Heska's (HSKA) CEO Kevin Wilson on Q3 2017 Results - Earnings Call Transcript
Heska Corporation (NASDAQ:HSKA) Q3 2017 Earnings Conference Call November 2, 2017 11:00 AM ET
Brett Maas - Hayden IR
Kevin Wilson - Chief Executive Officer and President
John McMahon - VP and Chief Financial Officer
Jason Napolitano - Chief Operating Officer and Strategist
Nicholas Jansen - Raymond James & Associates
Kara Anderson - B. Riley & Co., LLC
Mark Massaro - Canaccord Genuity Inc.
Jim Sidoti - Sidoti & Company, LLC
David Westenberg - C.L. King & Associates
Raymond Myers - Benchmark Company
Good day and welcome to the Heska Corporation Third Quarter 2017 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Brett Maas. Please go ahead, sir.
Hello and welcome to Heska Corporation's earnings call for the third quarter of 2017. I'm Brett Maas of Hayden IR, Heska's Investor Relations firm. Prior to discussing Heska Corporation's third quarter 2017 results, I would like to remind you that during the course of this call, we may make certain forward-looking statements regarding future events or future financial performance of the Company.
We need to caution you that any such forward-looking statements are based on our current beliefs and expectations that involve known and unknown risks and uncertainties, which may cause actual results and performance to be materially different from that expressed or implied by those forward-looking statements.
Factors that could cause or contribute to such differences are detailed in writing in places including Heska Corporation's Annual and Quarterly filings with the SEC. Any forward-looking statements speak only as of the time they are made and Heska does not intend, or specifically disclaims, any obligation or intention to update any forward-looking statements to reflect events that occur after the time such statement was made.
We have with us this morning, Kevin Wilson, Heska's Chief Executive Officer and President; and John McMahon, Heska's Chief Financial Officer; and Jason Napolitano, Heska's Chief Operating Officer and Strategist. Following managements comments we will open the call to your questions, followed by Mr. Wilson's closing comments.
Now, I'll turn the call over to Kevin Wilson, Heska's Chief Executive Officer and President. Kevin, floor is yours?
Thanks, Brett, and good morning, everyone. Today we report third quarter that shows continued strong execution in the core of our playbook, including 16% growing in our largest and key business of blood diagnostics subscriptions. Consolidated gross margin expansion of 210 basis points to 43.1%. Strong market share gains and nice growth in our cash providing from operations which is outstripped all of 2016 and best the first three quarters of the year.
This strong core execution was offset by delayed and otherwise missed shots on goal and our smaller imaging and heartworm business lines both of which I see becoming positives in 2018. I have to go back to May of 2015 for a period report to investors it was below my personal goal. After that call has good and delivered on eight above the expectation quarters that were powered by then unseen benefits from early stage initiatives.
The third quarter of 2017 feels much the same to me. Like in early 2017 I'm highly confident in the growth prospects of Heska and I'll thoughtful and long-term investors see what I see and made seized upon attractive entry points into Heska as they present themselves. For our part Heska teams continue our good work on our clear path in our growing space with the focus and the competitive intensity required to win.
Now I'll turn the call over to John McMahon to go through the details of the quarter and update you on the outlook for the balance of the year. Following John's comments I'll provide additional insight into our plans and operations and this week's major new element COAG analyzer launch and Heska's because big win in the corporate accounts area with PetVetCare Centers. Then we'll open the call to answer your questions. John?
Thanks Kevin, and good morning, everyone. For the third quarter of 2017 we recorded revenue of $31.4 million a 6% decline over $33.4 million in the third quarter of 2016. On a year-to-date basis revenue is up 5% to $96.1 million as compared to $90.5 million after three quarters a year-ago.
Revenue for the core Companion Animal Health segment or CCA was up slightly at $26.7 million as compared to $26.4 million in the third quarter last year. CCA revenue was comprised of blood diagnostic instruments and consumables, single-use pharmaceuticals, vaccines and diagnostic tests, which we referred to as PVD and sales of digital imaging products.
Revenue from our key core blood diagnostics continues to grow strongly rising 16% in the quarter and 23% year-to-date. We continue to grow net placements and gain market share in a very competitive space with our six-year reset subscriptions. With over 80% of installed placements under our unique multi-year reset subscriptions and nearly 100% of new placements occurring under a six-year initial term. We are encouraged that each new placement into a new address represents a secure and long-term gain in market share. We continue to see strength in competitive win and blood diagnostics and we anticipate these trends continuing into Q4 and throughout 2018.
Partially offsetting the strong quarter blood diagnostics growth in our CCA segment was PVD and imaging sales. We've been experiencing over 20% declines in heartworm in our PVD sales in 2013 as we made the decision to deemphasize the products because of low margin. We see those declines turning into growth in the first half 2018 with our upcoming reformulation and relaunch of heartworm supported by substantially lower cost and higher performance and competitiveness. While we had expected these reformulation benefits to hit in the second half of this year, we now expect them in the first half of 2018.
In Q3 of 2017, the global imaging revenue declined 27% compared to the prior year due to four factors. First, we were up against very strong 2016 comparables. Second, we have to integrate the wholly-owned imaging business systems into Heska, which limited resources to focus on the business and delayed cost savings opportunities both of which we expect to see in 2018. Thirdly, the impact of the shift to rental revenue recognition in 2017 compared to upfront capital equipment recognition in 2016 for some of this year placements. And fourth, broad-based imaging softness prior to the upcoming fourth quarters particularly strong new products release cycle that Kevin will detail later in the call.
Impending new releases cost some customers to delay purchases and because of this the third quarter ended with more unclosed and in-process imaging contracts than we had hoped leaving us a $1 million short on revenues for the period. The upside is that we entered the fourth quarter with a strong pipeline of ready to close sales. We believe all four of these factors have run off as we enter the fourth quarter and we expect imaging to close the year on an upswing and to return to growth in 2018 aided by a very strong new product additions in the fourth quarter this year.
Turning to our Other Vaccines and Pharmaceuticals segment or OVP. After a front half loaded start to the year that yielded 42% growth. We expected OVP revenue in Q3 to substantially moderate. As anticipated OVP revenue drop to $4.8 million from $7 million in the third quarter of 2016. Of note about $1 million of this revenue reduction was order shift as customers move schedules from Q3 to Q4. We expect OVP to finish the year well and to achieve the expected mid single-digit growth for the full-year.
Our gross margin improved in Q3 to 43.1% as compared to 41% in the third quarter of 2016. The improved margin was a result of beneficial product mix from a larger portion of overall revenue for the quarter in higher margin blood diagnostics sales which as we mentioned grew 16% in the period. As growth in our blood diagnostics business continues to outpace growth in our lower margin product lines, overall gross margin will take a bit higher. It is instructive to note that long-term trends and product mix between our CCA segment and OVP segment has for some time now seen mix favoring the higher margin CCA segment.
To illustrate, in 2015 OVP was 19% of consolidated revenues, in 2016 it was 17% and we anticipate this year it will be 15% and potentially lower in 2018 as CCA continues its much faster growth off of a much larger base. The result of this trend is that we anticipate continued year-over-year improvement in our consolidated margins over the next couple of years if the trend continues.
Total operating expenses on a year-over-year basis grew 6% to $9.8 million from $9.2 million driven by three expense areas. The first was related to work on new product and business development projects. The second was for expenses surrounding implementation of the new recognition standard that will go into effect in 2018, and the third is our expansion in headcount. This year we've expanded our team member count by 9% to enhance our sales efforts and operational capabilities for anticipated growth in 2018. For context, headcount was up just 1% in 2014, 4% in 2015, and only 2% in 2016. We believe our 2017 investments and the capabilities of our team will yield results in 2018.
Quarterly operating income was $3.8 million compared to $4.5 million in the third quarter of 2016, a 16% decline on a year-over-year basis. However, year-to-date operating income has risen 11% to $11.1 million compared to $10 million for the first nine months of last year.
Depreciation and amortization was $1.1 million in Q3 of this year and $1.2 million in Q3 of last year, and stock-based compensation was $0.7 million this quarter compared to $0.4 million in Q3 last year. And that's due to the initiation of a new long-term incentive plan for key non-executive managers and customer facing leaders. This new plan closely ties their performance to success and long-term meaningful operational initiatives and to important growth in stakeholder align metrics like stock price, stock outperformance relative to indices, total revenue and income.
Our effective tax rate for the quarter was 18.5%. As in previous quarters, our tax rates have been impacted by discrete tax benefits related to stock-based compensation. We received approximately $1.5 million of the discrete tax benefits in Q3, which were partially offset by a valuation allowance of $1.3 million, again future use of our deferred tax assets, after realizing the current tax benefit. We will continue to closely monitor these tax items in each subsequent period.
Net income attributable to Heska Corporation for the quarter was $3.1 million, or $0.40 per diluted share as compared to $3.3 million, or $0.45 per diluted share that was generated in the third quarter of 2016. On a year-to-date basis, net income attributable to Heska Corp was up close to 50% to $11 million, or $1.45 per diluted share, as compared to $7.1 million, or $0.97 per diluted share, in the first nine months last year. This is slightly ahead of our internal expectations, leading us to tighten increase the midway point of our outlook for the year.
For the full-year, 2017 we see revenues raising to between $137 million and $139 million, which is lower than our estimate earlier this year of $140 million to $144 million due to softness in imaging sales and the delay into the first half of 2018 of our heart warm lateral flow test reformulation and relaunch, which we have until recently expected late in Q4 and driven by strong growth in key core blood diagnostics and healthy margins, we see diluted earnings per share rising 41% to 44% to between 202 and 206 per share, up from $2 to 205 original estimate from earlier this year.
With that, I'll turn the call back over to Kevin.
Thanks, John. The third quarter of 2017 as John noted, imaging is dragged on core companion animal results as we have worked to integrated into Heska systems, which has taken additional time and incurred some cost implications.
At the same time, revenue softness has been exacerbated by power re-initialize rental recognition for some placements and profitability has been impacted by increased expenses for substantial new product development. This cycle is now largely complete and has to imaging it on a solid footing for return to growth and better profitability in 2018 aided by identifying savings and have imaging most exciting product release cycle in years.
To kick things off, we will release our new Slate Hub at the American Association of Equine Practitioners Conference in San Antonio on Nov 17. Slate Hub is 100% unique in addressing customer demands to consolidate multiple, portable imaging consoles, peripherals databases and power management needs into one expandable device.
Slate Hub is a fully wireless, battery powered multimodality imaging hug to save space time and money for mobile veterinarians by unifying digital radiography, wireless ultrasound, equine dental digital radiography and endoscopy and element POC blood diagnostics into a single device that performs and stores a full lifetime of results in each patient's medical record.
Pricing begins at $56,000, which is similar to older single purpose digital radiography devices, because Slate Hub is a multimodality imaging platform, it supports new product line extensions that were previously impossible. As mobile veterinarians seek to add new modalities to their general digital radiography capabilities, Slate Hub makes it easy to partner with has imaging for all of their needs by adding on one or more of Heska's worldwide exclusive accessory products for Slate Hub.
One such line extension is our new and exclusive handheld Slate wireless ultrasound, which is the markets first and only high resolution wireless battery powered ultrasound that can be operated, viewed and stored on Slate Hub.
This handheld Slate wireless ultrasound eliminates the multiple cables, power chargers, cases and control console, of standalone ultrasound models. Handheld Slate is available for order on November 17 for $6,500 when purchase with a new Slate Hub and for $10,000 when purchased separately.
Also on November 17, Heska Imaging will release the world's first and only equine size intraoral digital radiography solution. Slate DR Dental is similar to human dental centers, but several times larger ruggedized and accessorize to meet the unique means of equine dentistry, which is a rare growth offering for equine practitioners.
Slate Dental DR is available for prerelease order on November 17 for $12,500 when purchase with the new Slate Hub and for $18,000 when purchased separately. Preorders of both handheld Slate and Slate DR Dental will begin shipping in the first quarter of 2018. These exclusive add-on products will be compelling factors for customers with choosing Slate Hub for general digital radiography and will increase Slate Hub base unit sales while importantly raising the up sell average selling price of each unit by up to 30%.
Another imaging revenue stream now coming online for the first time is from new multi-year service extension contracts. When we began installing new small animal imaging solutions in 2012 customers purchased a point of care, five-year agreement as these customers conclude their original point of sale service and warranty coverage they are beginning to purchase to your extensions of coverage.
The early uptake on these offers and their positive financial contribution point to a steady multi-year imaging tailwind in 2018 and beyond. 100s of customers are now eligible and each year 100s more become eligible for these extensions which range in annual price from $2000 to $5000. The combined effect of our imaging initiatives and product releases points to a much improved fourth quarter performance on a strong contribution in 2018.
Now I'd like to share with you how we're working on other key areas of our business. I spend roughly 40% to 50% of my time on new product development and business partnership development, which roughly 50% of revenue in our industry traceable to new product launches and major upgrades to existing products growth from new analyzer segments is a key focus for Heska.
It is a very, very busy and key area for us my development team which includes our Chief Strategist and Operating Officer, Jason Napolitano has been quietly and hard work pursuing pure growth projects and business development in urine, fecal, imaging, coagulation, infectious disease, allergy, data, molecular, telemedicine and software.
Slate Hub, Slate DR dental, the new solo step formulation and relaunch, this week's new element COAG launch and the creation of our new imaging service contract businesses are some current period examples. We're also focused each day on catalysts that improve sales, margins and efficiency over a rolling four quarter period in each business area.
Today I'd like to share several of the drivers we see adding to our growth in our blood diagnostics analyzer and consumer business, which we continue to expect to grow between 15% and 20% in 2018. The first driver is market share and area of strength for our team. We target a minimum 1% standalone hospital market share pick up approximately 240 hospitals with our traditional sales team efforts. Our teams have exceeded this over 2014 to 2017.
Additionally, we target a 1% Corporate Group owned hospital market share pick up for an additional 240 hospitals. With this week's announcement that one of North America's top five largest and fastest growing Corporate Groups, PetVetCare Centers has selected has because their exclusive long-term primary provider. We have secured over 100 current and pending locations for 2018. Including roughly 35 specialty and referral hospitals which are often very large and regular users.
We anticipate that fast growing well-funded organizations like PetVetCare Centers or over 300 million annual healthcare sales will grow their current diagnostics usage and current hospitals and seek to acquire roughly 25 new hospitals annually over the next several years. Heska is excited and pleased to grow with PetVetCare Centers as they do so. We are now focused on attracting several additional groups like PetVetCare Centers.
With 12 groups currently between $50 million and $300 million in veterinary healthcare sales and an additional 15 groups between and $50 million annually. We see substantial opportunities to switch 1% or more market share to Heska in 2018 from corporate groups. The second driver is growth in our installed base is own utilization. From promotional programs by Heska to increase the use of targeted, installed base testing and from participation in the underlying growth within the hospitals diagnostics businesses themselves, which is estimated to be between 4% and 8% from increased visits utilization in price.
We think Heska's well-positioned to help these veterinary hospitals increase our utilization in 2018. The third driver is growth in our own reset subscriptions model price. We have not taken a starting protest subscription price increase in our major testing panels in the past couple of years. In some cases the competition has taken several price increases which has effectively increased the fair value gap between Heska's reset savings and the competition.
In late Q3 of this year, we were able to fairly increase our starting subscriptions per test price for some tests, while maintaining our fair, high performance, superior value positioning. The fourth driver is growth in new analyzer segments. For 2018 and 2018, we see a regular cadence of new analyzer launches occurring the first of which kicked off by this week's release of the new Element COAG for coagulation and blood typing.
The launch of Element COAG introduces a brand new testing line to Heska much like the element POC did in the second half of 2013 and the element I did in the second half of 2015 both of which stimulated new customer acquisition and current customer upgrade expand extend growth cycles. With Element COAG, we are pleased to again embark on another of these virtuous upgrade cycles. Heska's continued success with launches like Element COAG and friendship with individual veterinarians and corporate groups is causing a more and more next generation companies to choose Heska as their global Animal Health partner.
From these cutting edge businesses and our own internal development, our pipeline contains a steady stream of targeted launches of new technologies and major upgrades over the next one to three years. Some of these new Heska initiatives will create new markets and some will disrupt current ones. The fifth driver is expansion of our geographic opportunities. We spent the past year carefully evaluating potential geographic driven acquisitions. Geographic driven joint ventures and other structured relationships and we've compared them to independent go-to-market international strategies.
Our probing has at times taken us farther afield and in a much longer conversation than we anticipated. We're still having these conversations and we will continue to do so until we have run out every ground ball to arrive at the best play. My directive to the team is simple. It's not easy, but it's simple. Expand our geography in a healthy, sustainable, profitable, efficient, value creating way that establishes a 10-year runway with clear profitability in under 18 months from launch, while maintaining flexibility for future strategy that may not be right today. I appreciate the patience of our product partners and of investors while we do this work carefully diligently.
With that, I'd like to open up the call for your questions and we will follow-up with some comments after that. Operator?
[Operator Instructions] And we'll take our first question from Nicholas Jansen with Raymond James. Please go ahead.
Hey, Kevin and John. Thanks for all the color thus far. First, on me appreciates to the dynamic kind of pushed out some of the revenue that you were expecting this year into next, but maybe just help us understand how you're defining kind of growth as we think about 2018 on heartworm on imaging, certainly imaging it's been a little bit of a disappointment this year, so just the scope of the potential recovery and your thoughts on the size of the market that you're addressing with these new products?
Yes. That's a great question. To simplify things, if you look at the third quarter, the core of the business was fantastic. Blood diagnostics up 16% is the core of the business. Not that any business is peripheral, but the ancillary business in imaging was a disappointment and it came in roughly $1 million below where I'd hope it will come in. OVP, we expected to have a down quarter. We call that out as a mid to high single-digit grower and it grew 42% in the first half.
So that one I think shouldn't be too disappointing and come as a surprise, but about $1 million did push in the third quarter to the fourth quarter. So there's another $1 million on top of the million the year lost in imaging. And then as we go into the balance of the year, we expected to launch the reformulated heartworm which is a big deal. Roughly 2012, 2013 heartworm for Heska was about $8 million business.
We shrunk that to about a $2 million business just generally direct numbers. Over the last several years, in large part just because the cost structure and the marketing expense of that product just wasn't profitable. So we deemphasized it. But it has been a drag on revenue in the last couple years. It's just been one that has been called out, because everything else was growing so nicely.
We counted on that reformulation in the second half of this year that's our lateral flow development. It's on track. It's a little bit behind what I had hoped, and so instead of giving us an extra million or two in revenue because of that reformulated launch, which cuts the cost of that product to manufacture substantially and turns it into something that you do want to put some marketing muscle behind to get those revenues growing again. That growth won't start until the first half of next year, just really tending the USDA regulatory process.
So when you combine those kind of ancillary business, and I mentioned shots on goal. You use sports metaphors, if you're a great team that drills three point shots and you have a great and great offences used to draw on three point shots and you get the best three point shooters in the league.
You want them to take those shots and sometimes they hit the rim, sometimes they bounce around the rim longer than you had hoped, sometimes the whole stadium watching them bounce around the rim to see if it's going to go in, and unfortunately the third quarter was a little bit like that.
Okay, that's helpful. And maybe, just a follow-up on the imaging comments, how do you think about the growth trajectory there as we you now own the whole thing under your operation, you have the new products, is this the business that can grow double-digits or the movement towards subscriptions perhaps going to dampen the rate there?
Well, so two things, we rolled out subscription, I don't have at my fingertips here exact data, but maybe three quarters of $1 million of revenue recognition and it was booked as a long-term rental as opposed to an upfront sale, so meaningful on a business that's $20 million-ish meaningful.
I don't suspect we'll continue that path, until we rollout some of the professional services around the imaging business. I mentioned that we look at software and data and in telemedicine type services, which really turn imaging placements into much higher revenue growth based on the consumable, which would be in professional services of things like telemedicine and auto differential diagnosis based on images, those types of things.
So I think going into next year, the year-over-year will grow in part because I don't think will put the rental piece of it in the first three quarters of the year and so there's year-over-year growth on that.
The second piece and I didn't really put numbers to it, but the service contract business is worth probably three to four percentage points of growth on imaging right on top and that's something that we really didn't have access to literally to about 30 days ago when those placements in 2012 started to roll beyond their initial five year service agreement.
And when you look at traditional service businesses for imaging, whether it's the big three - on the human side GE, Siemens, Philips, the service business and in imaging business is a very, very important business. And really for the first time since imaging has been part of the Heska portfolio, we actually have the ability to add that services business.
So when you combine the services business 3% to 4% head start you combine the 750 and rental recognition that will probably forego in 2018 on a $20 million business. You already had mid to high single-digit growth before you look at just core growth based on some of these new product launches.
All of which to say is it's early to talk about specifics on 2018, but what has been a 25% to 30% drag on revenues this year I think will turn into a nice positive next year and probably as importantly what's been a significant drag and profitability as we spent some money on some product development and some of these initiatives will turn into better profitability. So I think imaging is really slated for a good 2018 off of admittedly and a less than impressive 2017.
That's very helpful. And I guess my last question would just be on the corporate strategy it was great to see that the news yesterday. Maybe just remind us today how many “corporate” customers you have tell in the water and how we should be thinking about the cadence of that share gain opportunity over time.
We have created a corporate accounts initiative we've staffed with an excellent manager and I think she's fantastic and has great relationships did a similar job at for a long time with key and corporate accounts. That's a big opportunity for Heska. The one thing I would really point out on PetVetCare Centers and this is really cool in terms of a validation of Heska's quality.
We earned that business over a couple year period because we on a one-by-one basis were able to displace competitors in some of their largest in fact some of the country's largest specialty and emergency accounts. And some of these really huge users converted to Heska just the old-fashioned way just basically looking at the market, looking at Heska's normal everyday reset offering. But probably more importantly for those folks is just looking at speed and quality and those kind of things.
And we were able to display both of our main competitors and some really large accounts then after a year two I think the corporate folks in operations were able to look at it and say look our biggest most demanding users have switched over to Heska and extremely happy maybe our other 100 facilities would do well by pursuing that. That's where these conversations with PetVetCare Centers started.
I do think we've done that with virtually every other major corporate group that I mentioned and roughly 25% of these groups are in that $15 million to $300 million range. So we think it's a great opportunity. And I would point out to you that you know 240 corporately owned practices is a full 1% of market share again roughly half of which as we enter 2018 we've picked up with PetVetCare Centers.
And so I feel very confident in our ability to get our 1% corporate target for 2018. The other thing that I would point out is PetVetCare Centers is a seven-year agreement. As they continue to acquire practices. Say that they acquire 25 practices a year. That's equivalent of sales representative costs and expansion that really you're much more efficiently able to grow with PetVetCare Centers as they acquire those hospitals and convert to Heska. Is another avenue to the picking up market share.
So it's not just an initial 100, 110 practices it's 100, 110 practices with compound annual growth of 25 to 30 over the next six years due to their acquisition efforts. So it's an important initiative for us and I think we're well positioned to have significant pickups there. The makeup of the analyzers that we were placed in these accounts appears to track what you see with market share in the market, so to 65% of our largest competitor 20% for our smaller large competitor, tends to be what we see when we look at these corporate accounts. So I hope that helps.
Absolutely Kevin. I hope back in queue. Thanks.
Our next question comes from Kara Anderson with B. Riley FBR. Please go ahead.
Hi, good morning. I have a follow-up to the previous I guess question-and-answer. Can you provide some color on the dollar value of the agreement with Heska for PetVetCare?
When the dollar value so I look at it a couple ways I can't give you specifics because each hospital within their group is different, so they're roughly 35 specialty and emergency hospitals some of which are $250,000 a year plus and some of which are going to be normal you know $2000 a month type of users.
So they really is very broad. I do think it's a healthier point of care customer for us and then some of the larger point of care customers out there that are related with reference lab ownership. So when you pick up a corporate account that doesn't own a reference lab they tended you more point to care than they do reference lab. So we do think it's healthy. I also think it's slightly above our general user population just because of the types of practices they may buy and the growth in those practices. They run their business. So I think it's additive to our user install base. It's definitely not dampening that usage.
Thank you on that. With respect to Heska Imaging, can you provide some context around the international piece how that's tracking against? I think it was about $6 million annual run rate when you acquired it and how that performed in the quarter?
In the third quarter it was substantially off. Some of that is timing. It's a little - you have to look at trade shows season in Europe. And this year the main trade shows did not occur in September for kick off, they occurred in the middle of October. And a lot of our international partners rightfully want the ability before they put in their big fourth quarter orders, and we didn't see large orders in the third quarter. They were also aware of product development with Slate Hub and some of these other things and they were rating pricing, they were rating release and so we had some orders held off as well. So the third quarter dragon international was disappointing, but not totally unexpected to me. I do see a turning around in the fourth quarter.
Thanks. I'll jump back in the queue.
And we'll take our next question from Mark Massaro with Canaccord Genuity. Please go ahead.
Hey guys. Thanks for taking the questions. Just on the quarter, I was hoping you could just maybe clarify some of the comments you made. I appreciate all the transparency that you provided, but just thinking you guys came in roughly $4.5 million below consensus. Kevin, you called out imaging was roughly I believe 1 million OVP, roughly 1 million and then of course you talked about the push out of the heartworm launch. If you could maybe just rehash maybe the buckets where you think the shortfall occurred in the quarter? I guess I'm really just trying to understand the impact of the push out of the heartworm.
I mean so heartworm I think when that comes to market we have the ability to move 1 million or two a product fairly quickly. Some of that is stocking orders, some of that is just preparing for distribution partnerships and things like that private label, other initiatives that we currently just have sitting on the side until we can put them in boxes and start shipping on, which is a regulatory question. But I think you have it. I think consensus probably didn't account for enough of the first half 42% outperformance in our domain business. And we call that out is kind of a high - mid to high single-digit grower this year and it was running at 42%. So I think consensus was probably a million ahead as well. So I'll own 3 million of it, if you guys own a million of it.
That's helpful. You indicated 15% to 20% growth for 2018 on your core blood business. Would you be willing to maybe communicate your degree of confidence around double-digit topline growth given, obviously you have the benefit of new products, but partially offset by potentially converting more - likely converting more imaging to the rental program. So just generally how are you feeling about 2018 and double-digit topline?
I'm confident in it. This year I think we're going to miss it. We just called out six, seven somewhere in that range year-over-year. And I'm disappointed in that. It's all logical. It all makes sense. It's not in the core of our growth engine, so it's like anything to improve in your peripheral businesses and return imaging and heartworm to growth. Is a lot of work and the teams have a lot of work to do, but it's really, really clear internally how that happens, with 15% to 20% growth in the blood diagnostics business, which I'm also confident and we kind of call that I think all year just as a long-term growth, and I think that's very doable.
So along in the short of it is, we report to the world on a 90-day rolling period and sometimes the shot clock runs out on you a little bit before you wanted to, but going in 2018 double-digit growth is absolutely my expectation for the business. And it's not a stretch to see how we get there, it's work. It's just work and we've got to keep throwing up shots on goal and then traditionally more of them go in and they did in third quarter.
That's helpful, thanks. And when we think about your imaging business, converting that book to the reset rental program, are you maybe half converted or can you say if you're above that or below that or any additional color you could provide on that?
Yes, so just the nature of the questions, I'll try to explain. We try to pilot things and we try to do it thoughtfully. So I entered the year, I really like the idea of converting a certain percentage of our imaging business to rental. The idea behind that is if you're going to sell the same amount of capital equipment sales and rentals are going to be additive.
In all candors what we found with our sales force and some of its training, but what we found is we didn't really grow - we didn't really grow, we converted. So the idea is that you would maintain your capital equipment sales and rentals would call customers into the market that weren't in the market otherwise.
And enough capital equipment customers chose rental, which turned that into a drag as opposed to a future additive, all of which is to say I'm unconvinced it is something that I want to scale and I want to continue in the fourth quarter and 2018, which maybe unusual for somebody in my position who does publicly say, we tried something.
I thought it was interesting. I was personally convinced that it would be a good project to pursue and the evidence shows that it didn't get the traction that I thought it would. So I don't think we'll pursue it going forward, until we're 100% ready with the ancillary services behind it.
And then I think rental place and start to make an awful lot of sense when you can turn a customers who is doing 100 radiographs a month, $60 for a radiologist over read turns a 6,000 hour professional services business. In my mind is more valuable than an $1,100 rental or $50,000 one-time upfront sale.
And so there is a model at some point in future as we build out some of these professional services ideas, where we're placements of equipment in return for long-term professional services much like placement for blood analyzers in return for long-term supplies agreements make sense, but I was early on that. Is that makes sense?
It does, I appreciate that and if I can ask just one last one on gross margins, 43.1% was solid and beat my estimate. You're seeing a greater mix shift to your core blood business, which is higher margin. Do you think as we look to 2018 that 43% can be viewed as maybe towards the lower end of where you think you might come in at the end of the year?
For 2018 43% if you're building out a model isn't a scary number. I think it's more. I would want to be conservative, Mark, and I guess - but it's probably more realistic than 41%. So I don't think that's a temporary trend we've seen diagnostics growing faster than OVP in Imaging both of which are our much lower margins and I think that accelerating you even see that in our cash flow, because it's growing much faster, but it's growing much faster off of the much larger base. So it's - that a cemetery just continues to increase, which improves gross margins
Got it, thanks for the color.
And we will take our next question from Jim Sidoti with Sidoti & Company. Please go ahead.
Hi, good morning. Can you hear me?
We can Jim. How are you?
Good. Good. Thank you. Couple questions. First, tax rate can you tell me what you're assuming for Q4 and what you think of it be in 2018 on a reported basis I know you're not paying a lot of that.
Hi, Jim, it's John. So we go into every quarter marking something in the low 30's I mean we don't have a lot of visibility to what benefits that we're going to get that are out of the ordinary. So we're always marking something in the low 30's. So if you're in the 32-ish, 33-ish range that's where we need to line up.
Okay. All right. Any impact from the Hurricanes in the quarter?
I'll take that one. I think companies who have things like Reference Lab businesses where carriers and drive and pick things up. It's a little bit more visible. But certainly there are major pockets of the country that just simply were closed for certain amounts of the quarter. I don't know that I want to call it out it feels a little weak to me to call that step how for company of our size. So I don't call it out when the weather is great. So will probably pass on calling it out, but yeah there was an exact. But I don't know meaningful was just keep going.
Okay and then questions a follow-up same question I asked you three months ago. Inventory it's gone up quite a bit this year, last quarter you said that's because you had a large purchase, in the first quarter of analyzers and you thought it would be coming down but continues to move up.
So Jim where we traditionally have a higher inventory level in Q3 as we get ready for the shows and the imaging shows in Q4. So you can see a lot of that start trending down into as we end the year and go into - move into Q1.
Okay. All right. Thank you.
Although Slate Hubs an element COAG's you know so when you're launching new products as well you build up analyzer inventory to launch those products and then as you start making those who have received a number come down.
Okay. So we should expect that number down in Q4 and then again in Q1 of eighteen?
Yes, and I would certainly in Q1 you start really seeing it go the other direction as we're topped up.
Right. Okay. Thank you.
[Operator Instructions] We will take our next question from David Westenberg with C.L. King. Please go ahead.
Hey, guys, thank you very much and for taking the call and all the good color. So I'm going to ask so the tougher one first and then I asked a little bit about the corporate accounts, but in blood diagnostics I mean you guys have seen like in Q4 of 2016 you had a 44% growth rate Q1 I can get a 22% growth rate in the 33% growth rate in blood diagnostics last year.
Now I understand that that definitely not sustainable those are mind boggling growth numbers, but just as we sort of reset and realize that you guys are you know now about 10% market share so much larger base of customers. Can you talk about kind of the confidence in that 15% to 20% growth rate in that blood diagnostic business and you just you're thinking on that?
Long-term growth rate I'm highly confident that and I did spend a good portion of the prepared comments I think I rolled out five key drivers of that space. So it's not just one. But I think you know combination of at least 2% pick up. I think we have price protection that includes price increases for that installed base. That again is your install base continues to grow and they continue to analyze you get price increases within the subscription.
We called out the starting price for some of those major tests that we had taken it in over two years. So the starting baseline price for comprehensives and things like that will be higher which improves margin and sales we've got growth in the actual end user. We've got corporate growth, so I see several members there that are being told and I've already been told and then you have analyzer releases.
And again like in 2013 when we did the point to care for blood gases you saw a nice upgrade extend renew Fecal and every time we do one of those we place new analyzer in there but importantly we generally pick up 72-month renewals. A lot of times those are contracts that will have three, four years left on them. I like it and that's why I spent a large part of the prepared comments on it.
Thank you. And then can you just talk about the PetVetCare deal that you signed? Can you talk about the competition and sort of the bid process and really what you think were the kind of drivers that made PetVetCare kick you guys, because I'm assuming it was a competitive process, I'm assuming that you show them some procedure that they like that made it perfect for their particular corporate accounts?
Yes. I think - obviously a very competitive process, but what I like about this process is the process kicked off few years ago and when we took a handful of the very largest accounts from our two bigger competitors the old fashioned way. We sent a sales rep in there; he explained why our stuff was better, faster, and more accurate, better value, greater performance, higher precision, great connectivity and the local people made the decision to convert to Heska on our normal offering.
And it really just became very logical I think at the corporate level to say our biggest users who are staffed with the most demanding specialists already converted because they think it's better and again great results and the economics are better and we should do that for the other 100. So that was really more of a process. It wasn't a bid where they sent out a bid and said send us your checklist, spreadsheet, all the parameters it didn't really go that way. And I find most of these corporate accounts don't go that way.
I think it's a better process. They look at what's working and then they try and replicate it across all the practices and then they also have the credibility as they replicated across all their practices because they have successful champions already within the group. That's how PetVetCare centers happened. And you guys run a good business. They're smart guys and we're super excited that they chose to go wholesale and with Heska.
Great. Thank you so much for that color. Apologies for the longer question here, but I know a lot of these corporate accounts have been hesitant to sign deals because what they call diagnostics or changing the sort of modus operandi, sort of a pain point. But as you see more and more consolidators these days, can you predict maybe that they're going to be looking at saving more money and then maybe bundling diagnostics is a good idea. And all this to say what's your thought about the movement in consolidators and aggregators to pick one diagnostic laboratory equipment vendor?
I personally think the move to aggregation benefits the smaller guy and we are the smaller guy. Because I think what happens is the same thing. We will go to an owner and owner, owner and individual owner, it's his own P&L, it's his own kids' college fund, it's his own staff and we'll make a pitches to why our stuff is better, faster, more accurate, dry chemistry technology, two way communication with their practice management software through five part laser hematology.
All these great benefits that we offer people and an individual owner will select Heska. When that individual owner gets acquired by one of the aggregators, he pulls his Heska solution into the aggregators business which then highlights that aggregator, the benefits and profitability and likeability of what he has as opposed to what some of the other clinics might have. And so they experience pain points, they experience lower profitability in diagnostics with for a lot of these guys it's 15%, in some cases upwards of 20% of their profitability, so it's meaningful.
They need to get diagnostics right and they started looking around the table with folks that have made really good decisions running really good practices, which is why they bought the guys practice in the first place. And he or she on the practice before they sold it to a corporate group raises their hand and says hey, we love our Heska stuff, I have no idea why you're still with this other guy. That's the best sales pitch that we could get with a large corporate group and we spent two or three years getting those individual practice owners to make the conversion and they're on our side and as they get acquired they do a lot of the sales for us because they have a successful history. So I think that trend favors us as opposed to the other direction.
Thank you guys very much and have a great rest of your day.
And we'll take one more question from Raymond Myers with Benchmark. Please go ahead.
Thank you. Kevin, I thought I heard you say on the call that the heartworm lateral flow was pending regulatory clearance. Have you submitted already?
We have the dossier and we've submitted the majority of the dossier. The way heartworm works and actually a lot of these infectious disease tests work. You have to show effectiveness in different buckets. And again, I'm not overly technical, but I'll explain it as I understand it. So if you're diagnosing heartworm you might have a bucket of 100 to 1000 worms, really significant infection and then you might have another bucket of 10 to 50 worms middle infection, and then you might have the smallest bucket which is just got infected last week, one worm. The hardest patients to find in the general population are those with one worm.
So we've submitted the dossiers and I believe they're complete for the larger buckets because that population is easier to find, but you actually have to find actual animals with this amount of actual worms and you can then show with your testing that your test has picked that up. And we've zero concerns about the accuracy and precision of the test in the formulation and those things. We literally are waiting for enough one worm dogs to come through that we can pull samples from - to validate the early infection. If you can't find them, you can submit that final piece of the doc CA.
The folks who are doing that work for us, we acquire those samples from universities generally and some other sources and they're finding every one that comes through their door, but we can't go out and make one worm infection. So that really is the sum total of the delay and it's very frustrating since it's because out your control. But we do based on the current run, we believe that we'll see that the first half of 2018 in terms of fully submitted and the ability to actually launch a product officially.
Okay, great. That's a very good complete answer. Regarding the imaging upgrade cycle, you're launching some products here shortly in November, when should we think about the imaging upgrade cycle impacting sales? Can it start already here in the fourth quarter or is this the first half 2018 event?
It's already starting the fourth quarter. We did start the fourth quarter with the - maybe a stronger pipeline than honestly I had hoped. So I think there has been a good start to the quarter. I think meaningfully a lot of these benefits will hit in the first quarter. The upside to launching something November 17 is very exciting and it helps for immediate sales and you get a certain percentage of your tax line, is in a hurry.
The downside is sometimes you have doing it so many days left in the year, once you start backing out customer vacations and holidays and shipping holidays and all those kinds of things and so sometimes you just the clock runs out and starships in January that you wish, you could get out the door in December.
So I think it's going to be a little bit of both. I don't see a fourth quarter blowout for imaging, but I do see an upswing. I don't see a drag like it was on profitability and revenue. And in the first three quarters of the year, I do think it's moving in the other direction as we enter the fourth quarter.
Okay, good. Thanks and the COAG business, can you help us to quantify the magnitude and timing of the revenue opportunity for taking on that product?
Yes, I mean it's a great opportunity and just like the second half 2013 with the blood gas analyzer when we launched element POC. We had a nice upswing and a good conversation starter and in 2015 we did the same thing with eliminate and at the end of 2017 we're doing the same thing with Element COAG.
So I think if you look at those up cycles that followed those analyzer launches and 2013, 2015, and now 2017 and I think it's every bit as important a segment as of the other two products where. It's not the chemistry segment, the hematology segment. It's definitely a peripheral device like the blood gas segment and the immunotherapy - Immunodiagnostic segment, but it's - I think it's significant. It's just now being rolled out to teams, all the marketing portals and teams started receiving training last week and so they'll be out, knocking on doors and it gives us something new to talk about. So it's good.
Very good and the G&A expense was quite low in Q3, for that any unusual factor? How can we think about G&A expense going forward?
So I think you've seen some compensation growth over the last couple of quarters and I think where you see us right now and plus we had some spending in Q2 related to accounting standards in Q2, we also had expenses related to our line of credit that we opened. So I think Q3 is more of a normal quarter that you'll see maybe a little bit of an uptick from there, but directionally that's probably a good target number for us.
Okay, very good. Thank you.
And there are no further questions at this time. I'd like to turn the conference back to our speakers for any additional or closing remarks.
Thanks, operator and I'd like to say thanks to all the shareholders and analysts on the call as well. Clearly, we're hard at work on a strong 27 finish and we're working hard to deliver on our full-year diluted earnings per share growth, which is 41% to 44% growth, which we think will be between 202 and 206 for the year.
We're also setting the table for a strong 2018. For 2018, we continue to see 15% to 20% growth in the key blood diagnostics, backed by return to growth in imaging and heartworm PVD products, all of which maybe supported and enhanced by broad-based veterinary hospital growth, some of our corporate account wins, improving margins and a series of new product upgrades and entirely new line additions like the element COAG.
We've been quietly and hard at work developing new lines of business in a broad range of areas and it's been a very busy time for us in terms of development activity for the year in space, sequel, imaging, the coagulation, which we just launched infectious disease, allergy upgrades, data, molecular, telemedicine and software and we've been thoughtfully and working really hard running out all the ground balls on all the healthy options for international expansion.
Everyone at Heska is busy building value and I just want to emphasize, since joining Heska in early 2013 and I never been as excited and encouraged by our position in the market by our capabilities in buyer growth prospects. I look forward to updating you again next year and throughout 2018 on our progress and the basis for my optimism and veterinary diagnostics generally and Heska specifically. Thanks for your interest and have a great day.
This concludes today's conference. Thank you for your participation. You may now disconnect.
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