to Heska Corporation of $2.6 million in the prior year period.

Cash and equivalents at June 30, 2014 totaled $6.3 million compared to $6 million at December 31, 2013. Total debt at June 30, 2014 was $3 million compared to $5.3 million at December 31, 2013. Accounts payable was $5.1 million at June 30, 2014, as compared to $4.4 million at year end 2013. And accrued liabilities were $4.3 million at June 30, 2014, down slightly compared to $4.4 million at December 31, 2013. With at least double-digit revenue increases in each of our segments increased gross margin and lower operating expenses this quarter represents the type of results we would like to continue to report to our investors. We look forward to building on the success we have this quarter.

With that, I will turn the call over to Bob for some comments about our expectations for the business going forward.

Robert B. Grieve

Thank you, Jason. Before we conclude our prepared comments I would like to spend a few moments providing you with some context regarding our expectations going forward. Now that we are well into the integration of the imaging business visibility in our outlook has improved. It's hard to be anything but very pleased with our second quarter results, the numbers speak for themselves. We have grown the top line and reduced expenses. Revenues were up in both our business segments and we expect this to generally continue in the intermediate term, with core companion animal revenue our largest segment expected to grow in the low double-digit percentages in the intermediate term and OVP to continue to grow in the low single-digit percentages over the intermediate term.

I want to stress that this is not short-term guidance and we would well experience individual quarters with higher or lower growth rates especially in quarters where we have had a particularly easy or difficult comparison for the given historical quarter. For example while OVP had an extremely strong quarter in terms of year-over-year growth, this portion of our business tends to be a little more lumpy and we experienced swings on a quarterly basis. The results of the second quarter do not form a trend that should be extrapolated into the near term quarters. Over long term we do expect continued modest growth in the OVP segment.

On the expense side, our operating expenses were down for the quarter and we will continue to tightly manage each expense category. With revenue growth in our sights and expense is well under control we look forward to coming quarters to build our profitability during this exciting promising time for Heska. Thanks for your attention today and we appreciate your continued interest in and support of Heska. At this time I would like to turn this over to the operator for Q&A.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And our first question comes from Joe Munda of Sidoti & Company. Please go ahead.

Joseph Munda - Sidoti & Company

Good morning guys, can you hear me okay.

Kevin S. Wilson

Yes, Joe.

Joseph Munda - Sidoti & Company

First of I would like to start with the OVP segment. The revenue here, the growth, was that related to a stocking order of some sort in the quarter from Elanco. It seems like an outsize number and you guys touched on it a little bit in your prepared remarks.

Jason A. Napolitano

Yeah, this is Jason Joe. Thanks for the question. Elanco took over the AgriLabs contract last year in the fourth quarter. So I don't think I’d characterize it as a stocking order. I also wouldn't go to the other extreme and say that we have got an expectation that they are going to double revenue every quarter in that business that's not realistic either obviously. So it’s probably something in the middle.

Joseph Munda - Sidoti & Company

Okay, that's very helpful. As far as the core companion segment goes it saw a nice growth there can you I am sorry, in your prepared remarks you talked about the imaging I think you said $3.2 million in Heska Imaging was that up or down year-over-year I didn't catch that last part?

Jason A. Napolitano

Sure, let me be sure I got the specific number we are talking about Q2 Joe?

Joseph Munda - Sidoti & Company

Yes.

Jason A. Napolitano

Okay, so the Heska Imaging number was $3.2 million and $2.7 million. That was for the second quarter, $3.2 million versus $2.7 million last year.

Joseph Munda - Sidoti & Company

Okay and that increase in Heska Imaging is that directly attributable to that rent to own model that you’ve undertaken here and you talked a little bit about possible revenues falling off here a little bit because you are switching the upfront sales with the rental. So how should we look at that going forward?

Kevin S. Wilson

Joe, it's Kevin. I touched on that in the prepared comments, so I’ll probably fill in some of the gaps. What I was trying to say is that we have been doing rentals now for some time and we anticipate continuing to do that model into the future. And so the increases is not really related per se to initiating our own program it's more related to more placements. The rental actually has an ironic effect in the early periods of reducing revenues because you don't recognize 60 months’ worth of revenue upfront, you recognize it over the period as adjourned. So the results that we are reporting now include actually a larger percentage of rentals and a larger quantity of rentals than it did even in the prior period and year-over-year.

Joseph Munda - Sidoti & Company

Can you breakout for us rentals versus sales in that segment?

Kevin S. Wilson

You know it's a moving target and I don't know how instructive that would be. Based on seasonality we will emphasize certain sales programs and in some months we will emphasize sales promotions that encourage capital expenditures and another months we will emphasize rentals that are operating expenditure for the veterinarian and it really just depend on which segment of the market we are going, what the market dynamics are, where we are in the product releases and upgrade cycles and so it is a moving target.

Joseph Munda - Sidoti & Company

All right, just two more here, Jason, did you touch on CapEx for the six months, I must have missed that number if you did?

Jason A. Napolitano

I did not, would you like to know the figure? One second. Okay, so this is six months numbers Joe, $1.5 million for 2014 versus $734,000 in 2013.

Joseph Munda - Sidoti & Company

Is that a number that we could annualize out possibly?

Jason A. Napolitano

You are just trying to get guidance again, aren’t you?

Joseph Munda - Sidoti & Company

Doing everything we can over here.

Jason A. Napolitano

I think we are going to watch how that comes in over the next six months.

Joseph Munda - Sidoti & Company

Okay, and then I guess my final question the Roche reserves here you saw a nice bump in gross margin is this a number that I mean in the back half of last year you were tracking in the low 40s, mid-40s, are those numbers that you can get back to in the back half of this year going forward?

Kevin S. Wilson

I would say again we are not issuing short term guidance here. But I would say that because the contribution of the relatively the lower gross margin from the OVP segment you have seen an impact on a consolidated gross margin here compared to historical norms, we will leave it there.

Joseph Munda - Sidoti & Company

Okay, all right. Thank you.

Operator

And [Ethan North] of Stifel’s has our next question. Please go ahead sir.

Unidentified Analyst

Thanks very much. I just had two quick questions here. The first in early '13 you made the decision to partner with one of the larger distributors that ultimately shifted back to a more direct model and was one of the primary diagnostic competitors recently announcing plans to go fully direct and several of the larger distribution players potentially opening up to new diagnostic lines. Has the prospect of partnering with distributors become more attractive to Heska today relative to where it was in 2013?

Kevin S. Wilson

This is Kevin. Thanks for the question Ethan. There are several ways to get to the market but the one thing that we are passionate about is making sure that the work that we do, the quality that we deliver in front of the customer we control. And having said that, that's our part of the job. There are some very capable, extremely impressive companies out there in the distribution space that do a fantastic job of getting in front of customers and they have a sales force that’s exponentially larger than our own.

So our focus over the last year was to really tighten up our ship, tighten up our message, get the team more efficient, more effective, so that we are in a position to leverage relationships with some of these distributors if it present itself. We don't know how that all will shake out. We will watch our competitor with interest to see how they do in the coming quarters and of course we will talk to the appropriate people as they become available.

Unidentified Analyst

Okay, great and then you mentioned that the team used to have some success in upgrading competing instruments to Element POC. Is the Element resonating with a particular type of practice for instance small or larger practices or is the success coming from displacing instruments from one competitor in particular or is it been more broad-based? Thanks.

Kevin S. Wilson

The primary device that we see upgrading is the i-STAT which comes from Abaxis, I believe it’s manufactured by Abbott. That's probably the most direct competitor and it is handheld and it really fits in the same space. We are pretty encouraged, the people who purchase blood gas and electrolyte analyzers tend to be the higher volume clinics. They tend to do more emergency medicine, more specialty medicine. So we are pretty pleased with the type of customer that has been going with the Element POC.

Unidentified Analyst

Okay, thanks for taking the questions.

Kevin S. Wilson

Thanks, Ethan.

Operator

And our next question comes from Nicholas Jansen of Raymond James. Please go ahead.

Nicholas Jansen - Raymond James & Associates

Hey guys, nice quarter. Did you gave consumable growth number in the quarter and I guess the main question I am trying to figure out here is you guys have done a great job of placing instruments over the last 18 months and it's not really reflected in the revenue because you are placing them versus selling them. So I am just trying to get a sense of where we are in the innings of pull through from all these interim placements. Are we early, mid, late, later stage of the acceleration of growth that you should be getting from all these placements that you have had over the last 18 months? Thanks.

Kevin S. Wilson

We did in our prepared remarks note that consumable sales for analyzers were up a little bit over 20%. And there is a mix between chemistry and hematology and blood gas and what not but we are pretty pleased with the trajectory of that and analyzer placements and success with programs like the reset and membership advantage most certainly helped that.

Nicholas Jansen - Raymond James & Associates

Okay, is -- are we -- have you, if you are thinking about the last six quarters or so how many of those instruments you put -- are kind of fully up to speed in terms of normalized ordering patterns? Just trying to get a sense of, is that 20% number is sustainable or is it going to decelerate meaningfully, just any color there might be helpful.

Kevin S. Wilson

It's a bit of a loaded question in terms of decelerate meaningfully or accelerate and those types of things. So I hesitate a little bit but maybe this will help. The membership advantage agreements and reset rental models tend to be multi-year agreements. And one of our initiatives was to love and hug and care for our current customers first. So a meaningful percentage of our current customers have elected to go with Heska on a multi-year relationship. So that's we think very helpful and we think that's a nice base to build upon as opposed to having any of the air leaking out of the back of the balloon.

Nicholas Jansen - Raymond James & Associates

Okay, that's helpful and then switching gears to the imaging franchise, I think you made some colors surrounding, and you provided some interesting colors surrounding some of your larger customer. They are now starting to buy the consumables or placing the instruments and buying some consumables. I am just trying to get a sense of how many imaging customers do you have, and then how many of those could potentially switch over a multi-year timeframe?

Kevin S. Wilson

The volume in imaging customers is going to be smaller than the volume in blood analyzer customers always. It's a smaller universe. So it's going to be in the hundreds not the thousands traditionally. They do tend to be good customers; they do tend to be high volume customers especially those that are upgrading to more recent Digital Radiography systems. But it's going to be in hundreds not the thousand or tens of thousands.

Nicholas Jansen - Raymond James & Associates

Okay, well thanks for the color guys. Nice quarter.

Kevin S. Wilson

Thanks Nick.

Operator

And at this time there is one question remaining in the queue. (Operator Instructions). And we will take our next question from Ben Haynor of Feltl.

Ben Haynor - Feltl and Company

Good morning gentlemen. Thanks for taking my questions. First off, good quarter you guys did a great job controlling operating expenses. You mentioned in the prepared remarks that you are going to be continuing to look hopefully but how, I guess I am not looking for guidance but have you picked most of the low hanging fruit in terms of reducing the operating expenses or is there still a decent amount of room to go there?

Kevin S. Wilson

Hey, Ben it's Kevin. I don't really look at it that way. What I find is if you want to go eliminate spend, you pay attention to the details and you make one weak decision at the time or one strong decision at the time. And so think I we have put in place a good culture where people are free to highlight weak decisions that can turn into strong decisions and they are compensated to do that and are starting to think that way. So I think it's more systemic than it is just taking a meat cleaver to something that's obvious and saying we are going to whack that. That tends to not be as sustainable and so I am pretty pleased with -- of them. I am really pleased with the culture that's kind of taking hold in that regard.

I think it's really important as we scale up and as we increase the sales that, that type of culture be in place. So I hope that answers the question, but there is no hard target other than to say better.

Ben Haynor - Feltl and Company

I think that's helpful. And then Jason I apologize, I missed depreciation and amortization in the quarter.

Jason A. Napolitano

No problem we gave the half year number but you can of course back [inaudible]. So $1.6 million was the first half of 2014 and $1.1 million was the first half of 2013.

Ben Haynor - Feltl and Company

Okay, great. And then I think Kevin you spoke last quarter about potentially providing some new metrics on how the business is operating in the future. Is that something that we can expect may be in the next couple of quarters or is that kind of a longer term plan?

Kevin S. Wilson

Yes, we are tightening that up for coming quarters and also longer term. We did take a tentative step out there and start to highlight the consumables. But again we want to be presenting you with numbers that help you model not divert your attention from the things that matter to operating the business. So we are still grappling with that a little bit. We are pretty pleased that the results are good. So that's kind of where we are starting.

Ben Haynor - Feltl and Company

Okay, terrific. That's all I had. Thank you very much, gentlemen.

Kevin S. Wilson

Thanks a bunch.

Operator

And that does conclude today's question-and-answer session. At this time I would like to turn the call back over to Kevin Wilson for any additional or closing remarks.

Kevin S. Wilson

Well, thank you. I would like to thank everybody for joining the call today. Heska had a great quarter. The team did a fantastic job and from all segments from OVP, [inaudible] to our analyzer business or imaging business, our operations from the warehouse, so everybody does just really has done a fantastic job and we look forward to continuing that effort. We will talk to you in another quarter. Bye-bye.

Operator

And that does conclude today's conference. Thank you for your participation.

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