IDEXX Laboratories (IDXX) Jonathan W. Ayers on Q2 2016 Results - Earnings Call Transcript

| About: IDEXX Laboratories, (IDXX)

IDEXX Laboratories, Inc. (NASDAQ:IDXX)

Q2 2016 Earnings Call

August 02, 2016 8:30 am ET

Executives

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

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

Analysts

Nick M. Hiller - William Blair & Co. LLC

Erin Wilson - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Jon Block - Stifel, Nicolaus & Co., Inc.

Mary Kate Gorman - Canaccord Genuity, Inc.

Nicholas M. Jansen - Raymond James & Associates, Inc.

Ben C. Haynor - Feltl & Co.

Operator

Good morning, everyone, and welcome to the IDEXX Laboratories second quarter 2016 earnings conference call. As a reminder, today's conference is being recorded.

Participating in the call this morning are Jon Ayers, Chief Executive Officer; Brian McKeon, 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, plan, 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, idexx.com.

In reviewing our second quarter 2016 results, please note all references to growth and organic growth refer to growth compared to the equivalent period in 2015, unless otherwise noted. And in order to allow broad participation in the Q&A, we ask that each participant limit his or her questions to one with one follow-up as necessary. We do appreciate you may have additional questions. So please feel free to get back into the queue. And if time permits, we'll take your additional questions.

I would now like to turn the call over to Brian McKeon.

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

Thanks. Good morning, everyone. IDEXX delivered exceptional performance in Q2 building on our strong start to the year. In terms of highlights, we achieved organic revenue growth of 13% in Q2, well ahead of expectations supported by 12% organic growth in the U.S. and 14% organic revenue gains in international markets.

Recurring CAG Diagnostics revenues increased 12% organically, up from strong Q1 levels, driven by double-digit gains in the U.S. and international regions. We had another outstanding quarter in terms of instrument placements as well with a 31% increase in premium instrument placements year-on-year, supported by the very successful launch of SediVue and 18% growth in Catalyst placements. Overall, SediVue added about 2% to revenue growth in the quarter.

Closer benefits from strong top line performance and controlled operating expense growth supported better than expected operating margin performance and very strong profit results. Q2 EPS was $0.74, up 23% as reported and 33% on a constant currency basis. As expected, foreign exchange provided headwind to reported results, lowering reported revenue growth by about 1% and EPS by about $0.06 per share with profit impacts driven primarily by the lapping of 2015 hedge gains.

Based on our strong year-to-date performance and positive momentum, we're increasing our 2016 full year revenue guidance by $25 million, which implies an organic growth outlook of about 10% to 11.5%. We're also increasing our 2016 EPS guidance by $0.14 per share to $2.32 to $2.39, or 19% to 23% growth on an adjusted constant currency basis.

This outlook incorporates improved expectations for operating margin gains year-over-year of about 100 basis points for the full year on a constant currency basis, adjusted for last year's software impairment charge. We'll review our updated 2016 outlook later in my comments.

Let's begin with a review of our Q2 performance by segment and region. Future performance was driven by accelerated Companion Animal Group gains and continued strong growth in our Water business.

Global CAG revenues were $400 million, up 13% organically, supported by strong CAG recurring diagnostic revenue gains across regions and modalities, as well as strong global growth in instrument sales.

Water revenues increased 12% organically to $28 million as we continue to see benefits from our commercial investments and solid global market growth trends. Water growth benefited by about 4% in the quarter from one-time project revenues and incremental testing associated with the 2015 Crypto outbreak in the UK. These factors will not aid growth to the same degree in the second half of 2016, when we expect high single-digit organic growth in Water revenues.

Livestock, Poultry and Dairy revenues grew 4% organically in Q2 to $33 million as gains in China and Brazil offset lower European bovine testing levels. By region, U.S. revenues were $286 million in the quarter, up 12%, supported by strong growth in premium instrument placements, including benefits from the launch of SediVue, which added about 3% to overall U.S. growth. U.S. CAG recurring diagnostic revenues grew 10% organically, supported by continued double-digit revenue growth in our U.S. Lab business, accelerating consumable volume gains and solid organic revenue gains in rapid assay, in part supported by the timing of promotional programs.

Recurring CAG revenue gains continued to be primarily volume-driven with improving benefits from net price realization, reflecting the benefits of innovation, such as SDMA and our strong field presence with customers. We also continue to experience moderation of growth in net customer acquisition costs, reflecting our success in differentiating IDEXX's diagnostic technologies from competitive offerings.

U.S. market growth, reflected in our data set of about 5,200 clinics, continues to trend solidly. In Q2, patient visits increased 1.7%, and clinic revenues increased 4.9% overall. There was likely a modest shift of some testing to Q1 this year, given favorable winter weather conditions in certain markets. For the first half overall, patient visits were up 3.9% and practice revenues increased 7.0%, reflecting continued strong market momentum.

International revenues in the second quarter were $181 million, reflecting 14% organic growth. CAG Diagnostic recurring revenue growth accelerated to 17% in international markets in Q2, supported by very strong instrument consumable growth. Our international results reflect momentum from exceptional success in expanding our Catalyst platform globally and accelerated Lab revenue growth in key markets such as Germany and the UK, aided by new business gains and improved customer visit trends in the quarter.

Global instrument revenues for IDEXX were $33 million, up 35% organically, supported by outstanding growth in premium instrument placements, including benefits from our very successful launch of SediVue. Globally, we've placed 1,334 Catalysts, 934 premium hematology analyzers and 467 SediVues.

Strong North America results were supported by accelerated competitive placement levels. We placed 502 Catalysts in North America in Q2 with 300, or 60%, at competitive or greenfield accounts. This reflects productivity growth by our North American direct sales team and additional benefits from expanded discussions with customers connected to our launch of SediVue. These gains and continued improvement in placement retention supported a 14% expansion of our U.S. Catalyst instrument base over prior-year levels.

International performance continues to be very strong as well, reflected in 1,373 premium instrument placements, up 16% over prior-year levels, supported by continued exceptional customer response to Catalyst One.

Strong placement gains are driving higher growth in CAG Diagnostic recurring revenues. Global CAG Diagnostic recurring revenues were $338 million in Q2, up 12% organically. By modality, instrument consumable revenues of $115 million grew 14% organically, supported by accelerating growth in the U.S and very strong international gains.

Reference laboratory consulting services revenues were $153 million in Q2. 14% organic gains were supported by solid double-digit growth across U.S. and international markets. U.S. lab revenue gains continued at a strong pace, with 13% organic growth supported by benefits from SDMA, which continues to drive accelerated growth in core chemistry panels.

Rapid assay revenues increased 7% organically in Q2 to $56 million, driven by volume gains in 4Dx. Q2 growth also benefited from favorable comparisons related to the timing of 2015 first half promotions. Underlying trends in rapid assay remain solid as we work through comparisons to prior-year impacts related to the introduction of competitive first-generation assay products.

Veterinary software services, our new name for our customer information management business, and digital imaging systems revenues were $29 million in the quarter, up 8% organically. Growth was driven by increased digital revenue, reflecting digital radiography placement gains and benefits from recognition of deferred revenues associated with long-term business commitments. Software services revenue was also up solidly.

Turning to the P&L, strong revenue growth and flow-through drove very strong profit results in the quarter. Operating profit was $104 million, up 18% compared to the prior year, supported by gains in our CAG and Water segments.

As expected, the lapping of $5 million in 2015 foreign exchange hedge gains and unfavorable year-over-year changes in foreign exchange hedge rates had a moderating impact on our reported second quarter financial results. Excluding currency impacts, operating profits increased 26%. Operating margins of 22.3% were up 230 basis points on a constant currency basis, reflecting volume leverage and controlled operating expense growth, including benefits from the shifting of some investments to the second half of this year.

Gross profit was $261 million in Q2, up 12% on a reported basis. Excluding foreign exchange impacts, including the lapping of $5 million in prior year hedge gains, gross profit margins increased 70 basis points. Constant currency gross margin gains reflect benefits from moderate price increases, productivity in our reference labs, including leverage of strong volume gains, as well as improvements in our software services business. Mix impacts from higher instruments revenues partially moderated these gains. For 2016, we had a very small foreign exchange hedge gain reported in gross profit in Q2.

Operating expenses increased 8% in Q2, in line with Q1 growth levels. Shifting of certain OpEx investments to the second half will drive relatively higher OpEx growth in Q3.

As noted, EPS was $0.74 per share, up 23% on a reported basis and 33% adjusted for currency impacts. The federal R&D tax credit, which benefited 2016 but not 2015's second quarter results, had a favorable 2% EPS growth impact. EPS growth continues to benefit from share repurchases advanced over the last year, supported by a strong free cash flow and optimization of our capital structure, which reduced average share count year on year by 3.7%.

In Q2, we repurchased 269,000 shares for $23 million. Year to date, we've repurchased over 1 million shares at an average price of $74 per share. We ended Q2 with $1.2 billion in debt outstanding with an average interest rate of about 2.4%, reflecting a gross leverage ratio of 2.7 times adjusted EBITDA. Cash and investment balances were $370 million at quarter-end.

Looking ahead, we're raising our full-year guidance today to reflect our strong growth momentum and operational performance. We're increasing our 2016 revenue guidance range to $1.755 billion to $1.775 billion, an increase of $25 million, yielding reported revenue growth of approximately 9.5% to 11%. As noted, this implies an increase in our 2016 organic growth guidance to approximately 10% to 11.5%, on track with the long-term double-digit growth potential we've outlined for our business.

We're raising our 2016 EPS guidance by $0.14 to $2.32 to $2.39, reflecting flow-through benefits from higher organic revenue growth and our outlook for relatively higher operating margins this year. We're now targeting operating margins of about 19% for 2016, up about 100 basis points compared to 2015 on a constant currency basis, adjusted for the 2015 software impairment charge. We've updated our outlook for foreign exchange impacts, with assumptions detailed in our press release.

For 2016, the recent weakening of the British pound was largely offset by improvements in other currencies such as the yen and the Brazilian real, as well as benefits from previously established hedge positions. At the updated exchange rates outlined in our press release, we estimate that foreign exchange rate changes will reduce year-on-year revenue growth in 2016 by about 1% and 2016 EPS by $0.20 per share, including net impacts from the lapping of $21 million in 2015 hedge gains, compared to projected hedge gains of about $4 million in 2016.

We continue to estimate our effective tax rate at 30.5% to 31% for the year. We're now projecting free cash flow at about 100% of net income, the high end of our previous guidance range, reflecting strong progress in managing down inventory levels. We're also updating our share count outlook, with expectations for an approximate 3% net reduction in average shares outstanding this year. This lower projected benefit incorporates impacts from our higher stock price on our diluted share projection. For Q3, we're projecting reported revenue gains of 9.5% to 10.5%, and organic revenue gains of about 10% to 11%.

As noted, we expect relatively moderated Water growth in the second half of this year and anticipate a moderated rapid assay gains, relative to strong Q2 growth levels. In terms of the P&L, we expect that operating margins will be about 100 basis points below 2015 Q3 levels, which were 19.7% adjusted for the one-time software impairment charge.

The Q3 outlook reflects timing of 2016 operating expense investments and impacts from foreign exchange, including the lapping of $5 million in 2015 foreign exchange hedge gains in Q3. Please keep in mind that year-on-year benefits from share count reductions will moderate in the second half. For Q3, we expect year-on-year average diluted share count will decline about 2%.

That concludes our financial review and I'll turn the discussion over to Jon for his comments.

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

Okay. Thank you, Brian. As Brian indicated, we delivered an exceptional quarter with accelerating organic revenue growth of 13% and strong contributions from all regions of the world. The quarter is a gratifying validation of the strategies we have put in place to serve our markets with profitable one-of-a-kind innovation supported by strong and deep customer relationships. Double-digit U.S. CAG growth benefited from continuing increases in the productivity of our direct sales organization and solidifying customer relationships that come from a consistent presence in the market.

Year-to-date in the U.S. our diagnostic professionals have made over 124,000 in-person visits to veterinary practices, or an average of five visits for every U.S. veterinary practice. During these visits, we bring value-added innovation in education, which results in deepening IDEXX relationships with customers of all types.

These visits drive achievement of our commercial objective of widespread adoption of our first and only innovations. For example, our U.S commercial team achieved greater than 50% growth in premium instrument orders over the second quarter of last year, including both exceptional growth in placements of our Catalyst chemistry system and outstanding results with SediVue analyzers, which began shipping in Q2 of this year.

Our international CAG team also continues to drive strong premium instrument placements, demonstrating the global potential for Catalyst and supporting accelerating growth in the recurring revenue of the instrument consumables. Overall globally, our 14% organic revenue growth in instrument consumables was achieved through a combination of strong instrument placements, continuing high 97% to 99% customer retention levels, modest price realization and the adoption of a new test menu by our installed base of Catalyst customers, most notably the successful adoption of our recently introduced T4 slide.

All of these are indicators that our strategy of bringing innovation to the in-house testing market is truly resonating with customers, leading to enduring growth and the profitable recurring revenue streams from in-house testing.

Our global reference lab organic growth of 14% was driven in part by the growing appreciation by the veterinary profession of the remarkable value that SDMA brings to our chemistry offering. One way to measure the SDMA impact is to consider growth of orders that include a chemistry panel. By way of background, these drive a little over 50% of our overall reference lab revenue. If we compare the relative growth of these revenues versus revenues from non-chemistry orders in our U.S. reference lab before and after the launch of SDMA, we can estimate that SDMA contributed about 2% to 3% to our overall U.S. reference lab growth in Q2.

We are earlier in the launch of SDMA in international markets, being only about six to eight months. But it is also nice to see our strong double-digit revenue growth in these markets.

Turning to SediVue, we're extremely pleased with the North American launch of SediVue in the second quarter. Our second quarter placements included the order backlog generated from the first quarter and orders from the second quarter, not including the order backlog extending into the third quarter. This is a testament to the compelling value proposition and the quality of the SediVue instruments that we placed 467 in that very first quarter of our launch. This is a record installation ramp for us compared to historical IDEXX major instrument launches. The market for SediVue is deep and broad, as there is nothing like it.

SediVue addresses a major pain point for in-house urinalysis. We expect the launch of SediVue in certain countries beyond the U.S. and Canada in Q4 2016 with the bulk of the international launches to take place in 2017. In the meantime, our international teams are having a field day with Catalyst One and SDMA.

Finally, before the Q&A, I want to turn to a couple of brief updates on our pipeline of future technologies. First, we expect to introduce software for SNAP Pro in Q4 this year that will upgrade the device to automatically interpret results of all of our SNAP tests. By way of background, we have over 11,000 SNAP Pros in the U.S. market with 8,000 customers, all of which will be upgradable to the new software, and we continue to place SNAP Pro mobile devices with customers who appreciate their role and practice productivity and profitability as part of our integration strategy. SNAP Pro adds value to the SNAP experience and thus helps drive retention and growth of this element of our Companion Animal diagnostic recurring revenues.

Second, we expect to introduce the SDMA test on the Catalyst slide for in-house use in Q4 of 2017. Given the success of SDMA, including this test as part of the Catalyst chemistry profile to be run right along with the rest of the tests in the panel in one run will be yet another game-changing impact of SDMA, and for our in-house chemistry offering. It will bring SDMA to a large set of customers who do not use or have access to our reference labs, expanding SDMA's clinical impact.

In the U.S., we expect the list price of the slide will be about $10 per test, and the average unit price realized will be a few dollars less than that due to the profile rebate programs as we will be aiming to drive adoption and volume growth.

Third, we expect to launch SNAP fecal in the first quarter of 2018 based on the development timeframes and the USDA approval process. SNAP fecal will bring more accurate technology for the antigen testing to an easy-to-use SNAP format for the screening of common intestinal parasites.

In summary, I'm very proud of what our teams achieved around the world, and what they have accomplished in the second quarter of 2016 and year-to-date. We are blessed to serve growing markets with innovations that come in the form of growing, profitable and enduring recurring revenues. In the process, we are serving our purpose to enhance the health and wellbeing of pets and their owners.

And yet our job is not done, as we are only in the early days of the adoption cycle of such blockbusters as Catalyst, SediVue and SDMA, not to mention many other products and services that are either aren't on-market or in our R&D pipeline. And as strong as our revenue and profit performance was in Q2, we see significant opportunities for continued productivity and how we achieve our potential for 10% constant currency revenue growth year-in, year-out, driving continued solid gains in operating margins in support of achieving our 15% to 20% constant currency EPS growth targets over our planning horizon.

And so that, Cynthia, we'll open the call to Q&A. Thank you.

Question-and-Answer Session

Operator

Certainly. And our first question will come from the line of Ryan Daniels of William Blair. Your line is open.

Nick M. Hiller - William Blair & Co. LLC

Hi, this is Nick Hiller in for Ryan Daniels. Thanks for taking my questions and congrats on the strong quarter. Could you speak a little more about the market reception to SediVue, obviously a very solid demand for the product, but how long do you believe the tail for this demand will be, meaning is it resonating only with the larger clinics or is it really more across the board?

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

Yeah, thank you for that question, Nick. We're really extremely pleased by SediVue's performance. It was a contributor to the 50% year-over-year growth in premium instrument placements by the U.S. sales team in the second quarter. I think we're in only very early days, top of the first inning here, with SediVue. The number of orders we generated in the second quarter was pretty close to the number of deliveries, and as I said, there is a broad and deep market.

Now, there are 25,000 veterinary practices, so it doesn't have to be a huge percentage to be a pretty big market opportunity for us in the U.S. and, of course, we believe there is opportunity around the world. Every practice does urinalysis. Every practice has the same problem and the analyzer is justified with really no more than one urinalysis a day, one to one-and-a-half. So it's a deep market and we have a great team to bring that technology – first and only; nothing like it in the market – to our customers.

Nick M. Hiller - William Blair & Co. LLC

Okay. And then just a quick follow-up on SediVue. What's been the response to the new consumable model there? Has it changed your philosophy on how you might sell consumables going forward to a pay-as-you-use model? Thanks.

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

First of all, the response is very positive to the pay-per-run that we introduced uniquely with SediVue. I think the customer conversation is mostly about the value that the analyzer brings to the practice. The pay-per-run is, if you will, icing on the cake. It's, "Oh! And I don't have to invest and worry about inventory." It's just like the reference lab model of supplies in advance and pay after I use. So it's sort of the final piece that is attractive.

We believe that there are elements of that that are unique to SediVue, but there is an element, which is what we call auto replenishment, which is automatically shipping based on usage, that we could apply in the future as we perfect that model and one of the unique benefits of our direct sales organization and direct sales model. But that would not be pay-per-run; that would still be a pay for the consumable in advance, but it would simplify the inventory management and actually eliminate the need to order the consumable. And that could be a nice customer benefit, but we're a ways away from that. We've got a lot of work to do in 2016.

Operator

Thank you. Our next question will come from the line of Erin Wilson with Credit Suisse. Your line is open.

Erin Wilson - Credit Suisse Securities (USA) LLC (Broker)

Great, thanks for taking my questions. You mentioned SDMA launch on the Catalyst, which is an interesting development, but you also mentioned SDMA is contributing to reference laboratory growth pretty considerably. Presumably this would increase testing overall, but do you view this will cannibalize any other reference laboratory gains? I guess, how should I kind of weigh those on balance? And will you still be adding SDMA chemistry to the chemistry panels, I guess, for free?

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

No. Well, so the bottom line is we think that SDMA expands the opportunity and the value of chemistry testing overall, okay? So it's a market expansion opportunity. Many of our customers are saying, "Oh, now I have a better reason, for example, to talk to my customers about preventive care testing, because there are things like chronic kidney disease that I can catch earlier when I have time to do something about it."

So I think in general, SDMA is a market expansion. We always have an in-house offering and a reference lab offering. And many of our customers say, "I would use SDMA, but I'm committed to real-time care. And getting the SDMA the next day after I've done the whole real-time care protocol with the customers isn't quite working for me." So I think what we'll do is it'll bring SDMA as a routine part of the chemistry panel to the in-house modality.

We don't anticipate changing our strategy with regard to reference lab pricing of chemistry panels from what we have today. We believe that SDMA will have an enduring impact on incremental growth for the reference lab overall.

Of course, as I mentioned in my prepared comments, we will be charging for the slide – on the in-house because it has a cost associated with us, but we think by the time we'll launch the slide we'll be two years into education of the market of the profound and remarkable value that SDMA brings, really as what I think is recognized as the most important among a whole set of important chemistry parameters but more reliable than the most frequently used and understood parameter today, called creatinine. And so, when you have a parameter that's more reliable than probably the top of the list, that has an impact on the value of the chemistry panel.

Erin Wilson - Credit Suisse Securities (USA) LLC (Broker)

Great, that's helpful. And there was a stepdown in operating expenses in the quarter. Can you elaborate on the delays in the timing for certain investments that you were referring to, and how should we think about that quarterly progression of operating margin trends? Thanks.

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

Yeah, we tried to give indications on that, Erin, so last year we were 19.7% in Q3, taking out the software impairment charge, and we think we'll be down about 100 basis points in Q3. The OpEx growth has been about 8% year on year, year to date. It will higher in the third quarter. It's largely a combination of select programmatic investments and just timing of some hires. And some of that just occurred later, and that added some favorability to the quarter. The second quarter was really more reflective of just exceptional top line growth and great flow-through, so I think we feel very good about the track that we're on. As I indicated, for the full year we're now projecting that we'll be about 19% for operating margins, which is up 100 basis points year on year on a constant currency basis. And, as Jon indicated, we feel very good about being on track to get operating margin leverage going forward in support of our 15% to 20% EPS growth goals, and we'll share more on that when we talk to everyone at Investor Day.

Erin Wilson - Credit Suisse Securities (USA) LLC (Broker)

Excellent. Thanks so much.

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

Thank you.

Operator

Thank you. And we'll go to the line of Jonathan Block with Stifel. Your line is open.

Jon Block - Stifel, Nicolaus & Co., Inc.

Great. Thank you and good morning. Jon, the first one just has to do with – the practice management figures that you provide are – they're robust; arguably, they reflect thousands of practices. And the industry sequential deceleration was maybe a bit greater than I would have thought from 1Q to 2Q. So can you just talk to what you're seeing with the industry so far in the third quarter? Clearly, a big part of everyone's bullishness has been on the favorable trends in the space, and are you picking anything up that gives us pause one month into 3Q?

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

Thank you, Jon, for the question. That's why I think Brian talked about the 7% growth. And, recognize, this is the reported revenues. The actual revenues from over 5,000 veterinary practices with, by the way, practice management systems of all types, so it's a pretty robust data set. It is the same-store sales data set, so it doesn't account for net practice formation.

I think that the first quarter was exceptional at 9%. I believe the fourth quarter was more like 7%. We've seen 5.5% to 7% kind of growth in the revenue on the same-store basis in this metric over the last several years. April was a little weak, probably for whatever reason, picked back up in May and June, and so one month or even a quarter does not a trend make.

But we see it's a pretty solid market. People love their pets. We've done some research that suggests that millennials love their pets even more than their parents, which is pretty amazing given what Baby Boomers have done in terms of taking care of their pets. So I think that the broad trends are favorable. The macro – it's relatively less sensitive to the macro but not insensitive to the macro, and of course your guess is as good as ours on where that's going.

Jon Block - Stifel, Nicolaus & Co., Inc.

Okay.

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

And Jon, I just add to Jon's comments, obviously, we disclose on the U.S. market, but the international markets, we saw very good underlying market growth trends in the quarter. That was one of the factors that was supporting the very strong European performance that we noted in strong lab growth.

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

I think, to take a point in case, we like to bring up Brazil, which is getting a lot of attention with the Olympics and all and is in I think one of their largest economic crises in the post World War II era, and we've got exceptional growth in Brazil. People love their pets, and so it's a favorable underlying cycle megatrend of value in their pets.

Jon Block - Stifel, Nicolaus & Co., Inc.

Got it. Very helpful. And then, Brian, I think you're now targeting, as you just mentioned, 100 bps of Op margin expansion in 2016, up from I believe what was 50 bps; and at the 2015 Analyst Day, I think you talked about 50 bps near-term, 50 bps to 100 bps long-term; you're already at 100 bps and so, I guess, where I'm going with this is, have these plans been accelerated and now we should start thinking about Op margin expansion goals of 100 basis points per annum going forward?

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

You know, we'll talk more about that at Investor Day. I think 50 bps to 100 bps is a good range for us on an annual basis to be targeting kind of a combination of gross margin benefits as we grow and with sustaining a healthy level of investment while getting a level of leverage off of our cost structure or our operating expense structure.

So I think the 50 to 100 basis points still makes sense. We've got a tremendous growth opportunity as a business and we're very focused on our core business. This is what we invest towards, right. We're not diversifying. We're ...

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

We've got a good market and we focus on execution here, as Brian said.

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

There aren't a lot of industries, I think, where you have this strong high single-digit organic growth and an opportunity as a company to grow even faster. So we want to balance the margin increments that we deliver, which we're committed to, with appropriately balancing that with investments for the long-term growth.

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

And Jon, again, thank you for the question. As you recall from our Investor Day last August, the 50 to 100 basis points for long-term margin expansion is very consistent with what we stated as part of our core financial model back then.

Jon Block - Stifel, Nicolaus & Co., Inc.

Got it. Last one from me, just a quick one. I may have missed it. The SDMA in clinic, Jon, that you mentioned in 4Q 2017, will that be compatible on the current catalyst sort of like a T4 backwards integrated, if you would, or will it require a new analyzer? Thanks, guys.

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

Thank you for the question. It's a great question, and you are exactly right. It's completely compatible with the over 20,000 installed base of Catalyst Dx and Catalyst One analyzers, and it will work just like T4.

Jon Block - Stifel, Nicolaus & Co., Inc.

Perfect. Thank you.

Operator

Thank you. Our next question will come from the line of Mary Kate with Canaccord Genuity. Your line is open.

Mary Kate Gorman - Canaccord Genuity, Inc.

Oh, sorry. Well, thank you. Mary Kate Gorman on for Mark Massaro. Congrats on the great quarter.

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

Thank you.

Mary Kate Gorman - Canaccord Genuity, Inc.

So my first question has to do with rapid and the 7% organic growth you posted in this quarter. Is there a certain seasonality baked into that number given, say, higher flea or tick revenue in the summer seasons? And to that extent, can you comment a bit on the promotional programs?

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

Yeah. Thank you again for the question. We've seen very solid performance in our overall rapid assay business, really for the last four quarters. There can be compares from – and it's a seasonal business, but, of course, if you're comparing to second quarter last year, you're comparing to the same season.

So there can be variations based on the timing of our promotional programs from quarter to quarter, but overall, we're very pleased with the effectiveness of our sales and marketing programs to communicate the clear clinical exceptional differentiation in our rapid assay technology and the accuracy that customers expect versus newer competitive offerings using lateral flow technology, and I think customers recognize that; they recognize the value of multi-analyte testing in one test as we have with 4Dx Plus, which has been very solid.

So we're going to be, of course, adding more value to the rapid assay business with the upgrade of SNAP Pro and SNAP interpretation, which has been a requested feature of our customers. Again, it's like the SDMA for the Catalyst. Our analyzers grow in value over time, and they grow through software upgrades. And those software upgrades can be delivered through the Internet of Everything, because almost all of our analyzers and the majority of our SNAP Pros are connected to the Internet, so we just in the background download these software upgrades. This is totally unique to the IDEXX platform, the information management platform.

And so, all of our offerings grow in value over time, and so we're very pleased with where we are with the rapid assay business. I'd say 7% was a kind of above average response, and if you average the first and second quarter, you probably get closer to what we think is – that where we are with that business.

Mary Kate Gorman - Canaccord Genuity, Inc.

Great. Thank you. That's very helpful. And if I could ask a second question, I'm not sure if you provided backlog numbers for SediVue as they currently stand, but you mentioned that SediVue contributed 2% in overall revenue in the quarter? And I was wondering if you could comment a little bit more, how we should think about those contributions in Q3 and Q4 given targeting still 1,000 SediVue placements for 2016? Thank you.

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

Yeah. We originally had estimates – goals this year for 1,000 placements. And I think Jon mentioned that we have a nice order pool in the second quarter that's sort of in line with your placement levels. And I think it's – our outlook incorporates that we think we can do 1,500 or more this year, so we built in some upside from that, and the timing is we'll see how it plays out over Q3 and Q4, but we think we are ahead of track of where we thought we might be and feel very good about the customer reception and this is a long-term build for us. We think there is a significant opportunity with SediVue in the North American market and globally and we'll be looking forward to sharing more of that.

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

Yeah. And SediVue, of course, is a razor/razor-blade business model, so when we talk about the placement of analyzers, well, of course, we get the revenue associated with the instrument sale. But we also start to build the recurring revenue of the pay-per-run and that happens year after year. So as we grow the install base over year after year, this will be a contributor to the instrument consumable growth for IDEXX, and it adds value to the rest of the suite so it improves the retention and helps us acquire customers for the entire in-house suite, which also supports the recurring revenue component of the business model.

Mary Kate Gorman - Canaccord Genuity, Inc.

Great. Thank you so much, and congrats again on the quarter.

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

Thank you.

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

Thanks.

Operator

Thank you. We will go the line of Nicholas Jansen with Raymond James. Your line is open.

Nicholas M. Jansen - Raymond James & Associates, Inc.

Hey, guys, congrats, gee, perfect quarter across the board. A couple of questions. Just first, I know some competitors are talking about bringing their own connectivity solution to the market later this year. And I just wanted to kind of bring that into context of how strong your instrument growth has been as of late. How do you feel – as competition starts to maybe get a little bit more apples-to-apples relative to your platform – how do you think about kind of instrument growth sustaining the 35% plus organic trend that you saw in the second quarter?

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

Yeah. Thank you, Nick, for those comments. Of course, it's all about the recurring revenue growth, because that's the enduring profitable sustainable part of what instruments bring. We've been working on our information technologies strategy for in-house instruments for a decade. Today, we have an installed base of 27,000 IDEXX VetLab Stations globally, about 90% of them are connected via SmartService.

We have 9,000 customers in the U.S. that are connected two-way; they're in-house and in practice management of all types. We have 23,000 VetConnect Plus activations. Interesting, utilization has grown year-over-year in the second quarter of VetConnect Plus by over 70%. And we're adding additional functionality. Of course, SediVue brings images. We have images from the reference lab. We've added reference lab ordering in the fourth quarter. All of this has helped and achieve an essential – an essential element of our integration strategy is the activities of our 80-plus field service reps. It doesn't happen unless they're in the field helping customers actually go through the installation and change management process of going to an integrated offering.

So I'd say that this is a strategy that is well developed but still progressing at a very rapid rate and we are very comfortable with the high-level differentiation and the ability in the field to be able to talk about the unique value that this integration strategy brings to IDEXX.

Nicholas M. Jansen - Raymond James & Associates, Inc.

That's helpful. And then secondly, just in terms of the organic growth outperformance, it's probably opening up opportunities perhaps to reinvest some of that outperformance back into the business to sustain this double-digit engine that you guys have developed. How do you think about R&D allocation over the next 12 to 18 months? Do you feel like you could potentially actually increase the development capabilities if you're continuing to deliver the organic growth that you're guiding to this year? Thanks.

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

Thank you. I think we have a sustained commitment to R&D. I think what's most notable is the level of productivity we've achieved in our R&D investments over the past few years to really generate some extraordinary products in the form of Catalyst One, which really nothing like it, you could see it by the world response to it. SDMA, which is the most important new parameter in the veterinary profession in 50 years. And SediVue, which is an entirely new in-house modality.

We have a significant investment in the current numbers for continued menu expansion, for continued advancement of our instrument platforms, and a very important area is information technology. Certainly, the cloud and the Internet of Everything, these are major technologies that we are – even though we've got now close to a decade of experience in these technologies, depending on which one you pick, we still feel like we're in the early days of what this can do for our business model.

And so this is all embedded in our R&D numbers and embedded in our long-term guidance. We don't see R&D growing faster than revenues, but we of course have a commitment to continue the innovation as a core part of the IDEXX business model.

Nicholas M. Jansen - Raymond James & Associates, Inc.

Great. And one quick follow-up in terms of – Brian, for you, in terms of 3Q margin guidance. I just wanted to make sure I understood that. I heard organic growth; I heard the hedging impact year over year; is there a spot number on year-over-year margin in third quarter as we true up our models for 3Q?

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

So what I said was effectively – like you said last year was 19.7% adjusted and we'll be about 100 bps below that, so in the range of 18.7%; that was the estimate.

Nicholas M. Jansen - Raymond James & Associates, Inc.

Perfect. Thanks, guys. Congrats again.

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

Thank you, Nick, and I appreciate your need to do the models. We really look at it on an annual basis, and there can be a quarter-to-quarter variation, but I think it's – from our point of view, from an execution point of view, and financial point of view, we're really driving the annual growth in revenue and margin.

Nicholas M. Jansen - Raymond James & Associates, Inc.

Great. Thanks, guys.

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

Great. Thanks.

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

Thank you.

Operator

Thank you. Next we will go to the line of Ben Haynor with Feltl & Company. Your line is open.

Ben C. Haynor - Feltl & Co.

Good morning, gentlemen. Thanks for taking the questions. First for me, you mentioned modest price realization in the prepared remarks. Any chance you could quantify the impact that the price realization might have had to the overall organic growth number?

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

For the U.S. market, we were – for recurring CAG, which is obviously the critical driver. We saw about 2% net price benefit in the quarter which is – where we think we can – we were hoping to get back to. We had moved a bit below that with some of the changes that had gone on and some of the impacts, and we think that's a good range to target and sustain going forward, and we're getting to that point now again, supported by the great innovation we're bringing to the market and also by the capability with the U.S. commercial organization to be with customers and communicate the value that we're delivering. So we think we're in a good place.

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

Yeah. Ben, yeah. Thanks for the question. Good answer, Brian. I also want to comment that we're pleased with the progression of the customer acquisition costs. Not only do we see a continuing pretty significant moderation, it's moving more towards customer acquisition, which is not something you see inside of it. These are true – a greater percentage were actually customer acquisitions. So I think all the pricing dynamics are favorable; 2% is kind of what we expect to be the run rate here, as we continue to drive adoption and volume growth.

Ben C. Haynor - Feltl & Co.

Okay. Great. And then to kind of follow up on that, is there any chance you might take it beyond 2%, just given the strong vet practice revenue growth we've seen over the last several quarters, or is that kind of where you would kind of stop?

Brian P. McKeon - Chief Financial Officer, Treasurer & Executive VP

That's a net number, so obviously, it's net of our list price changes, net of acquisition, customer acquisition impacts and things like that. We think that's a reasonable range to be in, and it'll be driven by how effective we are at communicating our value, and we think we're delivering a lot of value. But we think that range, as Jon said, is a reasonable ...

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

And just stepping back here, our purpose here is to expand the standard of care. We believe that we're still in the early days of the level of care that is delivered, and the level of care that actually pet owners will demand when they're fully informed. This is a volume-based strategy, and that's why the majority of organic growth is volume. We think 2% is reflective of the fact that our existing offerings are getting better and better, adding SDMA to the panel, and adding menu to the in-house analyzers, adding new software, new functional capabilities of SNAP Pro, we get to realize modest pricing gains. But we're really driving market expansion through primarily a volume strategy.

Ben C. Haynor - Feltl & Co.

Okay. Great. Thanks for the comments. That makes sense. That's it from me.

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

Thank you.

Operator

Thank you. Next, we will go to line of Erin Wilson with Credit Suisse. Your line is open.

Erin Wilson - Credit Suisse Securities (USA) LLC (Broker)

Hey. Thanks. Just a couple of follow-ups here. Can you speak to the consumable utilization trends for SediVue? Is it tracking higher than your initial expectations? Basically, I just wanted to know if the accounts where you have placed the product, are they testing more than what you initially anticipated from a volume perspective?

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

Yeah. Good. That's a great question. We know it's an important question. I think we're still very, very early days in the SediVue launch. And I really don't have any comments other than the earliest returns validate what we said in terms of consumable utilization, but it's just so early, given that we just started installing the instrument in April that we just would like to have a little bit more experience under our belt to be able to report that back to you. Thank you.

Erin Wilson - Credit Suisse Securities (USA) LLC (Broker)

Okay. And then you mentioned strong growth in the Water business, and you've highlighted it more frequently, more recently with also the product launch in the segment just this past week. Is this an area of increased investment and innovative offerings for you? How would you characterize your commitment to that business?

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

Erin, thank you for that question. It's a great question, because our Water business is really one of the most extraordinary business models with 95% recurring revenue; 99.9% customer retention; mid-40s operating margin; organic growth, we believe – I think Brian said in the high single-digit category. Our global Water team has delivered an exceptional first half, above our expectations, because they have really been quite entrepreneurial at pouncing on opportunities.

But as Brian indicated, we believe some of those, while they're impressive on the growth, they're not – they are project-based or outbreak-based. They don't necessarily build long-term trends, but we think, high single-digit growth for the Water business is just a great outcome for such an extraordinary business model. And so we're just very, very pleased with where we are in that business, the unique value that brings and the worldwide opportunity for sustained organic growth in that business with its enduring recurring revenue profile.

Erin Wilson - Credit Suisse Securities (USA) LLC (Broker)

Is there a significant synergy with that business in the base business?

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

Well, it is microbiology testing. We do microbiology technology in the reference lab. It's one of the technologies that's used in the reference lab, but also gives us scale in important markets like China and other markets in Asia and South America. We have country teams that cover all of the businesses. So it is a diagnostic technology. It's a recurring revenue technology. Everybody understands the business model and how similar to the Companion Animal recurring revenue business model. So given its diagnostics, given its microbiology, I think it's a nice fit with our business.

Erin Wilson - Credit Suisse Securities (USA) LLC (Broker)

Okay. Thank you.

Operator

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

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

Yeah. Thank you, everybody. A couple of comments in closing. First, I want to thank everybody on the call, but I want to also thank our employees who are on the call who make IDEXX such a great company. And also I'd like to remind investors that our annual investor meeting will be broadcast live on the afternoon of August 17 and the morning of August 18, and I invite all investors to join this meeting via our live webcast. And, of course, it will also be available for replay after the event on our website. And so with that, we will conclude the call. Thank you all very much.

Operator

Thank you. And ladies and gentlemen, that does conclude your conference call for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.

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