IDEXX Laboratories, Inc.

Good morning and welcome to the IDEXX Laboratory's third quarter 2020 earnings conference call. As a reminder, today's conference is being recorded. Participating in the call this morning are Jay Mazelski, President and Chief Executive Officer, Brian McKeon, Chief Financial Officer, and John Ravis, Senior Director, Investor Relations. IDEXX would like to preface the discussion today with a caution regarding foreign booking statements. Listeners are reminded that our discussion during the call will include forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those discussed today. Additional information regarding these risks and uncertainties is available under the forward-looking statements notice in our press release issued this morning, as well as in our periodic filings with the Securities and Exchange Commission, which can be obtained from the SEC or by visiting the investor relations section of our website, IDEX.com. During this call, we will be discussing certain financial measures not prepared in accordance with generally accepted accounting principles or gap. A reconciliation of these non-gap financial measures to the most directly comparable gap measures is provided in our earnings release, which may also be found by visiting the investor relations section of our website. In reviewing our third quarter 2020 results, please note all references to growth, organic growth, constant currency growth, and comparable constant currency growth refer to growth compared to the equivalent period in 2019 unless otherwise noted. To allow broad participation in the Q&A, we ask that each participant limit his or her questions to one with one follow-up as necessary. We appreciate you may have additional questions. Please feel free to get back into the queue, and if time permits, we will take your additional questions. I would now like to turn the call over to Brian McKeon.

Good morning, everyone. IDEXX delivered excellent financial results in the third quarter, reflecting continued strong gains in our CAG business globally. In terms of highlights, revenue increased 19% as reported and 18% organically, supported by 21% organic growth in CAG Diagnostics recurring revenues. CAG Diagnostics recurring revenue growth was high throughout Q3, building on the strong global trends we saw in our CAG business in Q2. For Q3 year-to-date, CAG Diagnostics organic recurring revenue growth increased 12.8%, reflecting the extraordinary global resilience of demand for companion animal health care. Flow-through benefits from high recurring revenue growth drove a 470 basis point improvement in comparable constant currency operating margins in the quarter, enabling delivery of $1.69 in earnings per share, an increase of 47% on a comparable constant currency basis. In Q3, we recorded a $27.5 million or $0.24 per share accrual related to an ongoing litigation matter. Our comparable constant currency operating margin improvement metrics and comparable constant currency EPS growth rates exclude impacts from this charge. For Q3 year-to-date, we delivered EPS of $4.70, up 28% on a comparable constant currency basis, supported by 10% overall organic revenue growth. We continue to be encouraged by robust CAG market trends, and we're planning for strong revenue growth and profit growth in our business moving forward aligned with our long-term goals. However, given ongoing potential dynamics and uncertainty related to the pandemic, we will not be providing specific financial guidance for 2020 and 2021 at this time. As we've done in recent quarters, we'll focus our review on the trends we're seeing in our markets and how we intend to manage our business effectively in this context. Let's begin with a review of our third quarter revenue results and recent market trends. Third quarter organic revenue growth of 18% was driven by 21% organic gains in CAG diagnostics recurring revenues, reflecting 22% organic growth in the U.S. and 19% organic growth in international markets. Strong organic growth was also supported by 18% gains in our LPD business, driven by continued strong growth in Asian markets, as well as by approximately 1% of growth benefit from our OptiHuman COVID-19 PCR test initiative. Overall gains were moderated by constraints on new IDEXX VetLab and diagnostic imaging instrument placements and moderate organic declines in water revenues, though trends on these fronts improved solidly compared to the second quarter. As noted, CAG diagnostic recurring revenue gains sustained at high levels through the third quarter reflected in approximately 24% organic growth in July and growth of approximately 20% combined in August and September. CAG growth dynamics remained healthy across regions in Q3, led by very strong gains in the U.S., and high organic growth in other key markets, such as Canada and Australia, aided by fulfillment of pent-up wellness demand. Revenue growth in Europe and other key Asian markets was also strong in the quarter, reinforcing the broad global recovery in our CAG business. For the year to date, CAG diagnostics recurring revenue growth has increased 13% in the U.S. and 12% overall in international markets. High CAG diagnostics recurring revenue gains continue to be aided by solid growth in clinical visits, as demonstrated in our same-store U.S. weekly tracking data published in our earnings snapshot available on our website. Overall clinical growth sustained at 6% in Q3, supported by continued solid 3% growth in non-wellness visits and 11% growth in wellness visits, including benefits from pent-up demand, which we estimate contributed 2% to 3% to overall clinical visit gains in the quarter. As Jay will discuss, a factor supporting clinical visit gains is an increase in first-time clinical patient visits, which we estimate added approximately 1% to overall clinical visit growth and 2% to wellness visit growth in the quarter. A continued focus on healthcare services supported an 11% same-store increase in overall veterinary clinic revenues in Q3, well ahead of 1% growth in overall visits to veterinary clinics in the quarter. IDAC's growth has been even stronger than these positive market trends, particularly in our core U.S. market, where Q3 CAG-diagnostic recurring revenue gains exceeded 20%. A key metric we follow for the U.S. market is the premium of CAG recurring revenue growth to overall clinical visit growth. In recent years, this metric has increased steadily from a 7.5 percent growth premium in 2016 to a 9 percent premium in 2019, reflecting enhanced commercial capability, program initiatives, and technology we've been advancing to support the development of diagnostic testing. In 2020, we've seen an acceleration of this trend. Year-to-date, the CAG diagnostic growth premium to clinical visits has expanded to 12%, supported by a further acceleration in growth in Q3. These trends reflect an increased focus on services overall at the clinic level, which helped drive growth in average diagnostics revenue per visit to 6% for year-to-date, compared to approximately 4% growth in recent years. These are encouraging trends that we're monitoring closely, and Jay will discuss in more detail. which point to a strong ongoing market growth dynamic for our CAG business. This positive market backdrop supported high Q3 organic gains, revenue gains across our major testing modalities. By modality, IDAC's global reference revenues increased 24% organically in Q3, led by more than 20% growth in the U.S. and mid-teen organic gains in international markets. Relatively higher U.S. gains are aligned with higher levels of wellness testing, which has benefited recently from fulfillment of pent-up testing demand. IDEXX VetLab consumable revenues increased 22 percent on an organic basis, reflecting similar high levels of strong growth in U.S. and international markets. Gains were supported by solid increases in testing utilization across regions, improved very high customer retention levels, and continued expansion of our global premium install base. CAG instrument placements recovered solidly in Q3 as sales access to veterinary clinics gradually increased and clinics look ahead to supporting strong growth in diagnostic testing. While improving from recent trends, overall placements continue to be constrained to a degree by restricted sales access to some clinics as well as near-term clinic work focus on supporting high demand for their services. These factors contributed to a $3 million, or 10%, year-on-year decline in reported CAG instrument revenue for the quarter. The quality of CAG instrument placements remained high, reflected in 303 catalyst placements at new and competitive counts in North America and 860 new and competitive placements in international markets. We also benefited from 372 second catalyst placements driven by momentum with North American customers. These new placements and high customer retention levels supported a 15% year-on-year growth in our global catalyst install base. We also achieved 978 premium hematology placements and 495 set-of-you placements, bringing our global set-of-you install base to over 10,000 instruments of 22% year-on-year. Rapid assay revenue increased 20% organically in Q3, driven by high growth in the U.S., supported by pent-up demand for wellness testing. Q3 year-to-date rapid assay organic revenue growth was 6%, driven by continued solid volume gains for 40X and specialty testing. Overall, CAG diagnostic revenue growth remains primarily volume-driven, with consistent net price gains of 2% to 3%. In other areas of our CAG business, our veterinary software and diagnostic imaging revenues increased 4% organically overall. Double-digit gains in recurring service revenues and strong increases in new software system placements, supported by the fulfillment of outstanding backlog orders, were moderated by lower diagnostic imaging system placements compared to strong prior year levels. Turning to our other business segments, water revenues declined 4% organically in Q3, impacted by pressures on non-compliance related testing, which represents about 20% of water revenues. As noted in our Q2 earnings call, the vast majority of our water testing volumes are compliance related, or mandated by government regulations, and these volumes have sustained as an essential service. We expect uneven demand related to non-compliance testing to persist as we continue to work through pandemic-related impacts. Livestock, poultry, and dairy revenue increased 18% organically in Q3, driven by strong growth in our Asia Pacific region. LPD results continue to benefit from strong demand for diagnostic testing programs for African swine fever, and improvement in core swine testing volumes in China, supported by large producer efforts to rebuild swine herds. We're also seeing continued solid growth for poultry testing globally. These gains more than offset lower herd health screening levels compared to strong prior year results. We expect to see moderation in our LPD growth rate moving forward as we begin to lap the benefits of our prior year expansion of our African swine fever testing programs. Turning to the P&L, profit results were very strong in Q3, benefiting from high CAG diagnostic recurring revenue gains and favorable product mix, as well as continued benefits from proactive cost management. These actions supported a 70 basis point improvement in reported operating margins, or gains of 470 basis points on a comparable constant currency basis, driving an increase in operating profits of 23% on a reported basis and 43% on a comparable constant currency basis. As noted earlier, we recorded a $27.5 million or $0.24 per share charge related to an ongoing litigation matter, which was recorded in G&A and is excluded from our comparable growth metrics. EPS was $1.69 per share, including benefits of $16 million or $0.18 per share, related to share-based compensation activity, bringing year-to-date share compensation-related benefits to a much higher than expected $27 million, or $0.31 per share. As noted, on a comparable constant currency basis, Q3 EPS increased 47%, adjusting for these benefits and the impact of the litigation. Gross profit increased 23% in Q3. Gross margins increased approximately 200 basis points on a on a constant currency basis, reflecting solid productivity improvement in our lab operations, supported by over 20% organic revenue growth, as well as favorable net mixed benefits from strong consumable sales and lower instrument revenues, and benefits from moderate net price gains. Foreign exchange hedge impacts, which are recorded in gross profit, reflected a $1 million loss in Q3 and $3 million of gains year-to-date. Recent FX rates would indicate a modest favorable year-on-year revenue growth rate of impact for Q4 and 2021 with profit benefits mitigated by previously established hedged positions. Operating expenses in Q3 increased 22% on a reported basis and 9% on a comparable constant currency basis, excluding impacts from the litigation accrual. Q3 operating expenses included a $10 million investment related to the funding of the newly established donor advised fund, the IDAX Foundation, which Jay will discuss in his comments. As noted in our last call, aligned with the strong recovery in global CAG demand, we're advancing targeted new hiring and prioritized investments in support of our long-term growth strategy, including augmentation of our international commercial capability. We also expect incremental R&D costs in Q4 as we advance final steps ahead of the ProSite 1 launch and expect employee health care and dental cost claims to increase as individuals seek previously deferred health care. Overall, we anticipate sustaining a relatively higher rate of OPEX growth moving forward as we support our solid growth trends. In terms of cash flow, we've generated $336 million in positive free cash flow year-to-date. On a trailing 12-month basis, our net income to free cash flow conversion rate was 90% or 96% adjusted for our investments in our Westbrook Headquarters expansion and German lab relocation, which are now complete. Our balance sheet is in a very strong position, aided by the exceptional financial performance we saw in P3 and the steps we took to enhance our liquidity and flexibility earlier in the year. We ended the quarter with leverage ratios of 1.2 times gross and 1 times net of cash, with $176 million in cash and no borrowings on our $1 billion revolving credit facility. We did not allocate capital to share repurchases in the quarter. Given our strong business results and positive cash generation and our confidence in the strength of the CAG market recovery, we will be looking at reinitiating share repurchases in the future aligned with maintaining a prudent capital structure. Overall, we're very pleased with the strong momentum and high level of operational execution demonstrated in our business in Q3. IDEX continues to show that we have a great business model in an amazing market with tremendous resilience and long-term growth potential. I'll now turn the call over to Jay for his comments.

Thank you, Brian, and good morning. IDEX delivered exceptional performance in Q3, driven by sustained, strong underlying market trends in our global CAG business. High CAG diagnostics recurring revenue gains were supported in part by pent-up demand for healthcare services. as well as a continued overall shift towards a provision of more veterinary services. These services are often enabled by a higher use and intensity of diagnostics. Delivering excellent patient care is the key value proposition of veterinarians, and to treat, they must first diagnose. Proprietary IDEXX diagnostics plays an important role in this paradigm. We've continued to see a clear V-shaped recovery in companion animal health care. And these trends point toward a potential sustained level of accelerated growth for diagnostics testing. Let me start with a brief update on our market trends, including observations on how our customers are adapting and review the exceptional execution of our commercial organization in engaging and supporting them. As Brian noted, we've seen solid growth in same-store clinical visits in key markets like the U.S., as well as sustained strong recovery in clinic demand across our international markets. A factor supporting these results has been pent-up demand for pet healthcare, evidenced by 11% growth in wellness visits in Q3. We've begun to see some moderation in these very high growth levels, while non-wellness visits, which we estimate account for approximately 60% of overall clinical visits, and approximately 70% or more of related diagnostic revenues continue to expand at a healthy 3% rate. Many pet owners, just like a significant number of IDEXX employees, continue to work from home and are spending significantly more time with their pets. We're likely more attuned to their well-being, resulting in higher practice visits. These trends further reinforce the strong global recovery and health of our markets. As we work through the market recovery, Additional factors are emerging, which have supported very high growth levels in CAG diagnostics recurring revenues. Veterinary clinics appear to be increasing their standard of care at an accelerated pace. Evidence of this can be seen in the average percentage of US clinical visits that use diagnostics. This averaged approximately 45% in Q3 of 2019. While in Q3 of 2020, this metric was approximately 200 basis points higher. To put this higher step up in context, an average 50 basis point per year increase was more typical in recent years. Not only do more visits include diagnostics, but the intensity, as measured by revenue, has also increased. Growth in average diagnostics revenue per visit in the U.S. has increased to approximately 6% year-to-date, compared to 4% growth in recent years. Pandemic workflow procedures like curbside drop-off and the desire to take a more comprehensive healthcare approach may be supporting these promising trends. Diagnostic revenue growth per practice continues to expand as a result of these factors. U.S. companion animal diagnostics revenue growth per practice increased 10.5% in 2020 compared to approximately 7.5% over the last five years. This is despite a slowing of clinical visits due to the pandemic to 1% year to date compared to a five-year average of 3%. Our expanded commercial presence and focus on supporting the vet practice with innovative technology and insight for practice development continues to drive these favorable dynamics at a steadily improving rate. While we may see some moderation in these trends moving forward, These healthy dynamics reinforce a potential long-term positive backdrop for diagnostics market growth. Increases in the use of diagnostics speak to the willingness of pet owners to prioritize care for the health and well-being of their family members, even during times of economic uncertainty. It also reinforces the increasing role of services in the vet clinic business model. reflected in an accelerated shift in diagnostics as a percentage of practice revenues. U.S. diagnostic revenues as a percentage of total practice revenue reached 16.3% in Q3, approximately 100 basis points above prior year levels, and compared to an average 25 basis point increase in recent years. For vet clinics, diagnostic services are one of the most profitable areas in the practice. And these trends can help mitigate the impacts of accelerated migration of product sales to online channels. An additional emerging factor that appears to be supporting higher service and diagnostics growth is an increase in first-time clinical patients. Anecdotally, we've all seen and heard about increased interest in adopting puppies and kittens during the pandemic. Well, this is a difficult area to measure. we are seeing a meaningful increase in first-time clinical visits in our market tracking data. Year-on-year growth in first-time clinical visits measured through our U.S. practice intelligence database has increased an average of 8% year-to-date, with accelerated growth since April, compared to approximately 2% year-on-year growth in recent years. As Brian noted, we estimate that incremental new patient growth added approximately 1% to clinical visit growth in Q3 overall. In our own business, we've seen a meaningful step up in the number of US hospitals running progesterone tests and average run levels, reinforcing a potential increase in breeding activity. While it's early to project the potential impact from these trends, evidence is emerging that there's an accelerated increase in growth in the US pet population. While we recognize the potential for future business disruption related to the pandemic, these very encouraging trends are reinforcing our confidence in the long-term potential for our CAG business. Our commercial organization is at the center of enabling this market development. So next, I will highlight key developments in our commercial agenda. Our commercial execution in Q3 was excellent. We saw solid continued recovery in instrument placements in North America and in international regions, with 3,173 premium instrument placements globally in a quarter, including 1,700 catalyst placements, with close to 70% in new and competitive accounts. Access to practices continue to improve through Q3, with in-person visits by our customer account managers now at approximately 50% in-person in the U.S. and approximately 60% in Q3 on average in Europe. While underlying market demand for diagnostics has remained strong, we expect that sales professionals' access to veterinary clinics will likely continue to be pressured as social distancing policies and measures to combat the spread of COVID-19 remain dynamic and continue to impact veterinary care. As highlighted during Investor Day, a key multi-year strategy is to scale our commercial footprint on a rolling basis in targeted international markets. These expansion efforts reflect a tremendous opportunity as two-thirds of the potential total addressable market over time will be outside the U.S. Leveraging the commercial playbook of best practices we developed through multiple expansions in the U.S., our international expansion roadmap is tracking a plan. In Q3, we successfully launched programmatic efforts to essentially double our commercial footprint in two important European markets over the coming months. We expect to continue to make great progress on these initiatives through the remainder of the year, with all talent hired, trained, and onboarded by the first half of 2021. These efforts complement the strong commercial momentum resulting from investments made over the past several years in Europe. For example, our newly opened and now our largest reference lab in the world in Chord, Westheim, Germany, is fully functional in providing differentiated menu, and excellent service levels across Europe. Additionally, hematology is a very important modality internationally, and the announcement of ProSite 1 has been enthusiastically received by customers. Finally, customers across Europe have embraced our IDEXX 360 program, which was configured to the unique needs of key markets in the region, with over 50% of premium instruments placed in the quarter using IDEXX 360, a new high. The combination of innovations like ProSite 1, Coren Westheim and IDEXX 360, coupled with an expanded commercial footprint in select countries, are key elements of our growth strategy. Growing enrollment and engagement in the IDEXX Preventive Care Program is a key focus for our commercial and corporate accounts team in the second half of the year. Program results recovered in Q3 with strong adoption of the IDEXX Preventive Care Program, with approximately 230 new enrollees in a quarter. supported by sustained high wellness visits traffic. This brings our total enrolled practice level to over 4500. Enrollments in the program approached pre-COVID levels in the latter part of the quarter, which is evidence that customers continue to embrace the IDEXX preventive care approach and consider it a foundational element of their care offering as they look to uncover more with IDEXX proprietary diagnostics. Another prioritized area of ongoing focus is supporting customers with integrated solutions that support practice productivity and best medicine. A great example of this is our new hematology analyzer, ProSite1, recently launched for presale. Both our commercial teams, which were trained last month, and customers are very excited by the performance, usability, and cost profile of the analyzer. We are making solid progress with field trials. with approximately 20 units at customer sites and more to follow over the next month. Customer use feedback in a live environment is part of our time-tested approach to ensure that we only ship when the solution is ready to support patient care in the most demanding and varied practice environments. We plan to begin shipping in Q1 with a gradual build in placements over the balance of the year. Expanding our premium installed base is a long-term objective for IDEXX. with approximately 200,000 opportunities for placements globally, including almost 100,000 hematology placements, encompassing competitive, greenfield, and upgrades for current customers with legacy analyzers. ProSite 1 enables us to access a much broader part of the marketplace, as it's packed with the latest technology and simplicity, facilitating efficiency at the practice and trusted reference lab quality results. It also has affordable economics, including paper-run billing and inventory replenishment. From a clinical perspective, chemistry and hematology complement each other to provide a forward clinical patient profile. Coupled with our Catalyst One chemistry platform with a growing menu of eight new tests in eight years, ProSite One is yet another proof point of our commitment to bring comprehensive reference lab quality blood analysis to the point of care through solutions that are both suited to small and large practices globally. And with our comprehensive program, IDEXX 360, we make access to advanced diagnostics easy and hassle-free for customers with no upfront equipment costs. We have, over the last year, expanded IDEXX 360 to offer programs with flexible early year commitments for new practice formations. This has been extremely well received by these practices. and enables us to grow with them from their earliest days. We also continue to see positive customer experience and adoption of our innovations and product initiatives introduced at VMX in January. A great case in point is our digital cytology service offering. Our first customer satisfaction survey scores were best in class. Customers are delighted with the under two hours, 24 by 7 results promise we consistently deliver on. Moreover, we make reference lab services ordering and results viewing easy and convenient for our customers with our VetConnect Plus diagnostic results portal, and more recently with IDEC's reference lab data on IVLS. IVLS was formerly used by customers just with our point of care in-clinic suite, but now approximately 2,700 customers are already taking advantage of this new IVLS functionality for reference lab results too. As noted on our last earnings call, our CityView Advanced Bacteria Detection Kit started to ship in April, and over half our North American customers have used the Advanced Bacteria Kit to date. Detecting bacteria in urine is a key driver of clinical value, and we are confident that this enhanced capability will drive even greater appreciation of our CityView platform. Our IDEXX Urinalysis Anywhere strategy further differentiates us by offering customer solutions that are unique providing customer flexibility to test at the practice or our lab with seamless order integration and unified pricing. Our customers' value, our holistic customer-centric approach like your analysis anywhere. And we see that appreciation reflected in very high customer retention rates. Moving on to our veterinary software services and diagnostic imaging businesses. We saw strong new software system placements in Q3. supported by the hard work of our commercial organization and the healthy pipeline they built earlier in the year, with 35% growth year-over-year in new PIMS placements globally, including on-premise and cloud systems. Although diagnostic imaging new system placements decreased year-over-year, as access to veterinary practices was pressured by COVID-19, our customers are excited about the ImageView DR30, our new digital imaging system we announced in August. The DR30, along with our other imaging products, offers the most advanced digital imaging technology in the market with software capabilities that provides streamlined workflow and efficiency at the practice. The continued growth of our software and digital imaging systems install base and subscription customers for cloud solutions are driving strong double-digit growth in our recurring service revenues. As we advance our commercial capabilities, We're also advancing our commitment to the positive impact we make in the communities we serve. Today I'm excited to share that we have established an IDEXX Foundation, a donor advised charitable fund with a contribution of $10 million to support activities aligned with our purpose to enhance the health and well-being of pets, people, and livestock. As part of IDEXX's overall corporate responsibility efforts, IDAX has invested for decades in organizations and initiatives aligned with our purpose and guiding principles. The IDAX Foundation will complement our ongoing local partnerships while also broadening our geographic reach and social impact. The IDAX Foundation's priorities will be on long-term outcomes-focused investments in areas such as supporting education in the veterinary and STEM fields, including diversity, equity, and inclusion in animal health care. We're excited about this important step in support of our purpose and mission. The health and safety of our workforce and their families and our communities also continues to be a top priority for us. The majority of IDEX employees continue to work remotely, and as travel remains limited, employees leverage virtual technology to stay connected and engaged from their home offices. Our on-site teams continue to execute at very high levels to support exceptional market demands. while maintaining important health and safety procedures. Overall, we're excited about the strong continued market performance and resilience in animal health, and more specifically, in our category. We're positioning ourselves to support continued strong growth aligned with our long-term potential and financial goals. This means continued investment in innovative solutions that solve the most challenging problems faced by veterinarians. and the expanded commercial capability to bring these innovations to new and existing customers and markets. While the resilience of our industry, and IDEX's business in particular, is extraordinary, the situation remains dynamic. We will continue to monitor closely the pandemic's impact on consumers and pet owners and react appropriately. Lastly, I would like to take the opportunity to thank both our employees and customers for their resilience and perseverance during economic uncertainties, and new challenging workplace and employee safety requirements. I'm extremely proud of what we've accomplished together in the last two quarters and look forward to the journey still before us. And that concludes my opening remarks. We now have time for some questions.