Heska Corporation
Q3 2008 Earnings Call Transcript

Published: 20 Nov 2008

[Operator:]

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Heska Corporation third quarter 2008 earnings conference call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator instructions) As a reminder, this conference is being recorded today, Monday, October 10, 2008. I would now like to turn the conference over to Dr. Bob Grieve, Chief Executive Officer. Please go ahead, sir.

[Bob Grieve:]

Thank you. And thank you all for joining us today for our conference call. I’m joined today by Jason Napolitano, our Chief Financial Officer. We appreciate having the opportunity to review the results for the third quarter 2008. Prior to discussing our 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 leads 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 on our press releases for our annual, quarterly or other filings with the SEC. These forward-looking statements speak only as of today and except as otherwise required by law, Heska does not intend to update any forward-looking statements to reflect events that occur after today. Before I turn the call over to Jason, I want to make a few points. We are very pleased to report increases in both revenue and gross profit on a year-over-year basis. In particular, we’ve reported a 21% increase on Core Companion Animal Health Revenue. Revenue from our DRI-CHEM Veterinary Chemistry Analyzer and associated consumables were a key factor in that growth. As I noted in our last quarter’s call, we are all concerned about the potential effects of the current macroeconomic environment on our business. Historically, it’s been well-documented that Companion Animal’s spending was generally unaffected by economic downturns, but this downturn is looking much more serious than anything we’ve experienced in recent history. We’ve been unable to determine any such effects on our current business with any precision. We do believe that we are experiencing these negative effects, however. We see from third quarter earnings results from our competitors that their results have been softer than would have been expected. In the case of our largest competitors, the 2009 outlook was lowered. As recently as Friday, we have seen an industry consultant’s newsletter describing a soft Companion Animal Health market. Clearly, there is a general anxiety for most of the population that they did commit to significant purchases. For customer, the veterinarian is no different. Beyond this general anxiety, there are also concerns for those customers seeking credit to make capital equipment purchases. This could be important for our line of medical analyzers and in turn, in associated consumables from that install-based. We would like investors to be assured that we are vigilant in our observation on the economic events in our market. We will continue to react appropriately as we manage our business. Beyond these comments on our third quarter performance and the underlying uncertainty in our market, I wanted to address the other release this morning. Mike McGinley has been promoted to the position of President and Chief Operating Officer, effective January 1, 2009. Dr. McGinley is a very talented executive with a long history in the industry, including 11 years of service at Heska. In the most recent timeframe, Dr. McGinley has been serving as Executive Vice President, Global Operation, with full responsibility for operations in Des Moines, Iowa, as well as international responsibility. We believe his background outstanding leadership skills and principal focus on day-to-day operations will be very helpful toward successfully executing on both our current business and future opportunities. This promotion, in turn, allows me more opportunity to focus on our ongoing strategies and potential growth opportunities. I would now like to turn this over to Jason. He will provide detailed information on our financial results and future financial expectations.

[Jason Napolitano:]

Thank you, Bob. In the third quarter of 2008, we generated $21.7 million in total revenue, an increase of 11% from $19.5 million in the third quarter of 2007. For the nine months ended September 30, 2008, we generated $66.2 million in total revenue, up 6% from $62.3 million in the prior year period. In our Core Companion Animal Health segment, we generated $18.9 million in product revenue in the third quarter of 2008. This is a 21% increase from $15.6 million in product revenue in the third quarter of 2007. Increased revenue from sales of our chemistry instruments, our instrument consumables, domestic sales of our Heartworm preventive and our Heartworm diagnostic tests, and our hematology instruments were all key factors in the increase. It is worth noting that we launched our HemaTrue Hematology Analyzer in the third quarter of 2007 and closed that quarter with approximately $756,000 in customer orders, which we did not have the inventory to fulfill as our source supplier did not deliver on the schedule we had anticipated. For the nine months ended September 30, 2008, we generated $53.6 million in Core Companion Animal Health product revenue, a 10% increase from the prior year period. In our Other Vaccines, Pharmaceuticals and Product segment (OVP), we generated $2.4 million in product revenue in the third quarter of 2008. This was a 29% decline from $3.4 million in the third quarter of 2007. Lower sale of our fish vaccines was the primary reason for the decline. This was somewhat offset by an increase in sales of bovine vaccine under our agreement with AgriLabs. We reported on our last earnings call that Aqua Health, a unit of Novartis, had informed us they were taking production of their fish vaccine in-house beginning immediately. This is the first quarter in which we are seeing a year-over-year effect of this decision. We generated $11.6 million in OVP product revenue in the nine months ended September 30, 2008, a decrease of 6% compared to $12.3 million in the prior year period. In the third quarter of 2008, we had research, development and other revenue of $316,000, a decrease of approximately $175,000 from $491,000 in the third quarter of 2007. A key factor in the decline was lower revenue from a service contract related to a worldwide patent portfolio covering a number of major allergens and the genes that encode them, which I will refer to as the Allergopharma Portfolio with the buyer of the Allergopharma Portfolio, which we sold in December 2006. We received our final payment under this contract in the third quarter of 2007. Research, development and other revenue was just over $1 million in the nine months ended September 30, 2008, down approximately $188,000 from the prior year period. Gross margin, that is total gross profit divided by total revenue, was 37.8% in the third quarter of 2008, down from 39% in the third quarter of 2007. The reason for the decline can be best understood by looking at the underlying components of gross margin, product gross margin and other gross margin. Product gross margin, that is gross product on product revenue divided by product revenue, was 37.3% in the third quarter of 2008, down slightly from 37.8% in the third quarter of 2007. Product mix was a key factor in the decline. Other gross margin, that is gross profit on research, development and other revenue divided by research, development and other revenue, was 72.3% in the third quarter of 2008, a decline of over 15 percentage points from 88.2% in the third quarter of 2007. A key factor in the decrease was a higher percentage of revenue generated from sponsored research and development activity, which tends to yield below average margins in the third quarter of 2008 as compared to the third quarter of 2007. For the nine months ended September 30, 2008, gross margin was 37%, down from 42.2% in the prior year period. Selling and marketing expenses were $4.5 million in the three months ended September 30, 2008, a 17% increase from $3.8 million in the prior year period. Key factors in the change were increase expenditures on market research and an increase in personnel. In the third quarter of 2008, research and development expenses declined by approximately $157,000, compared to the prior year period of $506,000. A key factor in the increase was less space at our corporate headquarters being used for research and development activities. In late 2007, we implemented a plan to move and expand space for certain activities within our corporate headquarters, which reduced the space dedicated to research and development activity. General and administrative expenses were $2.1 million in the third quarter of 2006, up 6% compared to $2 million in the prior year period. Year-over-year differences in sales and property tax were factors in the increase. Total operating expenses were $7.1 in the third quarter of 2008, an increase of about 10% compared to the prior year period. Third quarter 2008 income from operations was $1.1 million, down slightly from the third quarter of 2007. For the nine months ended September 30, 2008, total operating expenses were $22.2 million, a 5% increase compared to the prior year period. Income from operations was $2.3 million in the nine months ended September 30, 2008, down over $2.7 million from $5 million in the prior year period. Depreciation and amortization was $2.3 million in the nine months ended September 30, 2008, as compared to $1.4 million in the prior year period. A key factor in the change was greater depreciation for instruments used by our customers on a rental basis and capitalized as property and equipment. Interest in the other expense net was $153,000 in the third quarter of 2008, up $59,000 compared to $94,000 in the third quarter of 2007. There are two components underlying this line item, net interest expense and net foreign currency gain. Net interest expense was $111,000 in the third quarter of 2008, down $3,000 from $114,000 in the prior year period. The change was caused by decreases in the prime rate of interest, which were largely offset by greater borrowings under our revolving line of credit. The large change in this line item year-over-year was caused by foreign currency effects. We experienced a net foreign currency loss of $42,000 in the third quarter of 2008 compared to a net foreign currency gain of $20,000 in the third quarter of 2007, a $62,000 change year-over-year. Current income tax expense was $54,000 in the third quarter of 2008, up $31,000 from $23,000 in the prior year period. The primary reason for the change was recognition of certain state income taxes in the 2008 period. Net operating loss usage and other deferred tax expense was $314,000 in the third quarter of 2008, up $310,000 from $4,000 in the prior year period. The 2000 period contains only foreign net operating loss usage tax expense recognition. At the beginning of this year, we began to recognize domestic net operating loss tax expense as we utilize our domestic net operating loss deferred tax asset. The 2008 period includes both foreign and domestic net operating loss tax expense. The large year-over-year increase is a result of recognizing domestic net operating loss usage in the 2008 period but not the 2007 period. This accounting effect is noted in our press release and we have included pro forma financial information in the press release for investor’s convenience. We expected the year-over-year comparisons will be based on consistent accounting when we begin to report our 2009 results compared to 2008 next year. It is important to remember that net operating loss tax expense is a non-cash accounting consequence only, and that it does not impact the significant potential tax yield we may enjoy from our large net operating loss position. In the third quarter of 2008, total income tax expense was $368,000, up $341,000 from $27,000 in the prior year period. Net income was $577,000 in the third quarter of 2008, a decrease of approximately $435,000 compared to $1 million in the prior year period. Net income was $1 million in the nine months ended September 30, 2008, down $3.4 million as compared to $4.4 million in the prior year period. As we have noted throughout the year, the nine months comparison is particularly difficult due to several situations. I think it is worth reviewing these items as well as other challenges we are currently facing or may face in the future to underscore the reality of doing business as a small company, especially in the uncertain economic environment we face today. The largest year-over-year item we have highlighted in the nine months ended September 30, 2007 is approximately $1.6 million in revenue recognized in the first quarter of 2007 upon receipt of payment for products and “take or pay” minimums as part of our now settled dispute with United Vaccines, Inc. (United), a former customer. As the payment was for product previously shipped and “take or pay” minimums for 2005 and 2006, which previously had not been paid, it was at virtually 100% gross margin. United had been struggling to make its business work and has ceased operation, which contributed to a difficult year-over-year comparison in our OVP segment. The Aqua Health situation is an example of a current challenge we are facing. Just to review, on our last earnings call, we discussed Aqua Health’s decision to take production of their fish vaccines in-house and intent to use us as search capacity only. While the underlying cause is different than United, as we believe the success of the underlying products in the field created a volume level that made sense for Aqua Health that they can have, the result is the same, a difficult comparison. I mentioned we face a difficult comparison this quarter in our OVP segment as a result of this situation and we expect this to continue in the first half 2009. We generated approximately $2.8 million in product revenue from the sale of fish vaccines to Aqua Health in the first half of 2008. While we are always searching for new revenue opportunities, we do not expect to be able to make up to this level of volume this quickly. On the research, development and other revenue line item, I mentioned earlier a service contract related to the Allergopharma Portfolio for which we received our final payment in the third quarter of 2007. This contract provided $250,000 in relatively high gross margin revenue in the nine months ended September 30, 2007, which did not replace in the first nine months of 2008 and have highlighted as the cause for a difficult year-over-year comparison on this line item. A more current challenge related to this line item is some of the sponsored research and development work related to our OVP segment. This is an area of our business in which a third party is providing the initial funding for products and development, which we intend to manufacture at our facility upon the proper regulatory approval. Unfortunately, we have experienced unanticipated regulatory delays in costs in this area. This has not only lowered our gross margins, but it has also delayed the introduction of the products we have hoped to introduce, which may never be approved if the third party is unwilling to provide further funding to complete the necessary work. In our Core Companion Animal Health segment, we have previously discussed the difficult year-over-year comparison caused by the Japanese distribution of our canine heartworm preventive. In the first quarter of 2007, we recognized over $575,000 in sales of this product, which was sold to Novartis for distribution in Japan. This was relatively high gross margin revenue. Novartis subsequently acquired a business with a product competitive to our Heartworm preventive and informed us they would no longer market and distribute our product. We have investigated alternative distribution relationships in Japan, although nothing has come to fruition at this point. Obviously, this presented us with a difficult year-over-year comparison in 2008. A more current situation we are monitoring is in relation to our canine heartworm preventive in the United States, where Schering-Plough Animal Health Corporation (NYSE

[Bob Grieve:]

Thank you, Jason. Well, you know what? The uncertainty is associated with the overall external economic conditions. Now, those conditions may affect our business. We remain enthusiastic to the business opportunities over the long term. We will remain vigilant and adaptable in these uncertain times and, as evidence by the key promotion I described earlier, we intend to continue to build the company for the most effective business execution today, as well as laying the groundwork for future growth. Thanks for your attention today. We appreciate your continued interest and support of Heska. At this time, I would like to turn this over to our moderator for purposes of conducting our Q&A session.

[Operator:]

(Operator instructions) Our first question comes from the line of Kirk Fox with State of Wisconsin Investment. Please go ahead.

[Kirk Fox:]

Hi guys.

[Bob Grieve:]

Hi Kurt.

[Jason Napolitano:]

Hey Kurt.

[Kirk Fox:]

Could you maybe give us update in regards to today’s comments about the new responsibilities of Michael and how yours will change, Bob? Just a little more detail and color.

[Bob Grieve:]

Sure. I think, it intentionally, very damply [ph], and to try and keep it, particularly, in these form, I’ll try and keep this the same. We think about our business as it is growing and it’s increasingly complicated. There are two major areas that we’d emphasized from the first year’s operations, and operational excellence, factorable execution. Secondly, and apart from that, to a large degree is strategy – strategic focus, new business alternatives, growth opportunities, partnerships; and that’s really how we see this segregating. We work together closely over the years. And Mike will then assume, as we indicated, the responsibility more for the operations and tactical side of the business, while I get to renew the focus on strategy and growth.

[Kirk Fox:]

Okay, thanks. And then also maybe, I guess, the products that we have expectations for and what’s happening there with the landscape; and if you could separate our macro environment from the competitive landscape and discuss all those two factors that are affecting non-product sales.

[Bob Grieve:]

Well, again, that’s a large question but I’ll give it a shot. I think, again, that’s – Jason made these comments, but I’ll try and paraphrase some of what he said and then I’ll ask him to embellish a few things I’ve addressed appropriately. In large major critics [ph], it’s very difficult right now to tease apart competitive issues from overall external economic issues. We do believe, as we both indicated that there are – there’s reluctance from the part of customers, there’s an anxiety on the part of customers. And again, when we talk about our customers, we’re talking about veterinarians. We have a dynamic there with the veterinarian that is separate to some large degree, even some of the dynamic of the pet owner. So, much as we discussed a few months ago on the last earnings call, with geographic differences in this economic effect, there’s practice differences within those geographies and how people view the businesses whether they pull back or they more aggressively market. Again, really hard to tease apart competitive issues. I would say it’s quite clear, as Jason mentioned earlier, that our largest competitor is building scale on their chemistry analyzer that they have been talking about launching for a time. I know they’ve created a lot of interest and noise, and I would argue they’ve probably stalled some sales as well. All customers wait to see what this product actually is and how it would compare to our offering. So these are the high level comments that have on the analyzer business. Separately from that, how does our consumable is going to be affected? Clearly, if you don’t have analyzer placements, you don’t have the consumable drive through those placements. Then, I think, separately, if we go beyond the placements and the veterinary customer, if people now are visiting the veterinarian and, whatever proportion of people this is, we aren’t sure, but if they visit a veterinarian and say, “We’d like to basically eliminate all optional considerations and maybe instead of doing a full panel, chemistry panel, maybe let’s just focus on a single test or single product,” and then, maybe a reluctance in the consumer base of the pet owner base to take advantage of what opportunities the veterinarian can actually offer. So, again, no hard concrete evidence in this industry. Those data aren’t readily available, but we need to keep those considerations in mind. And then, finally, we have things like our single-used products, our heartworm diagnostics, as an example, have done really rather well this year. They’ve been strong and competitive, and the benefits and features of health and wellness is the product that’s least likely to be excluded in the pet owner’s consideration or the veterinarian. It’s a product that’s used annually, every year to make sure the dogs are not infected with heartworm before they get heartworm preventive. And so, that’s going to be stuck in this. It’s going to be seen as more essential and in this case, as I said, we’ve done rather well year-to-date.

[Kirk Fox:]

Okay.

[Bob Grieve:]

I hope that’s helpful.

[Kirk Fox:]

It is. Thank you.

[Operator:]

Thank you, sir. (Operator instructions) And at this time, there are no further questions. I’d like to turn it back to Dr. Grieve for any closing remarks.

[Bob Grieve:]

Thank you, Lorray, and again, thank you all for your interest in Heska, and for taking the time to join us today. Goodbye.

[Operator:]

Thank you. Ladies and gentlemen, this does conclude the Heska Corporation third quarter 2008 earnings conference call. Thank you for your participation. You may now disconnect. Have a pleasant day.