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IDEXX Laboratories, Inc. (NASDAQ:IDXX)

Q2 2012 Earnings Call

July 20, 2012 09:00 am ET

Executives

Jon Ayers – Chairman, President & Chief Executive Officer

Merilee Raines – Corporate Vice President, Chief Financial Officer & Treasurer

Pete Levine – Director, Investor Relations

Analysts

Ryan Daniels – William Blair

David Clair – Piper Jaffray

Erin Wilson – Bank of America Merrill Lynch

Ross Taylor – CL King & Associates

Nicholas Jansen – Raymond James and Associates

[Del Hader – Salestel and Company]

Mitra Ramgopal – Sidoti & Company

Operator

Good morning, everyone, and welcome to the IDEXX Laboratories’ Q2 2012 Earnings Conference Call. As a reminder, today’s conference is being recorded. Participating in the call this morning are Jon Ayers, Chief Executive Officer; Merilee Raines, Chief Financial Officer; and Pete Levine, 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 management’s future expectations and plans, and IDEXX’s future prospects constitute forward-looking statements for purposes of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements can be identified by the use of words such as “expects,” “may,” “anticipates,” “intends,” “would,” “will,” “plans,” “believes,” “estimates,” “should,” and similar words and expressions. Such statements include but are not limited to statements regarding management’s expectations for financial results for future periods. Listeners are reminded that actual results could differ materially from management’s expectations. Factors that could cause or contribute to such differences are described in IDEXX’s quarterly report on Form 10(q) for the quarter ended March 31, 2012, in the section captioned “Risk Factors,” which are on file with the SEC and also available on IDEXX ‘s website at www.idexx.com.

In addition, any forward-looking statements represent IDEXX ‘s estimates only as of today and should not be relied upon as representing the company’s estimates as of any subsequent date. The company disclaims any obligation to update or revise any forward-looking statements in the future even if its estimates or expectations change. Also during this call we will be discussing certain financial measures not prepared in accordance with generally accepted accounting principles or GAAP. A definition of these non-GAAP financial measures is provided in our earnings release which can be found on our website at www.idexx.com.

Finally, we plan to end today’s call by 10:00 AM Eastern. 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 be more than happy to take your additional questions. I would now like to turn the conference over to Merilee Raines. Please go ahead.

Merilee Raines

Good morning, and thank you for joining our call today. As we reported in our press release this morning, our Q2 revenues were $335.6 million yielding organic growth of 7%; and diluted earnings per share were $0.91, a year-to-year increase of 10%. Revenues were slightly below our thinking at the time of our April call, the result of a few factors; first, unfavorable changes in currency rates relative to our thinking in April resulted in about $2 million of lower revenues. Post currency input, somewhat lower growth in reference lab revenues currently offset by stronger growth in instrument consumables revenue in North America, were the primary factors netting to organic revenue growth that was about 1% lower than our expectations.

Earnings per share for Q2 were in line with our thinking in April. The impact of lower revenues was offset by lower-than-anticipated spending on operating expenses, in part due to discretionary spend and in part due to timing. While actual currency rates versus expectation yielded a modest unfavorable impact on revenues for the quarter the impact to EPS was immaterial.

As a backdrop to the discussion of our Q2 performance in our companion animal group, the following is what we are seeing in the US veterinary market based on a subset of roughly 500 practices using our Cornerstone Practice Management System. In Q2, patient visits grew by 4% and practice revenues grew by just over 5.5%. While both metrics continue to be favorable to the growth rates seen throughout 2011 when patient visits were flat and practice revenues were up 2.5%, they were slightly lower than the Q1 metrics of 5% patient visit growth and 7% practice revenue growth. Further, the growth rates for both metrics decelerated somewhat over the course of Q2. We believe this trend indicates that some of the strong pickup in Q1 was due to the mild weather experienced over much of the US.

In Europe overall we saw stabilization of organic growth for our companion animal group segment at 5%. This is consistent with the growth in Q1 which had seen a step down from 8% in Q4 2011. As was the case last quarter, the growth rates for this region varied by product and service line and by country. All in all these data reaffirm our thinking that given the continued challenges to consumer confidence in both the US and Europe, we will see only a modest benefit from the macro environment to volume growth in 2012 over 2011, and the pace of improvement may not necessarily be steady.

Let me now give some further detail on the top line performance of our companion animal group. Overall, companion animal group revenues grew organically 8% in Q2 or 9% when further normalized for changes in distributor inventories. Lab instruments and consumable revenue of $104 million grew 9% organically. Sales of instruments were $23.3 million, a [two-year] organic growth of 15%. As for placements, our worldwide catalyst placements were up 7% and vet [test] placements were flat. An important placement metric for us as we think about follow-on consumable growth, is the percentage of placements into accounts new to IDEXX, and in Q2 about 40% of the catalyst placements were in that category.

Given first half combined chemistry placement growth of 12% and the more difficult comparison in the second half due to the placement success generated by our protocol-based rebate program introduced in Q3 last year, we project total year combined chemistry placement growth of about 5%. We saw strong performance in our hematology placements with a combined placement growth of 19%. ProCye remains an attractive choice for our larger customers, and sales of new and recertified LaserCytes are continuing to do well in accounts with lower volumes. If you will recall, we launched ProCyte in Japan in Q1. As anticipated, the market interest is very high and nearly 15% of the Q2 placements of ProCyte were in Japan. Roughly one-third of placements of ProCyte in Q2 were into accounts new to IDEXX, which we believe is a solid metric given its relatively recent launch. We expect combined ProCyte and LaserCyte hematology placement growth to be 15% to 20% for the full year.

Consumable revenues of $68.9 million grew organically 7% or 10% when further normalized for changes in distributor inventory levels. This is a modest acceleration from the 9% growth that we experienced in 2011 and Q1 of this year, a [reflection] of our growing installed base increased testing in the neighborhood of 15% to 20% as current IDEXX customers upgrade their in-clinic labs with Catalyst and ProCyte; and increased same-store testing as a result of improving patient visit metrics. We now expect full-year 2012 normalized organic growth for instrument consumables to be 9% to 10% based on the momentum of each of the growth drivers just noted.

Our Q2 rapid assay sales of $45.6 million grew organically 4%. When normalized for changes in distributor inventory levels, revenues grew by 5%. This growth, though down from the 10% normalized organic growth we saw in Q1 is largely consistent with our thinking at the time of our April call. We expect that the favorable impact on growth from price to be lower sequentially due to the benefit experienced in Q1 from changes to seasonal marketing programs have resulted in lower discounts. We continue to project 4% to 6% normalized organic growth through the year as we anniversary the list price increase we took in the latter part of 2011.

US distributor inventories for instrument consumables and rapid assays averaged four weeks at the end of Q2 based on forward-looking demand, which is within their normal and customary range. Our records laboratory and consulting services business with revenues of $106.4 million grew organically 7% in Q2. The majority of our organic growth came from higher test volumes with the addition of new customers. As mentioned upfront, the overall growth in the quarter fell somewhat below our expectations, driven in roughly equal parts by lower realized pricing and lower than anticipated volume growth primarily in Europe as European performance continued to be affected by economic headwinds.

Volume growth in North America and Asia-Pacific was solid and relatively on par with volume growth rates in 2011. Lower realized pricing was primarily due to the increasing success we have had over time selling our lab services in conjunction with our in-clinic diagnostic offerings. In such situations, discounts on laboratory services are used by our customers to purchase our capital equipment – digital, vet lab and computer systems. This is a positive for us in that the discounts are invested back into IDEXX. It is also positive for our customers as when they use our in-house equipment in conjunction with our reference lab they achieve the benefits that come from an integrated approach to diagnostic testing – test results at the time of the patient visit and deeper insights with follow-on testing at the reference lab.

These benefits are now further enhanced via the consolidation and management of diagnostic information from both venues – in-clinic and outside lab sources – with our launch of VetConnect Plus this month in the US. As for footprint expansion, we opened a new day lab in Connecticut during the quarter, bringing our total global network to 58 labs. We have plans to open a couple of additional labs over the remainder of the year including a lab in Germany in Q4. This new German lab will serve as a centralized hub for testing samples picked up by our European logistics partner from customers outside of major metropolitan areas. The lab and direct ship service through our logistics partner will open up new markets for us in areas of Europe where we do not have lab presence today. It will also allow us to consolidate evening testing from our visiting European lab to take advantage of scale economies. This replicates the successful strategy we have employed in the US through our methods lab and will greatly enhance our reach and service levels across Europe and including the Nordic countries.

For full-year 2012 we now expect organic growth for labs and consulting services of 8% to 9%. This change from our previous guidance of 10% is due to the expected continuation of the factors that we mentioned in both our Q1 call and today – lower pricing realization due to marketing programs that benefit our total CAG business combined with lower testing volume in Europe due to the economic environment. That having been said, we do expect the impact of marketing program lab discounts to abate somewhat over ensuing quarters as the number of bundled yields per quarter is now leveling off after ramping through 2011 and early 2012.

Our practice management and digital imaging systems, with revenues of $22.1 million, grew organically by 24% in Q2. Implicit in the full-year organic growth guidance of high single to low double digits that we provided in April was Q2 growth in the high teens given a relatively weak year-to-year compare. The better than anticipated Q2 performance reflects both products lines benefitting from market momentum driven by our steady rollout of enhancements to the offerings. Customers continue to appreciate ongoing software innovations that support practice efficiency, better medicine and client communications. We now expect low- to mid-teen double digit organic revenue growth for this line for 2012.

Our livestock and poultry diagnostic revenues declined 4% organically to $23.1 million in Q2. This decrease was in line with our expectations, driven largely by the events we had mentioned previously including a decline in BSE revenues due to the change in the EU testing regulation and the step down in testing from an eradication program in Germany. We project relatively flat organic growth for the year for poultry and livestock diagnostics. This implies a second half growth of 6% to 7% driven by a couple of factors. Frist, BSE, which was a significant drag on growth in the first half should have a negligible impact on second half growth as we anniversary in Q3 the change in the EU testing regulation. Second, we anticipate a moderate pickup in growth from new products and certain government programs from their levels in the first half.

Our water business grew 5% organically to $22 million, reflecting contributions from new accounts in North America and gains in our core Colilert testing business in Europe. This growth was in line with our thinking and is consistent with our expectations for full-year organic growth.

Turning to the rest of the P&L, gross margin of 55% was in line with our expectation that gross margin in Q2 would be about 100 basis points higher than in Q1 due to some seasonality in our vector-borne disease testing franchise. Operating expenses at 32% of revenue as mentioned were modestly below our thinking in April, reflecting somewhat lower discretionary spending and timing between quarters. Our revenue profile was relatively higher parasitic disease testing in Q2 combined with our operating expense profile with certain commercial activities such as trade shows and sales meetings more prevalent in Q1 tends to result in operating expenses as a percent of revenue lower in Q2 relative to Q1. Our effective tax rate of 31.9% and our share count were roughly in line with our expectations.

As for the balance sheet and cash flow we ended the quarter with $202 million of cash and $247 million of debt for a net debt position of $45 million. Our inventory balance of $144 million was up by about $3 million from our expectation and from the level at the end of March. This was due to the receipt of a shipment of ProCyte from our OEM supplier in Q2 that was originally anticipated to occur in Q3. As we indicated in April, we expect inventory levels to come down over the next couple of quarters and to end the year at approximately $140 million. DSO at 42 days remains stable and in good shape. Our free cash flow was $50 million or 98% of net income, a bit lower than our expectations due to the somewhat higher inventory balance as just mentioned and the timing of payables runs.

Looking forward, we project full-year revenues of $1.3 billion to $1.31 billion, a decrease of about $10 million to the low and high ends of our range relative to the guidance provided during our April call. This is a result of the unfavorable impact of currency. Reported revenue growth is now projected to be 7% to 8% as a 2% unfavorable impact from currency more than offsets a 1% favorable offset from acquisitions. Our organic growth of 8% to 9% remains consistent with our previous guidance. The components of growth have evolved as we expect somewhat stronger growth from our instrument consumables and practice information management and digital imaging systems businesses, and somewhat lower growth in our reference laboratory and diagnostic consulting services business.

Consistent with our thinking in April, we project a somewhat improved economic environment to benefit volume growth by about 1% to 2% for the full year. We continue to project gross margin to be about 54% for the year, about 100 basis points above the full-year 2011 percent; and operating expenses to be between 34% and 35% of revenues for the year. We expect operating expenses as a percent of revenue to be modestly higher in the second half of the year relative to the first half of the year. This is a reflection of investments we are making to continue to bring innovative products and services to our served markets. A notable example is the introduction of Pet Health Network Pro, a web-based client communication and education service for veterinarians and their support staff. VetConnect Plus, which we described in our Q1 call, is also having its full commercial launch this month.

Our expectation for gross margin and operating expenses yields a projected operating margin between 19% and 20% for the year, which represents an improvement of roughly 50 basis points relative to last year when 2011 is adjusted for the favorable impact of discrete pharma payments we received that totals about $4 million. We expect the tax rate to be between 31.5% to 32.0% for the full year which is unchanged from our previous guidance. As a reminder, our projected tax rate is approximately 50 basis points to 100 basis points higher than in 2011 due to the fact that we have not incorporated the benefit of the federal R&D tax credit in our 2012 rate.

All of this leads to updated full-year EPS guidance of $3.05 to $3.10. The unfavorable impact of currency relative to rates assumed during our April call accounts exclusively for the decrease of $0.02 to the low and high ends of our range relative to our previous guidance. Our overall financial outlook related to business performance is consistent with our thinking at the time of our April call. Details on currency rates implicit in our guidance and our currency rate change sensitivity analysis is included in our earnings press release. We project free cash flow to be approximately 105% to 110% of net income for the full year.

And now I’d like to turn it over to Jon for some further comments.

Jon Ayers

Thanks, Merilee. Overall we had a solid quarter and are tracking to our goal of achieving 8% to 9% organic growth set at the constant currency. Like all companies that do business internationally, we’re impacted by the strong dollar and our guidance reflects the current foreign exchange rates accordingly. Regarding the economy, after the early part of the year that benefited from favorable weather comparison in North America we see the resumption of a more continued slow improvement in our markets. Success comes at the individual customer level in the companion animal market. It is this segment of our customers that are effectively responding to the needs of the pet-owning clients that are seeing strong growth in their practice, and our strategy is to provide the tools to help drive that growth and get more customers to adopt those tools.

In the area of new products we’ve been particularly productive in 2012 within our companion animal group, which makes up 82% of the company’s sales. So far this year we have introduced or plan to introduce shortly an impressive list of new tests, services, and software solutions. Let me list a few. In April as investors know, we started shipping SNAP 4Dx Plus, an upgrade to our highly successful SNAP vector-borne disease test that added two new tick-borne diseases to a single kit, bringing the total number of diseases detected in one SNAP to six. The response on that has been very, very favorable.

In April we introduced the Pet Wellness Plan service in partnership with [VerenaCare]. In April we began shipping phenobarbital for our Catalyst Dx chemistry analyzer, a new test that is receiving rave reviews for the value it brings to a patient that is prescribed phenobarbital for therapeutic treatment and the ability to test right on site for that level. We are saving and improving lives with this new test according to feedback we are receiving from practices who started using the Catalyst Dx. Also in May we introduced allergy testing in our reference labs in conjunction with GREER. This is a whole new category of testing that addresses a common condition in dogs and continues to build upon our strategy of specialized testing capability that sets IDEXX reference labs apart.

Fifth, in June, we introduced a new version of our digital radiography [Constant] software v3.6 that adds Image Coach which guides the physician through the process of taking a high-quality digital image, a very helpful feature that ensures first shot quality. Sixth, just this week we’ve formally launched VetConnect Plus after a beta phase, a capability I introduced in the April call. VetConnect Plus is a cloud-based service that allows a veterinarian to see a patient’s entire blood work history from IDEXX both in-clinic and at the reference lab in one interactive screen. The history allows for trend analysis which adds a whole new dimension to the value of blood work for the practitioner and the pet owner. The customer signup for this new service has been amazing and we are close to 500 customer activations between our beta customers and a couple of hundred that have signed up so far this week.

Seven, also this week we introduced, as Merilee mentioned, Pet Health Network Pro, a new cloud-based service that will support the practice’s ongoing relationship with their clients between appointments. By improving communication and increasing client understanding of pet health and the value of veterinary care, Pet Health Network Pro helps practices promote the importance and the relevance of the veterinarian, which increases both visits and revenues per visit at the practice level. And eight, in August we’ll be providing a new set of capabilities that will upgrade our franchise hematology analyzers, both LaserCyte and ProCyte. First, they’ll both be able to run body fluids other than blood, a sought-after capability that is unique to IDEXX. Second, we’ll be adding several new species and third, in particular in ProCyte, we’ll be adding the capability to detect the presence of banded neutrophils and nucleated red blood cell counts – huge additions to the existing CDC parameters that help determine conditions such as inflammation and other significant abnormalities. Again, these capabilities are totally new to any veterinary hematology analyzer, and previously these parameters could only be determined by looking at the blood sample under a microscope.

That’s eight new important and significant products and services launches in five months, and each adds value to the whole companion animal group offering continuing to build upon the strong foundation of instruments, test kits, lab services, digital imaging and information technology offerings that we have today in the market and which we think are unique to the veterinary market. These products and services expand the practice of veterinary medicine. With these product launches we are truly achieving our mission of enhancing the health and well-being of pets, people and livestock.

As to the matter of our US distribution strategy we discussed in April, there’s not much to report other than our process is moving forward in discussions with our distributors and that no decisions have been made. At this time we anticipate that we’ll have identified a general distributor and have agreed at least preliminarily on the terms of a generalist agreement by Labor Day. It is still our assumption that the effective date of any changes to our distribution agreement will be January 1, 2013. In terms of how we are reaching a decision on what changes to make, we are looking at all the relevant factors including the degree of each distributor’s interest in becoming a generalist, the historical performance of each distributor in selling IDEXX products, and any unique strategic attributes that each distributor might bring to [elevate] our relationship going forward. As expected, we continue to keep the FTC informed and they are monitoring the process closely, and are also in regular communications with our distributors.

As you have seen in our press release we’re very pleased to announce the promotion of several of our executives to Executive Vice President, with two filling new operating roles: Michael Williams and Johnny Powers. Michael and Johnny have each made significant contributions to the success of IDEXX to date and I am delighted they are taking on expanded portfolios.

In addition, we have filled a third operating Executive Vice President role with Jay Mazelsky who comes to us from Philips Healthcare, where he was General Manger and Senior Vice President of Computer Tomography, Nuclear Medicine and Radiation Therapy Planning. In that role he led a business that is well over $1 billion in scale. One of Jay’s accomplishments was to lead the revitalization of Philip’s Computer Tomography Unit and over the last several years has brought an improved innovation in the product line; and through better delivery of customer service his Business saw several points of North American market share gain in the world’s biggest and most competitive diagnostic imaging region. He’s got a great track record, he’s a seasoned executive and we think he’ll be a great addition to our Senior Team. He’ll be an effective leader in innovation and growth and help us take the company to a new level of scale and profitability.

In addition to the three operating EVPs that I just mentioned, we’re elevating Merilee Raines whom you know, and Bill Brown, our Chief Scientific Officer, to the Executive Vice President level in recognition of their contributions and the importance of both finance and technology to the ongoing success of IDEXX. We were also pleased to announce the addition of Ann Szostak to our Board of Directors effective earlier this month. Ann brings extensive executive and board experience to IDEXX, and we are delighted to have someone of her caliber in this important capacity.

In summary, we’ve had a solid quarter. We have a strong new product momentum, an augmented management team and Board of Directors, and a good outlook for the remainder of the year. So at this point I’d like to open it up to Q&A.

Question-and-Answer Session

Operator

Certainly. (Operator instructions.) Our first question will come from the line of Ryan Daniels with William Blair. Please go ahead.

Ryan Daniels – William Blair

Yeah, good morning; thanks for taking my question. I’ve got one macro and then one company-specific follow-up. On the macro you mentioned in your prepared comments that the end market slowed a bit in Q2, which is not surprising, but also that you saw some deterioration throughout the period. And I’m curious first off if you can talk about the magnitude of that slowdown through Q2, and then number two, is there any ability to perhaps determine how much of that was weather-related? Maybe it was more flea and tick weakness throughout the quarter; anything you can help with kind of setting that between macro weakness and pull forward weakness would be helpful.

Jon Ayers

Ryan, it’s certainly a question of great interest to us all. To answer the first part of the question, I think the growth was a couple points less in the third month than it was in the first two months but I do caution that monthly data can be quite noisy because you’ve really got a very small amount of time that you’re measuring that year-over-year compare. It’s hard for us. We don’t really have direct visibility to the flea and tick piece and pull forward and such, so it’s just really hard to speculate. Certainly there was a very favorable weather compare in Q1 which we mentioned in April, and I think it’s not a secret to anyone that consumer confidence and general economic trends seemed to deteriorate a little bit over Q2 and that was consistent with I think what we saw in our markets, again subject to, with a caveat, a volatility in monthly data.

Ryan Daniels – William Blair

Okay, that’s helpful. And then the company-specific, just with the resolution of the distribution agreement it sounds like it now may be in place by Labor Day. Does that mean in Q4 you’ll start to make some changes and is that contemplated in your guidance related to things like maybe ramping up your direct sales force? Or will that really mostly take place in F13? Thanks.

Jon Ayers

Yeah, thanks. Of course I’ll remind investors that our distributor contracts do go through the end of the year, and it is our anticipation in our discussion with our distributors, although anything can happen, that they would like us to honor those contracts through the end of the year. So any actual changes that would take place in that conflated scenario would be at the beginning of a new contract year of January, 2013. And so our guidance really incorporates all the different moving parts of the company and we would see that that transition is something that we can manage within our numbers.

Ryan Daniels – William Blair

Okay, thanks a lot.

Operator

Thank you. And our next question comes from the line of David Clair with Piper Jaffray. Your line is open.

David Clair – Piper Jaffray

Hi, good morning, Jon, and congratulations, Merilee. The first question I have, just if you could maybe give us an update on Europe? It sounds like on the reference lab side we might have seen a little weakness there. Do you think this has stabilized or are you expecting some additional deterioration throughout the year?

Merilee Raines

David, as I mentioned, even though the overall companion animal group growth in Europe was constant at 5% in Q2 as with Q1, it did vary by product line, vary by country. It’s really hard for us to predict where that will go. I think implicit in our guidance is we’ve kind of presumed that what we’ve seen will just continue, and obviously we’re closely monitoring the situation. But you know, that was just a little bit tough to call.

Jon Ayers

Yeah, and in the meantime of course we will be starting that new significant lab during Q4 and we’ll get a little benefit from that as it starts up.

David Clair – Piper Jaffray

Okay. And then I’m not asking for any 2013 guidance here, but just as we kind of think about the impact from the distributor change, any kind of initial thoughts of should we assume there’s a little bump up in sales and marketing or any kind of color there?

Jon Ayers

Well, we anticipate that the impact on the changes and the modest refinements in the composition of our marketing and sales and channel costs, where we have… Whenever we will have a difference in advocacy at the distributor level we will replace with direct costs – I don’t think the bottom line will be different or the trends will be different, although of course the composition might be a little bit different. So we really see as we mentioned in the April call, that any shifts will offset each other.

David Clair – Piper Jaffray

Okay, thank you.

Operator

Thank you. Our next question comes from the line of Erin Wilson with Bank of America Merrill Lynch. Your line is open.

Erin Wilson – Bank of America Merrill Lynch

Hi, thanks for taking my questions. On the consumables side of the business can you break that down by volume and maybe how it was trending in the US in particular?

Merilee Raines

Erin, as far as the instrument consumables, almost all that growth and virtually all the growth is due to volume; it’s very, very minimal price. And as I mentioned, the growth was particularly strong in North America. As you might expect it was a little bit less though actually, up a bit in Europe from Q1 to Q2 and the increase continues to be strong in Asia-Pacific. So it’s a good solid growth across regions.

Erin Wilson – Bank of America Merrill Lynch

Okay, and then on the reference laboratory type of business it’s obviously with the slight deviation from that 10% trajectory you’ve seen I guess over the last several quarters. You mentioned some of the marketing changes before, but were some of the more competitive pressure involved particularly in the US?

Merilee Raines

I don’t think there’s really any change in the competitive environment. That’s always been pretty intense, as we’ve said, and I really do think that what we’ve found is that you know, our ability with our strong offerings and the fact that they’re increasingly becoming more integrated in the way that they work together, that there’s just a real opportunity for us to drive growth in all areas by selling these products and services together. And it’s just the way that accounting works that the expense of these programs is largely born by [less] but the benefit accrues across our companion animal group business.

Erin Wilson – Bank of America Merrill Lynch

Okay, great. Thanks so much.

Operator

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

Ross Taylor – CL King & Associates

Hi, this is my first question. I just wondered if you could give any color on what the role or function of the new Executive that you hired from Philips is going to be.

Jon Avery

We are, between the three, they’ll take large responsibility collectively for the lines of business and the regions of the company. Michael Williams is going to move to run our international business, and also the water, livestock and poultry diagnostics, dairy; and retain responsibility for OPTI Medical Systems. All four of those businesses are the majority international. We really see a very significant opportunity around the world to grow our businesses and we’re really delighted to have Michael do that, and so that leaves the instrument business where Jay Mazelsky will take leadership in addition to the software businesses of the companion animal group and our North American commercial region.

And then Johnny Powers will continue to run the lab services business but will have an expanded portfolio that includes also what we call the rapid assay or the [neo] assay business, really the specialized test development business that goes both into the test kits and reference labs, as well as our worldwide operations and our bioresearch strategy. As you know, we made an acquisition in November which we’re very excited about it. It’s not a big opportunity but we’re excited about the growth opportunity in bioresearch so that will be his portfolio.

They’re going to work very closely together. They’ll work very closely with me because really everything is connected to everything else at IDEXX and so we’ve very pleased with this new team.

Ross Taylor – CL King & Associates

Okay, that’s helpful. And then my second question is I just wondered if you’d help me understand the lower price realization on the lab side compared to I think your earlier expectations. Is that simply a function of you’re just selling a lot more products through the bundle of deals and that’s where the impact is coming from, or is it just something else?

Merilee Raines

Yes, that is the case, Ross. Really the change there is largely a result of these marketing programs, and again, just the way that the accounting works for those. The cost is borne primarily by the reference labs. I do want to just emphasize, though, that we are getting price realization. There is price growth in the lab business; it’s just that, as we talked about a year ago at this time, maybe a third of our growth was coming from price realizations. Now that price realization is a good 2.0 points to 2.5 points left on that. So there is still growth there.

Ross Taylor – CL King & Associates

Okay, thanks very much.

Operator

Thank you. (Operator instructions.) We’ll go to the line of Nicholas Jansen with Raymond James and Associates. Please go ahead.

Nicholas Jansen – Raymond James and Associates

Hi, yeah, just a quick question on the distribution changes. I wasn’t sure if you guys were anticipating any impact on inventories in Q4 as you would anticipate the generalists to perhaps cut back on inventories, or how does that change?

Jon Ayers

Well one of our anticipated elements of this is that the generalists would continue to carry our product lines, so I don’t really see… We would fully anticipate they would continue to carry the product line as generalists into 2013. And so I’m not sure that that would impact much of a change.

Nicholas Jansen – Raymond James and Associates

Okay, and then back on the reference lab side of things, I know you guys have been successfully capturing share over the last three or four years relative to your largest peer. Are you starting to see maybe the easier share gains starting to subside and maybe that’s what’s contributing a little bit to the slower growth? Or is it just on the European side and you’re continuing to have success on the North American side? Thanks

Merilee Raines

Nick, I would just reiterate that the volume growth that we are seeing in North America is very consistent with what we saw last year. So I think that this really, as far as volume goes the primary contributor was Europe; and as I said, in equal parts though, a contributor is the impact of price.

Jon Avery

Exactly. And in addition we continue to be excited about the reference lab opportunity and to make investments in the reference lab. I mentioned in my opening comments the allergy testing which I think is a major category. Dogs get really itches and skin rashes and it’s really a real problem, and we have really not been a large commercial lab that’s offered a comprehensive allergy testing and immunotherapy business. And so we’re excited about that.

The other thing that I want to reiterate is VetConnect Plus and the ability to see the historical data on a patient, whether that data came from IDEXX reference labs or the in-house, it’s really exciting. And I think it’s adding a new dimension, a new level of excitement to our customers. You can see it by close to 500 practices have already started using, not only just signed up but they’re actively using this capability. They’re seeing just as you see, it’s a lot more interesting to look at several years of a company’s financial history than it is to look at a one-year snapshot. They’re really valuing it and it’s given a lot of energy to our sales force to continue to sell the IDEXX innovation into the market.

So the nice thing is that we’ve got some nice new, we’re taking it to a new level in the reference lab as we are in the in-house side of our diagnostic offering.

Nicholas Jansen – Raymond James and Associates

Thanks, and maybe if I can just squeeze in one more in terms of the companion group gross margin. It was down a little bit year-over-year, and is it more just on the reference labs not getting the price realization? I would have assumed that with the pretty strong consumable growth that we would have saw a little bit of leverage there. Thanks.

Merilee Raines

Nick, it is really not a result of pricing. I mean look, year-over-year again there was price realization so that was not a drag. We did, there is however some mix impact just as you again, are looking year-to-year in the relative growth rates of the business. Some of our relatively lower gross margin businesses have been growing at a faster rate than the relatively higher businesses, and so that mix impact was really about a point of un-favorability year-on-year. So counterbalancing that is really a couple of different things: we had some favorable impact from currency and that is a function of the hedging gains that we have this year versus having hedging losses last year; and also the price realization that we’ve been getting in our rapid assay business. So there’s a few puts and takes going on there but that kind of all in all led things to be relatively on par year-over-year, but mix is the primary unfavorable impact.

Nicholas Jansen – Raymond James and Associates

Alright, thanks very much, guys.

Operator

Thank you. (Operator instructions.) We will go to the line of [Del Hader with Salestel and Company]. Please go ahead.

[Del Hader – Salestel and Company]

Good morning, thanks for taking my questions. On VetConnect Plus, is there a revenue component associated with that or does it just help to solidify your position within the practice?

Jon Avery

Yeah, thank you for that question. There is not a revenue component today. We’re offering this as a service at no charge associated with using IDEXX diagnostics, whether they be in-house or reference labs. It is a cloud-based service. It can be accessed via browser and that would be on a PC or laptop; it can be accessed inside of Cornerstone if you’re managing your medical records with Cornerstone, and we have 6000 Cornerstone customers; and it can be accessed on a tablet such as an iPad. So you run the diagnostics in the back, with the in-house lab for example, and second you’ve got it on the tablet to show it to the pet owner.

It just really supports real-time care in addition to that whole integrated view of the patient with the history. So it is a real differentiator for our four diagnostics lines and really it brings the context that whether the diagnostics are run in-house or in reference labs they’re important parameters, and it doesn’t matter. And what’s really important is monitoring the health of the patient.

[Del Hader – Salestel and Company]

That sounds like a very nice product. And then on the distribution side of things, have multiple distributors expressed interest in taking on the generalist role or do you plan on choosing a single distributor to be the generalist come next year?

Jon Avery

In our conversations, I think the first preference of all three distributors was to be value-added. I think they built value on the IDEXX relationship over the long time period they’ve been associated with us and our level of innovation. And so but we are in discussion with all three of them with regard to that value-added role going forward versus what a generalist role would be going forward. We want to have a relationship with the generalist that is strong and we need to be able to compensate them at a level that will maintain the acceptable level of services that we receive from them; and our goal is to provide the best result for both our business and the business of our distributors while being attentive to the issues of the FTC’s concerns. And as I said we believe, while we can’t guarantee we believe that moving this would address the FTC’s concerns. And so we’re in discussions with distributors and flexible as to how we might get there, and in the context of two value-added and one generalist.

[Del Hader – Salestel and Company]

Okay great, that’s helpful. Thank you very much.

Operator

Thank you. Our next question will come from the line of Mitra Ramgopal with Sidoti & Company. Your line is open.

Mitra Ramgopal – Sidoti & Company

Yes hi, good morning. Just a quick question as it relates to Europe: you said you had another lab there. Are you seeing some opportunity in terms of just [speaking of] to grow or expand as a result of the weakness there?

Jon Avery

I would say just to be clear, we are going to be opening another central lab in continental Europe in Q4 but we have been opening labs there all the time. I say that our growth is despite the economic [reasons], not as a consequence; but there clearly is an opportunity to provide superior reference lab services across the geographies of Europe. That’s a growth opportunity and that’s a growth opportunity that’s there somewhat independent of the economy. Certainly the economy impacts our business but not to the extent that we aren’t generating good solid, continued mid-single digit growth in our labs in Europe which I think is a pretty impressive accomplishment given all that we’ve heard that Europe is dealing with at this point in time.

Mitra Ramgopal – Sidoti & Company

Thanks. I also have a quick question as it relates to the medical device tax for next year. I just wanted to be sure, does that impact you in any way?

Jon Avery

Not in the veterinary business, and I guess I would put this in the area of very, very immaterial: our OPTI Medical Systems sells in the human market but the majority of those revenues are, a good majority of those revenues are outside the US. To the extent they’re inside the US I think they are. I’m not entirely sure but I think they would be subject to that tax, but that’s a very, that’s well less than 1% of IDEXX’s revenues.

Mitra Ramgopal – Sidoti & Company

Okay, thank you very much.

Operator

Thank you. We have a follow up from the line of Erin Wilson with Bank of America Merrill Lynch. Your line is open.

Erin Wilson – Bank of America Merrill Lynch

Hi, thanks for taking my follow-up. I guess there seems to be some varying news out there on the market opportunity associated with the anticipated distribution changes. And I guess it seems to be different than maybe what you have articulated. Where is the disconnect here, or how should we think about this disconnect amongst the industry constituents?

Jon Avery

Well, I would say, I can really only speak from our perspective. First and foremost, our strategy is providing great innovative products and services that help the practice deliver a higher standard of care, be more efficient, provide more client value. And that is the hallmark of IDEXX; it’s the hallmark of our strategy. Our sales and marketing, of which distribution is a piece but of course we have a very significant direct sales force in the US, is a way to bring those innovations to the market, but really it starts with the innovations and then we have some marketing and channel strategies to do so.

So we remain excited, and as you can see just in the last five-month period the level of additional innovations that we’re bringing to the market that build upon real-time care and the deeper insight of our highly differentiated reference labs, and the unique capabilities of our SNAP test kits – the vast majority of that is unique and proprietary capability; not to mention the information technology offerings which saw a really nice growth in Q2. We really think that that is the hallmark of IDEXX, and so these changes in our distribution strategy are a refinement to a piece of our go-to-market strategy in one, albeit an important, country – the US – that is the executional component of that innovation strategy.

So I think when you start from that perspective you really see that this is a refinement as opposed to thinking that distribution is everything. It’s different in this market.

Erin Wilson – Bank of America Merrill Lynch

Yep, that’s great. Thanks.

Operator

Thank you. Next we’ll go to the line of David Clair with Piper Jaffray. Your line is open.

David Clair – Piper Jaffray

Hi, thanks for taking my follow-up question. The question that I have, I just want to get an update: has FTC actually signed off on this as kind of a strategy to resolve their concerns?

Jon Avery

Well, we can’t ever guarantee what the FTC might or might not do. And there’s always the risk of regulatory action – I mean that’s just the nature I think of the environment that we’re in, and that doesn’t really go away until we have a consent decree in place. But as we said in April, we’ve gone down this path of identifying a generalist distributor both because we felt it was an acceptable solution from a business perspective and because we believed it would satisfy the FTC’s concerns. Of course those beliefs came from our discussions with the FTC.

As you can imagine, we wouldn’t have undertaken this very public process if we didn’t have confidence in the prospects of avoiding litigation based on our discussions. And I just might note, David, that since April we’ve communicated regularly with the FTC regarding the status of the process and we know they’re also in regular communications with our distributors. And to our knowledge, the FTC is still putting their process on hold of proceeding to litigation as we pursue this solution.

David Clair – Piper Jaffray

Okay, thank you.

Operator

Thank you. And our final question is a follow-up from the line of [Del Hader with Salestel and Company]. Your line is open.

[Del Hader – Salestel and Company]

Hi, thanks for taking the follow-up. Do you plan on any increased incentives or rebate offerings in the second half of this year prior to the distribution agreements or one of them changing?

Jon Avery

No, not anything in the context of the evolving nature of our distributor relationships.

[Del Hader – Salestel and Company]

Okay, thank you very much.

Operator

Thank you, and with that, speakers, I’d like to turn it back over to you for any closing comments.

Jon Avery

Alright, thank you. I’d like to thank everybody for attending the call. I want to congratulate also all the IDEXX employees that have been involved in bringing Q2 to conclusion and bringing these innovations to the market. We really have just really a lot of excitement at IDEXX on this, and so I do appreciate the investors’ interest in IDEXX and we look forward to continuing to update you as the year progresses to its conclusion. That completes the call, thank you.

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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