Heska Corporation
Q2 2017 Earnings Call Transcript

Published: 31 Jul 2017

[Operator:]

Good day everyone and welcome to the Heska Corporation Second Quarter 2017 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Brett Maas, Hayden IR. Please go ahead, sir.

[Brett Maas:]

Hello and welcome to Heska Corporation's earnings call for the second quarter of 2017. I'm Brett Maas of Hayden IR, Heska's Investor Relations firm. Prior to discussing Heska Corporation's second 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; John McMahon, Heska's Chief Financial Officer; and Jason Napolitano, Heska's Chief Operating Officer and Strategist. Mr. McMahon will detail the results we reported today, then we will open the call to your questions, followed by Mr. Wilson's closing comments. Now, I'll turn the call over to John McMahon, Heska's Chief Financial Officer. John?

[John McMahon:]

Thanks, Brett, and good morning everyone. We are pleased to report a strong performance for the second quarter of 2017. Our business was healthy; our customers were broadly strong; volume, margin, and price improved in key products; and veterinary industry-wide market indicators continued to be positive and encouraging. Heska's good momentum continued into the second quarter of 2017 with revenue rising 15% to $34.3 million as compared to $30 million in the second quarter of 2016. Revenue in our Core Companion Animal Health segment or CCA was $27 million, a 10% increase over $24.5 million in the second quarter last year. Revenue from core blood diagnostics grew 33% year-over-year, driven by strong testing supplies sales and the successful extension of our standard new subscription term from five to six years, which triggers capital lease upfront instrument revenue and expense recognition. We will discuss the impact that will have on modeling in future quarters in a little more detail shortly. In line with our expectations, we saw a 7% decline in imaging as we are in the initial phases of rolling out our subscription program for the imaging product line that has been so successful for us in blood diagnostics. In imaging, we purchased with cash the remaining minority interest in Heska Imaging US business and have integrated it with International Imaging into a consolidated Heska Imaging Global business. We are on our way towards integrating this global imaging diagnostics capability into a broader Heska strategy of providing the industry's best end-to-end diagnostics testing and software suite to veterinarians throughout the world. Our Other Vaccines and Pharmaceuticals segment or OVP once again had an outstanding quarter that came in a bit ahead of schedule, generating revenue of $7.3 million, up 33% from $5.5 million in the second quarter of 2016. While growth was broadly spread throughout the entire customer base, increased revenue from our agreement with Eli Lilly Elanco unit served as the main driver. We expect OVP revenue to moderate in the third quarter before finishing off the year strongly in Q4. Gross margin improved in Q2 to 43.5% as compared to 42.3% in the second quarter of 2016. As we've mentioned in the past, we typically expect margins to remain consistently in the 41% to 42% range, with fluctuations primarily resulting from product mix. That was the case this quarter as the OVP business achieved significantly stronger margins from their own product mix in Q2 than they did a year ago, while at the same time delivering a larger percentage of consolidated revenue in Q2 this year as compared to last year. We were also pleased to see margins at the higher end of our internal range in blood diagnostics and imaging during the period, along with a favorable mix of higher-margin blood testing supplies over lower-margin imaging sales and rentals. Total operating expenses as a percentage of sales improved 30 basis points to 30.2% from 30.5%, coming in at $10.4 million as compared to $9.1 million in Q2 of 2016, which represents a 14% increase. This increase was driven partially by expenses related to our International Imaging business which we did not own for most of the comparable Q2 period. Excluding those costs, operating expenses grew 12% on a year-over-year basis. Operating income grew 28% in Q2 to $4.6 million compared to $3.6 million in the second quarter of 2016. Depreciation and amortization was $1.1 million in both Q2 of 2017 and 2016, and stock-based compensation was $0.7 million this quarter compared to $0.6 million in Q2 last year. Our effective tax rate for the quarter was 32.9%. As we discussed in Q1 of this year, our tax estimates have been greatly impacted by the new ASU 2016-09 Accounting Standard that changed the accounting for the tax treatment of stock exercises. We received approximately $2.2 million of tax benefits from this change in Q2. Taking into consideration the relative size of these continuing benefits along with other factors, including, but not limited to, estimates of future taxable income and the length of the carryforward period of our deferred tax assets, we took a partial valuation allowance of $1.8 million in the quarter as an offset to these large stock benefits that may affect our ability to use all of our deferred tax assets in the future. Net income attributable to Heska Corporation for the quarter was $3.3 million or $0.44 per diluted share, a 32% increase over the $2.5 million or $0.35 per diluted share we generated in the second quarter of 2016. Turning to our capital management and balance sheet, late last week we announced a new $30 million revolving line of credit with JPMorgan Chase, which can be expanded to $50 million subject to condition. This new revolver replaces our $15 million asset-based line of credit and this improves liquidity, flexibility and expandability, gives us options as we continue to pursue strategic growth initiatives. Moving on to the balance of the year, as mentioned earlier, we have now completed a full year since moving our standard new blood subscription term from five to six years. As we lap a full year of these stronger commercial programs, we'd like to help investors and analysts who have not updated their revenue models to do so. Securing an additional year of blood diagnostics subscriptions has enhanced the overall value of each annuity and lengthened the benefit period between Heska and its customers. With the launch of six-year terms last year, the equipment portion of each subscription moved from operating lease to capital lease recognition, resulting in more upfront instrument revenue matched by more upfront costs. As we enter our fifth quarter under this accounting, instrument revenue and cost recognition in the first month of newly signed subscriptions will now be similar and more easily comparable to the prior year period. Assuming steady new subscriptions and current user activity going forward, we currently expect the contribution of blood diagnostics revenue increases to vary but to be generally between 15% and 20% compared to the prior year period which will now also have similar first month instrument revenue and cost treatment. This accounting treatment of the initial month of equipment revenue and cost does not alter prior agreement and generally improves the total combination of margins, return on capital, profitability and subscription value for six-year terms as compared to five-year terms. And because these six-year agreements are better for customers and for Heska, we intend to continue to offer these standard longer terms going forward. Now with all of these things in mind and consistent with our last call, we reiterate that for the balance of the year we continue to see revenue in the range of $140 million to $144 million and diluted earnings per share in the range of $2 to $2.05. With that, we would like to open up the call for your questions. Operator?

[Operator:]

[Operator Instructions] Our first question today comes from Nicholas Jansen with Raymond James. Please go ahead.

[Nicholas Jansen:]

Congratulations on a strong quarter. Just a couple of questions from me, first on the kind of blood diagnostics revenue growth acceleration, that 33% in the second quarter, certainly stronger than what I think you saw in the first quarter. So maybe just wanted to parse through what's going on there as we think about your market share gains and how successful these new subscribers are from a utilization perspective? Thanks.

[Kevin S. Wilson:]

It's Kevin. I think the folks we added in the first quarter were great. I think some of the tests that we added towards the end of the year and some of the utilization from the folks towards the end of last year was also strong. So I wouldn't read too much into it. I think it was just a good continuation of subscriptions models picking up steam.

[Nicholas Jansen:]

Okay, that's helpful. And if you look at the OVP success, I know it can be lumpy from Q to Q, but how do we think about that business longer term, particularly with some of your broad strategic partnership with Elanco? I know they had a relatively soft second quarter themselves. So just want to kind of get a better sense of the OVP business profile longer-term.

[Kevin S. Wilson:]

I mean I think clearly 33% is not the sustainable long-term number. We set for a long time kind of a little bit above inflationary growing, which maybe given that inflation is non-existent, maybe that's a little bit conservative. So I can't draw out a specific number but it clearly hasn't been 5%, it clearly hasn't been 33% on a long-term basis. I think we did callout that we think they will moderate a little bit. They were a little bit ahead of schedule for the second quarter. I think that will moderate a little bit in the third quarter and our visibility for the full year is generally pretty good in that business and we think the fourth quarter will be fairly strong.

[Nicholas Jansen:]

Okay, that's helpful. And then on gross margins, this is the second consecutive quarter of 43.5% gross margin. I think that's reasonably strong relative to where we've seen you guys in the last let's call it seven or eight quarters. So how do we think about the recognition of these subscriptions onto gross margins, and if imaging business continues to be somewhat lumpy tied to the transition to the subscription model in that segment, should we think about gross margins being a bit stronger going forward as more and more consumables run through your long-term duration contracts?

[Kevin S. Wilson:]

I think the ramp is steady. I wouldn't model in the ups and the downs. I think our guidance on that is a little bit below where we came in this quarter and we just feel a little more comfortable modeling that than modeling the high watermark. When we have lower imaging and lower allergy and lower TRI-HEART, some of these other things that are lower-mix products in a period compared to higher-margins and subscriptions, margins will tick up over time, and I think we've seen that over the last couple of years. So, as long as we continue to gain more subscriptions and we retain those folks and we layer on new folks and subscriptions become a larger percentage of our revenue, I think we're going to pick up a basis point here or there, but I would be cautious about adding 150 basis points because we had a couple of good quarters in a row.

[Nicholas Jansen:]

Okay, and then the last question from me if I can squeeze it in, just in terms of the investments necessary as we think about the opportunities for 2018, I think you have rapid assays, I think you have geographic expansion, you just updated your capital structure with this new term loan commitment. So how do we think about your need for resources as those opportunities are getting closer and closer to realization?

[Kevin S. Wilson:]

I think we have the power that we need to do the things that are on our list currently. And so I think the finance team has just done a great job peeking around the corner on that and giving us not only the $30 million but the ability to under some conditions to add the additional $20 million. And we're like anybody else, we have maybe five opportunities and five could come to fruition or two could come to fruition, and so we want to have enough ability and flexibility if it turns out to be all five. So I think we're in a pretty good place there. I think we're not ready to outline exactly what 2018's business development and strategy will be, but I think we have enough powder to execute on the targets that we have in front of us right now.

[Nicholas Jansen:]

Great, that's it for me.

[Operator:]

Moving on to our next question, our next question comes from David Westenberg with C.L. King.

[David Westenberg:]

Congrats on another good quarter. It's almost like clockwork for you guys. So, just the macro was really good in Q2, I mean you saw that with same-store sales and BCA. Our survey data also said that macro was very good. Can you give us any color as to whether or not that's where maybe spending above their monthly minimums, and as a follow-up to that, are you seeing any directional changes or do you anticipate maybe changes in the way you structure your monthly minimum?

[Kevin S. Wilson:]

David, it's Kevin. We see good end user prosperity; vets are doing well, they are in the middle of their busy work season. Summer tends to be their busiest time seeing patients. So it tends to be lower volume in terms of looking at a strategy and optimizing their own business. And what I mean by that is, they are so busy seeing patients and running tests that they are probably not in the throes of trying to make modifications to their testing equipment and those types of things because there's clients in the exam room. So we see really good end-user use. I had a laugh just yesterday. There was a CNBC article that came out with some mortgage data and 33% of millennials consider dog-friendly features like a fenced yard as I think it was the #3 factor in wanting to purchase a home, and that was ahead of having children and some other things that you would normally put ahead of dog-friendly features. So, I think the long-term trend of moving towards kind of humanization of pets, how valuable they are to kind of the family experience, is definitely intact as well. So all of which will say, yes, there's a very nice macro market, but still a lot of work to grow within a rising macro market and I think our teams are doing a really, really good job at doing that.

[David Westenberg:]

Okay, thank you. And I know I ask this probably every quarter, but the R&D expense in the rapid test, are we anticipating now that still maybe back half of the year or should we maybe push that back a little bit?

[Kevin S. Wilson:]

I think we're still planning on at least one lateral flow test launch in the fourth quarter, and as that launch comes online, there may be an increased spend late in the fourth quarter and on into the first half of next year to add the additional test. For us, the bigger hurdle is getting the first test through. So, I think we're on track, actually we were discovering that we can spend a tad less money than we had maybe forecast on the front end.

[David Westenberg:]

Got it, it's great. And just any anticipated changes with EPOC changing hands? I'm guessing you guys already have some sort of supply agreement in play, but any disruption or any color on what that impact might be?

[Kevin S. Wilson:]

No, and actually we like very much where that product landed. Siemens acquired the EPOC Blood Gas Analyzer equipment because of the Abbott-Alere acquisition. And our contract is very solid and follows the product, so we don't see any disruption. We're somewhat excited that it landed at Siemens. I think that bodes very, very well for the long-term investment and scalability of that product, very well. And the more they are able to invest and expand that product line and expand volumes on a global basis, I think obviously it's good for us in the veterinary space where we have some exclusivity in some key markets. So, we were very happy to see how that landed.

[David Westenberg:]

Perfect. And if I can just squeeze in one little short one, just for clarification, when we're talking about blood companion diagnostics, we're talking about chemistry, hematology, and handheld, we're not talking about like the heartworm and [indiscernible], correct?

[Kevin S. Wilson:]

Correct.

[David Westenberg:]

Okay, thank you, and congrats on another good quarter.

[Operator:]

Our next question today comes from Ben Haynor with Aegis Capital.

[Ben Haynor:]

In the release you mentioned that you're laying the foundation for the launch of the international subscription model. I guess, when is that plan to commence and will it look pretty similar to what you're doing in the U.S., are there any key differences there?

[Kevin S. Wilson:]

I don't think there are really going to be key differences in the program, and it's taking a little longer than I know some people would like. So we're okay with that. The core business is very healthy and growing and we're not in a rush to get it wrong. So we're being very thoughtful and being very careful about it. And I would just reiterate, I think I've said this in the past, subscriptions require I think a greater level of confidence and a greater level of performance with the end-user customer in an international launch than say maybe a distribution model. If we were in a hurry, we would be looking for some distributors to buy 50 boxes and we would recognize the revenue and we would hope for the sell-through. When you do a subscription model, you're on the ground in that location and you might go with some local partners, but you're obligated over a six year period to provide supplies, provide warranty, to provide technical support, basically to do all of the things that the customer needs to ensure that they have a successful long-term testing plan in their hospital under the subscription. But it takes us a little bit longer to make sure that that experience exceeds their expectation, and we think long-term for our own shareholders and the equity they are building for our shareholders, I think building out those things and bonding with a customer in say Germany for six years is probably a much greater success than trying to find a local distributor to take 50 or 100 boxes off our hand so that we kind of show some revenues in a quarter earlier than we otherwise would have. So I hope that makes sense. I'm not disappointed with the team's pace. There's a lot of work involved in making that subscriptions model work [indiscernible].

[Ben Haynor:]

All right, that's very helpful. And then can you maybe talk a little bit about the early returns that you've seen from moving to the imaging rental model?

[Kevin S. Wilson:]

Off the top of my head, I don't know what percentage in the second quarter we booked those rentals. I know we had some success booking $899 a month digital radiography rentals in the period, and I think it was in line with what our previous kind of – what meaningful percentage was. It wasn't 50% of our deals and it wasn't 5% of our deals, it was probably somewhere in between. So I'd have to get that number discreetly and specifically and get back to you on it, because I don't have it off the top of my head, but I think it's going well and the team seems to be getting the customers that they wouldn't get to without a rental option.

[Ben Haynor:]

Okay, that's helpful. But just the mechanics of these types of deals, assuming you've got a customer that maybe signed up a rental reset two years ago, you go back to them and say, okay, we've got the synergy in rental model now, does that customer wind up signing up for an additional six years based upon the way that you're structuring the model?

[Kevin S. Wilson:]

It depends on a specific deal. In general, when we add new capabilities in a clinic , in general, customers will renew their whole book of business with us for the full term. Imaging has been separate in the past, and I know we've done some that will renew the entire book of business, and I know we've done some that will remain separate, but it's still early days. We would never force a customer to renew their blood diagnostics benefits in order to get the imaging piece or vice versa, and some customers see that advantage and they want to lock in those benefits for six years from today, and some customers don't want to go back and reopen that, they are happy where they are at, they just don't have time to think about what the renewal means for them, so they leave it alone. So, it's [indiscernible] no rule at this point.

[Ben Haynor:]

Okay, great. That's it for me. Congrats on the quarter.

[Operator:]

Our next question today comes from Jim Sidoti with Sidoti & Company.

[Jim Sidoti:]

A quick question on the balance sheet, inventories have jumped up quite a bit the first half of the year from where you ended the year. Is that related to the Cuattro acquisition or was there something else there?

[John McMahon:]

No. So, Jim, those are minimum commitments that we've made throughout the year for our analyzer placements, for our analyzer purchases. So we had a minimum commitment that came due in Q1. So we'll spend the rest of the year working through all of that.

[Jim Sidoti:]

Okay, so you think you'll get back closer to where you ended the year by the end of 2017?

[John McMahon:]

Yes, I think so. Close.

[Jim Sidoti:]

Okay, all right. Then my second question on the R&D pipeline, you've talked about the rapid assay tests and expecting to have those start to come out late this year or early next year. Are there any other areas that you can tell us about where you are focused now either through your R&D pipeline or through your acquisition activity?

[Kevin S. Wilson:]

It's Kevin. Yes, so you'll recall last year, Jason Napolitano assumed the position in Chief Strategy and is really focused on that business development side of our business. He is a busy guy and I think he and that team are doing a great job. There's really nothing that we're prepared to roll out publicly at this point, other than to say certainly it's a busy position and he's doing a great job. So I wish I could be more specific than that, but I can't.

[Jim Sidoti:]

Okay, and can we read anything into the fact you extended the line of credit into his getting closer or was that just one that a blind was up?

[Kevin S. Wilson:]

I think that's a combination of, and I'll throw kudos to John and his team, I think that's a great professionalization happening in the finance department, I think they are doing a great job and they really upgraded our banking relationship with JPMorgan and walked through that process and got them familiar with our current business but also our growth plans. So I don't know if you can read into it other than to say, we think we're good stewards of the business that our shareholders own, and I think we've done a good job in the last three or four years bringing on new products that have moved that shareholder value forward, and part of that is finance has to optimize the cost of capital and make sure that we have enough capital available when business development is ready to pull the trigger, and I think that those two teams are working really well together and our banking partner kind of sees that future. So, I don't know what you can read into it specifically other than to say, I think it's an indication of a healthy business laying the groundwork to do more things in the future.

[John McMahon:]

And Jim, let me just add that moving or transitioning away from asset-based lending into a traditional revolver just gives us so much more flexibility. It's easier on the team, there are no asset audits and there's just more liquidity as a result. So it just makes us a lot more flexible and we can react to opportunities whenever they come across our desk.

[Jim Sidoti:]

Okay, great, that's it for me.

[Operator:]

And there appear to be no further questions in the queue. I turn the conference back over to your host for any additional or closing remarks.

[Kevin S. Wilson:]

Thanks, operator. This is Kevin Wilson and I just want to thank everybody who joined the call today. I am super pleased with the results that we had in the second quarter. The teams did a great job. We're working inside a market that has fantastic long-term dynamics in both companion animal and production animal, and our blood diagnostics team led by Steve Eyl is doing a great job in that space. Our OVP segment under Mike McGinley similarly had 33% growth in the period, just had a fantastic quarter. The finance team with John McMahon and the relationship that they've created with JPMorgan Chase and the new line of credit is fantastic. So everybody seems to be working together well and the market is very healthy and we're encouraged. Lot of work to do, lot of big competitors, but we enjoy the competition and I look forward to updating everybody again in another couple of months on our progress. So, until then, thanks for your interest in Heska and goodbye.

[Operator:]

That concludes today's conference. Thank you for your participation. You may now disconnect.