Heska Corp (HSKA) 2017 Q3 法說會逐字稿

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

Hello, and welcome to Heska Corporation's earnings call for the third quarter of 2017. I am Brett Maas of Hayden IR, Heska's investor relations firm. Prior to discussing Heska Corporation's third 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 and involve known and unknown risks and uncertainties, which may cause actual results and performance to be materially different from that expressed or implied by those forward-looking statements. Factors that could cause or contribute to such differences are detailed in writing in places including Heska Corporation's annual and quarterly filings with the SEC. Any forward-looking statements speak only as of the time they are made and Heska does not intend 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; and John McMahon, Heska's Chief Financial Officer; and Jason Napolitano, Heska's Chief Operating Officer and Strategist. Following management's comments, we'll open the call for your questions followed by Mr. Wilson's closing comments. Now I will turn the call over to Kevin Wilson, Heska's Chief Executive Officer and President. Kevin, floor is yours.

Thanks, Brett, and good morning, everyone. Today, we report our third quarter that shows continued strong execution in the core of our playbook, including 16% growth in our largest and key business of blood diagnostic subscriptions. Consolidated gross margin expansion of 210 basis points to 43.1%, strong market share gains and nice growth in our cash provided from operations, which is outstripped all of 2016 in just the first 3 quarters of the year. This strong core execution was offset by delayed and otherwise missed shots on goal in our smaller imaging and heartworm business lines, both of which I see becoming positives in 2018.

I have to go back to May of 2015 for a period report to investors that was below my personal goal. After that call, Heska then delivered on 8 above-expectation quarters that were powered by then unseen benefits from early-stage initiatives. The third quarter of 2017 feels much the same to me. Like in early 2015, I'm highly confident in the growth prospects of Heska. And I hope thoughtful and long-term investors see what I see and may seize upon attractive entry points into Heska as they present themselves. For our part, Heska teams continue our good work on our clear path in our growing space, with the focus and the competitive intensity required to win.

Now I'll turn the call over to John McMahon to go through the details of the quarter and update you on the outlook for the balance of the year. Following John's comments, I'll provide additional insight into our plans and operations in this week's major new Element COAG analyzer launch and Heska's big win in the corporate accounts area with PetVetCare Centers. Then we'll open the call to answer your questions. John?

Thanks, Kevin, and good morning, everyone. For the third quarter of 2017, we recorded revenue of $31.4 million, a 6% decline over $33.4 million in the third quarter of 2016. On a year-to-date basis, revenue was up 6% to $96.1 million as compared to $90.5 million after 3 quarters a year ago. Revenue for the Core Companion Animal Health segment, or CCA, was up slightly at $26.7 million as compared to $26.4 million in the third quarter last year. CCA revenue was comprised of blood diagnostic instruments and consumables, single-use pharmaceuticals, vaccines and diagnostic tests, which we refer to as PVD and sales of digital imaging products.

Revenue from our key core blood diagnostics continues to grow strongly, rising 16% in the quarter and 23% year-to-date. We continue to grow in net placements and gain market share in a very competitive space with our 6-year reset subscription. With over 80% of installed placements under our unique multi-year resets subscriptions and nearly 100% of new placements occurring under a 6-year initial term, we are encouraged that each new placement into a new address represents us a secure and long-term gain in market share. We continue to see strength and competitive wins in blood diagnostics, and we anticipate these trends continuing into Q4 and throughout 2018. Partially offsetting the strong core blood diagnostics growth in our CCA segment was PVD and imaging sales. We've been experiencing over 20% declines in heartworm in our PPD sales since 2013, as we made the decision to deemphasize the products because of low margin. We see those declines turning into growth in the first half of 2018 with our upcoming reformulation and relaunch of heartworm supported by substantially lower cost and higher performance and competitiveness.

While we had expected these reformulation benefits to hit in the second half of this year, we now expect them in the first half of 2018. In Q3 of 2017, global imaging revenue declined 27% compared to the prior year due to 4 factors. First, we were up against very strong 2016 comparables. Second, we had to integrate the wholly owned imaging business systems into Heska, which limited resources to focus on the business and delayed cost-saving opportunities, both of which we expect to see in 2018. Thirdly, the impact of the shift of rental revenue recognition in 2017 compared to upfront capital equipment recognition in 2016 for sum of this year's placements. And fourth, broad-based imaging softness prior to the upcoming fourth quarter's particularly strong new products release cycle that Kevin will detail later in the call. Impending new releases cause some customers to delay purchases, and because of this, the third quarter ended with more unclosed and in-process imaging contracts than we had hoped, leaving us $1 million short on revenues for the period. The upside is that we entered the fourth quarter with a strong pipeline of ready-to-close sales. We believe all 4 of these factors have run off as we enter the fourth quarter and we expect imaging to close the year on an upswing and to return to growth in 2018, aided by a very strong new product addition in the fourth quarter of this year.

Turning to our other vaccines and pharmaceutical segment, or OVP, after a front-half loaded start to the year that yielded 42% growth, we expected OVP revenue in Q3 to substantially moderate. As anticipated, OVP revenue dropped to $4.8 million from $7 million in the third quarter of 2016.

Of note, about $1 million of this revenue reduction was order shift as customers moved schedules from Q3 to Q4. We expect OVP to finish the year well and to achieve its expected mid-single-digit growth for the full year. Our gross margin improved in Q3 to 43.1% as compared to 41% in the third quarter of 2016. The improved margin was a result of beneficial product mix from a larger portion of overall revenue for the quarter in higher margin blood diagnostic sales, which, as we mentioned, grew 16% in the period. As growth in our blood diagnostics business continues to outpace growth in our lower margin product lines, overall gross margin will take a bit higher. It is instructed to note that long-term trends and product mix between our CCA segment and OVP segment has for some time now seen mix favoring the higher margin CCA segment. To illustrate, in 2015, OVP was 19% of consolidated revenues. In 2016, it was 17%. And we anticipate this year, it will be 15% and potentially lower in 2018, as CCA continues its much faster growth off of a much larger base. The result of this trend is that we anticipate continued year-over-year improvement in our consolidated margins over the next couple of years if the trend continues.

Total operating expenses on a year-over-year basis grew 6% to $9.8 million from $9.2 million, driven by 3 expense areas. The first was related to work on new product and business development projects. The second was for expenses surrounding implementation of the new revenue recognition standard that will go into effect in 2018. And the third is our expansion and headcount. This year, we have expanded our team member count by 9% to enhance our sales efforts and operation capabilities for anticipated growth in 2018.

For context, headcount was up just 1% in 2014, 4% in 2015 and only 2% in 2016. We believe our 2017 investments and the capabilities of our team will yield results in 2018. Quarterly operating income was $3.8 million compared to $4.5 million in the third quarter of 2016, a 16% decline on a year-over-year basis. However, year-to-date operating income has risen 11% to $11.1 million compared to $10 million for the first 9 months of last year.

Depreciation and amortization was $1.1 million in Q3 of this year and $1.2 million in Q3 of last year. And stock-based compensation was $0.7 million this quarter compared to $0.4 million in Q3 last year, and that's due to the initiation of a new long-term incentive plan for key nonexecutive managers and customer-facing leaders. This new plan closely ties their performance to success in long-term meaningful operational initiatives and to important growth and stakeholder aligned metrics, like, stock price, stock-out performance relative to indices, total revenue and income.

Our effective tax rate for the quarter was 18.5%. As in previous quarters, our tax rates have been impacted by discrete tax benefits related to stock-based compensation. We received approximately $1.5 million of these discrete tax benefits in Q3, which were partially offset by evaluation allowance of $1.3 million, against future use of our deferred tax assets after realizing the current tax benefit. We will continue to closely monitor these tax items in each subsequent period.

Net income attributable to Heska Corporation for the quarter was $3.1 million or $0.40 per diluted share as compared to $3.3 million or $0.45 per diluted share that was generated in the third quarter of 2016.

On a year-to-date basis, net income attributable to Heska Corporation was up close to 50% to $11 million or $1.45 per diluted share as compared to $7.1 million or $0.97 per diluted share in the first 9 months last year. This is slightly ahead of our internal expectations, leading us to tighten increase the mid-way point of our outlook for the year. For the full year 2017, we see revenues rising to between $137 million and $139 million, which is lower than our estimate earlier this year of $140 million to $144 million due to softness in imaging sales and the delay in the first half of 2018 of our heartworm lateral flow test reformulation and relaunch, which we have, until recently, expected late in Q4. And driven by strong growth in key core blood diagnostics and healthy margins, we see diluted earnings per share rising 41% to 44% to between $2.02 and $2.06 per share, up from $2 to $2.05 original estimate from earlier this year.

With that, I'll turn the call back over to Kevin.

Thanks, John. Through the third quarter of 2017, as John noted, imaging has dragged on Core Companion Animal results as we have worked to integrate it into Heska's systems, which has taken additional time and incurred some cost duplication. At the same time, revenue softness has been exacerbated by our reinitialized rental recognition for some placements and profitability has been impacted by increased expenses for substantial new product development. This cycle is now largely complete, and Heska Imaging is on a solid footing for return to growth and better profitability in 2018, aided by identified savings in Heska Imaging's most exciting product release cycle in years. To kick things off, we will release our new Slate Hub at the American Association of Equine Practitioners Conference in San Antonio on November 17. Slate Hub is 100% unique in addressing customer demands to consolidate multiple portable imaging consults, peripherals, databases and power management needs into one expandable device. Slate hub is a fully wireless, battery-powered, multi-modality imaging hub that saves space, time and money for mobile veterinarians by unifying digital radiography, wireless ultrasound, equine dental digital radiography, endoscopy and Element POC blood diagnostics into a single device that performs and stores a full lifetime of results in each patient's medical record.

Pricing begins at $56,000, which is similar to older single-purpose digital radiography devices. Because Slate hub is a multi-modality imaging platform, it supports new product line extensions that were previously impossible. As mobile veterinarian seek to add new modalities to their general digital radiography capabilities, Slate hub makes it easy to partner with Heska Imaging for all of their, by adding on 1 or more Heska's worldwide exclusive accessory products for Slate hub. One such line extension is our new and exclusive [Sono] Slate wireless ultrasound, which is the market's first and only high-resolution, wireless, battery-powered ultrasound that can be operated, viewed and stored on Slate hub. Sono Slate wireless ultrasound eliminates the multiple cables, power chargers, cases and control console of stand-alone ultrasound models. Sono Slate is available for order on November 17 for $6,500 when purchased with a new Slate hub and for $10,000 when purchased separately. Also, on November 17, Heska Imaging will release the world's first and only equine size, intraoral, digital radiography solution. Slate DR Dental is similar to human dental sensors, but several times larger, ruggedized and accessorized to meet the unique needs of the equine dentistry, which is a rare growth offering for equine practitioners. Slate Dental [DR] is available for pre-lease order on November 17 for $12,500 when purchased with a new Slate hub and for $18,000 when purchased separately.

Preorders of both Sono Slate and Slate DR Dental will begin shipping in the first quarter of 2018. These exclusive add-on products will be compelling factors for customers when choosing Slate hub for general digital radiography and will increase Slate hub base unit sales, while importantly raising the upsell average selling price of each unit by up to 30%.

Another imaging revenue stream now coming online for the first time is from new multiyear service extension contracts. When we began installing new small animal imaging solutions in 2012, customers purchased a point-of-care 5-year agreement. As these customers conclude their original point-of-sale service and warranty coverage, they are beginning to purchase 2-year extensions of coverage. The early uptake on these offers and their positive financial contribution point to a steady, multiyear imaging tailwind in 2018 and beyond. Hundreds of customers are now eligible and each year hundreds more become eligible for these extensions, which range in annual price from $2,000 to $5,000. The combined effect of our imaging initiatives and product releases points to a much improved fourth quarter performance and a strong contribution in 2018.

Now I'd like to share with you how we're working on other key areas of our business. I spent roughly 40% to 50% of my time on new product development and business partnership development. With roughly 50% of revenue on our industry traceable to new product launches and major upgrades to existing products, growth from new analyzer segment is a key focus for Heska. It is a very, very busy and key area for us. My development team, which includes our chief strategist and operating officer, Jason Napolitano, has been quietly and hard at work pursuing pure growth projects in business development in urine, fecal, imaging, coagulation, infectious disease, allergy, data, molecular, telemedicine and software. Slate hub, Sono Slate, Slate DR Dental, the new Solo Step formulation and relaunch, this week's new Element COAG launch and the creation of our new imaging service contract businesses are some current period examples.

We are also focused each day on catalyst that improve sales, margins and efficiency over rolling 4-quarter period in each business area. Today, I'd like to share several of the drivers we're seeing -- we see adding to our growth in our blood diagnostics analyzer and consumer business, which we continue to expect to grow between 15% and 20% in 2018. The first driver is market share, an area strength for our team. We target a minimum 1% stand-alone hospital market share pick up, approximately 240 hospitals, with our traditional sales team efforts. Our teams have exceeded this over 2014 to 2017.

Additionally, we target a 1% corporate group-owned hospital market share pick up for an additional 240 hospitals. With this week's announcement that won a North America's top 5 largest and fastest-growing corporate groups, PetVetCare Centers has selected Heska as their exclusive long-term primary provider. We have secured over 100 current and pending locations for 2018, including roughly 35 specialty and referral hospitals, which are often very large and regular users. We anticipate that fast-growing, well-funded organizations, like PetVetCare Centers, that are over $300 million in annual health care sales, will grow their current diagnostics usage in current hospitals and seek to acquire roughly 25 new hospitals annually over the next several years.

Heska is excited and pleased to grow with PetVetCare Centers as they do so. We are now focused on attracting several additional groups like PetVetCare Centers. With 12 groups currently between $50 million and $300 million in veterinary health care sales and an additional 15 groups between $15 million and $50 million annually, we see substantial opportunities to switch 1% and more market share to Heska in 2018 from corporate groups. The second driver is growth in our installed base's own utilization. From promotional programs by Heska to increase the use of targeted installed base testing and from participation in the underlying growth within the hospital's diagnostics businesses themselves, which is estimated to be between 5% and 8% from increased visits, utilization and price. We think Heska is well positioned to help these veterinary hospitals increase their utilization in 2018. The third driver is growth in our owned reset subscriptions model price. We have not taken a starting per test subscription price increase in our major testing panels in the past couple of years. In some cases, the competition has taken several price increases, which has effectively increased the fair value gap between Heska's reset savings and the competition.

In late Q3 of this year, we were able to fairly increase our starting subscriptions per test price for some tests, while maintaining our fair, high performance, superior value positioning. The fourth driver is growth in new analyzer segments. For 2018 and 2019, we see a regular cadence of new analyzer launches occurring, the first of which kicked off by this week's release of the new Element COAG for coagulation and blood typing. The launch of element COAG introduces a brand-new testing line to Heska, much like the Element POC did in the second half of 2013 and the Element I did in the second half of 2015, both of which stimulated new customer acquisition and current customer upgrade, expand, extend growth cycles. With Element COAG, we are pleased to again embark on another of these virtuous upgrade cycles.

Heska's continued success with launches like Element COAG and friendship with individual veterinarians and corporate groups is causing more and more next-generation companies to choose Heska as their global animal health partner. From these cutting-edge businesses and our own internal development, our pipeline contains a steady stream of targeted launches of new technologies and major upgrades over the next 1 to 3 years. Some of these new Heska initiatives will create new markets and some will disrupt current ones. The fifth driver is expansion of our geographic opportunities. We spent the past year carefully evaluating potential geographic-driven acquisitions, geographic-driven joint ventures and other structured relationships, and we've compared them to independent go-to-market international strategies. Our probing has, at times, taken us farther afield and into much longer conversations than we anticipated. We're still having these conversations, and we'll continue to do so until we've run out every ground ball to arrive at the best play. My directive to the team is simple. It's not easy, but it's simple. Expand our geography in a healthy, sustainable, profitable, efficient, value-creating way that establishes a 10-year runway with clear profitability and under 18 months from launch, while maintaining flexibility for future strategies that may not be right today.

I appreciate the patience of our product partners and of investors, while we do this work carefully and diligently. With that, I'd like to open up the call for your questions, and we'll follow up with some comments after that. Operator?

(Operator Instructions) And we'll take our first question from Nicholas Jansen with Raymond James.

First on me, appreciate some of the dynamics that kind of pushed out some of the revenue that you were expecting this year into next, but maybe just help us understand how you are defining kind of growth as we think about 2018 on heartworm, on imaging? Certainly, imaging has been little bit of a disappointment this year. So just the scope of the potential recovery and your thoughts on the size of the markets that you're addressing with these new products?

Yes. That's a great question. To simplify things, if you look at the third quarter, the core of the business was fantastic. Blood diagnostics up 16% is the core of the business, not that any business is peripheral. But the ancillary business in imaging was a disappointment, and it came in roughly $1 million below where I'd hope it come in. OVP, we expected to have a down quarter. We call that out as a mid-to-high single-digit grower, and it grew 42% in the first half. So that one I think shouldn't be too disappointing and come as a surprise, but about $1 million did push in the third quarter to the fourth quarter. So there's another $1 million on top of the $1 million that you lost in imaging. And as we go into the balance of the year, we expected to launch the reformulated heartworm, which is a big deal. Roughly in 2012, 2013, heartworm for Heska was about an $8 million business. We've shrunk that to about $2 million business, just generally direct numbers, over the last several years, in large part, just because the cost structure and the marketing expense of that product just wasn't profitable. So we deemphasized it. But it has been a drag on revenue in the last couple of years. It's just been one that hasn't been called out, because everything else was growing so nicely. We counted on that reformulation in the second half of this year, that's our lateral flow development. It's on track. It's a little bit behind what I'd hoped. And so instead of giving us an extra $1 million or $2 million in revenue because of that reformulated launch, which cuts the cost of that product to manufacture substantially and turns it into something that you do want to put some marketing muscle behind to get those revenues growing again. That growth won't start until the first half of next year, just really pending the USDA regulatory process. So when you combine those kind of ancillary business -- I mentioned shots on goal, you use other sports metaphors if you're a great team that drills 3-point shots and you have a great offense that's used to drilling 3-point shots and you got the best 3-point shooters in the league, you want them to take those shots. And sometimes they hit the rim, sometimes they bounce around the rim longer than you had hoped. Sometimes the whole stadium watches and bounce around the rim to see if it's going to go in. And unfortunately, the third quarter was a little bit like that.

Okay. That's helpful. And maybe just a follow-up on the imaging comments. How do we think about the growth trajectory there as you now own the whole thing under your operation? You have some new products. Is this the business that can grow double digits? Or is the movement toward subscriptions perhaps going to dampen the rate there?

Well, so 2 things. We rolled out subscriptions -- I don't have at my fingertips here exact data, but maybe 3 quarters of $1 million of revenue recognition that was booked as a long-term rental as opposed to an upfront sale. So meaningful on a business that's $20-ish million, meaningful. I don't suspect we'll continue that path until we roll out some of the professional services around the imaging business. I mentioned that we looked at software and data and telemedicine-type services, which really turned imaging placements into much higher revenue growers based on the consumable, which would be the professional services and things like telemedicine and auto differential diagnosis based on images, those types of things. So I think going into next year, the year-over-year will grow, in part, because I don't think we'll push the rental piece of it in the first 3 quarters of the year, and so there's year-over-year growth on that. The second piece, and I didn't really put numbers to it, but the service contract business is worth probably 3 to 4 percentage points of growth on imaging, right on top. And that's something that we really didn't have access to -- literally to about 30 days ago, when those placements in 2012 started to roll beyond their initial 5-year service agreement. And when you look at traditional service businesses for imaging, whether it's the big 3, on the human side: GE, Siemens, Philips, the service business in an imaging business is a very, very important business. And really for the first time, since imaging has been part of the Heska portfolio, we actually have the ability to add that services business. So when you combine the services business 3% to 4% head start, you combine the [750] in rental recognition that will probably forego in 2018 on the $20 million business. You already adding it to high single-digit growth before you look at just core growth based on some of these new product launches. All of which to say is, that it's early to talk about specifics on 2018. But what has been a 25% to 30% drag on revenues this year, I think will turn into a nice positive next year. And probably, as importantly, what's been a significant drag in profitability is we spent some money on some product development in some of these initiatives, it'll turn it into better profitability. So I think imaging is really slated for a good 2018, off of admittedly a less than impressive 2017.

That's very helpful. And I guess my last question will just be on the corporate strategy. It was great to see the news yesterday. Maybe just remind us today how many "corporate customers" you have a toe in the water? And how we should be thinking about the cadence of that share gain opportunity over time?

We have created a corporate accounts initiative. We've staffed it with an excellent manager. I think, she's fantastic and has great relationships, did a similar job at Antech for a long time with key corporate accounts. That's a big opportunity for Heska. The one thing I would really point out on PetVetCare Centers, and this is really cool in terms of a validation of Heska's quality. We earned that business over a couple of year period, because we on a one-by-one basis were able to displace competitors in some of their largest -- in fact, some of the country's largest specialty and emergency accounts. And some of these really huge users converted to Heska just the old-fashioned way, just basically looking at the market, looking at Heska's normal everyday reset offering, but probably more importantly for those folks who're just looking at speed and quality and those kind of things. And we were able to displace both of our main competitors in some really large accounts, that after a year or 2, I think, the corporate folks in operations were able to look at it and say, "Look, our biggest most demanding users have switched over to Heska and they're extremely happy. Maybe our other 100 facilities would do well by pursuing that. That's where these conversations with PetVetCare Centers started. I do think we've done that with virtually every other major corporate group that I mentioned, and roughly 25 of these groups are in that $15 million to $300 million range. So we think it's a great opportunity. And I would point out to that 240 corporately owned practices is a full 1% of market share gain, roughly half of which as we enter 2018, we've picked up with PetVetCare Centers. And so I feel very confident in our ability to get 1% corporate target for 2018. The other thing that I would point out is PetVetCare Center is a 7-year agreement. As they continue to acquire practices, say, they acquire 25 practices a year, that's equivalent of sales representative cost and expansion that really you're much more efficiently able to grow with PetVetCare Centers as they acquire those hospitals and convert to Heska. It's another avenue to picking up market share. So it's not just an initial 100, 110 practices. It's 100, 110 practices with compound annual growth of 25 to 30 over the next 6 years due to their acquisition efforts. So it's an important initiative for us. And I think we're well positioned to have significant pickups there. The makeup of the analyzers that we replaced in these accounts appears to track what you see with market share in the market. So 65% for our largest competitor, 20% for our smaller large competitor tends to be what we see when we look at these corporate accounts. So I hope that helps.

Our next question comes from Kara Anderson with B. Riley FBR.

I have a follow-up to the previous, I guess, question and answer. Can you provide some color on the dollar value of the agreement with Heska for PetVetCare?

Well the dollar value. So I look at it in a couple of ways. I can't give you specifics because each hospital within their group is different. So they're roughly 35 specialty and emergency hospitals, some of which are $250,000 a year plus and some of which are going to be normal $2,000 a month type of users. So it really is very broad. I do think it's a healthier point-of-care customer for us than some of the larger point-of-care customers out there that are related with reference lab ownership. So when you pick up a corporate account that doesn't own a reference lab, they tend to do more point of care than they do reference lab. So we do think it's healthy. I also think it's slightly above our general user population just because of the types of practices they buy and the growth in those practices. They run a good business. So I think it's additive to our user installed base. It's definitely not dampening that usage.

Great. With respect to Heska Imaging, can you provide some context around the international piece how that tracking against? I think it was about $6 million annual run rate when you acquired it. And how that performed in the quarter?

In the third quarter, it was substantially off. Some of that is timing. It's a little -- you've to look at trade show season in Europe. And this year, the main trade shows did not occur in September for kickoff. They occurred in the middle of October. And a lot of our international partners are rightfully wanting visibility before they put in their big fourth quarter orders. And we didn't see large orders in the third quarter. They were also aware of product development with Slate hub and some of these other things. And they were waiting pricing, they were waiting release, and so we had some orders held off as well. So the third quarter drag in international was disappointing, but not totally unexpected to me. I do see it turning around in the fourth quarter.

And we'll take our next question from Mark Massaro with Canaccord Genuity.

Just on the quarter, I was hoping if you could just maybe clarify some of the comments you made. I appreciate all the transparency that you provided. But just thinking, you guys came in roughly $4.5 million below consensus. Kevin, you called out imaging was roughly, I believe, $1 million, OVP roughly $1 million. And then of course, you talked about the push out of the heartworm launch. If you could maybe just rehash, maybe the buckets, where you think the shortfall occurred in the quarter. I guess I'm really just trying to understand the impact of the push out of the heartworm.

Yes. I mean, so heartworm, I think, when that comes to market, we have the ability to move $1 million or $2 million of product fairly quickly. Some of that's stocking order, some of that is just preparing for distribution partnerships and things like that. Private label, other initiatives that we kind of just have sitting on the side until we can put them in boxes and start shipping them, which is a regulatory question. But I think you have it. I think consensus probably didn't account for enough of the first half 42% outperformance in our Des Moines business. And we call that out as kind of a high -- mid-to-high single-digit grower this year, and it was running at 42%. And so I think consensus was probably $1 million ahead as well. So I'll own $3 million of it if you guys own a $1 million of it, and there's your 4.

That's helpful. You indicated 15% to 20% growth for 2018 on your core blood business. Would you be willing to maybe communicate your degree of confidence around double-digit top line growth, given, obviously, you have the benefit in new products, but partially offset by potentially converting more -- likely converting more imaging to the rental programs. So just, generally, how are you feeling about 18 and double-digit top line?

I'm confident in it. This year, I think, we're going to miss it. We just called out 6, 7, somewhere in that range year-over-year, and I'm disappointed in that. It's all logical. It all makes sense. It's not in the core of our growth engine. So it's like anything to improve in your peripheral businesses and return imaging and heartworm to growth is a lot of work and the teams have a lot of work to do, but it's really, really clear internally how that happens. With 15% to 20% growth in the blood diagnostics business, which I'm also confident in, we've kind of call that out, I think, all year. This is a long-term growth, and I think that's very doable. So the long and the short of it is, we report to the world on a 90-day rolling period. And sometimes the shot clock runs out on you a little bit before you wanted to. But going into '18, double-digit growth is absolutely my expectation for the business. And it's not a stretch to see how we get there, it's work. It's just work, and we got to keep throwing up shots on goal; and traditionally, more of them go in than they did in the third quarter.

That's helpful. And when we think about your imaging business converting that book to the reset rental program, are you maybe half converted? Or can you say if you are above that or below that or any additional color you could provide on that?

Yes. So just the nature of the question, so I'll be -- I'll try to explain. We try to pilot things. And we try to do it thoughtfully. So when I entered the year, I really like the idea of converting a certain percentage of our imaging business to rental. The idea behind that is that you're going to sell the same amount of capital equipment sales, and rentals are going to be additive. In all candor what we found with our sales force and some of its training -- but what we found is, we didn't really grow, we converted. So the idea is that you would maintain your capital equipment sales and rentals with total customers into the market that weren't in the market otherwise. Enough capital equipment customers chose rental, which turned that, that into a drag as opposed to a future additive. All of which is to say, I am unconvinced that it is something that I want to scale and that I want to continue in the fourth quarter in 2018, which may be unusual for somebody in my position to just publicly say, "We tried something. I thought it was interesting. I was personally convinced that it would be a good project to pursue. And the evidence shows that it didn't get the traction that I thought it would." So I don't think we'll pursue it going forward until we're 100% ready with the ancillary services behind it. Now I think rental placements start to make an awful lot of sense when you can turn a customer who is doing 100 radiographs a month at $60 for a radiologist overread, turns a $6,000 professional services business. In my mind, it's more valuable than a $1,100 rental or $50,000 onetime upfront sale. And so there is a model at some point in the future as we build out some of these professional services ideas, where placements of equipment in return for long-term professional services, much like placement for blood analyzers and return for long-term supplies agreements make sense, but I was early on that. Does that make sense?

It does. I appreciate that. And if I can ask just one last one on gross margins, 43.1% was solid. It beat my estimate. You're seeing a greater mix shifts to your core blood business, which is higher business. Do you think -- as we look to 2018, 43% can be viewed as maybe towards the lower end where you think you might come in at the end of the year?

For 2018, 43%, if you're building out your model, isn't a scary number. I think it's more -- I always want you to be conservative, Mark. But it's probably more realistic than 41%. So I don't think that's a temporary trend. We've seen blood diagnostics growing faster than OVP and imaging both of which are much lower margins. And I see that accelerating, you can even see that in our cash flow. Because it's growing much faster, but it's growing much faster off of a much larger base. So that asymmetry just continues to increase, which improves gross margins.

And we'll take our next question from Jim Sidoti with Sidoti & Company.

A couple of questions. First, tax rate. Can you tell me what you are assuming for Q4? And what you think it's going to be in 2018 on a reported basis? I know you're not paying a lot of that.

Jim, it's John. So we go into every quarter marking something in the low 30s. I mean, we don't have a lot of visibility to what benefits that we're going to get that are out of the ordinary. So we're always marking something in the low 30s. So if you're in the 32, 33-ish range that's where we need to line up.

Okay. All right. And then -- okay. Any impact from the hurricanes in the quarter?

I'll take that one. I think companies do have things like reference lab businesses where careers can't drive and pick things up. It's a little bit more visible. But certainly, they are major pockets of the country that just simply were closed for certain amounts of the quarter. I don't know that I want to call it out. It feels a little weak to me to call that stuff out for a company of our size. So I don't call it out when the weather is great. So we're probably past on calling it out, but yes, there was an effect, but I don't know how meaningful it was. We'll just keep jugging.

Okay. And then the last question is a follow-up, same question I asked you 3 months ago, inventory. It's gone up quite a bit this year. Last quarter, you said that's because you had a large purchase in the first quarter of analyzers and you thought it would be coming down, but it continues to move up.

So Jim, we traditionally have a higher inventory level in Q3 as we get ready for the shows and the imaging shows in Q4. So you could see a lot of that start trending down as we -- in the year going to -- moving into Q1. Although, Slate hubs and Element COAGs -- so when you're launching new products as well, you buildup analyzer inventory to launch those products, and then as you start making those deliveries, you see the number come down.

Okay. So we should expect that number down in Q4 and then again in Q1 of '18?

Yes. And I would say certainly in Q1 you start really seeing it go the other direction as we're topped up.

(Operator Instructions) We'll take our next question from David Westenberg with CL King.

So I'm going to ask the tougher one first and then I'll ask a little bit about the corporate accounts. But in blood diagnostics, I mean, you guys have seen like in Q4 of '16, you had 44% growth rate; in Q1, I think, you had a 22% growth rate; and 33% growth rate in blood diagnostic last year. Now I understand that's definitely not sustainable. Those are mind-boggling growth numbers, but -- just as we sort of reset and realize that you guys are now about 10% market share, so much larger base of customers, can you talk about kind of the confidence in that 15% to 20% growth rate in that blood diagnostic business and your thinking on that?

Long-term growth rate, I'm highly confident in that. And I did spend a good portion on the prepared comments. I think I rolled out 5 key drivers in that space. So it's not just 1. But I think, combination of at least 2% pick up. I think we have price protection that includes price increases for that installed base. That -- again, as your installed base continues to grow, they continue to analyze you. You get price increases within the subscription. We called out the starting price for some of those major tests that we hadn't taken in over 2 years. So the starting baseline price for comprehensives and things like that will be higher, which improves margin and sales. We've got growth in the actual end-user. We've got corporate growth. So no, I see several levers there that are being pulled in and have already been pulled and then you have analyzer releases. And again, like in 2013, when we did the point-of-care for blood gases, you saw a nice upgrade, extend renew cycle. And every time we do one of those, we place a new analyzer in there. But importantly, we generally pick up 72-month renewals. A lot of times, those are contracts that will have 3, 4 years left on them. So -- no, I like it. And that's why I spent a large part of the prepared comments on it.

And then can you just talk about the PetVetCare deal that you signed? Can you talk about the competition and sort of the bid process and really what you think were the kind of drivers that made PetVetCare pick you guys, because I'm assuming there was competitive process. I'm assuming that you showed them some features that they liked that made it perfect for their particular corporate account.

Yes. I think -- obviously, it's a very competitive process, but what I like about this process is the process kicked off 2 years ago when we took a handful of the very largest accounts from our 2 bigger competitors, the old-fashioned way. We sent a sales rep in there, he explained why our stuff was better, faster, more accurate, better value, greater performance, higher precision, great connectivity, and the local people made the decision to convert to Heska on our normal offering. And it really just become very logical, I think, at the corporate level to say, well, our biggest users, who are staffed with the most demanding specialists, already converted because they think it's better and they're getting great results and the economics are better, and we should do that for the other 100. So it was -- that was really more of the process. It wasn't a bid where they sent us your silly checklist, spreadsheet of all the parameters. It didn't really go that way. And I find most of these corporate accounts don't go that way. It, honestly, I think, is a better process. They look at what's working and then they try and replicate it across all their practices. And then they also have the credibility as they replicate it across all their practices, because they have successful champions already within the group. That's how PetVetCare Centers happened, and you guys run a good business. They're smart guys, and we're super excited that they chose to go wholesale in with Heska.

Great. And apologies for the longer question here. But I know why these corporate accounts have been hesitant to sign deals because what they call diagnostics or changing the vets sort of modus operandi, sort of a pain point. But as you see more and more consolidators these days, can you predict maybe that. They're going to be looking at saving more money and then maybe bundling diagnostics is a good idea. And all this just to say, what's your thought about the movement in consolidators and aggregators to pick 1 diagnostic laboratory equipment vendor?

I personally think the move to aggregation benefits the smaller guy, and we're the smaller guy. Because I think what happens is the same thing. We'll go to an owner, an owner-owner, an individual owner. It's his own P&L, it's his own kid's college fund, it's his own staff. And we'll make a pitch as to why our stuff is better, faster, more accurate, right chemistry technology, 2-way communication with their practice management software, true 5-part laser hematology. All these great benefits that we offer people, and an individual owner will select Heska. When that individual owner gets acquired by one of the aggregators, he pulls his Heska solution into the aggregator's business, which then highlights to that aggregator the benefits and profitability and likability of what he has as opposed to what some of the other clinics might have. And so they experience pain points, they experience lower profitability in diagnostics, which for a lot of these guys is 15%, and in some cases, upwards of 20% of their profitability. So it's meaningful. They need to get diagnostics right, and they start looking around the table with folks that have made really good decisions, running really good practices, which is why they bought the guy's practice in the first place. And he or she that own the practice before they sold it to a corporate group raises her hand and says, "Hey, we love our Heska stuff. I have no idea why you're still with this other guy." That's the best sales pitch we could get with a large corporate group. And we spent 2 or 3 years getting those individual practice owners to make the conversion, and they're on our side. And as they get acquired, they do a lot of the sales for us, because they have a successful history. So I think that trend favors us as opposed to the other direction.

We'll take one more question from Raymond Myers with Benchmark.

Kevin, I thought I heard you say on the call that the heartworm lateral flow was pending regulatory clearance. Have you submitted that already?

We have the dossier, and we've submitted the majority of the dossier. The way heartworm works and actually a lot of these infectious disease tests work is you have to show effectiveness in different buckets. And again, I'm not overly technical, but I'll explain it as I understand it. So if you're diagnosing heartworm, you might have a bucket of 100 to 1,000 worms, really significant infection. Then you might have another bucket of 10 to 50 worms, middle infection. And then you might have the smallest bucket, which is just got infected last week, 1 worm. The hardest patients defined in the general population are those with 1 worm. So we submitted the dossiers, and I believe they're complete for the larger buckets, because that population is easier to find. But you actually have to find actual animals with this amount of actual worms that you can then show with your testing that your test has picked that up. And with 0 concerns about the accuracy and precision of the test and the formulation and those things, we literally are waiting for enough 1 worm dogs to come through that we can pull samples from to validate the early infection. And if you can't find them, you can't submit that final piece of the dossier. The folks who're doing that work for us, we acquire those samples from universities, generally, and some other sources. And they're finding everyone that comes through their door, but we can't go out and make 1 worm infection. So that really is a sum total of the delay, and it's very frustrating, because it's out of your control. But we do, based on the current run rate, believe that we'll see that in the first half of 2018, in terms of fully submitted and the ability to actually launch product officially.

Okay. Great. That's a very good, complete answer. Regarding the imaging upgrade cycle, you're launching some products here shortly in November. When should we think about the imaging upgrade cycle impacting sales? Can it start already here in the fourth quarter? Or is this a first half '18 event?

It's already started in the fourth quarter. We did start the fourth quarter with maybe a stronger pipeline than honestly I'd hope. So I think they're having a good start to the quarter. I think, meaningfully, a lot of these benefits will hit in the first quarter. The upside to launching something November 17 is it's very exciting, and it helps for immediate sales, and you get a certain percentage of end of your tax buying that's in a hurry. The downside is sometimes you have -- you don't have so many days left in the year once you start backing out customer vacations and holidays and shipping holidays and all those kinds of things. And so sometimes you just -- the clock runs out and stuff ships out in January that you wish you could get out the door in December. So I think it's going to be a little bit of both. I don't see a fourth quarter blowout for imaging, but I do see an upswing. I don't see a drag like it was on profitability and revenue in the first 3 quarters of the year. I do think it's moving in the other direction as we enter the fourth quarter.

That's good. And the COAG business. Can you help us quantify the magnitude and timing of the revenue opportunity for taking on that product?

Yes. I think it's a great opportunity just like the second half 2013 with the blood gas analyzer when we launched Element POC. And we had a nice upswing and a good conversation starter. And in 2015, we did the same thing with Element i. And at the end of 2017, we're doing the same thing with Element COAG. So I think if you look at those upcycles that follow those analyzer launches in '13, '15, and now '17, I think it's every bit as important a segment as those other 2 products were. It's not the chemistry segment, the hematology segment. It's definitely a peripheral device like the blood gases segment and the immunodiagnostic segment. But I think it's significant. It's just now being rolled out to the teams. All the marketing portals are up. The team's started receiving training last week. So they'll be out knocking on doors, and it gives us something new to talk about. So it's good.

Okay. Very good. And the gross -- no, sorry, the G&A expense was quite low in Q3. Was that for any unusual factor? Or how can we think about G&A expense going forward?

So I think you've seen some compensation growth over the last couple of quarters in the end, I think, where you see us right now. And plus we had some spending in Q2 related to accounting standards. And Q2, we also had expenses related to our line of credit that we opened. So I think, Q3 is more of a normal quarter that you'll see, maybe a little bit of an uptick from there, but directionally that's probably a good target number for us.

And there are no further questions at this time. I'd like to turn the conference back to our speakers for any additional or closing remarks.

Thanks, operator. And I'd like to say thanks to all the shareholders and analysts on the call as well. Clearly, we are hard at work on a strong 2007 (sic) [2017] finish. And we're working hard to deliver on our full year diluted earnings per share growth, which is 41% to 44% growth, which we think will be between $2.02 and $2.06 for the year. We're also setting the table for a strong 2018. For 2018, we continue to see 15% to 20% growth in the key blood diagnostics, backed by return to growth in imaging and heartworm PVD products. All of which maybe supported and enhanced by broad-based hospital growth, some of our corporate account wins, improving margins and a series of new product upgrades and entirely new line additions like the Element COAG. We've been quietly hard at work developing new lines of business in a broad range of areas, and it's been a very, very busy time for us in terms of development activity for the urine space; fecal; imaging; the coagulation, which we just launched; infectious disease; allergy upgrades; data; molecular; telemedicine and software. And we've been thoughtfully and working really hard, running out all the ground balls on all the healthy options for an international expansion. Everyone at Heska is busy building value. And I just want to emphasize, since joining Heska in early 2013, I've never been as excited and encouraged by our position in the market, by our capabilities and by our growth prospects. I look forward to updating you, again, next year. And throughout 2018 on our progress and the basis for my optimism in veterinary diagnostics, generally, and in Heska specifically. Thanks for your interest, and have a great day.

This concludes today's conference, and thank you for your participation. You may now disconnect.