Heska Corp (HSKA) 2008 Q3 法說會逐字稿

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.

Thank you all for joining us today for our conference call. I am joined today by Jason Napolitano, our Chief Financial Officer. We appreciate having the opportunity to review the results from 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 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 our press releases, on 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 in 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 has been well documented that companion animal spending was generally unaffected by economic downturn. 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, and in the case of our largest competitor the 2009 outlook was lowered.

As recently as Friday, we've seen an industry consultant's newsletter describing a soft companion animal health market. Clearly there is a general anxiety for most of the population today to commit to significant purchases. For customers, the veterinarian is no different. Beyond this general anxiety there also are concerns for those customers seeking credit to make capital equipment purchases. This could be important for our line of medical analyzers and in turn the associated consumables from that installed base.

We would like investors to be assured that we are vigilant in our observation on economic events in our market, and 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 McGinely has been promoted to 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 time frame Dr. McGinley has been serving as executive vice president, global operations 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.

His promotion in turn allows me more opportunity to focus on our ongoing strategies with 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.

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 supplier (technical difficulty) 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 products segment or 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 sales of our fish vaccines was the primary reason for the decline.

This was somewhat offset by an increase in sales of bovine vaccines 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 vaccines in-house beginning immediately. This is the first quarter in which we are seeing the 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. (technical difficulty) in the prior year period go. 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 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 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 (technical difficulty) 37%, down from 42.2% in the prior year period go.

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. These factors in the change were (technical difficulty) 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 to $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 the 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 difference sales and property tax were factors in the increase. Total operating expenses were $7.1 million from 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 (technical difficulty) 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 and other expense net was $153,000 in the third quarter 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 $3000 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 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.

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've included pro forma financial (technical difficulty) in the press release for investor's convenience. We expect 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 shield 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 product and a take or pay minimums as part of a now settled dispute with United Vaccines Inc., or 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 have 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 to take in-house, 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 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 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 in development, which we intend to manufacture at our facility upon the proper regulatory approval. Unfortunately, we've experienced unanticipated regulatory delays and costs in this area. This has not only lowered our gross margin, but it has also delayed the introduction of products we 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've 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 (technical difficulty) a product competitive to our heartworm preventive and informed us they would no longer market and distribute our product. We've 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 with Schering-Plough Animal Health Corporation, or SPA, as exclusive distribution and marketing rights. We believe a unit of SPA has obtained FDA approval for canine heartworm preventive product with additional claims compared with our canine heartworm preventive product.

Should SPA decide (technical difficulty) a sales and marketing efforts of this product rather than our product or cancel our distribution and marketing agreement in this area, our sales could decline significantly. SPA has informed us of no such decision, and we have firm purchase orders for the near future from SPA. By contract SPA is required to give us firm purchase orders at least 120 days prior to requested delivery. Unfortunately, SPA has informed us they would like January delivery of a purchase order we had hoped to ship prior to year end, which will lower our expected fourth-quarter revenue in this area. We have built this into our guidance expectations I will discuss later.

Another area of recent challenge has been the placement rates of our recently launched chemistry instrument, the DRI-CHEM. Replacements have significantly lagged our expectations throughout the year. Ironically, this product has been a consistent growth driver in 2008 and our 2008 DRI-CHEM placements may still exceed the best calendar year placement of any of our previous chemistry offerings.

However, our expectations for this analyzer were higher than that as we believe this product had significant advantages over any other chemistry instrument we have historically sold. It seems clear now that some combination of the product itself, the efforts of our largest competitor who is in the process of producing commercial quantities of a new chemistry unit of their own and overall economic conditions are contributing to the shortfall versus our expectations. We cannot say with any precision how much to weigh any given factor.

We can say we have been disappointed with recent DRI-CHEM placement activity and our expectations for fourth-quarter placements and affiliated high-margin consumable sales have declined significantly from recent estimates. I will obviously include this in the guidance I will discuss later in the call.

Finally, we have been working on a large international distribution deal for certain of our products. We felt an agreement was highly likely and even decided not to open our trading window for senior executives and our board after our last earnings call because we felt an agreement was pending. Citing concerns regarding the global credit crisis reported in the media, the other side proposed a contract differing materially from our term sheet. We will not accept the deal they have proposed.

While it is possible we may be able to come to an agreement in the future, we think this is unlikely. Of course, the consequence of not signing this agreement is that we will not have the affiliated orders we had anticipated prior to year end. Again, I will build this into the guidance I will discuss later in the call.

We've also seen an impact from recent news reports of a global credit crisis with our direct customers. Perhaps it should not be surprising that capital equipment sales would be affected in such an environment. Capital expenditures are generally a fairly easy item for the short-term. Many veterinarians may see little downside in deferring a purchase until they perceive the economy to be stronger and are more confident they will have the customer flow to justify their investment. Undoubtedly, access to credit is an issue for some.

In any case, the anecdotal evidence is strong that veterinarians are concerned about the effect of the credit crisis and are conservatively adjusting their behavior. Obviously (technical difficulty) to any forecast will rely on the duration and depth of any such behavior change. This is a major unknown. Investors should weigh when considering the guidance I will discuss in a moment.

We closed the books for October late last week and were disappointed with the results. As we consider these results in the near-term outlook for our business, we turn to our financial covenants, which are required conditions to have access to borrowing under our credit and security agreement with Wells Fargo to fund our operations. Do not expect we will be able to comply with all financial covenants through the end of 2008 under our credit and security agreement with Wells Fargo, and we have informed Wells Fargo of this.

We consider our relationship with Wells Fargo to be good and believe we will be able to negotiate a waiver and new covenants with Wells Fargo. In the past we have always been able to negotiate wavers of noncompliance with Wells Fargo when necessary. Despite (technical difficulty) publicity of a global credit crisis, we've also had other banks pursuing our banking business aggressively. Of course, we can't guarantee any (technical difficulty) lend to us or that we will be able to negotiate any modification to our existing agreement with Wells Fargo. Equity investors should take this into account.

I think it is worth noting, however, that we face this situation in a stronger position than we have faced similar situations in the past. At this point we face an operating covenant problem, not a capital problem. At September 30, 2008 we had $4.2 million in borrowing capacity based upon eligible accounts receivable and eligible inventory. When our 10-Q is published later today investors will see our cash provided by operating activities in the nine months ended September 30, 2008 was $4.3 million, up from $2 million in the prior year period. We experienced a $3.1 million increase in cash provided by inventory on a period over period basis, and actually provided net cash of $823,000 in cash from inventory in the nine months ended September 30, 2008.

While this number is obviously subject to timing issues and should not be used as a predictor of future events, it is a far cry from where we have historically been when we had trouble complying with financial covenants. Before I turn to guidance, I think it is appropriate to once again discuss the subject (technical difficulty). We received a (technical difficulty) from NASDAQ informing us that we did not comply with the $1 minimum bid price requirement for continued NASDAQ listing. In the same communication NASDAQ informed us that given the recent turmoil in the US and world financial markets they were suspending enforcement of the minimum bid price requirement until January 19, 2009.

We will be afforded a 180 calendar day compliance period after that date or until July 20, 2009 to regain compliance with the minimum bid price which requires our stock to have a minimum closing bid price of $1 or more for at least 10 consecutive trading days. If we cannot (technical difficulty) compliance by July 20, 2009 NASDAQ rules allow us an additional 180 day compliance period assuming we meet the other initial listing criteria for the NASDAQ capital market. We believe we currently meet these criteria and will as of July 20, 2009, so expect to have until early 2010 to regain compliance.

If we reach that point and still have not regained compliance, we could pursue a reverse stock split to regain compliance with the minimum bid price requirement. I think it is worth noting that we have faced the listing twice since 2002 and regained full compliance with NASDAQ rules in both cases without a reverse stock split. The strategy then was the same as it is now, demonstrate business success over time and grow the stock price organically.

The last time we faced delisting our board concluded we should use the full benefit of the compliance period granted by NASDAQ and then request a hearing to inform NASDAQ of our intent to pursue a reverse stock split if we fail to regain compliance. I imagine this would be our approach this time, although this is obviously a board decision.

When considering guidance I think it is worth noting that our business is difficult to project in general as I think our historical guidance this year indicates. However, the recent economic uncertainty amplifies this difficulty significantly. The depth and length of any economic slowdown and/or change in customer behavior may be a major factor in the (technical difficulty) and will be highly difficult to estimate with any certainty. This increasingly becomes problematic as the time periods we are considering reach further into the future. Investors should take this into account when considering our guidance and calibrate accordingly.

For the fourth quarter of 2008 we are guiding investors to roughly a 10% decline in Core Companion Animal Health product revenue, $1.6 million (technical difficulty) in OVP product revenue and $275,000 in research development and other revenue. These numbers add to approximately $17.25 million in total revenue for the quarter. I note that $1.6 million in product revenue will be the lowest revenue quarter in this segment in over five years, and we expect corresponding gross margin pressure due to the relatively low unit volume absorbing overhead costs (technical difficulty) our facility in Des Moines. We anticipate gross margin for the quarter to be between 31% and 32% and approximately $6.75 million in operating expenses.

We expect net interest and other expense of approximately $175,000 and an income tax benefit of $600,000 to $650,000. On the bottom line we are expecting a net loss of approximately $850,000 to $900,000 in the fourth quarter of 2008.

Guidance for the full year is essentially an exercise in adding fourth-quarter guidance to the nine month results. Doing so we obtain a resulting guidance for 2009 of over $83 million in total revenue. Gross margin of about 36%, about $29 million in operating expenses, (technical difficulty) $675,000 in net interest and other expense and $100,000 to $150,000 in income tax expense. On the bottom line our guidance is for net income in the $150,000 range for 2008.

We are aware of the challenges we face, with the caveats discussed earlier we expect 2009 will be better than 2008, although our current expectation is that we will generate a net loss in the first six months of 2009 and net income in the second half of the year. We have not completed our budget process for 2009 we will have no further comment on our outlook for 2009 at this time.

We are also aware of the volatility outlook and the corollary that we may have to adjust our plans accordingly. While we are clearly living in difficult times, we have faced difficult circumstances which were far more daunting in the past, and have managed through them to continue to move this business forward. That is what we intend to do now. We remain excited about the long-term prospects for our company. With that, I will turn it back over to you, Bob.

Thank you, Jason. While we acknowledge the uncertainty associated with the overall external economic conditions and how 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 evidenced by the key promotion I described earlier, we intend to continue to build the company for the most effective execution today as well as laying the groundwork for future growth.

Thanks for your participation today. We appreciate your continued interest in support of Heska. At this time I would like to turn things over to our moderator for purposes of conducting our Q&A session.

(Operator Instructions) Kirk Fox, State of Wisconsin Investment.

Could you maybe give us an 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?

Sure. I think essentially (technical difficulty) and to try to keep it particularly in this forum I will try to keep this succinct. We think about our business as we are growing and increasingly complicated. There are two major areas that we would emphasize in the first case operations and operational excellence, tactical execution. Secondly, and apart from that to a large degree is strategy, strategic focus, new business alternatives, growth opportunities, partnerships, and that is really how we see this segregating. We've worked 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.

Okay, thanks. And then also maybe I guess the products that we have expectations for and what is happening there with the landscape; and if you could separate out kind of the macro environment from the competitive landscape and discuss how those two factors are affecting product sales.

Again, that's a large question or, but I will give it a shot. I think again that Jason made these comments, but I will try and paraphrase them of what he said and then I'll ask him to embellish if he thinks I've addressed it appropriately. It is in large measure very difficult right now to tease apart competitive issues from overall external economic issues. We do believe, as we both indicated, that there are as a reluctance on the part of customers; there is an anxiety on the part of customers. And again, when we talk about our customers we are talking about veterinarians. We have a dynamic there with a veterinarian that is separate to some large degree even from the dynamic of the pet owner.

So much as we discussed a few months ago in the last earnings call, was geographic differences in this economic effect, as practice differences within those geographies and how people view the businesses, whether they (technical difficulty) more aggressive (technical difficulty) again really hard to tease apart the issues. I would say it is 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.

They created a lot of interest and noise and I would argue they've probably stalled some sales, as well while customers wait and see what this product actually is and how it will compare to our offering. So these are sort of the high-level comments that have in the analyzer business. Separately from that, how does consumable, our consumables 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 from if we go beyond the placements and the veterinary customer the people now are visiting the veterinarian in whatever proportion of people this is, which we aren't sure, but if they are visiting a veterinarian and say we would 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 product. And there may be a reluctance in the consumer base or the pet owner base to take advantage of what opportunities a veterinarian can actually offer.

So again, no hard concrete evidence; in this industry those sorts of data aren't readily available, but we need to keep those considerations in mind. And then finally with things like our single use 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 have held up well and this is the sort of product that is least likely to be excluded in a pet owner's consideration or the veterinarians. It is a product that is used annually every year to make sure the dog is not infected with heartworm before (technical difficulty) heartworm preventive. And so that is going to be something that is going to be seen as more essential. In this case as I said, we've done rather well year to date.

Okay.

I hope that's helpful.

It is. Thank you.

(Operator Instructions) At this time there are no further questions. I would like to turn it back to Dr. Grieve for any closing remarks.

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

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.