Heska Corp (HSKA) 2018 Q4 法說會逐字稿

Good day, and welcome to the Heska Corporation Fourth Quarter 2018 Earnings Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Jon Aagaard. Please go ahead, sir.

Thank you, and good morning, everyone. Welcome to Heska Corporation's Earnings Call for the Fourth Quarter of 2018. I am Jon Aagaard, Director of Investor Relations for Heska.

Prior to discussing Heska's fourth quarter and full year 2018 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 this morning's earnings release and 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 and specifically disclaims any obligation or intention to update any forward-looking statement 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; Catherine Grassman, Heska's Chief Accounting Officer; and Jason Napolitano, Heska's Chief Operating Officer and Strategist. Ms. Grassman and Mr. Wilson will provide details surrounding the results as well as consolidated outlook for 2019, and then we will open the call to questions.

At this time then, it is my pleasure to turn the call over to Catherine Grassman, Heska's Chief Accounting Officer. Catherine?

Thanks, John, and good morning, everyone.

For the fourth quarter of 2018, we recorded revenue of $34.1 million, a 5.5% decrease over $36 million in the fourth quarter of 2017; and full year revenue of $127.4 million, a 1.5% decrease over $129.3 million in 2017.

Revenue for the Core Companion Animal health segment, or CCA, which includes our point of care laboratory products inclusive of our subscription agreement, our point of care imaging products and our single-use pharmaceutical vaccines and diagnostic tests for companion animal use was $28.3 million in the fourth quarter of 2018, a 4.9% decrease over $29.7 million in the fourth quarter of 2017. The decrease is primarily due to decreased sales of our point of care imaging products.

CCA revenue was $108.9 million for the full year of 2018, a 3.5% (sic) [3.6%] increase over $105.2 million in 2017, largely due to an increase in sales of point of care lab consumables of $5.6 million, offset by a decrease in sales-type lease revenue recognition of $1.5 million as a result of placing more operating-type leases, which do not result in upfront revenue recognition; and $1 million of lower sales of low-margin infusion pumps.

Our Other Vaccines and Pharmaceuticals segment, or OVP, generated revenue of $5.8 million in fourth quarter of 2018, down from $6.3 million in the same quarter last year. On a year-over-year basis, the OVP segment revenue decreased 23.3% to $18.5 million in 2018 from $24.2 million in 2017. Decreases in the fourth quarter and full year of 2018 are driven by decreases in orders by our customers, most significantly by Elanco.

Our consolidated revenue for 2018 missed our expectations, as set forth in our 2018 outlook, of $135 million. Within our CCA segment, full year 2018 point of care lab consumable sales grew 14.3% to $44.8 million, demonstrating strong full year growth, yet missing our 2018 outlook of 15% to 20%, mainly due to less-than-expected installs in PetVet Care Centers Hospital.

Our point of care imaging diagnostic sales increased 4.2% to $22.8 million, but missed our full year 2018 outlook of 10% to 12%, mainly due to lower domestic sales of digital radiography and ultrasound products.

Point of care lab instruments, including sales-type lease placement revenue recognition and lower sales of infusion pumps contributed to the miss. Sales to Merck related to Tri-Heart were $500,000 below expectation. Finally, except for a $500,000 revenue shortfall related to vaccines for Elanco, our OVP segment revenue was in line with our expectations for the year.

Our fourth quarter 2018 consolidated gross margin declined to 45.4% as compared to 46% in the fourth quarter of 2017. Full year 2018 gross margin decreased to 44.4% from 45% in 2017. Full year 2018 consolidated gross margin of 44.4% was 60 basis points below our 2018 outlook. Of the 60 basis points miss, 43 basis points is attributable to the inventory reserves taken specifically on equine-related imaging products, primarily in the fourth quarter. The remainder of this miss is due to lower point of care lab consumable sales than anticipated, offset by slightly favorable OVP gross margins of approximately 30 basis points.

Total operating expenses on a year-over-year basis grew 32% to $52.8 million from $40 million, which includes approximately $7.4 million of onetime nonrecurring charges. As previously disclosed in our Form 8-K filed with the Securities and Exchange Commission on October 16, 2018, while strongly denying the claim pending final court approval, Heska executed an agreement to fully and forever discharge and settle claims in a class-action complaint related to legacy marketing faxes and recorded a onetime preliminary litigation settlement charge. Payment of the settlement amounts of $6.75 million is expected in March of 2019.

Excluding this charge, total operating expenses increased 13.5% to $45 million. Increased stock-based compensation costs of $2.5 million, increased compensation and benefits costs of approximately $1.6 million and increased research and development expenses of $1.3 million relating to new product development all contributed to increase in operating expenses year-over-year.

2018 fourth quarter operating income declined 53.3% to $3.3 million compared to $7.1 million in the fourth quarter of 2017. Excluding onetime charges of approximately $200,000 relating to the previously mentioned settlement litigation and other onetime charges during the fourth quarter, operating income declined 50% to $3.5 million, compared to $7.1 million in the fourth quarter of 2017. 2018 full year operating income declined 79.2% to $3.8 million compared to $18.2 million in 2017. Excluding the onetime nonrecurring charges of approximately $7.4 million, operating income declined 38.5% to $11.2 million as compared to $18.2 million for the full year of 2017.

Consolidated full year 2018 operating income, adjusted for the $7.4 million onetime nonrecurring charges, was $4.8 million lower than our 2018 outlook of $16 million, which was primarily driven by lower-than-expected revenue. Additionally, research and development costs related to new product development were approximately $500,000 greater than anticipated, as was general and administrative expenses associated primarily with international expansion efforts.

Depreciation and amortization was $4.6 million in 2018 as compared to $4.8 million in 2017. Stock-based compensation was $5.2 million in 2018 as compared to $2.7 million in 2017.

Our effective tax rate for the quarter was a benefit of 5.2% and a benefit to 55.6% for the full year. Excluding the tax effect of the onetime nonrecurring charges previously discussed, our effective tax rate for the quarter was a benefit of 3.3% and a benefit of 0.2% for full year.

Including impacts from the onetime nonrecurring charges of $200,000 previously discussed, fourth quarter 2018 net income attributable to Heska was $3.5 million or earnings of $0.40 -- $0.44 per diluted share, as compared to a net loss attributable to Heska of $1.1 million or a loss of $0.15 per share, which includes the impact of a $5.9 million accounting charge taken during the fourth quarter of 2017 related to the adoption of the 2017 Tax Cuts and Jobs Act. Excluding the previously mentioned onetime nonrecurring charge in each respective quarter, net income attributable to Heska was $3.6 million for the fourth quarter of 2018 or earnings of $0.46 per diluted share compared to net income attributable to Heska of $4.8 million or earnings of $0.63 per diluted share.

Including the impacts from onetime nonrecurring charges of $7.4 million, 2018 full year net income attributable to Heska was $5.9 million or $0.74 per diluted share, as compared to net income attributable to Heska, including the impacts related to the 2017 Tax Cuts and Jobs Act of $10 million or earnings of $1.30 per diluted share. Excluding the impact of the onetime charges previously discussed for each respective year, full year 2018 net income attributable to Heska was $11.2 million or earnings of $1.42 per diluted share, as compared to net income attributable to Heska of $15.9 million or earnings of $2.07 per diluted share for the full year 2017.

Now I'll turn the call over to Kevin Wilson, Heska's President and CEO, for additional comments. Kevin?

Thanks, Catherine. Good morning, everybody. I have to beg your pardon this morning. I caught the flu. So if I go on mute, we're not having a sidebar, I'm probably coughing. I'll do my best to speak clearly. Thanks, Catherine. Good job.

Today's release is detailed so I won't take your time reading it to you, but I do encourage you to look at it closely. I think it's full of a lot of great information that will be helpful to investors.

I do want to take the time to highlight a few things this morning. Today, we reported our fourth quarter and full year financial results for Heska. They're a mixed bag. While the scoreboard has fewer points on it than I'd like, the reasons are manageable and they're offset by the very solid underlying performance in the key areas that we hold as most important and core to our long-term value. As many of you know, that is the Point of Care Lab Diagnostics business is Heska's primary focus because it's our largest highest-margin and fastest-growing business.

Our core Point of Care Lab Diagnostics subscriptions performance largely exceeded our outlook in 2018. In this most important area of our business, I want to congratulate our Heska teams for doing an amazing job in 2018. They delivered 14.3% point of care lab consumables growth to $44.8 million, along with point of care lab total business margin expansion of 170 basis points. Because of their hard work in 2018, Heska once again won market share, had strong increases in test utilization and delivered on retention of 95% of multiyear subscribers and saw strong renewals in record extensions, all of which delivered subscriber base metrics well above our outlook in 2018 key metrics, including months under subscription and minimum contract subscription value.

Active subscriptions at the end of the year were 2,175, up 12%, which is still short of our expectations due to low activations in one corporate group hospital account in the year. We're working with that account to rectify that in 2019, and we're optimistic that we'll get back on track. Despite this challenge, Heska teams delivered on-target individual subscription gains and above-target upgrades and extensions in the year, leading the outperformance increases in all other outlook metrics, including months under subscriptions, which rose 20%; and minimum contract subscription value, which rose to $71.9 million, a 28% increase. These achievements were well above plan and demonstrates strong work with high-volume hospitals, excellent retention, healthy pricing and utilization and growing minimum commitments in new accounts and extending accounts.

This excellent performance was unfortunately swamped in December by lower-than-expected imaging sales, which grew 4.2% for the year, but below our goal of 10% to 12%. Imaging had an unexpectedly light December for a number of reasons, and that swamped the boat.

Now I'd like to provide a little context that may be useful concerning our plans and our performance on a go-forward basis. When I arrived at Heska in 2013, Heska contained a small core of key businesses that represented the future, namely the point of care diagnostics lines. The [knock] on Heska at that time was that Heska did not sell what it made and did sell what it did not make, meaning we manufactured things that were sold on a contract manufacturing basis, and the things that we sold to end-user veterinarians, we did not manufacture. While not entirely true and not entirely applicable to Heska alone, there is normally a truth in criticism. And in this case, that truth was that Heska should move farther up the innovation and value-creation chain while using its hard-won and highly coveted place within veterinary hospitals as a platform from which to expand and solve additional problems for veterinarians and pet owners. That's been the plan.

Now I'm a big believer in 5-year plans. To accomplish this move up the value chain while innovating to leapfrog our competition, we decided for two 5-year plans. What we term as The First Act was from 2013 through 2017, and was designed to strengthen Heska's core business and diagnostics and make it sustainable and thriving through subscriptions. We did this well. The second 5-year plan is from 2018 through 2022, and is designed to launch substantial, new innovations into Heska's strong and growing customer base while also expanding Heska's geography to key international markets. Doing both of these things well have a substantial multiplier effect and will deliver incredible results.

With our focus on core products and de-emphasis on noncore products, let's take a second to define how we view each. Heska core products are those where Heska adds significant value and sustained innovation value or differentiation while solving meaningful customer problems. We consider our core product lines to be our Core Companion Animal segment and to include point of care laboratory instruments and consumables, imaging and ALLERCEPT allergy therapy and diagnostics. Our core products grew from $84.4 million in 2017 to $89.3 million, a 5.9% increase in 2018. Heska noncore products are legacy products that Heska contract-manufactures but does not itself sell to help the customers, or that Heska does not manufacture and does not add a substantial, sustainable innovation or channel advantage. Products fitting in this definition include PVD Tri-Heart and SoloStep heartworm products, infusion pumps in the CCA segment and the OVP segment, which is contract manufacturing in research and development. We have seen for some time that a runoff of noncore products to lower levels of sales is appropriate. This trend has dampened consolidated revenues in the past several years, offsetting solid growth in core products. Noncore products fell from $44.9 million in 2017 to $38.1 million, a negative 15.2% result in 2018.

As many of you know, we've been hard at work since 2013 remaking our business, and we made a remarkable progress in our efforts to focus on and grow our high-quality core product revenue faster than lower-margin legacy noncore product revenue to better position Heska for increased scale. Since 2013, we have grown our core line for the future to 70% of sales, while our noncore legacy lines have faded to 30%. Our retooling and refocus is nearly complete. Heska's future is now firmly in the point of care diagnostics and informatics market, where Heska solves important problems for global veterinarians and pets through innovations developed, made, solved and/or controlled by Heska. This is the huge-value opportunity we've been targeting since 2013, and we've made incredible progress.

Our Second Act from 2018 to '22 will transform Heska into a high-margin, high-growth focused company, with highly coveted domain expertise in the markets we serve and in the development, manufacturer and global sales of the exclusive in-house innovations we offer. While 2018 was uncharacteristically light in step-function events and the financial scoreboard was challenged by some real negatives, I'm confident in the substantial progress we've made in dramatically growing the value of Heska in the first year of our Second Act. In the second year of our Second Act, we are greatly expanding the utility of our current diagnostics lines that represent the future, developing and launching new lines that leapfrog the competition and selling our broadening proprietary solutions into our growing subscriber base and international geographies. Fully aware of the strength and size of our competitors, I'm optimistic that we can do these things well in 2019.

To get there, Heska continues to expand its research and development focus. For 2018, Heska invested $1.3 million more in a research and development than the prior year, and $1.5 million more in sales and marketing to expand the domestic sales team and advance the product launches. Product development, assay development, new analyzer releases and test menu expansions are progressing positively for 2019 releases. To further publicly announced initiatives and others, in the third quarter of 2018, Heska invested approximately $8 million in unconsolidated affiliates as part of our strategy and an additional $8.2 million in software technologies from Cuattro LLC. We continue to track and expect to win several more business development opportunities of various sizes and types, with a particular focus on adding more next-generation technologies, geographies and product line extensions in the 2019 to 2020 period.

2019 is off to a big start in product releases for Heska. We detailed 6 key launches occurring in 2019 in this morning's release, and also, a major new launch set for 2020, which I'd like to focus on for a moment. In the second half of 2019, the Element RC rotor chemistry will launch in international markets. This is the first global product for Heska that allows us to go international with our core point of care lab solution. Also in the second half of 2019, the Element i+ immunodiagnostics product will launch globally as well. This product is the first product that is scheduled to have its test manufacturer in Heska's facilities in Des Moines. And in early 2020, Element UF, the urine and fecal product, which is being innovated designed, developed and also scheduled to be manufactured by Heska is scheduled for release. This product, we think, is the biggest product release of Heska's history.

Moving on to business development acquisitions. Heska closed its acquisition of Optomed in France in February of this year. Optomed designs, develops and manufactures imaging solutions, with a primary focus on endoscopy technologies. Optomed generates approximately EUR 3.8 million in annual sales with 18 employees, and provides Heska with a base of operation in Europe out of its Paris, France facility.

Heska continues to track, and we intend to win several more business development opportunities of this type and size in 2019 and 2020.

Now I'll turn the call back to Catherine to detail our consolidated outlook for 2019. Catherine?

Great. Thank you, Kevin.

Turning to 2019. Heska believes that pet owners, veterinarians, pricing, utilization and overall industry trends continue to display broad-based health, and that these factors will continue to drive meaningful investment, innovation, consolidation and strategic activity in industry throughout the coming year. To this end, Heska estimates full year 2019 revenue of $123 million and consolidated gross margin of 44.4%. Heska estimates CCA revenue of $105 million and OVP revenue of $18 million.

As discussed, Heska's core revenues include point of care laboratory instruments and consumables, imaging and ALLERCEPT allergy products. These core products grew from $84.4 million in 2017 to $89.3 million or 5.9% in 2018, and are anticipated to grow to $100.5 million or 12.5% in 2019. Detailing this further, Heska anticipates global Point of Care Lab Diagnostic consumables growth of 12% to 17%, up to $50 million to $52.5 million; domestic Point of Care Lab Diagnostic hospital share growth of 1% to 1.5%; domestic Point of Care Lab Diagnostics instruments and others to remain flat at $9.8 million, which assumes a similar mix of sales-type and operating lease recognition as well as outright sales of instruments as compared to 2018; international Point of Care Lab Diagnostics revenue of $1 million; and global imaging growth of approximately 21%, which includes the anticipated impacts of our recent acquisition of Optomed in France.

And finally, international PVD, which consists of our allergy products residing in our CCA segment, are expected to remain consistent with 2018 at $3 million.

As Kevin discussed, Heska noncore products include part Tri-Heart and SoloStep heartworm products and infusion pumps within our CCA segment and also includes our OVP segment products. Noncore products fell from $44.9 million in 2017 to $38.1 million or a decline of 15.2% in 2018, and are anticipated to fall to $22.4 million or a decline of 41.2% in 2019, but stabilize to $24 million in 2020. Noncore products represented 35% of total sales in 2017; 30% in 2018; and are anticipated to be 18% in 2019. Detailing this further, Heska estimates domestic PVD down $15 million to $10.7 million due to a drop of $14.6 million, resulting in $1 million in revenue related to Tri-Heart heartworm preventative manufactured by Heska in the U.S. exclusively for Merck Animal Health. 2019 revenue from Merck related to Tri-Heart is anticipated to be $1 million primarily in the fourth quarter. Due to this timing, the first 9 months' plant utilization charges may cause fluctuations in CCA gross margins outside of the outlook range provided. Infusion pumps are expected to decrease by $500,000 to $2 million. OVP is expected to be around $18 million and approximately 10% gross margin.

Operating expenses are expected to increase 20% when compared to 2018 non-GAAP operating expenses. The increase of $9 million is driven by an investment of $4.5 million in research and development related to new products Kevin spoke of previously and $4.8 million related to sales and marketing expense attributable to both domestic but primarily international expansion, offset by a slight decrease in general and administrative expenses. The timing and capitalization of future research and development expense could fluctuate based on product development and commercialization schedules.

As a result of the lower expected revenue from noncore products, coupled with increased spend on research and development and international expansion, operating income is expected to be breakeven.

Heska has a normalized estimated effective tax rate for the full year of between 25% to 28%. While we expect the future underlying effective tax rate to be in this range, these rates may be impacted by volatility due to excess tax benefits from employee share compensation and possible limitation on the deductibility of executive compensation. Even though our current tax expense may be minimal due to low booked income and projected tax losses, it is still possible for Heska to record deferred tax expense for the 2019 tax year based on our deferred tax inventory.

With that, Kevin, Jason and I would like to open up the call for your questions. Operator?

Operator, if we could open the call to questions?

(Operator Instructions) And we'll take our first question from Bruce Jackson from The Benchmark Company.

If we could look at the international revenue, to what extent is that incorporated into your guidance for 2019? And then, secondly, if you could talk a little bit about the status of Australia and New Zealand in terms of the international product launch.

Yes. So first, revenues for Australia and New Zealand should happen in the first quarter of this year. And that team is stood up, trained. Facilities, they're ready to go. And so they're out contacting customers, and I think they're off and running. In terms of the extent to which the revenues are baked into 2019, I assume that's the question, I would point out -- it's in the release, that we pursue a subscriptions model. So the ramp on a lot of these initial international placements will be similar to what we saw in 2013 and 2014, meaning you don't get a large onetime pop on the front end because we're placing them directly with end users on a subscriptions model. So you'll see something more on the order of USD 1,000 to USD 1,500 per placement on a 3-month period per quarter with each placement. The real economic value is you retain that customer now for 6 years. So it is in the guidance. But that's why the ramp is what it is.

We'll take our next question from Mark Massaro from Canaccord Genuity.

Kevin, I hope you feel better soon.

Thanks, Mark.

So my first question is on the consumable growth rate in Q4. It came in at around 5%, 6%. I think most of us were modeling closer to 20%. And I know it's a lot of small numbers, looks like it's a $2 million miss. But can you help us think about what specifically happened in Q4 that resulted in the shortfall in the quarter?

Mark, this is Catherine. I would say there's 2 primary drivers resulting in the growth of 5% to 6% as opposed to closer to 20%. It relates to the corporate install, or I should say, lack thereof of PetVet Care Centers, that has a compounding effects going through the fourth quarter; as well as changing purchases by some of our distributors, specifically Henry Schein at year-end. But purchasing has returned to normal in the early part of this year.

Okay, great. And then on a similar basis, as we think about consumables for next year, you guided 12% to 17%. I think that's lower than historical 15% to 20%. So can you also walk us through the puts and takes on that?

So I'll start, and then Catherine who's actually the expert can round it out. The first thing is, is 14.3% is actual for '18. I think it's prudent to guide to the middle of actual. So 12% to 17%, I think, is based on the run rate that we actually delivered in 2018. So from a broad principal standpoint, I think that's just consistent with what I've done in the past. I do think we have some positives that are assisting us there. The test releases that we outlined in the release are very helpful, both in terms of price and utilization. Price increases, same thing, based on the subscriptions. So with that, I'll -- same trends that we've seen for the last several years. I just think we're being conservative in basing it on what we actually delivered in 2018.

Great. And then as we think about the shift going on in mix, obviously, 35% to 30% to 18% on noncore products, that I certainly understand. But Kevin, can you speak to why you're confident that things will stabilize at 18%? Why is it not a step function to 10% to 5% to 0?

Yes. No, actually, so for -- because we have several pieces of noncore. So you have infusion pumps, things like that. They're just less value-add, which is what makes them noncore. They're not bad products. They perform well. Customers like them. Heska just doesn't add tons of value on the value chain in getting them to customers. Things like heartworm, where Heska makes the product on a contract-manufacture basis -- in the case of Tri-Heart for Merck, exclusively in the United States, Heska doesn't control the sales out to the end-user customers. So we do rely on Merck's forecast. And we do think inventory levels will normalize in '19. So that's, by far, the biggest gap down for the '19 guidance. And we think we have indications that, that product will have good sell-through and normalize in 2020, sort of return to more normalized levels. In the OVP business, I'll let Jason speak to that, but there's a wide group of products that come out of that facility.

Yes. Historically, on the OVP side, we've increasingly moved logistics out there into that facility, where they handle a lot of the shipping and receiving of the core products. We historically have had that facility and done our best to generate revenue and profit to provide cash flow to reinvest here, in what we -- have historically been the Core Companion Animal segment. Right now, we have -- our largest customer out there is Elanco. That's what -- is a large part of what's flowing through the OVP segment. We were a little disappointed in the total volume that Elanco has done with that line. We were hopeful when we signed that deal about 5 years ago, they'd do significantly more than they've done. And of course, that's a highly competitive segment. That's a cattle vaccine line. There's a lot of really strong players out there. And we're hopeful that over time, Elanco, perhaps, will do a little bit better. We do have an agreement with minimums in it that drives that Elanco relationship, and we're in the middle of some discussions about the appropriate minimum and is there a way to recut this deal that's better for both sides. You never know how those things go. It's always difficult to negotiate, especially with a large player in a relatively large product line. And then what we also have out there is several other smaller customers. And it's hard on a call like this because you're talking about a piece of a piece now to really give you fine details on what those little customers are doing. And sometimes, they have a big uptake, and all of a sudden, it's another $2 million because the customers got a hot product. We do have one that's built into the guidance. I won't call them out by name, but they did about $2 million last year. And they have had a change of leadership, and we're not quite sure what they're doing. So our outlook for them, what we have in these numbers, I'll tell you, is $250,000. We hope they do better. We hope they come back. But as we look at it now, we're not getting the consistency of dialogue and outlook that we would really like to see. And there's, again, several of those and they tend to wash over time. But that's what's baked into these numbers, and you should understand that sort of underlying dynamics that's going on in that OVP segment.

Great. If I can -- yes, go ahead.

So I think we're trying to be conservative there, Mark. And I think we're aligned with investors that having a stable and longer-term horizon baseline as opposed to periodic noise is a far better solution for everybody. And I think we've been working to get there, and I think we're pretty close.

Great. And if I can sneak one last one in. I wanted to ask if -- with noncore products sort of lower than expected, impacting revenue; and 2019 looking like an investment year with higher operating expenses, how are you guys thinking about your long-term targets that you showed last year, both on the revenue and the operating margin line?

Still like them. And I think they're supported by our model. This is -- [it doesn't change], and I'll use the term my investment thesis. I feel like an investor here as well. I am. This period, I think, is the -- it's one of those periods where you spend 3 or 4 quarters not looking great. And in the end, you look great. And that's how I feel about where we sit. We've got a lot of work to do, but it doesn't -- nothing is fundamentally altered in the outlook or my perception of that. And we'll go back and remind everybody, too, that we do think in 5-year buckets. We also compensate in 5-year buckets, not in 1-year buckets. And so we incentivize this type of thinking. And I like our 2020 number. It's an aggressive number. But I think with the 5 launches we have, the geographical launches we have and a couple of other things that we got in the hopper, it's a gettable number.

Okay. And just for clarification, Kevin, you said you do like them. So you are -- you think the targets are achievable?

I do, yes. And Jason said yes.

We'll take our next question from Ben Haynor from Alliance Global Partners.

First off for me, you talked quite a bit about the efforts that you're going to be making in R&D, innovation, even manufacturing. Just kind of thinking back, over the years, you've clearly done a pretty good job finding quality innovations that may have come from other companies, maybe on the human side and such. I guess, my question is, should we at all be concerned that -- maybe not a shift in strategy but a move in the direction that you're taking could lead to kind of a not-invented-here syndrome and maybe you might miss some of the innovations that you could bring in from third parties and drop into the install base at relatively minimal cost?

That's a great question. It's not a binary situation. There's no hard stop here. The Element i+ is a perfect example. That's an in-licensed global opportunity and it's primarily targeted towards human medical use. The largest investment we made last year, similarly, is a global license that allows Heska to manufacture and have global exclusivity in veterinary and animal health. So that's what we mean by that. Urine and fecal is a little bit different. When you go out and you look at the market for urine and fecal, there are urine solutions out there, that our competitors have gone to human companies and converted human solutions to veterinary solutions. We don't think that's the best path forward because the veterinary solution requirements for fecal point of care are substantially different than anything that will be developed for human use. And so in that case, you take baseline technology and you do innovate in-house, specifically for veterinary use. But they're both end solutions. I think the key is that we have global rights, we have both veterinary and animal health rights and we have the ability to manufacture these tests within our own facilities, which moves us up the value creation chain, drops your cost of goods and gets you a return on your investment.

Okay, that's definitely helpful. And then just with this Optomed acquisition that you guys made. Is that something where you -- there's been opportunity to bring the products to the U.S.? And I guess, what do the margins look like on that? Are they pretty similar to the existing imaging business, a little bit better, a little bit worse? Or how does that stack up?

There is the opportunity to bring there, as an endoscopy -- primarily endoscopy-based business, and there is opportunity to introduce those into the U.S. market. And the margins are slightly actually more favorable than our existing imaging product.

If -- and do they do the manufacturing? I'm sorry. Go ahead.

They do.

They do. They make them in France. We view them as a relatively premium line in that space.

Okay, great. Excellent. And then, I guess, lastly for me, in the press release, you mentioned the business that you have with VCA Animal Hospitals. Can you talk about maybe your footprint there and whether there might be some opportunities to expand it here in the near future? Now I know it's probably a common question you've gotten over the last several years and certainly more recently with the acquisition, but just any new color that you could provide there would be great.

Yes. So I don't know if there's a ton of new color. We have a great footprint, primarily in VCA specialty hospitals. They're our largest facility. I think, widely prefer our DC5X, the high-volume dry chemistry solution; and our HT5, our hematology, in the places like oncology. I think, they widely prefer those solutions just based on straight-up quality. So we have a great, great footprint in those facilities. Other Mars properties -- Mars owns VCA now, yes, I don't know if anything has changed. We compete more on an individual basis, and I don't know if there's a kind of a group tender that has been offered yet.

We'll take our next question from Andrew Cooper from Raymond James.

Just a quick one. As we look at kind of the subscription counts coming out of the year versus the outlook that you had, and I think the biggest callout was PetVet Cares, but even if you strip out the 118 that they still have remaining, it looks like you were about 75 or 80 shy of sort of the goal. Is there anything you can give us in terms of color what may have gone on there, if there's maybe something I'm missing in terms of the numbers?

I think that the chart, maybe, that you're referring to is really is -- it's -- those contracts are, over a period of time, those corporate installs will occur. So it's not necessarily a shortfall in '18. Are you referring to the number remaining?

Right. I'm saying, if you included that full 118 as if it had happened in 2018, you'd still be about 77 shy of the 2,370 that you had at the 2018 outlook in the table.

Yes. I think we candidly underestimated the change management, the time it takes to install corporate accounts. So even in Pathways and other corporate accounts, it just simply takes time. So you get a list of 5 or 10 in a month and you have to interact with them, but you can't just push out 50 in a quarter. So even with Pathways and our other corporate accounts that are doing a great job, I think we had to reset some of those expectations. I called that out a little bit, I think, in the release. I know there's a lot in there so I'm not slapping your hand or anything on it, but it's in there, that Pathway will continue on schedule in '19. They were originally scheduled to be, I think, fully completed by April. And that will slide. We do think we'll get there in '19. So it just takes a little bit longer. I think that's the difference between the 2,175 that we installed versus the 2,370 that we targeted to install. So put another way, we secured the right to install that 2,370. We just didn't physically get to install them all.

Okay, that's helpful. And then, secondly, just in terms of imaging. I think the guidance you said includes Optomed. So is there -- how are you thinking about that kind of core base imaging business in the U.S. and kind of the rebound from a disappointing 4Q, especially given, I think you called it out, some supply chain issues on at least 1 product? Just kind of the overarching view on that segment would be helpful.

Yes, I mean, 4.2% increase for the year. It was just not 10% or 12%. And I think we entered the fourth quarter at, like, up 16%. So we thought we would even probably beat our 10% to 12%. It was just soft. And actually, it was all December. And we called out a couple of reasons, I don't know if they're reasons or excuses, probably a little bit of both is my guess. So I -- January and February have been positive. We haven't had customers leaving. We haven't had customers expressing that they made a decision for another solution. We probably should be doing a better job of bundling with our point of care lab solutions, and I think we'll do a better job of that in '19. But I think, broadly, it's doing fine. It just didn't do what we hoped it would do in December.

We'll take our next question from Jim Sidoti from Sidoti & Company.

Can you hear me?

We can, Jim.

Great. I just want to be clear. The revenue from Merck, do you expect part of that to come back in 2020?

Yes, Jim.

We do.

Yes.

And do you think it comes back to where you were in '17 and '18 or it's somewhere in between?

No, I don't think so, Jim. I think they were overoptimistic on some of their marketing programs, and they obviously purchased based on those assumptions. And those plans have not come to fruition. They have a new product manager out there who, I think, is really strong. And as the supplier, we always like optimists, since the producer, I think, he's a little bit more of a realist. And he's indicated to me, they still have a strong market position, but he doesn't think the levels they had hoped to achieve are going to be attainable. So he's dialing back, I think, his expectations. And we're seeing, unfortunately, the corresponding adjustment here in 2019.

Sorry, I know you're hesitant to give 2020 guidance, but if we assume that a portion of that revenue comes out, and then you get the new product launches, I assume you'll expect -- you got to think 2020 is going to be 15% to 20% higher than 2019?

In terms of what?

Of revenue.

Yes, I think -- and I reaffirmed for Mark Massaro, it's an aggressive goal. It's been an aggressive goal since we launched it. But that number is $172 million for 2020, and I think we can get there.

Okay. So quite a bit higher than even that, than the 15% to 20%? Okay.

Yes, that's what our team is pushing forward.

In terms of the incremental expense in 2019, sales and marketing and R&D, do you expect those to remain at those levels for the next few years? Or are there any onetime items in there that will go away in 2020?

I think the research and development costs -- I mean, clearly, as we continue an innovation strategy, we'll evaluate that on a go-forward basis. The sales and marketing, I would anticipate to continue just based on mostly around international expansion, and that includes headcount increases.

Okay. And you said R&D might come down a little in '20, depending on how things are working out?

Yes, I think the R&D expenses will fluctuate over time. We will see a significant spike for us in '19. I expect that to come down slightly in '20. But as we continue to innovate, we -- clearly, we'd have to update that, yes.

Yes, the final stages of the urine and fecal will cause a significant spike. Ongoing R&D will be assay development on things like the Element i+, where we just had tested the platform. So they'll be working on heartworm, lyme, ehrlichia, anaplasma solution on that analyzer. And so that will just be ongoing R&D assay development.

Okay. And I think I saw it in the press release, but I can't find it right now. Where did you end 2018 in terms of sales force headcount?

Right around 105. That was up 25%.

Okay. And then you indicated that as these new products are launched and things pick up, you will add again, starting in the back half for 2019?

I think in the fourth quarter, we'll do it again.

We'll take our final question from David Westernberg from Guggenheim Securities.

All right. So just on the R&D spend, as you guys know, I actually do like that. I like the product innovation and that strategy, I think, is great. I just want to actually ask you guys about your confidence level, that you allocated correctly where to spend that R&D dollars and your confidence that you're spending it correctly. And as kind of a follow-up to that, can you maybe give us some color as to how that R&D dollars are allocated? Is that allocated towards new teams or is it just projects? Any kind of color there would be helpful.

It's mostly project-related. So you'll have Element i+, who'll work with our outside licensing partner who has the expertise. They're the ones who can help us set up production lines, those types of things. Assay development and those types of things. The urine and fecal team, different team, different methods of operations, so a different project. We think we've got the R&D allocated properly. Ironically, for me, the 2013 to 2017 period is primarily about model, operations and model. And the '18 to 2022 period is primarily about scaling the model with innovation. Me, personally, I'm more comfortable in the innovation portion of the challenge, and I think we're doing a great job there. I'm excited. I think 2020 and those product releases will do well.

Got it. So in other words, you can pull back and add -- you kind of said this on the answer to the last question, but you can pull back and add to those R&D dollars in kind of an ad hoc basis pretty well, pretty fluidly. That's correct, right?

Correct. So if the assay teams says they can make a faster launch by spending an extra, pick a number, there's a budget. And if we add another assay developer or 2 for $250,000, we can get there quicker, then just basic math getting to the market quicker with the new test, with our ability to market the test, which could be the limiter. We might accelerate or we might choose to not accelerate. So there's some flex in there.

Got it. I know you kind of already answered that to Jim's question, but I appreciate the additional clarity there. So just on Pathway, does that deal include Thrive, if you're allowed to disclose that?

It does not.

That does conclude our question-and-answer session. I would like to now turn the call over to Kevin Wilson for any closing remarks.

Thank you, operator, and thank you to everybody who logged into the call. I just want to reiterate, we thank your time and we value your investment. We take those very seriously. Look forward to updating you on our next quarter, and thanks again for your interest in Heska. Bye-bye.

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