Neogen Corp (NEOG) 2014 Q2 法說會逐字稿

Welcome to the Neogen Quarter 2 fiscal year 2014 earnings results conference call. My name is Joe and I will be your operator for today's call. At this time, all participants are in a listen-only mode, and later we will conduct a question-and-answer session.

Please note that this conference is being recorded. And I will now turn the call over to your host, Mr. Jim Herbert. Please go ahead, sir.

Thanks, Joe, and good morning and welcome to our regular quarterly conference call for investors and analysts. Today, as you know, we'll be reporting to you the results of our second quarter that ended on November 30.

And I'll remind you that some of the statements that are made here today could be termed as forward-looking statements and these forward-looking statements, of course, are subject to certain risk and uncertainties. Actual results may differ from those that we discuss today. And those risks that are associated with our business are covered in part in the Company's Form 10-K, as filed with the Securities and Exchange Commission.

In addition to those of you who are joining us today by live telephone conference, I'd also welcome those who may be joined by way of the simulcast on the worldwide web. Following comments this morning, we'll entertain questions from participants who are joined by this live conference; and I'm joined today by Steve Quinlan, our Chief Financial Officer, and Steve Snyder, Neogen's President and Chief Operating Officer.

Earlier today, Neogen issued a press release announcing results of our second quarter that ended on November 30. Again, revenues broke all records for the Company's second quarter, at approximately $59.6 million, or a 17% increase, compared to last year's revenues of $50.7 million. Our year-to-date revenues through the first two quarters have increased by 18%, to approximately $118 million from last year's approximately $100.5 million.

The second quarter net income was $6.2 million, compared to the prior year's $6.8 million. Adjusted for the 3-for-2 stock split that was effective on the 31st of October, earnings per share in the current quarter were $0.17 per share compared to $0.19 a share a year ago. Current year-to-date net income -- current year for the net income is approximately $14 million, or $0.38 a share, compared to $13.5 million, or $0.37 a share, for the same six months last year.

I think it should be noted that as a result of option exercises and dividend adjustments, the number of fully diluted shares is approximately 3% greater at the end of this quarter than it was last year. This second quarter marks the 87th quarter in the past 92 quarters that Neogen has reported revenue increases as compared with the prior year.

The last time we missed a quarter was now eight years ago. I know that all of us in the Company are proud to continue this steady growth that we've established now for 23 years. We're not as proud of the earnings drop compared to year ago that we're reporting to you today. I said in the press release this morning that some of the investments that we made this quarter to accelerate future growth impacted current quarter earnings.

Those of you who have followed the Company know that one of the primary metrics that we use in overall management is to monitor operating income. We found that 20% operating profit is a good tipping point. When this drops below 20%, we know we need to look back upstream and find out where there might be some leaks or improvements that we need to do to restore to the 20%. When it goes over the 20% mark, we found that this is generally the time to step up resources aimed at increasing revenues in future quarters.

When we completed the first quarter with operating income over 21%, we thought a tipping point was at hand and we could see market opportunities that were developing perhaps faster than our resources would be able to capture. This increased spending, combined with a few other changes made during the quarter, make the drop in net income very understandable, actually. In a nutshell, operating expenses rose $3 million for the quarter, while gross margins increased $2.2 million, and this resulted in lower operating income for the quarter.

A number of pieces all fell together in the quarter to make it a test for management's ability. First of all, we've known for the past year that this was going to be a tough quarter for comparisons. This quarter a year ago, we were recorded revenue increases of 13%, but net income increases of 30%. That year-ago quarter was really driven by excellent gross margins, the highest the Company had ever experienced, at 53.8%, as compared to normally we've been running around the 50% to 51%.

At that time, we pointed out that given our strategy it would be difficult to compare to these kind of gross margins in future quarters. This quarter's 49.5% gross margin, though sub par for us, is certainly not disastrous, unless you compare it to a year ago.

Almost immediately as the numbers began to come together for this quarter, we began to look at where that 4.3% margin difference came from for the quarter. And at this point, our accounting finance people can clearly account for 3.9% of that. And I've looked at each of those and I can tell you that none of those spells disaster.

We made investments in the operating side of the business this quarter to take advantage of future growth possibilities. This included an increase in sales and marketing expense, most of which have not started to drop dollars to the bottom line. We increased our R&D expenses for the quarter. This is, of course, aimed at new products that will be introduced later. Administrative expenses showed a big jump for the quarter, and I'll let Steve Quinlan talk more about that as he takes over in a few minutes.

I feel a bit like Henry Ford's advice once when talking to an investment analyst and he said, don't complain and don't explain. And I say that with a due amount of reverence. And I think there's a lot of positive developments in the Company that led us to the 17% increase in revenue. Part of this came from our second quarter acquisition of the veterinary instrument business, when we bought the assets of Prima Tech, the first of November. So we had one month of that acquisition in the quarter.

We had had our eyes on this one for about three years and in fact, had made a couple of different offers. So this business does line up well with the rest of our Veterinary Instrument business, since it gives us some new product technology that has now been widely used in the livestock industries.

Back in the beginning of July, Neogen acquired SyrVet, another strong veterinary instrument business that brought new products and customers. Both of these joined to Neogen's Ideal Veterinary Instrument division, that's been a part of the family now for over 25 years, has put together a very nice position. Combined, we think that we are truly in a leadership position in the veterinary instrument market in North America, and in many other parts of the world. These products are used predominantly by farmers and ranchers in the production of animal protein products.

Most of our existing businesses showed nice increases during the quarter, with the exception of diagnostic tests for the detection of presence of mycotoxins in grain. And I think this is probably a good spot for me to stop and turn the call over to Steve Quinlan, our Chief Financial Officer, to give you a bit more of the color behind some of my general comments. Steve?

Thanks, Jim. Jim's already reported on the overall sales and profit performance for the second quarter of our fiscal year, and it was definitely a mixed bag; good revenue growth, with some earnings challenges as a result of gross margin changes. In the next few minutes, I'll address some of the significant highlights for the quarter, and I'll start by discussing our Food Safety Group.

The Food Safety Group recorded revenues of $28.4 million, an increase of 9% for the quarter; and all of that growth was organic. This was a difficult comparative quarter, coming off last year's second quarter, when there were significant outbreaks of aflatoxin in the corn crop in the US and mycotoxin outbreaks both DON and aflatoxin in Europe. These outbreaks occurred just as we were introducing our new quantitative lateral flow devices, and our sales in that period were up over 60% over the prior year.

This year's corn crop in the US was very clean. And although there are sporadic outbreaks in Europe, our overall mycotoxin kit sales for the quarter were down $1.1 million. Growth across almost all of our other product lines more than offset the lower mycotoxin numbers; however, this growth was at lower gross margins, which I'll discuss shortly.

Revenues for our industry-leading product line to detect inadvertent allergen contamination, which includes our diagnostic tests for milk, peanuts, gluten and processed soy, among others, continues to be very strong and were up 25% in the quarter, as we continue to have a leading position in a rapidly growing market. Our gluten test kit sales were particularly strong, up 28%, as gluten-free food production continues to expand significantly.

Our line of AccuPoint samplers and readers, which are used to monitor environmental cleanliness at food processors, rose by a robust 30% in the quarter, building on momentum from a strong first quarter. Revenues from products such as ampuled media and filters which are used to test and monitor water quality at beverage manufacturers continued their recent strong growth, rising 41% in the quarter, as we penetrate this important market. And our Acumedia line of dry culture media rose by 16% during the quarter, as we were able to capture incremental sales from existing customers and we also gained a number of new customers.

Revenues for our tests to detect the presence of antibiotics in raw fluid milk rose by 15% in the quarter. This product line had declined in the first quarter, due primarily to order timing and inventory levels at a large European distributor; and they recovered nicely in the second quarter, aided in part by higher sales of our BetaStar product line in Brazil.

We had strong sales in our Soleris line of optical microbial test systems, which are used to detect spoilage organisms like yeast and molds in foods. Both disposable vial and instrument sales rose in this product line in the quarter, with an overall increase of 46%. We saw strong instrument placements during the quarter, which should bode well for future vial sales.

Jim's going to talk about our international operations in detail in a bit, but Neogen Europe, Brazil and Mexico all had strong results in the quarter. Combined, these operations improved revenues by 26% for the quarter, and that was building off a strong start to the year.

We'll move over to the Animal Safety Group. That Animal Safety segment recorded revenues of $31 million for the quarter. This was a 26% increase over last year's second quarter, and that was aided by about $2.9 million in revenue from the recent acquisitions of SyrVet and Prima Tech that Jim talked about. Organic growth for the segment was 13%.

Animal Safety's Lexington Division recorded revenue increases of 29% for the quarter. The division completed the move of the SyrVet operations from Iowa to our Lexington operations during the quarter, while also integrating the Prima Tech acquisition. And our employee group, in particular the Operations, Customer Service and Accounting groups, put in long hours and did an outstanding job of getting that done seamlessly, with minimal disruption to our customers.

We had a number of product lines which performed very well in the quarter, including our market-leading line of detectable needles with revenue increases of 23%. Biologics, which includes our vaccine for equine botulism, rebounded from a weak first quarter to post a 14% revenue increase in the second quarter.

In our Diagnostics business, forensic kit sales rose by 33%, driven by increased business with testing labs. Our Animal Care line increased 7%, as we had nice increases in wound dressing, joint care products and vitamin injectables. GeneSeek, our genomics-based testing and bioinformatics business, located in Lincoln, Nebraska, had an outstanding quarter with revenue increases of 56%, as a number of custom programs which were developed to aid beef and dairy cattle producers continued to gain share in the market.

As we mentioned on the last quarterly call, we've outgrown our current facility in Lincoln and have purchased a 26,000-square foot building, also located in Lincoln. We bought that in August. We've begun renovating that building and anticipate moving in early next year. And at that point, we'll exit our current leased space.

Animal Safety's Hacco Division, which is located in Randolph, Wisconsin and produces rodenticides, and cleaners and disinfectants, which are important pieces of effective bio security programs maintained by animal protein producers, recorded an overall sales increase of 9% for the quarter, with strong 27% growth -- and that growth was primarily international -- in our line of cleaners and disinfectants, offset by a 5% decline in rodenticides, and that was due to weakness in the Mexican sugar cane market.

Now gross margins were 49.5% for the quarter, and this compares to the 53.8% in last year's second quarter. This decrease was largely the result of product mix shifts within each of the Company's operating segments.

On the Food Safety side, the lower sales of the mycotoxin test kits, which we talked about earlier, which carry higher gross margins, adversely affected our margin percentages. Strong growth in most of the rest of the Food Safety product lines made up those lost mycotoxin revenues, although at lower gross margins.

On the Animal Safety side, product mix shifts from the incremental product sales from the SyrVet and Prima Tech acquisitions resulted in a lower gross margin percentage overall for the segment. These businesses are bolt-ons. And although their gross margins fall somewhere in the middle of the Animal Safety average, they require less operating support and should provide nice contributions to operating income, once fully integrated into the Company.

Other mix shifts within the segment included GeneSeek, which recorded lower gross margin percentages as they completed a couple of high volume, lower margin products; and at Hacco, where higher sales of cleaners and disinfectants, which are a lower margin product, were offset by lower sales of rodenticides, which carry higher margins. So we had a product mix shift there. Overall, gross margins rose by $2.2 million for the quarter.

Our operating expenses were up 18% in the quarter, and that compares to last year's second quarter. Sales and marketing expenses were up 12%, due to increases in personnel, marketing, advertising activity and shipping expense, all directly related to our volume increases.

General and administrative expenses rose 28% for the quarter. This was due to higher compensation-related expenses, increased stock-based compensation expense from our 2013 grants, increased amortization expenses of intangible assets from our acquisitions, and higher legal fees. The stock option expense and the amortization charges are non-cash charges.

Research and development expenses increased 15% over the prior year, reflecting the continued elevated levels of new product development and product improvement activity for the group. Overall, approximately $500,000 of the increase in operating costs for the quarter are the direct result of our acquisitions, and of these costs, $200,000 are not expected to recur.

But with operating expenses up $3 million and our gross margins up $2.2 million, our operating expenses declined to $9.7 million for the quarter, a 7.5% decline from last year's $10.5 million second quarter, and dropped as a percent of sales from 20.7% last year to 16.3% in this quarter. This decline is almost entirely explained by the 430 basis point change in our gross margin percentage for the quarter. The difficult mycotoxin comparison which we saw this quarter could continue to impact us near term, although not as much as this quarter, as the tail from last year's outbreak was not long.

On the balance sheet, we finished the first half of the year with a strong cash position, even after spending $22 million on the SyrVet and Prima Tech acquisitions during the first half. Our receivable balance is up 18% since last year-end, reflecting pretty much in line with our revenue increases. We also purchased about $1 million of Prima Tech receivables when we bought that business at the end of October.

Our inventory increased by $9 million from last year-end levels. And of that increase, about $4.5 million is due to inventory purchased in the SyrVet and Prima Tech acquisitions, which we will be right-sizing over the next few months. And as you can see from our summarized balance sheet, our financial position remains strong.

Now that wraps up my prepared comments. I thank you for your attention. And at this point, I'll turn the call back to Jim Herbert.

Well, thank you, Steve Quinlan. I'd like now to turn the call over to Steve Snyder, who is soon going to be celebrating his six month anniversary with Neogen as our Chief Operating Officer. And Steve's catching on pretty fast. And at the end of six months, I think we might just like him well enough to keep him around. Steve?

Thanks, Jim. It's been a good six months. And thanks, Steve, for the recap of the performance this quarter. On the call today, I wanted to comment briefly on the quarter's financial results, but then really focus on some examples of ongoing strategic programs, achievements and opportunities that we see as important to our growth and to our mission of delivering Food and Animal Safety solutions to our customers.

In the results reported earlier, I think it's interesting to note that revenues and gross margins did grow across the board in most of our product lines. This was true with the exception of just a few areas, which Steve mentioned, that struggled against prior year comparisons, and namely, that was mycotoxin. At the same time, our sales and marketing investment spend came into play this quarter. As you probably recall, we've been adding sales and marketing capabilities to help support our continued growth. In fact, we added 14 professionals in sales and marketing since the beginning of the year, and just in North America.

This surfaces a couple of points. First, while we brought in new talent, we also know it takes time for even our best recruits to learn our product lines and become familiar with their territories before they can begin generating profits with customers. The second point on the product side is that we know it can take some time to get new products introduced, tested and adopted by customers. With both new commercial hires and new products being launched recently, both of these factors may have come into play this quarter.

With that said about results, let's shift over to our growth activities in the Food Safety business. I'm working closely with our Food Safety leadership team, including all of the functional leaders in sales, marketing, product management, technical service and R&D, to design and implement programs that will allow our sales force to leverage Neogen's broad microbiology-oriented product lines to meet our food customers' growing needs. This is significant for us, since we probably have the largest line of microbiology products in the industry.

Along with the attention that the FDA's Food Safety Modernization Act has created in the food industry, we know that brand protection and public safety continue to rank as high priorities to our customers. These programs will expand our team's ability to deliver practical, cost-effective solutions to our customers in the microbiological area, including pathogen detection. We can do this today with existing products, such as our Reveal line, ANSR, Acumedia, AccuPoint and Soleris lines, but we also have some newer additions to our microbiological product tool kit that support the effort.

A good example is NeoSEEK, which provides highly accurate pathogen and speciation confirmation in meat products. The NeoSEEK offering leverages our world-leading genomics analysis capability from Neogen's GeneSeek laboratory in Lincoln, Nebraska.

Our newest and recently announced microbiology product addition, NeoFilm, provides a better solution for microbial test count applications. It is designed with the user in mind, offering a range of benefits including simplified work flow and freeing up valuable work space on the bench. We're excited to offer this new product to a market that had heretofore few current options for similar applications. All the products I just mentioned make up a powerful portfolio in micro solutions -- or microbiology solutions -- that we are using to better help support our existing and new customers.

Other initiatives we feel make a difference in coming quarters include a renewed focus on meeting the needs of larger strategic customers, such as leading beverage, meat, grocery, grain, dairy, or pet food customers. For example, we're continually adding staff around the world, increasing global coverage for multinational accounts. We believe that the combination of our global reach and strategy of addressing food safety all the way back inside the farm gate is attractive to these large global players.

In another example, we're commercializing new equipment that allows for improved data management, like our new AccuPoint 2 sanitation monitoring system with an RFID reporting feature. This new offering allows users to automatically track locations for test results and identify trouble spots in their manufacturing environment. These results then can be easily and accurately sent electronically to a central location for remote monitoring, analysis and data storage. It's a great product and it has seen significant success in the market.

A last example I would give is aimed at the dairy market. It's our BetaStar Combo enhanced test for antibiotic contaminants in milk. It allows customers to check for the presence of both tetracycline and beta lactam antibiotics in the same test strip. This saves time and makes testing easy. We look to add more innovations in this important space, as well.

Moving over to the Animal Safety business, an encouraging note to mention was the double-digit increases in same-store sales figures in the quarter. Our team in Lexington achieved these results, while at the same time digesting the recent acquisitions of both SyrVet and Prima Tech. Clearly, our team in Lexington did not take their eye off the ball while integrating these acquisitions. It's a great example of focus in the face of change.

Also within the Animal Safety business this quarter, we continued to develop our important bio security businesses and cleaner disinfectants and rodenticides. We continuously look at new formulations and applications to grow this line. These products are important inside the farm gate to break the cycles of disease transmission and improve sanitation. We also see benefits outside the farm gate in final processed meat, poultry and eggs, when our products are used to reduce the contaminant load prior to processing.

In general, chemistry-based solutions will continue to be a source of customer solutions and revenue growth. And my background with chemical businesses tells me that this is a significant opportunity for Neogen. We are looking to build this capability in the future.

Regarding international growth, I visited our operations in Brazil recently and I'm really excited about the potential our team sees there to implement our Food and Animal Safety strategy. We appear to be constrained only by our ability to hire talent, and that's in the face of very low unemployment and a growing economy.

So while still learning the details of our business, I'm now digging into the activities, the businesses, -- the activities and businesses I just mentioned -- to improve our product offering and approach with customers. I am confident that our talented teams at Neogen will apply their winning, can-do attitude to all of our important initiatives and help deliver our goals. With that, Jim, I'll turn it back to you for wrap-up.

Thanks to the two Steve's for their updates and outlooks. Now that we're already part way into the third quarter, I think you'd be interested to know some of the developments that we see ahead.

We've not talked much here today about the international side of our business, but this is quite promising, with revenues from international sources up 21% on a year-to-date basis compared to a year earlier. Our Neogen Latino America operations and Mexico continue their growth, being up 11% for the quarter. We're completing a move there into larger quarters to accommodate the increase in growth, as well as improve our efficiencies.

This subsidiary markets both our Food Safety and Animal Safety products, as does Neogendo Brazil that Steve just referred to. Brazil revenues for the quarter are up 56%, albeit from a smaller base. But we're growing very nicely there. We still haven't achieved full traction, but I believe it's coming.

Shifting geographies a bit, following Chinese New Year, we're set to make some important changes in consolidating our China business to move a significant portion of that business into our Company-owned subsidiary, Neogen Bioscientific Technology Limited, located in Shanghai. As pressure of food safety continues to increase in China, China officials are anxiously trying to come up with solutions. In our new unified program, we believe that we'll be able to more capably handle some of those opportunities.

The other part of the world where the middle class is developing rapidly is in India. We are in India today only in small waves through independent distributors. However, we've set a strategy to go forward with our own boots on the ground and we're exploring some acquisition opportunities right now that will enable us to do this.

Neogen Europe, headquartered in Scotland, continues to be the star of the international front. Their revenues for the quarter were up 24%, and 38% for the first six months. I'm just back from a week in Scotland, working with our management team there. New food safety programs in the European Union are more advanced, truly now, than they are anywhere in the rest of the world. While I was there, in fact, a new report on economic adulteration of meat was released, and it contained strong recommendations to make more use of the tests for meat speciation, like the products that Neogen offers.

We have a great management team and a good facility in Scotland to take on our future expansion in those countries. It's also a good time for me to say thanks to the 820 Neogen employees now around the world for their continued strong efforts that's kept our growth in such an aggressive fashion.

The coming two quarters should also benefit our new products that are now finding their way into the marketplace. We have over a dozen new or improved products that will be finding their way to the market before the end of the fourth quarter.

As Steve Quinlan indicated, our balance sheet continues to be strong. Shareholder equity has grown about 9% in the first half of the year. We have no long-term debt; and cash flow continues strong, even though we use cash for acquisitions.

On that acquisition front, things continue to look promising. Since the beginning of the calendar year in January, we've now done three acquisitions, and all have been or soon will be accretive to both bottom line and the top line. And we'll provide a promise to provide some future growth with all of them.

Though we don't have anything to announce today, we do have a soft circle around a couple of opportunities that could come on board in the near future and be very synergistic to our existing businesses. Let me stop at this point, and Joe -- and invite any questions that we have from our telephone audience.

Thank you. We will now begin the question-and-answer session.

(Operator Instructions)

And it looks like we do have some questions here. The first is from Mr. Paul Knight. Please go ahead, sir.

Hello. This is actually Bryan Kipp on behalf of Paul. Just to start off here on the operating level, on the gross margin level. So you guys alluded to the fact that there was 3.9% that can be accounted for and you're looking upstream to get back up to that 20%.

With sales and marketing, G&A and R&D basically remaining at that 33.2% of sales as we saw last year, where do you see those upstream opportunities, ex- mycotoxin coming back on or aflatoxin demand coming back on, where you guys can drive that up in the near term to get closer to that 20% margin level?

Well, I know what the gross margins were on that set of products, but I'm not going to disclose it with all my competitors on the phone. That is a very high gross margin product, our diagnostic test for mycotoxins. So a $1 loss there could be as much as $3 or $4 loss someplace else.

The mycotoxin testing is not going to -- we didn't lose any market share, we don't believe. That market is not going to grow any until we begin to see some grain crops come back somewhere in the world. So it's little chance of anything happening in the mycotoxin area in our third quarter.

Where I do think that we think we've got a lot of things coming, Steve talked about a couple -- Steve Snyder talked about a couple of new products that are coming on. We'll make up for it with revenues that won't have quite as good a gross margin as the ones in mycotoxins, but we think we've got opportunities for revenue growth out there that are going to take care of that void.

On the Prima Tech and SyrVet, how long do you think that will take to get accretive op margin levels? Is it a year out from now, or do you think it can be more near term?

No, no, no, no, no. The SyrVet is probably there now. It's certainly there at the top line, and at least most of the way there at the bottom line. We just simply moved everything that was in those warehouses in Des Moines, Iowa to our existing facility where we had space, primarily in Lexington, Kentucky.

By and large the same sales force that we already had is now selling more products that customers were 90% the same as the customers we already had. So when you get a bolt-on that's a true bolt-on like that it moves pretty fast.

The Prima Tech one, I haven't really looked at the -- it's only been in the numbers for one month, the month of November. So Steve Quinlan can probably tell us, but I'm sure it probably wasn't accretive at the bottom line, because given new accounting rules, used to all of those costs for bringing a new business on and the legal expenses for acquisitions used to get thrown into the capitalization of the business and depreciated out over some period of time. Now you put it all in the month that you close the acquisition.

So I'm sure we had some expenses related to that acquisition that hit the first month that would have diluted out or obstructed any profits much that came through. But that will get itself cleaned up. We get through the accounting gymnastics, as I can't always predict, most of them non-cash, that we get through that through the next month or two. I think by -- really towards the end of this quarter, it certainly will be accretive at the bottom line, probably not to its maximum capacity, but coming on pretty quick.

Okay. Appreciate the color.

Yes.

We also have a question here from Mr. Steven Crowley from Hallum Capital. Please go ahead, sir.

Hello, guys. It's Steve Crowley from Craig-Hallum Capital. Good morning to you.

Good morning to you, Steve.

Good morning, Steve.

In terms of trying to understand some of the financial dynamics you have at work, you've certainly given us the landscape that you just dealt with. But in terms of understanding, with Prima Tech coming on for three quarters in the February -- all three quarters, so a full impact on the operating expense side, you referenced a couple hundred thousand that were deal-related.

So I'm trying to get a sense for the foundation operating expense run rate for the Company. And it seems like it probably goes up a little bit from the $19.8 million that you just reported, but with some efficiencies, not that much. Is that the right way for us to think about it?

I'm not sure, Steven, I understand the question.

Well, expenses should go up from here. I'm wondering how much.

Okay. Well, I'm not sure I know how to answer that, because I don't know the total impact of non-cash accounting that we may be facing. And let me give you some examples. And I'd love to blame the world on FASB, but I can't. It doesn't matter. That's the hand that's dealt us.

But at one point in time, goodwill was goodwill. Now we buy a company, we take what was goodwill and we put part of it in the customer based intangible and that gets -- we think we know what that number is. We start to use that in our accounting.

It gets tossed around by the auditors and several other people. Sometimes it comes back. That number goes up or goes down based upon outside opinion. Nothing that ought to be of a concern at all to shareholders. It's a non-cash item. But it certainly does impact our financial statements.

I talked about the fact that once, when you bought a business and you had inventory, you put it on the books at what it was from the seller and that was your basis going forward. Now with some new pronouncements, there's some sort of new calculation that says to finished goods you add 16% to those finished goods, perhaps, and then your basis then for profit for the operating for that next quarter or whenever you liquidate those, you have lesser profit.

So all of a sudden you had maybe a low gross margin group of products that were at -- say, maybe they were at 30%. Now you've lost 16% of that gross margin, which is totally not cash.

So I sound like I'm giving you a politician's answer, which I probably am. But I wish I could predict all that in advance. The basis of all of it is good.

We know that we're buying businesses at 15, 16, 18 times earnings, and we know that we're folding them in and we're getting a lot of economy of scale. Neither one of these two veterinary businesses, we're not using much of their old existing sales cost at all. We already had that built in place. I don't know how to tell you how much that will go up.

Now, Steve Quinlan, in terms of the stock comp expense and those amortization expenses that hit in Q2, maybe a starting point for us who are forced to take a stab at the future income statement of your company, that data would be helpful, and if you have a best guess on what those numbers will be in Q3. But at least you have them -- I know you have them for Q2.

Yes. Steve, the stock option expense for the second quarter is about 7 -- I'm sorry, about $900,000.

Okay. And the amortization number that you referenced?

Did you want both depreciation and amortization, or just amortization?

Well, if you have both of them -- somebody else will ask it anyway, so we could just get that out of the way.

Sure. Second quarter depreciation number is $1.2million, $1.3 million, let's call it, and amortization's another $920,000.

Okay. And the $920,000 will go up by some amount with a full quarter of Prima in Q3, is that the way we should think about that?

Yes.

Okay. Really where I'm angling here is to try and figure out what your operating margin can do for this year. Through the first half of the year, it's down about 200 basis points year over year for the six month period. And it looks like, given some of the margin trends we're talking about today, that it's going to be down for the total year versus the 19.4% you reported last year.

And I'm just trying to figure out if you could make up some ground so it's only down 100 basis points, or whether or not you do have some rabbits to pull out of a hat to make it more comparable to the 19.4% a year ago. As you've done the modeling, what's the range of outcomes there?

That's an interesting question, Steve. Obviously, it's all dependent on the gross margin levels and it can range -- we're at 49.5% here. It could go to as high as 51.5% maybe, in the second half of the year.

I can't give you an exact answer there. But it's going to be somewhere in between there. Maybe you split the difference and you say it's 50.5% for the rest of the year.

And the biggest variables to drive gross margin higher in the product mix are which products? You had a good quarter in dairy. Is the outlook -- I know that's a higher margin area.

You've got some mix shifts in GeneSEEK. How's the pipeline look there? Help us understand the bigger table-tilting variables to future gross margin. And then I'll hop back in the queue and let some other folks ask some questions.

Well, you know, it's no secret that if you're looking strictly at gross margins, the Food Safety Division has always offered more gross margin -- better gross margins than the Animal Safety. However, we've always said, Steven, we look at running the Company based on operating profit. And whereas, as an example, Food Safety may be perfectly in a perfect position to spend 30% on sales and marketing expenses, because they've got the margin to absorb it and they've got the open market out there, whereas the Animal Safety Division with lower margins is operating on sales and marketing expense of perhaps 10% lower.

So if you're looking at what's going to bring in the gross margins, the best opportunity to increase gross margins, it would be some of those products in the Food Safety side, though we've got a few products on Animal Safety that have gross margins in excess of 70%, probably. But the real opportunities are going to be big opportunities, it's going to be on the Food side. However, as a friend of mine once said, it's hard to write a check for percent.

If we want to look at what's going to happen at the bottom line, I think we've got to carry it all the way through to the operating profit side. And those places where we are bringing in, these two veterinary instrument businesses, as long as the one that we've owned for 28 years, are strong contributors to profit, strong contributors to growth, the original one and we think the new ones, but yet their operating profits -- their gross margins are not all that good. But we spend 1% or 2% on R&D, and they don't carry a lot of administrative expenses to go with them, so they're a great contributor.

So if your question is where are the gross margins going to come from that's going to be the most promising, it would be some products coming out of Food Safety. If we're looking at what's going to be the greatest contributor to the operating profit side, that could come from either place.

And out of Steve Snyder's list of new products that you reference coming in the second half, is there one or two of those products or product lines that has the highest potential for more immediate contribution?

You know, Steve, I think NeoFilm is still very new, so we don't know exactly how that's going to go. We have great expectations and it's been adopted well so far, and we're still early on.

But I would probably have us look back to some of the areas of our traditional strength, allergens and areas where we've had success in the past, and look at the continued steady effort, maybe combined with some retooling and effort that we're giving with the sales team to increase those sales. So nothing -- no big flashes in the pan, per se.

As an example, Steven, I spoke of having been in Scotland last week, and it was -- the timing was not necessarily happenstance. But a report was given to -- that was ordered by the British Parliament on the whole issue of the food security based on what happened with the horse meat that got introduced to beef, and everybody's been in an uproar on that.

We've got a number of products that look at speciation. I think -- we think that that's going to be increased testing, certainly in parts of the European Union, not just for horse meat -- and that's not where it is now -- but they talked about, this special report talked about the fact that a lot of white fish -- turbot is being sold to be cod and haddock is sold as cod.

The economic adulteration that's going on, we think that we're going to see some changes there. We're in a very strong position there competitively, and we have very good gross margins in those products. So it's hard to say where lightning's going to strike tomorrow. But it's going to strike.

Great. Thanks for taking my questions. Excellent, sir. Thank you.

(Operator Instructions)

And we do have a question here from Mr. Greg Halter of Great Lakes Review. Please go ahead.

Thank you and good morning.

Good morning, Greg.

I know you talked a lot about the different areas of your international operation. But I wondered what the international sales are as a percentage of the total in the quarter?

Let's see. They can give you that. It's, though up good year over year, it's probably, I'm guessing probably not quite as good as a percent of sales as this time a year ago.

For the second quarter, that number's 39%. Year-to-date, it's 40.7%.

All right.

-- which is getting skewed, for instance, by Prima Tech, as an example, had no sales, to speak of, outside of the US, and that folded in this quarter. However, you take a product line like that, we're already looking at opportunities to go to Mexico with that product line. We can move those out pretty fast.

One of the great things about those, where we've got feet on the ground in places like Canada and Mexico and Brazil, we can take products that the existing owners or the former owners didn't have the power to do and we can push them into those markets pretty quick at no additional cost.

Would that be true also for Europe and other parts of the world, besides just Mexico, Canada, Brazil, and so forth?

We don't have good footing on the ground in Europe for our Animal Safety Group. We've got strong sales in some areas, such as our detectable hypodermic needles. In fact, by Danish law, if it's a food animal, you have to use a needle that is detectable by a metal detector in our processing plant. So we've essentially got all that business.

But we don't have the full line of business there. It's an area that we've talked about. We continue to talk about. We need to be there. We need to have an animal presence, Animal Safety presence in Europe. But at this point, it's pretty confined.

So that's a huge opportunity for us going forward. We've got to find the time to get it done.

Okay. And Steve, relative to foreign exchange, what kind of impact did that have on sales and the pretax income?

For sales, it was negligible, almost zero. And pretax income, it was actually a pick-up of about $136,000 for the quarter.

Okay. So still relatively minor. Looking at your -- sorry, the cash flow statement, I don't know if you provided the cash flow from operations, either for the six months or for the quarter? Do you have that available?

I didn't, but I'll be happy to. Cash flow from operations for the quarter is $5.2 million. So that should be $10.7 million for the year-to-date period.

Okay. And that's down about, I don't know, $500,000 or so year over year. Any reason why you wouldn't see that number improve as the year progresses?

It actually should improve. We've got a little bit of a buildup of receivables in inventory that should dissipate over the rest of the year, so you should see that number improve.

Okay. And I can't remember what the number is, but any change in your capital spending plans now that you have the Prima Tech business? I think before we had been looking at around $10 million for the year.

Yes, there's no change there.

All righty. And I presume the tax rate around 36% is about where you'll come out. Are there any opportunities to bring that rate lower over time?

There are. Over time, I think we're -- maybe that's a longer period than the rest of this year. We don't have any plans right now to do anything that's going to move that rate markedly for the rest of the year, but we are looking at future tax planning strategies that will make sense for the Company.

All righty. Thank you.

Sure.

And I'm showing we do have another question here from Mr. Drew Jones of Stephens Inc. Please go ahead.

Good morning, guys. A question just about longer term opportunities.

I guess under the Food Safety Modernization Act, there's been a little bit of talk about animal feed and maybe doing a little bit more screening on that side of the business. Can you talk about how you guys are prepping for that and when those opportunities might start to manifest?

Yes, thanks, Drew. And that's clearly one of the areas that we are addressing, are looking at.

For some time, for a quick background, for some time there's been a feeling that the -- I don't remember what the percentage is, it may be that 70 something percent of all antibiotics in this country go to animals, maybe 80%. It's a very little amount goes to humans when you look at the total antibiotic usage. Most of that, in the past, has gone to animals, as what I would call a management crutch.

We fed them low levels of antibiotics to hold down infections, so that we could improve performance in the animals. And this was particularly animals going to market, whether it was beef or sheep or hogs or whatever. There's been some feeling that the use of those antibiotics have slipped through in the animal protein products into human consumption, and we've built up some resistance, as humans, to some of the antibiotics that we need to protect us in the event of we get sick.

So there's been a lot of move to push, to restrict, or some cases even prevent the use of antibiotics in animal feed on a prophylactic basis, that you could only use it therapeutically. And to make sure, then a veterinarian had to sign a prescription. We've moved a lot in that direction, but still not very far.

The way that that will be controlled -- and it's going to be controlled in Europe first. In fact, we're seeing it in Europe now -- is they will be testing the animal protein product for residue. So if you can find the residue in the liver of a calf, not just is that liver going to be thrown out, but that carcass would be condemned.

So the testing is going to come there. How fast will it come? FDA is making noises now, and it's a part of what we're looking at with the Food Safety Modernization Act. I don't know how far it will go.

But it's clearly an area that we're addressing. We have a new group, Ed does, it's a part of his group that's looking strictly at more -- we've been looking at drug residues in milk, dairy products before, but now we're looking at it more seriously as it relates to animal proteins and the meat products. So it's there.

It's probably not going to make a big difference in this quarter. Though we'll be spending some more money this quarter, that's part of what's in R&D is the development of tests to meet that, as those requirements get more stringent.

So clearly important to us in the future, Drew. Probably won't add a lot to the bottom line, though, in the next couple of quarters.

Thanks, guys.

And yes, we do have another question here from Mr. Jonathan Weiss of G2 Investment. Please go ahead.

Hello. I just wanted to go back a little bit to gross margins. You answered most of my questions. But how confident are you that you're going to be able to get back to over 50% gross margins in the next two quarters?

We have a pretty high degree of confidence, but there's a lot of moving parts there. We have a broad product line. And depending on how the pieces and parts come together is going to dictate what our margins are going to be.

We were just below 50%. And that's a fairly historical low, near term low, for the Company. So I think getting back to 50% is -- the probability is high there.

Yes, it depends on some of these extraneous things that I talked about earlier. We've got to work our way through some of that. And obviously, any new acquisitions that might come along between -- we've got half the year left -- anything that might come in in the way of acquisitions makes that a little less predictable.

Okay.

I can assure you we've now done 26, I believe it is, since the year 2000, and they've all worked. So are we up to have a bad one? Well, I don't think so.

I think the things that we're doing to monitor what we're doing on acquisitions and how we do our due diligence and where we place our dollars is going to continue to work for us. So it's--

Thank you very much.

Thank you.

And also a question here from Mr. Joseph Potvin of Wells Fargo. Please go ahead.

Well, congratulations, guys. Another great quarter.

Thanks, Joe.

Talk to us about acquisitions. What's going on out there? (Laughter)

Well, I did mention that we've got a soft circle around some opportunities that we think are interesting. I can't say any more than that right now.

One might happen. One might not happen, or may never happen. We don't know until -- you never know until the fat lady sings. And we're pretty tight on making acquisitions.

We've walked away from them in the 11th hour before. But we think that there's, particularly in -- and I've got some friends in the investment banking area, talking to one of the big guys from New York yesterday -- there's just a lot of activity out there now, particularly among private companies that are privately owned that are selling and looking at taxes and where they might be. So that, of course, will tend to probably dissipate here in the next two weeks.

But there's some opportunities, and some opportunities for us, as we continue to be a consolidator. So it's great to have bank lines available, no debt, cash in the bank that's kind of worthless.

But if we can use it, it'd sure be helpful to be going forward into somewhat troubled times. Regardless of which way we go, I think we're going to be in good shape and acquisitions will continue to be an important part, Joe.

Are there sellers starting to pop up that you hadn't noticed before?

No, I don't think -- I mean, you know, we've got a checklist that's on our radar that -- I talked about the Prima Tech. We've looked at that one for three years. In fact, made offers in two different years to buy it and couldn't get together.

That was a private owner, and he came back and decided that he wasn't sure how much more taxes he was going to have to send to Washington if he sold it next year. So we got that one done here just before the end of the year.

It's hard to say. There's some divestiture opportunities going on that we might be able to nab into. It's interesting that both Novartis and Merck came out within the last month or so saying they didn't know whether they were going to keep their Animal Health Divisions, that they might be interested in divesting those.

We saw Pfizer spin theirs out into -- So we won't know whether that was successful, from an operating standpoint, for months ahead yet, because they're still trying to absorb it into this new company.

Novartis has got a product or two that we'd like to have, if they don't end up going in a package. We don't know where Merck is going. Merck's picked up some things that -- of course, we're not in a position to either one of them to be in a position to either want to or have the wherewithal to go in and pick up either one of those divisions.

But it's going to be -- it's interesting, and I love -- it's going to be changes. And I love changes, you know. Every time there's a change, you can get in there and take advantage of where you might not have been able to before. So we're kind of looking forward to the changes.

Do you find yourself bidding against acquirers like that?

No, not against the Novartises and the Mercks. I guess they're not acquiring good businesses. That's the reason they might be up for sale.

But the others -- we see some pretty sizable guys. I won't mention who they are. But we see -- we run -- in acquisitions, we run up against companies that are oh, probably five times our size, or better. So we're not down playing marbles in the sand box.

Thank you.

Thank you, Joe.

And it looks like that was our last question. And I'll turn the call over back to Mr. Herbert.

Well, thank you all. We appreciate your understanding and your patience.

We perhaps fired the gun a little too quick on the tipping point, but it's all there and it's all future growth. And I think you listening to this management team this morning, hopefully you felt that we're confident as ever about where we're going and what we're doing.

In the meantime, well, we wish you all a Merry Christmas and Happy Holidays. And we'll see you on the other side of the New Year, when we make our next reports in 2014. Good day.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for your participation and you may now disconnect.