Heska Corporation
Q1 2018 Earnings Call Transcript

Published: 6 May 2018

[Operator:]

Good day, ladies and gentlemen, and welcome to the Heska Corporation First Quarter 2018 Earnings Call. Please note, today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Jon Aagaard, Director of Investor Relations with Heska. Please go ahead, Jon.

[Jon Aagaard:]

Good morning, everyone, and welcome to Heska Corporation's earnings call for the first quarter of 2018. I'm Jon Aagaard, Director of Investor Relations. Prior to discussing the company's first quarter results, Heska would first like to remind listeners that during the course of this call, certain forward-looking statements may be made with regards to future events or future financial performance of the company. Any such forward-looking statements are based on our current beliefs and expectations and involve known and unknown risks and uncertainties, which may cause actual results and performance to be materially different 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 and specifically disclaims any obligation or intention to update any forward-looking statements to reflect events that occur after the time such a statement was made. We have with us this morning, Kevin Wilson, Heska's Chief Executive Officer and President; Jason Napolitano, Heska's Chief Operating Officer and Chief Strategist; and Catherine Grassman, Heska's Vice President, Chief Accounting Officer and Controller. Mr. Wilson will begin with commentary surrounding the results reported today, followed by additional comments from Ms. Grassman. And after Ms. Grassman, we'll open the call up for questions before closing with final remarks from Mr. Wilson. At this time, then I will turn the call over to Kevin Wilson, Heska's Chief Executive Officer and President. Kevin?

[Kevin Wilson:]

Thanks, Jon. Good morning, everybody. Today, we're pleased to discuss the first quarter 2018 results that are detailed in our release this morning. I'm very pleased with these results, and they slightly exceeded my expectations. Net revenue increased 10.8% to $32.8 million, led by our Core Companion Animal segment, which rose a healthy 12.8% in sales led by a 17% increase in point-of-care consumables and a 33% increase in imaging. On our last call for 2018, I called out three clear jobs at Heska for the year. First, we are to continue to win in our baseline domestic plan that emphasizes Heska Reset diagnostic subscriptions. We are doing well in this area. As we entered the year, our outlook for point-of-care laboratory consumables was for 15% to 20% growth. We continue to see this outlook as reasonable. In the first quarter, point-of-care laboratory consumables rose 17%, while quantities utilized by our customers rose above this level. In addition to solid sales growth, laboratory consumables and instruments gross margins improved 1.4 percentage points to 52%, demonstrating the benefits and reliability of our Heska Reset subscriptions model to deliver growth, profitability and cash flows. Regarding market share gains for point-of-care laboratory, we entered the year seeing 1.5% to 2% share gains, and we continue to see this outlook as reasonable. End user customer demand and growth for point-of-care diagnostics appears to be strong. Heska continues to gain market share from individual hospital accounts at a rate consistent with our goal, and we have now begun installations to our larger corporate accounts, which were won at the end of last year, which we see accelerating into the back half of the year. Helping Heska to win the largest accounts is the launch of the Element DC5X, the industry's most powerful specialty grade, high-volume dry chemistry analyzer. Element DC5X is on-track for deliveries in the coming quarter, and preorders have begun with notable high-volume wins already booked. The second job called out for the year on our last report is to deliver 10% or higher growth in Heska's imaging product line. We are currently exceeding this target. Investors may recall that last year was an integration and resetting year for imaging. As we entered the year, we called out several positive drivers to return imaging to 10% growth for 2018. The first quarter outperformed our goals with a 33% increase in sales that also delivered an increase in gross margins of 3.8 percentage points over the prior year period to 40.8%. With new products on tap to begin shipping in the second half of the year, positive momentum and other tailwinds, we remain confident in the imaging performance goals for 2018. The third job called out for the year on the last report is to work to deliver on our next big product and geographic expansion opportunities to drive major step-ups in growth. These key growth initiatives are scheduled to be more fully shared during our Investor Day scheduled for May 15 in New York City, where we will share our progress on three key growth initiatives and provide several updates on our Reset subscriptions program, which we believe will be useful and encouraging to investors seeking to understand Heska's strength at a deeper level. Growth initiatives covered at Investor Day will include research and development investments for projects slated for launch in 2019 and 2020, major new product line extensions into addressable markets in excess of $100 million, and an update on Heska's geographic expansion strategy and investments outside of the United States. We look forward to seeing you at our Investor Day or having you participate remotely via webcasting. Now I'll turn the call over to Catherine to go through the details of the quarter. Following Catherine's comments, we'll open the call to answer your questions. Catherine?

[Catherine Grassman:]

Thanks, Kevin. For the first quarter of 2018, we reported revenue of $32.8 million, a 10.8% increase from $29.6 million in the first quarter of 2017. Revenue for our Core Companion Animal segment, or CCA, increased 12.8% to $26.8 million in the first quarter of 2018, up from $23.8 million in the first quarter of 2017, driven primarily by strong point-of-care laboratory consumables revenue increase of 17% and point-of-care imaging products revenue increase of 33%, offset by a decrease in instrument revenue of 29%, largely due to lower capital lease revenue recognition and lower levels of noncore diagnostic pump sales. Revenue for our Other Vaccines, Pharmaceuticals and Products segment, or OVP, increased 3% to $5.9 million in the first quarter of 2018, up from $5.8 million in the first quarter of 2017. First quarter 2018 gross profit rose 0.7% to $13.3 million compared to $13.2 million in the first quarter of 2017. Our first quarter gross margin was 40.6%, a decline of 4.1 percentage points from 44.7% gross margin in the first quarter of 2017. This decline is due to a decline in gross margin in OVP to 9.4% in the first quarter of 2018 from 37.4% in the first quarter of 2017, resulting from primarily unfavorable product mix. Total operating expenses in the first quarter of 2018 were $11.4 million or 34.9% of sales compared to $10.4 million or 35.3% of sales in the prior year period. The increased operating expenses were related to stock and other compensation expense recognition, research and development expense related to new product development and consulting fees related to advisory services. Operating income decreased 33% to $1.9 million during the first quarter of 2018 compared to $2.8 million in the first quarter of 2017. Operating margin of 5.7% for the first quarter of 2018 was negatively impacted by OVP product mix, which was affected by the timing of a higher revenue but lower margin contract manufacturing product shipment. This unfavorable product mix impacted gross margin by approximately five percentage points. Net income attributable to Heska Corporation decreased to $2.2 million or $0.28 per diluted share in the first quarter of 2018 compared to $4.6 million or $0.61 per diluted share in the first quarter of 2017. The company's effective income tax rate for the first quarter of 2018 was a benefit of 15% compared to a benefit of 51% for the first quarter of 2017. The effective tax rate for this quarter was favorably impacted by the discrete tax benefits associated with the vesting of restricted stock units but to a lesser extent than this impact of the first quarter of 2017. The company estimates the discrete tax benefits associated with the vesting of restricted stock units resulted in a tax benefit of $0.8 million for the first quarter of 2018 or $0.10 of diluted earnings per share as compared to approximately $2.2 million impact of discrete tax benefits or $0.29 of diluted earnings per share for the first quarter of 2017. The company has an underlying annual effective tax rate of about 27% to 29% minus the effect of discrete tax benefits related to stock option exercises and the vesting of restricted stock units that could result in a tax deduction in excess of the book compensation expense recognized. While the company expects the underlying annual effective tax rates to be in the 27% to 29% range, these rates could be impacted on a quarterly basis by volatility due to accounting for income taxes associated with previous and future stock-based compensation awards. At this point, we'd like to take this opportunity to open the call up for your questions. Operator?

[Operator:]

[Operator Instructions] We'll take our first question from Jim Sidoti with Sidoti & Company.

[James Sidoti:]

First question I want to ask you is not really about anything that happened in the quarter but about Henry Schein and their plans to spin off their vet business, and how you think that will impact your business?

[Kevin Wilson:]

So first, I think it's a positive for the Henry Schein Animal Health team. I think it's a fantastic structure. I think it'll free them up to be more aggressive in the space and more focused, which we believe impacts our business positively. I think, as you know, we partnered with them in terms of distribution on a -- an exclusive basis for the core companion laboratory business, and we anticipate partnering with them on international initiatives as well. So we think it's a winner. We think the combination with the vets first choice and their analytics and their software skills and capability, especially when combined with the market share leadership that Henry Schein has in practice management solutions, we think that's a very powerful combination of data. And the more valuable they are to the veterinarian and the pet owner, the more valuable they are as a partner to Heska. So it's a very long way of saying we like it.

[James Sidoti:]

Okay. And on that distribution note, the last call, you talked about ramping up your direct sales force by, I think, about 25% in 2018. Can you give us an update on how that's going?

[Kevin Wilson:]

Yes. So we called that out for June through November. We've probably got a little tiny head start on that. I think, as you know, Jim, we're always adding opportunistically one or two here and losing one there, and -- but I think we're probably getting a little bit of jump on that. It's not quite June, but we've begun that, and we don't see that being a problem. That's roughly a net add of 20%. And I do want to draw a distinction for folks that, that is primarily related to new product launches that we see happening towards the end of the year. And if you have a sales force that is the size of our sales force and you increase the value of the bag that they are carrying, what you want to avoid is a situation where they don't hit their core laboratory number while promoting a brand-new product. So we think that increasing the sales density while decreasing the size of their territory while increasing the number of items they have to sell into those addresses and doing that kind of in a synchronized way make sure that you get core companion lab growth of 1.5% to 2%, which we feel confident in, and then you get the incremental benefits of new product releases. So that's the reason behind that sales force increase. It's not really related to the distribution strategy, which we're comfortable with.

[James Sidoti:]

Okay. And I assume we'll hear more about the new product launches in a couple weeks at the Investor Day?

[Kevin Wilson:]

That's correct. Yes.

[James Sidoti:]

All right. And then last question for me. You talked about some consulting fees in the quarter. Can you give us a little color? Is that related to the new products? Or is that related to the sales strategy or M&A activity?

[Kevin Wilson:]

It's probably business development, little bit of tax, little bit of structure. As we contemplate some of these things, there are times when we need outside help to make sure our structure is correct for the development that we're pursuing. And I think that's probably the majority of that, those outside fees.

[James Sidoti:]

Okay. And you commented that you expect the gross margin to expand modestly in 2018 with the sales force hires and some of these other expenses. Can you give us any guidance on where you think operating margin will end for the year relative to last year?

[Kevin Wilson:]

Yes, I think we're going to try and update that on Investor Day as well, Jim. And it's a thoughtful question. We want to make sure we give a thoughtful answer. We've got a lot of moving pieces. I think, so far in the first quarter and going into the second quarter, our message has been that sales are good. Product margin, gross margin is good. End user demand is good. We're on track for all those things, but with some of these moving parts, we thought it was a little bit early to try and get more precise on what the timing of some of these spends are. And I think, we'll be able to be little more precise on Investor Day. So I want to defer that for a couple days, because I think context around those spends and timing and what it does to operating margin is important. So we have to be a little more fulsome on Investor Day than we can be on our earnings call.

[Operator:]

Our next question today will come from David Westenberg with CL King.

[David Westenberg:]

As tempting as it is, I'm going to refrain from asking about products because I know I don't want to get in front of you on Investor Day. So anyway, just -- we saw OVP -- and I think you even suggested it might be down year-over-year. Can you talk about what might have grew 3%? So was that above expectations? Or was that at expectations? Or just kind of help us think about OVP, which -- at least, my model has it going down year-over-year.

[Kevin Wilson:]

Yes, year-over-year, I think, we called out a pretty discrete number. I want to say it was $21 million. And so the number for last year is out there as well. So it is down year-over-year, and we called out a pretty specific number. And I think we also called out a pretty specific number on gross margin. So the good news with that business is, we feel like we have good visibility on a yearly basis, but timing of product mix, because most of the product that comes out of that facility are on contract manufacturing agreements, which means we're providing manufacturing for the timing of third parties. And so in the first quarter, we had a large shipment of 3% gross margin product that is tied to a larger relationship that ships much higher gross margin product throughout the year. So the timing of that 3% gross margin obligation affects quarterly gross margin but not annual gross margin. I hope that makes sense.

[David Westenberg:]

Got it. Yes. And then just as a follow-up to a question Jim asked for the Henry Schein, Henry Schein actually has something brewing in their merger that's really going to help them develop the industry. But Henry Schein also has a lot of strength outside the U.S. So I mean, do you see any potential strengthening of Henry Schein outside the U.S. that you could leverage for your own products, given the fact that you already have a very strong relationship with Schein?

[Kevin Wilson:]

We do. I think it's probably a reasonable anticipation for most folks that we would partner with Henry Schein globally as we have in the U.S. Obviously, they have been quite busy. We have been quite busy, so we haven't made any announcements and moves towards that. But I think, we'll talk about that a little bit more on Investor Day as well.

[David Westenberg:]

And then I'll just ask one more. You've noted a lot of corporate account wins. You have a product that's good for high volume. You have consumables that are cheaper than or less expensive than market rate. So you have also these Petcos and other stores that are trying to drive same-store sales and opening veterinary clinic. So can you talk about maybe the opportunity for your products in those kind of settings if you have any relationships there brewing? And what kind of opportunity for growth do you see there? And that will be my last question.

[Kevin Wilson:]

Yes, David, I think we're more focused on full-service veterinary hospitals. Our equipment, I think, is generally acknowledged to be very precise, very accurate and kind of a professional-grade type of product. I think, when you get into more of the consumer end of the market where maybe it's not full-served veterinary medicine, I think, ease-of-use, smaller form factor, those types of things and price tend to really drive some of those purchase decisions. So we really are focusing kind of on the higher-end, full-served veterinary hospitals. And those are folks like the pet vet care that we got at the end of last year, and we think those folks will continue to acquire other high-quality veterinary -- full-served veterinary hospitals. And so we'll grow alongside of them but we're less focused on some of the false starts that I see kind of in the more consumer places like the Petcos versus PetSmarts versus Walmarts versus there's a lot of opportunity, I guess, there, but I haven't seen a lot of tangible opportunity. I think, the entity, that is executed -- has executed well, the Banfield entity that's part of the Mars family. But I haven't seen much more than that in terms of opportunity for Heska. So we're going to focus on the full-served veterinary hospitals.

[Operator:]

[Operator Instructions] Our next question will come from Andrew Cooper with Raymond James.

[Andrew Cooper:]

Just a couple for me. First, kind of looking at the instrument front, revenues were down. I think we all expected that. But could you give us some color on sort of tracking to the 1.5% to 2% was the general install number in line? And then just a little -- with what you were thinking. And then just a little bit of color on sort of the ancillary pumps piece that you called out there. I don't think that's something we've heard you talk about much before.

[Kevin Wilson:]

Yes. So that's great question. The installs were in line. The nature and the mix of the installs is always important. So capital equipment recognition will drive instrument revenues differently than operating lease recognition, which would be lower revenues in the current period. So the mix, for instance, corporate accounts tend to be under operating lease, whereas individual hospitals tend to be under capital lease, and the mix of installs, operating lease versus capital lease can vary. In addition to that, we also have a pretty big effort to install new devices into existing hospitals in return for extensions of their subscription. And that has different instrument accounting treatment as well because you're taking the balance of their current deal and rolling it into a 72-month new deal, which will affect the equipment portion, all of which is to say the instruments portion of revenue is far, far less important to our business. And I think we will explain that in much more detail on Investor Day to help people understand that. We think it's fair we should call it out, but there are so many factors driving that. They don't really indicate health or weakness in that area that I think understanding the moving parts on Investor Day will help. Non-core pumps is just a straight traditional -- we have the leading infusion pump in the market and people have bought hundreds and thousands of these things over the years. All of the major distributors also sell these pumps, and that's a timing question. So in some quarters, you might get $1 million in pump orders, and in some quarters, you might get $200,000 in pump orders because those are stocked at the distributor level. And when that moves the numbers meaningfully as it did this quarter year-over-year, we call that out for you. I think it was approximately $500,000 difference in pump deliveries for distribution for the quarter compared to the first quarter of 2017. So it was a meaningful number, so we wanted to call it out.

[Andrew Cooper:]

But no change in kind of the end market or competitive landscape there, correct?

[Kevin Wilson:]

Yes, correct.

[Andrew Cooper:]

And then moving -- this one's a little bit of housekeeping but in terms of those consulting fees and I think some of that was stock comp as well for the OpEx, what's the right sort of go-forward basis to think about as we look at layering in the growing investments in R&D and in the sales force just to make sure we have kind of the right plans set to go off of?

[Catherine Grassman:]

Yes. I think, I'll defer back to Kevin's response to the last caller's question in regards to operating margin and discussing that more fully at Investor Day, because, clearly, those -- we have strategic plans in place and those clearly do affect our operating margins, and I think we want the opportunity to be thoughtful about it and discuss in person.

[Andrew Cooper:]

And then just one more for me and it may be a sort of similar answer but we saw the hire of a Head of International last Friday, I believe. And I know people have already asked about Schein being OUS and kind of some of that color, but if there's anything you can give about that hire and kind of what you're thinking is? That would be really helpful.

[Kevin Wilson:]

Yes. So I almost put it in my prepared comments, Jason Aroesty is a fantastic hire for Heska. He comes from, most recently, Siemens, where he was managing point-of-care diagnostics, which I think was, by a couple multiples, larger than the size of Heska. He has 10 years of experience being based in Europe, most recently out of London but also reporting into Germany. So I think he's an ideal executive to lead our rest of the world expansion. I can't say a whole lot more about that until we kind of tie it together with what the logistics and marketing strategy outside of the U.S. is, but I'm tickled to have him. I've been trying to get him for a while, not officially, but he's a friend of mine. I think very highly of him, and I think you'll like him a lot when you meet him.

[Operator:]

Our next question will come from Raymond Myers with Benchmark.

[Raymond Myers:]

Kevin, please excuse me, if you've already covered this. I came late to the call, but I wanted to ask you about your OVP gross margin in the quarter being so low to -- almost to the point where I've a question why even ship product if it has such a low gross margin?

[Kevin Wilson:]

It's a great question. There's a very large customer that we have in the OVP segment, and part of that relationship is we have an obligation to ship that product as part of our overall relationship with them. So we ship some very high-margin products for that large customer as well. And as a good partner, when they need a $1.5 million to $2 million or 3% margin product, we agree every year to produce that and ship that for them. So that's the answer as to why ship it. It's part of the overall $21 million in sales and 20% gross margin that OVP does every year. And so the 3% product that we shipped was not a surprise to us. It just depends on which quarter it ships. And obviously, it doesn't show up quite as greatly if it ships over multiple quarters as opposed to stacked into one quarter. And this year, it's stacked more into one quarter than maybe it has in the past.

[Raymond Myers:]

That's very helpful. Can you help us to know whether there's more of the 3% margin to be shipped this year?

[Jason Napolitano:]

Yes, there is. This is Jason Napolitano. I'm the COO. You'll see more of that [indiscernible] go out this year.

[Raymond Myers:]

And can you give us any sense of the magnitude? Is it mostly out in Q1? Or is it mostly coming later?

[Jason Napolitano:]

I think it's built into the number that we've given you in terms of financials. Obviously, we're sensitive to giving any particular customers' product mix in general. Ray, it is kind of $21 million outlook and sort of 20% outlook, and we don't see that changing. So probably a little bit more loaded into this quarter, where -- or which dragged down consolidated gross margin. It is the only [indiscernible] but it's the full year outlook. It normalizes over the year.

[Raymond Myers:]

And my last questions about the pet vet care facility. What's the progress in converting them to Heska's equipment?

[Kevin Wilson:]

There's not so much converting. We have a contract with them that calls for a very high percentage of their hospitals to convert within 2018, and so all of those conversions are contracted to be completed in 2018. But laying the groundwork and getting the first batch of those installed is always a slower more gentle process than what you see once you get momentum in that. So I think you'll see higher increases of installations, but it's not so much a conversion question as it is logistics question on their side. They have communication and training and swapouts, and we have logistics in terms of shipping and training and installation and those kind of things. So the first quarter was very light. The second quarter will be heavier in terms of installs and first quarter. And I think by the third or fourth quarter will be right along to get to that kind of 80% targeted conversions in 2018.

[Operator:]

And at this time, we have no further questions in our queue. We'll turn the conference back over to our speakers for any additional or closing remarks.

[Kevin Wilson:]

Thank you. I want to thank everybody who took the time to listen to our call and to follow us. I'm pleased with our first quarter results, and I'm proud of the work that the entire Heska team did. I think we built value for investors. We certainly improved the lives of veterinarians and pet owners and most importantly, pets. I remain super excited about what the next five years looks like, and we look forward to updating everybody on May 15 during our Investor Day in New York to share details on why I remain excited about the next five years and Heska's bright future. So I hope you can join us, either in person or by webcast, and we look forward to speaking with you soon. Thanks and have a great day.

[Operator:]

Thank you, again, ladies and gentlemen. This does conclude our conference for today, and thank you for your participation.