Well-Healed IDEXX Laboratories

Summary

• IDXX provides a unique background to its growth story due to its relationship to the explosive growth of the US pet industry over the past decade.
• IDXX provides an array of proprietary, easy to use, high end diagnostic technology, consulting and laboratory services to the largely independent veterinary space in the US and abroad.
• IDXX biggest risk comes from being closed out of the US market as corporate interest in the pet market growth continues through acquisitions, consolidation and standardization of care delivery.
• IDXX continues to offer investors strong growth and outsized stock appreciation in the immediate and medium terms.

Idexx Laboratories (NASDAQ:IDXX) maintains a rather lucrative, even symbiotic relationship with the explosive $62.75 billion discretionary consumer spending market on household pets that has grown a whopping 198.81% since 1996, according to American Pet Products Association (APPA) data. In a 2015-16 APPA survey, there are an estimated 77.8 million dogs and 85.8 million cats in the US. The average annual cost for a household owning a dog came to $1,641 and for a cat $1,125 per annum. Surgical and/or routine annual veterinary visits for the dog owning household came to $786 or 48% of the annual expenditure, just shy of three times the annual cost of dog food. For cat households, the annual breakdown came to $594 or 53% of total expenditures went toward veterinary care, almost two and a half times the annual cost of cat food. Just how lucrative is the pet market for IDXX? Five-years ago, IDXX's stock price hovered around $43.73; through yesterday's market close, the IDXX share price had soared to $153.40 for a cool 252% market romp. By way of comparison, the S&P 500 is up just over 67% over the same period, almost four times less.

Roughly 85% of IDXX's annual revenue comes through its Companion Animal Group (CAG) segment which provides point-of-care diagnostic equipment, reference laboratory, consulting services, information management products and biological materials testing to veterinary practices across the country. Globally, the company does business in Europe, Britain, South Africa and Canada. In Asia, IDXX has significant sales and laboratory facilities in South Korea, Japan and China as well as the Pacifica countries of New Zealand and Australia. A full 39% of its total revenue through the end of 2016 derived from international sales of equipment and services, making exchange risk a top company priority. Other business segments include water quality products (about 6% of revenues) as well as providing both diagnostic and service products for livestock, poultry and dairy, which comprises about 8% of total revenue.

The following analysis will be exclusively devoted to IDXX's CAG segment.

At its core, the IDXX business model serves up a virtuous circle of its own, delivering high-end diagnostic testing solutions to the veterinary space. The company develops, manufactures and markets easy-to-use proprietary in-clinic and mobile analyzers along with hand-held test kits-all of which drive the recurring use of consumable products, consulting/diagnostic services and accompanying accessories and maintenance contracts while providing real-time, accurate point-of-care test results and office efficiencies that enhance the bottom lines of both IDXX's network of veterinary practices worldwide and a company that calls Westbrook, Maine its home base of operations. The technology and resulting revenue mix is as follows:

• The IDEXX VetLab is a proprietary suite of in-clinic analyzers that provide chemical, hematological, immunoassay, urine, sediment and coagulational analysis, all in real-time. The Suite is available mainly through sales, leases and rental agreements. The related consumable sales associated with the VetLab is responsible for just over 84% of CAG annual revenue with over 43,000 units installed globally through the end of 2016. Revenue from the sale, rent or lease of capital instruments grew just over 23% through the end of 2016 year-over-year (YOY) and comprised just over 9% of total CAG revenue. IDXX installed 31,000 units of its latest generation of hematology analyzers in 2016, up from 29,000 through the end of 2015 and 27,000 installed in 2014. Recurring consumable sales grew just under 14% YOY and comprised over 35% of CAG revenue for the period.
• IDEXX SNAP are single use hand-held assay test kits that work without instrumentation allows the testing for a variety of vector-borne diseases, including Lyme, canine heartworm, parvovirus, pancreatitis and waterborne infections such as Giardia. Single-use hand-held test kits for feline include tests for immunodeficiency virus, leukemia, pancreatitis, Giardia and cardiac biomarker. Rapid assay products grew 3.53% YOY through the end of 2016 and provided 15% YOY growth for the period.
• IDXX offers reference laboratory diagnostic and consulting services to veterinarians throughout the world with major reference laboratories located in Memphis and Leipzig, Germany. The laboratories include an array of specialized and proprietary tests with most results having same-day or next-day turnaround times. Consulting services include radiology cardiology, internal medicine and ultrasound consulting via the telephone and the internet. Reference laboratory and consulting services continue to provide both the bulk of CAG annual revenue and healthy YOY growth of over 13% for the period, comprising just over 45% of total CAG revenue for the period.
• Diagnostic services and accessory sales grew just over 7% YOY and provided just under 5% of total CAG revenue for the period.
• Managerial software specifically designed for veterinary practices large and small which a total integration package that includes the computerization and cloud storage of client records, communications, scheduling (including pet grooming and boarding services), billing and inventory control. Diagnostic imaging systems capture radiographic images in digital form which replaces the traditional x-ray film imaging. Software and imaging revenue grew at a 8.56% rate YOY and supplied over 9% of total revenue.

IDXX has posted YOY average revenue growth of 8.25% for the past five years with a range high of 10.83% (2016) and a range low of 6.47% (2012). In comparison, the S&P 500 did post a higher average growth rate of 10.40% for the five-year period with a much more volatile range, posting a high of 19.32% (2013) and a low of 0.39% (2015). The year saw IDXX's revenue growth hit a five-year YOY high, driven by its primary CAG segment which returned 11.70% YOY growth. Based on its CAG results, overall IDXX growth is expected to post in the 8.75% YOY range in 2017 and in the 9% to 9.25% range for 2018, driven primarily by further CAG diagnostic capital instrument, consumables and reference laboratory/consulting service growth that all experienced double digit YOY growth in 2016. The introduction of new equipment, such as the SediVue DX diagnostic equipment introduced in 2016, will further add to overall revenue growth moving forward. The SediVue DX is the first and only in-clinic analyzer to provide urine sediment analysis on a pay-per-run basis. Total revenue thus far for the technology came to $24.2 million through the end of 2016.

While total CAG revenue rose 11.70% through the end of 2016 on a YOY basis, operating costs for the segment rose 4.64% for the period YOY. From a percent of total revenue, 2016 fell to 34.1% YOY, down from 36.6% through the end of 2015. Operating costs include such things as sales and marketing (including customer promotion costs), administration and R&D. Meanwhile, gross profit for the CAG segment returned 12.48% through the end of 2016, driven mainly by higher sales volumes. International sales in the CAG segment accounted for just over 33% of total segment revenue with the strength of the US dollar in world currency markets shaving an estimated 90 basis points off gross profit due to lower currency hedging gains.

Shifting gears, the veterinary space resides in a kaleidoscope of contrasting realities, the realization of which shareholders and future shareholders need to appreciate-as well as understand. Unlike human medicine which is regulated at literally every turn by a plethora of governmental agencies, veterinary medicine remains for the most part unregulated. A holdover from yesteryear, the Department of Agriculture regulates the administration of vaccines for all animals, including companion animals such as dogs and cats-not the FDA. Pet owners largely do not carry insurance and almost universally pay up-front for services rendered, a classic example of a cash-cow enterprise. The explosive growth of pet-related products and services over the last decade merely reinforces the cash-cow analogy-a view that has not been lost on corporate America. Veterinary Centers of America, a corporate name that has since morphed into VCA, pioneered the standardization of medical services to the animal world back way back in the 1980s. VCA (WOOF) readily absorbed hundreds of animal hospitals across the country and offered up a powerful and highly lucrative corporate model of franchises and salary positions under corporate tutelage to the heretofore single, often rural private practitioner. Portland-based Banfield Pet Hospitals plied a similar path, gathering up single practitioners into professional, salaried practices that offered up similar financial rewards in both rural and urban centers. The concept of a "vet-in-a-box" brought franchised practices into big-box retail stores like PetSmart, all of which would eventually be overseen by proprietary software and strict, menu-driven treatment protocols. Corporate back office efficiencies were married with assigned daily, weekly and monthly product, procedure and testing targets that have proved most effective at driving both local business results and corporate bottom lines. Whether the interest and well-being of the patient have also been similarly enhanced in the transition remains moot.

Another corporate attraction to the pet business is the structure drops outsized savings directly to the bottom line: The legal consequences for veterinarians in cases of patient injuries and/or fatalities are minimal which, in direct contrast to the practice of human medicine, means malpractice costs for veterinarians hover close to insignificance. Accordingly, few lawyers are willing to pursue wrongful injury and/or death cases in the animal care world if, on the very rare occasion, such a case does indeed reach the litigation stage. And then there is the legal system itself: The courts continue to view pets as property - a far cry from the popular mindset that has apotheosized pets over the years if not to outright divine status - at least in to the lofty realm of surrogate children, complete with Mother's and Father's days greeting card selections.

The competition to IDXX and its diagnostic approach to the veterinary space comes across as a collision of contrasting business models: one centered on achieving ever higher levels of standardization in the delivery of animal medicine and another that readily embraces the notion of independent and group practices not affiliated with a corporate structure. For the moment, the IDXX model exercises a tenuous reprieve of sorts: Most states have laws prohibiting the corporate ownership of veterinary practices, a structure that is viewed as too prone to compromise the health and well-being of animals for the sake of increasing revenue streams. To get around this apparent legal roadblock, corporate ownership in the veterinary space comes by way of "management service agreements" between doctor and corporation. The moral hazard, of course, remains. That the legal entity is not challenged for the seeming fig leaf the structure is comes from the long-running acknowledgement that veterinarians themselves more or less want the structure-particularly retiring practitioners desirous of selling their client base for top market value. The animal world remains low on state regulatory regimes, while the purchaser of such independent practices invariably is corporate. It will likely take several more generations given the current pace where the transition from individual to corporate practice is largely complete.

Further consolidation came with the announcement in January that the closely held candy giant and pet food manufacturer (Mars bought the pet food section of Proctor & Gamble in 2014) Mars agreed to purchase VCA . The maker of Snickers bars, M&M's and Dove chocolates will acquire all the outstanding shares of VCA for $93 per share or $9.1 billion, gathering under its Petcare umbrella 795 animal hospital and 61 diagnostic laboratories throughout the US and Canada. Hospital revenue for VCA through the end of 2016 came to $2.092 billion, providing gross margins of just over 16% YOY. Antech Diagnostics, VCA's in-house laboratory, brought in revenues of $433.2 million with YOY gross margins of just under 60% for the same period. As for reported gross profits, VCA's hospital unit generated just over 57% while its Antech diagnostic unit provided 37% of the company's profits through the end of 2016. The VCA deal, together with the already Mars owned Banfield Pet Hospitals (purchased in 2007) and BluePearl Animal Hospitals brings Mars Petcare to just under 10% of the total North American animal hospital market. The pending deal is scheduled to close in the 3rd quarter.

IDXX remains a solid portfolio pick despite its competitive challenges here in the US as well as the seeming opprobrium being assigned to the stock by a leading rating company for its rich valuation of 62.75 P/E (TTM) in relation to its immediate competitive peers. Neogen (NEOG) provides a full line of consumable products dedicated to animal safety and carries a 62.09 P/E ratio . Heska (HSKA) provides core companion animal products, vaccines and pharmaceuticals and carries a P/E ratio of 69.03 . VCA which was recently purchased by candy and dog food manufacturer Mars, carried a P/E ratio of 35.75 while Abaxis (ABAX), which develops, manufactures and distributes portable blood analysis kits carries a P/E ratio of 32.84 . The actual verdict on valuation appears more nuanced. Indeed, IDXX lives and works on an up-scale street. I would argue the investor attention the stock has received to date is more a function of the particulars of the veterinary space and the demonstrated growth reality the pet industry generates-married fast to the willingness of consumers to expend an ever-increasing level of its discretionary dollars for the benefit and well-being of their pets they so clearly and adamantly adore.

Disclosure: I am/we are long IDXX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.