Neogen Corp (NEOG) 2017 Q3 法說會逐字稿

Welcome to Neogen's third-quarter FY17 earnings results conference call. My name is Christine and I will be the operator for today's call.

(Operator Instructions)

I will now turn the call over to Jim Herbert. You may begin.

Good morning, and thank you, Christine. Welcome to our regular quarterly conference call for investors and analysts. Today we will be reporting to you the results of our third quarter that ended on February 28. I'll remind you, to start with, 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 risks and uncertainties. The actual results may differ from those that we discuss today. But the 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 joined this morning by this live telephone conference, I'd also welcome those who may be joined by way of simulcast on the World Wide Web. Following our comments this morning, we will entertain questions from the participants who are joined on this live conference. And I'm joined today by Rick Calk, Neogen's Chief Operating Officer; and Steve Quinlan, Neogen's Chief Financial Officer.

Earlier today, Neogen issued a press release announcing the results of this third quarter, which ended on February 28. Net income for the third quarter of this FY17 increased 24%, to $10.3 million, or $0.27 per fully diluted share. That is an increase from last year's $8.3 million, which equated to $0.22 per share. Current year-to-date income for the first nine months is approximately $31.3 million, or $0.82 a share. This compares to $0.71 per share last year.

Revenues for the third quarter increased 15%, to $88.4 million. This compares with the previous year's third-quarter revenues of $76.7 million. The quarterly revenue and net income results both, for this third quarter, both represent records for the third quarter for our 34-year-old Company. On a year-to-date basis, revenues for the first three quarters of the year increased 14%, to $262.7 million.

A dedicated group of 1,500 employees around the world kept our success record going yet for another quarter. This third quarter was the 100th in the past 105 quarters that Neogen reported revenue increases as compared with the previous year. This record now spans 26 years and includes all consecutive quarters for the last 11 years.

Operating income for the quarter came in at 16.2%, compared to 14.7% in the same quarter last year. Gross margins, which are, of course, a major component of operating income, settled in at 46.3%, and that compared to last year's third quarter of 45.9%.

Adverse currency translations continued to detract from our revenues, our gross margins, and our operating income. When we started the year nine months ago, I thought that the currency tradewinds should at least be neutral after the year we'd had before. However, devaluation of the British pound, its relationship to both the dollar and the euro, along with the Mexican peso, have all stirred up headwinds. I'll let Steve give you more of the details on that later in the call.

I think I can probably stop at this point by pointing out that our balance sheet continues to be solid, with growing assets and no debt. Shareholder equity has improved by 12% when compared to where we were at the beginning of the year on June 1. I plan to come back a little bit later in the call and talk about our growth strategy, give you a view of both our international and domestic acquisitions, and then talk a bit about programs where we think we will continue to grow. Let me stop, though, at this point and give Rick Calk an opportunity to talk about some of the growth over the past quarter for both our Food Safety and our Animal Safety groups. Rick?

Thank you, Jim, and welcome to everyone who is listening. Jim has already reported on the overall sales and profit performance for the third quarter of our FY17. I'd like to provide a little more detail on the performance of our Food and Animal Safety segments, as well as offer you some perspective of the markets in which we participate. Now before I discuss our results for the quarter, it's important to note that these results reflect the adverse impact of strength of the US dollar compared to other currencies. And as Jim said, Steve will provide more detail on the effects of these adverse currency translations during his portion of the call.

As stated in the press release, revenues of our Food Safety segment increased 24% during the third quarter, compared to the prior year. Now this was aided in part by the acquisitions of Deoxi and Rogama, both of which report to our Brazil subsidiary, as well as Quat-Chem, which reports to our Neogen Europe group. Organic growth for the Food Safety segment was 12% for the quarter. Food Safety highlights for the quarter include a 29% increase in sales of our rapid tests to detect natural toxins. This increase was largely due to the increase sales of tests to detect the mycotoxins DON and zearalenone in corn and wheat, which is grown in the US, Canada, and in Europe.

Neogen's ability to rapidly respond throughout the value chain to these unforeseen mycotoxin outbreaks gives us a strong competitive advantage in the milling and grain markets. We expect this increased testing for mycotoxins to continue at least through the late spring. Needless to say, Neogen will be ready to respond to whatever grain producers and processors need from us during the growing season. In fact, the excitement from our customer base is heightened this year as we respond with testing options for mycotoxins which address additional customer concerns. At the end of January, we launched our full line of Reveal Q+ MAX mycotoxin test.

There are two main factors making these tests superior to anything else on the market. One, they use water in the extraction process, eliminating the need for hazardous materials in the testing process. Eliminating the handling and disposal of these materials for our customers is a true game changer. And, number two, our platform brings to the market the only tests available allowing our customers to test the same process sample for more than one mycotoxin. That's a major timesaver for operations that can run many tests in a single day for multiple mycotoxins.

Each year, millions of Americans have allergic reactions to food, and we read about it daily in the newspapers. Although most food allergies cause relatively minor symptoms, some food allergies can cause severe reactions and may even be life-threatening. Now, there is no cure for food allergies. Strict avoidance of food allergens and early recognition and management of allergic reactions to food are important measures to prevent serious health consequences. Sales of Neogen's rapid test for food allergens such as milk and gluten increased 14% in the quarter compared to the prior year. Consumers and regulators around the world continue to increasingly demand that process food is virtually guaranteed not to contain an unlabeled food allergen.

One other Food Safety highlight was increasing sales of our rapid microbial test systems which were up 20% in the quarter. When we acquired the BioLumix product line in 2014 to add to our Soleris product line, we thought it would be a case of one plus one equaling three, and it has truly turned out that way. The automated systems allow the food and nutraceutical industries to test for spoilage microorganisms in a fraction of the time of conventional testing methods.

The Animal Safety side of our business reported a revenue increase for the quarter of 8%. On an organic basis, our Animal Safety revenues for the quarter were about even with our prior year's third quarter. As we detailed in previous quarters, we knew we faced a difficult comparison with the prior year due to the removal of our thyroid replacement product for dogs, and that happened last July. The impact of the loss of this multi-million dollar product will continue to be felt in the fourth quarter of our current fiscal year.

In last year's third quarter, our Animal Safety rodenticide business benefited from an outbreak of voles in the Northwest United States. Voles are a rodent of particular concern in orchards, and have a damaging effect on the overall fruit market. That outbreak, and the increased application of our rodenticide, has now subsided, leading to the softness that can be seen in quarter-over-quarter comparison in our rodenticide business.

But with all of that said, we had a number of highlights in the quarter for our Animal Safety group. Our sales of rapid tests to detect drug residues and forensic samples increased 39% compared to the prior-year quarter, and this was due mainly to the lab business in the US and Brazil.

In the quarter, we also had a significant increase in sales of durable syringes for the veterinary market. Our durable syringes are primarily intended for large-animal injections where the same syringe and needle are used repeatedly to deliver vaccines and other medications to several animals. Neogen has been in the business of developing and selling durable veterinary syringes since 1985 when we acquired our Ideal Instruments subsidiary. We see the precise delivery of medications as a critical step in the overall health and safety of livestock. And this led us to acquire the Prima Tech veterinary instruments company late in 2013. The innovations in syringe technology coming from the Prima Tech acquisition helped fuel our third-quarter increase in syringe sales.

In the third quarter, we also launched a line of disinfecting products specifically formulated for the effective cleaning and disinfection of veterinary practices and animal care facilities. This product line complements our comprehensive line of bio-security products formulated specifically for a wide variety of animal care applications. Jim, can I turn it back to you?

Thanks, Rick. Steve, how about providing us a little color behind the financials, and talk a bit -- we are all hinting at what happened on the currency conversions but lay that out for us. And, more importantly, we haven't discussed our genomics business. Cover that in your comments, would you?

Sure, Jim. As Jim and Rick have both indicated, we were overall pleased with our results for the third quarter, as we achieved solid revenue and earnings growth. The currency wins did continue to be in our face this quarter but with a little less intensity than previous quarters this year.

The pound sterling is worth 15% less this quarter versus the dollar than it was in last year's third quarter, with the decline primarily the result of the Brexit vote in the UK last June and the accompanying uncertainty on how messy that exit may be. The Mexican peso has declined 14% relative to the US dollar and has been volatile. At one point during this quarter, with all the noise regarding the wall and immigration, the peso fell to almost MXN22 to the dollar before recovering somewhat to close the quarter at MXN19.8 to the dollar. The Brazilian real, on the other hand, strengthened significantly during the quarter and was 23% higher than it was this time last year, helping boost the comparative revenues and earnings at our Brazilian operations.

Overall the negative impact of the stronger dollar on our comparative revenues for the third quarter was $1.7 million, and this was about a $0.01 hit on the bottom line. In constant currency, our overall growth was 17% versus the 15% we reported today. And reported overall organic growth of 5% would have been 7%. On the Food Safety segment, where all of our international operations report, and where the effects of currency movements are primarily recorded, the impact was even more pronounced. The reported 12% organic growth was actually 16% in constant currency.

Rick has already discussed some of the highlights of our growth in the domestic Food Safety business and a good portion of our Animal Safety business. In a little while, Jim is going to discuss some of our international operations. I am going to focus on highlights in the genomics business and then give you some financial color on a consolidated basis.

The genomics testing business continued to develop nicely in the third quarter, with worldwide growth of 20%, and 24% for the year-to-date period. This business, which has more than doubled in volume in the past two years, is based in Lincoln, Nebraska, and has expanded in the past year as we added capacity in Scotland to serve the European market, and then purchased the Deoxi Labs, a leading genomic laboratory in Brazil.

Volume gains have been made on the strength of [incremental] poultry business, gains in testing for the commercial cattle market, and university research projects. Of particular note are new testing options offered to the commercial dairy market, allowing the producer to understand a heifer's genetic potential well before breeding. These tests, which were developed in Lincoln and are sold through our Lexington Animal Safety field sales force, have been well received in the marketplace, with sales up 500% in this last quarter. We will continue to invest in capital equipment and, perhaps more importantly, information technology to support the needs of this business as it continues to expand.

Looking now at the corporate financials, Jim mentioned that our gross margins were 46.3% for the quarter, compared to 45.9% in last year's third quarter. We had strong organic growth in the Food Safety segment and favorable product mix, primarily the result of the DON outbreaks in North America and Europe, and strong allergen and forensic kit sales. And these helped to overcome the loss of the higher margin ThyroKare business that Rick discussed and the negative impact of currency movements.

For the year to date, our gross margins were 47.6% versus 48.1% last year. Our operating expenses overall were up 11% for both the third quarter and the year to date. Sales and marketing expenses rose by 10% for each period, with the largest components of this increase commissions, shipping and royalty expenses, all of which are based on revenue increases, and higher salary expense the result of increased staffing and compensation increases.

Our general and administrative expenses rose 13% for the quarter and has increased 19% for the year to date. Recent acquisitions account for the bulk of the quarterly and year-to-date increases, with the largest components salaries, non-cash amortization of intangible assets acquired, and related legal expenses. Depreciation, primarily related to information technology and equipment expenditures, was also a component of the increase for each comparative period.

Research and development expenses were 8% over the prior quarter and are up 6% for the year to date as the Company continues to invest in its product development programs in both new products and enhancements to existing products, primarily in the Food Safety segment. Operating income rose almost 28%, to a total of $14.4 million, or 16.2% of sales, compared to $11.3 million, or 14.7%, recorded in the third quarter last year.

Other income for the third quarter was $1.1 million, compared to $264,000 in the prior-year quarter. The Company recorded a gain of $660,000 related to the settlement of a licensing agreement during the quarter, and also recorded $440,000 of income related to net currency gains primarily related to dollar-denominated business in the UK. Interest income in the current quarter was significantly higher compared to the prior year due to interest received on funds on deposit in Brazil, higher cash balances, and rising interest rates on those balances.

Our effective income tax rate in the quarter was 34% and that compares to 29% in last year's third quarter. Last year in the third quarter, the Company amended its tax return based on revised calculations of its research and development and domestic production activities, and claimed higher credits and deductions, resulting in the lower rates in that period. For each year-to-date period, the effective rate was about 34%.

We generated $15.9 million in cash from operations during the quarter and invested about $2.6 million in property and equipment. For the year to date, we've generated $45.4 million from operations and spent $8.9 million in property and equipment. Our inventory balances have increased 17% since the beginning of the fiscal year. This is largely due to continued efforts to build up some of our key inventories, both domestic and international, to minimize back orders and improve overall service levels. In addition, the Company has acquired about $3.1 million in inventories from its two acquisitions this fiscal year.

Accounts receivable balances were flat, in spite of the increase in revenues. And our DSO has remained at 63 days for the past three quarters. The balance sheet, indeed, does continue to be solid. Overall, it was a very solid quarter and we are going to work hard to close this fiscal year on a strong note. Jim?

Thanks, Steve. As I listen to these two guys talk, it sounds like we are talking a lot about international at the expense of not talking about a lot of great things that have happened domestically. But I think, in focus, the international importance is we believe, and have for some time, that probably two-thirds of our total market opportunities lie outside the US. We've been growing good both places, domestically and international, but domestic has outgrown international. We've had an opportunity to play a little catch-up at an opportune time when we look at the problems of wind in our face on currency translations. If you're buying properties with US dollars, it's to your back.

Let me talk a little bit about our international performance as a part of the overall growth strategy. That's one of the strategies at the Company, as you will remember. Our operations in Europe, where we now have nearly 200 people, once again showed strong growth, up 31% in British pounds, compared to the prior year, though this increase was reduced to 12% when we translated it to the dollars, as we've discussed.

Our Neogen do Brasil operations were up 47% in British (sic) real. And in this case, I think as Steve mentioned, we actually got a boost, pushing them up to 81% when we converted to dollars, as the real strengthened from its position a year ago. It is still below where it was two years ago but they did get some recovery during the past year.

Our Neogen China operations for the quarter were up about 68%. Indian operations were up over 200%. Canadian revenues were about 5 times what they were the previous year. These last three are all working from much smaller bases.

Mexico was the exception to our revenue growth internationally. In Mexican peso, our revenues were up a strong 15%. However, due to the continued decline of the peso versus the dollar, when we recorded these in US dollars, that 15% up was actually down 1.7% when converted to US dollars.

Those of you that are close to the story will remember that we believe that this international strategy is important for our future growth in years to come, in addition to what we're able to show right now. And the future strategy is paying off in current dollars and current performance. When one looks at food security and the need to produce higher-quality food for that emerging middle class around the world, it clarifies that Neogen's focus, I think, is dead on. It is estimated that by the year 2030 -- and that is just 13 years away -- the middle class will grow from approximately 1.8 billion people to 4.9 billion people. It is not difficult to foresee that China and India will have the two largest and fastest-growing middle-class populations.

That's why Neogen is in China and India. We are making good progress in China but we still have tremendous amount of expansion still available to us. India is one that is requiring a bit more patience, and especially for somebody like me. But I'm intrigued at the base that our folks are building from our Company operations located in southwestern India. I think it's also clear that neither of these two countries, or many others, in fact, that have that growing middle class are going to be able to produce the quantity of higher-quality food that this population is going to demand.

That's what brings Neogen, really, to both Brazil and to Mexico. Brazil, as an example, with the largest cattle population in the world, 2 times that of the US, along with available land and educated population with a good work ethic, will continue to be in a position to likely become the world's largest food exporter. Because of proximity, we believe that Mexico will continue to have good growth in food production, especially since its west coast ports are an easy reach to Asia.

As we look at the Neogen's growth strategy, you talked about the international but we obviously have had good growth based on acquisitions. These acquisitions have not been haphazard, even though we've done 36 of these since the year 2000. All of them have been accretive and all of them are still producing revenue for the Company.

We made four acquisitions in the last 12 months. Now, that's not this fiscal year but the last 12 calendar months. And I think they illustrate our continued focus on the Company's mission. I will take just a second to talk about those. This time a year ago we acquired Deoxi, the largest animal genomics testing laboratory in Brazil. We purchased that one on a Brazilian real basis, which took fewer US dollars than it would've cost us a year earlier. I've already mentioned how large the animal population is in Brazil, and Steve has talked some about our animal genomics business and how it has grown on a worldwide basis.

In May of last year we acquired Preserve International, our largest competitor in the US for cleaners and disinfectants. They brought not just US market share but also chemistries that we needed in order to enhance our competitive position. In December we acquired Quat-Chem, another cleaner and disinfectant company, located in Manchester, England. We bought the English business valued in pound sterling, so, again, it took us fewer dollars to make that transaction than it would have a year ago. These two acquisitions will likely produce approximately $30 million in disinfectant revenue on an annual basis. However, they did not come without some revenue casualty.

Back a number of years ago Neogen acquired a part of its current line of cleaner and disinfectant products from DuPont, and at the same time acquired distribution of other DuPont cleaner and disinfectant products in all of the Americas. Over time, DuPont sold that business to another firm and then the latest firm sold it to LANXESS last August. Though we did not have any products that competed with the LANXESS product line, in 13 of our 15 distribution countries, LANXESS canceled our distribution agreement, which was -- that's their prerogative. Though we think that we will make up all of that lost revenue from that distribution fairly quickly, in the short term we're likely to lose up to $1 million in revenue that we would normally have enjoyed in the fourth quarter.

The most recent acquisition was in December when we acquired Rogama, the largest rodenticide company in Brazil, and also a producer of insecticides that are used in animal agriculture. This one, again, fits into our worldwide strategy of bio-security with cleaners, disinfectants, insecticides, and rodenticides. To tell the story again, if you can take a clean animal to a clean farm, and keep the farm clean by keeping out insects and rodents, we can deliver meat, milk, or eggs to that farm gate without great concern about animal diseases, while at the same time reducing the concern about antibiotic residues. This bio-security program I think obviously gets more important to us every day. Of course, the Rogama acquisition further bulks up our presence in Brazil. We purchased that one in Brazilian real, but we fund it with US dollars.

International growth and acquisitions are two of the four legs of our ongoing growth strategy. The third is market share. Those of you familiar with the story have heard this one. As the market grows and we continue to keep up with that growth, and perhaps take a bit away from our competition along the way, this one will continue to help propel our growth and the bottom-line results.

Even though efforts toward food safety have increased in the past decade -- really, on a worldwide basis the emphasis has been there -- we're still having increasing problems as we try to produce more food on the same landmass, running our processing plants at higher speeds, and trying to distribute food further from the point of production. Just in the US in 2016, we had 273 food recalls from FDA, and that's about a 23% increase compared to the prior year.

The fourth leg of our growth strategy is new product development. I think we continue to stay close to the marketplace and we're working on new products that food producers and processors are going to require. We have 75 scientists that are working in three principal locations around the world that are keeping that pipeline full. We have several exciting ones that will be coming out over the next few months.

In conclusion, I think I can say we're at the right place at the right time with the right products and the right Management Team to continue the same programs that have made us successful over the last almost 35 years now. We began our annual planning and budgeting process last week and I get an opportunity to see how the new fiscal year starts to unfold. What I'm seeing at this point, and the opportunities that I saw in visits to our Brazilian, English, and Scottish operations last month, again leave me excited about the future and where we're going. Let me stop at this point, Christine, and open up for any questions.

(Operator Instructions)

Paul Knight, Janney Montgomery Scott.

This is actually Bill Mark on for Paul. First question, what was the organic growth rate in animal safety?

It was virtually flat, Bill.

Okay. And then just on the revenue dynamic in terms of food safety and animal safety coming in closer to parity than what we have seen over the past six or eight quarters, how do you think about operating margin and the long-term goal of getting back to 20%? What do you guys need to do in order to get to that figure?

We, of course, made some progress based on third quarter last year. There are a lot of things they get involved in that.

Those that are new to the story, our program for some time has been taking a look at operating profits and 20% is our bogey there. When we get above 20% we start to look at where we can put money back into the growth of the business, as long as those growth opportunities present themselves. When they get below the 20% we start looking back upstream at where we might have some leakage or where we might have missed estimated something.

The one thing we don't know how to do, and we'll never know how to do, I guess, is what to do with the currency fluctuations. The currency fluctuations again this quarter took away a piece of operating profit. Had we been dealing with a level playing field it would have been higher.

The second thing is, I kid my folks and my friends in accounting that they come up with all sorts of ways to make life harder, too, by changing the way we report things from quarter to quarter. Once upon a time, when you made an acquisition you took all the cost that was involved in the due diligence and you fold it into the cost, and what was left over you called it goodwill and you amortized it over 17 years, and it was all clean and simple and we all knew what to do. But it was too simple and over time accounting rules have made it more complicated, including the fact that now, if you spend money in due diligence -- which you damn sure should do -- you expense it the month in which you spent it not over the life of the transaction.

So, it is possible to do an acquisition that cost you $200,000, $300,000 in due diligence costs that you write off before you ever record the first dollar's worth of sales. So, those are some things of the things that complicate it.

Having made all those excuses, we will play the hand that is dealt us. I think we're going to get back to the 20%. We've got a ways to get back there.

I feel good about, as we mature some of these businesses, we are improving our growth margins. I sat through a session yesterday with one of our major groups that are looking at budgeting. They are talking about improving gross margins high single digit compared to where they are this year.

So, those are some opportunities that are out there. 20% is still our bogey. I think we can still be there. That was a long political answer to a simple question but that is what I see.

Thank you. And then just a second one on the genetic testing business, what's driving the growth in that segment? And then have you seen any increased demand associated with your partnership with Illumina?

We are in the budgeting process there so I can speak pretty knowledgeable as we look at wrapping up in a year and starting a new year -- I guess without saying too many things I shouldn't say. Steve is looking at me across the table saying -- don't start telling things that everybody else don't know. And I won't.

The Illumina partnership, for instance, continues to be good. For those people who are unfamiliar with that story, quickly, we had developed our own models for genetic prediction on bovine species and on some other things. We gave that to Illumina and Illumina made the chips for us. We used the chips but then we were also selling those chips to other people who were using their own equipment to get results.

That was money that Illumina thought maybe they ought to be getting themselves. So, as a part of the process we said we'll license you to sell your chips with our content and you pay us what is like a royalty fee on what you sell. I think that helps us in the long term because it makes our genomics model even more popular. But it also gives Illumina something to sell there.

And that program is coming along pretty good. And I think it shows opportunity for expansion around the world. I don't remember exactly what the numbers were and I probably should not say if I did remember. But that one is doing well.

What's driving that business? We driven some of it ourselves by increasing where we are. I think last month we did 218,000 samples in one month, which pushes us to well over 2 million samples this year, which would make us clearly the world's largest animal genomics testing laboratory. And in addition to that, we've built out a nice lab in our operations in Scotland where we are doing a good bit of business there. Some of it might, one time a year ago, had come to Lincoln, Nebraska, and now we can get it done closer to home.

As I mentioned in my comments, we purchased Deoxi in Brazil within the last 12 months and that piece of the business is growing. I think maybe when Steve talked about his numbers he was talking about consolidated genomics business.

On top of that, we bought that business -- some awful smart guys -- we'd been wanting to be in the genomics business for a number of reasons. It was part of our strategy. We didn't think we could get there on our own. We needed to buy our way, and we did.

We talked to the scientists there and I said; if you can do all of this with a little Holstein calf at a week of age, what could you do, could you do the same thing with salmonella and E. coli? And they said; absolutely, we can do that genotyping there, we can tell you where it came from. And we are expanding that business going forward using that genomics capability to help in the food safety business, as we knew all along we could.

Ed Bradley and his people have put together a program where now we're working with two or three of the largest meat producers in the world and helping them establish a method in which, if they get a break in the field with one of those pathogenic bacteria, that we can help them probably determine where that might have come from. All of that is leading towards saying that that's another one of those right products, right place, right time. I think the timing and all is fortunate but I think we will be able to take advantage of it.

Thanks. Have a good one.

Brian Weinstein, William Blair & Company.

Thanks for taking the questions. If we can start just on the dry culture media in the other segment, that was up significantly in the quarter, up from trend line. Can you just talk about more specifics about what was going on there?

Do you want to take that one, Steve? Are you talking about our dehydrated culture media business?

It is in the 10-Q, the reported line, dry culture media and other. The other includes our genomics business that is running through Neogen Europe. It includes our animal safety products that are running through Brazil and Mexico. Those are the things, Brian, that are running through that other line.

The genomics business in Europe, we have talked about the lab we expanded in Scotland last year to increase our capabilities for the European market. The genomics business there has grown tremendously. So, that's probably the biggest line item in that number.

I just was going to blame it on my accounting buddies again. In an effort to simplify, sometimes we complicate.

That business has been trending pretty consistent, or that line rather, have been trending consistently in that $12 million or so. The top up there you're saying is all really related to genetics over in Europe. It just seems like that is a big jump in the quarter.

There is another piece that is smaller than that but of magnitude, and it's the forensics kits we are selling into the Brazilian market to serve the commercial labs in that market. There was a law that changed last year requiring all commercial drivers be drug tested prior to getting their license. And that's a big piece of that.

Okay. And then the rodenticide --?

If I might, Brian, just bring focus on what we call the dehydrated culture media business. We had an operation here that we acquired back a number of years ago that is important to what we're doing. We call it our Acumedia operations.

This is growth media that causes things to grow. It is very important in the diagnosis of certain microorganisms because you've got to grow them up to get the quantity enough to be able to find them. This goes back to an invention of Louis Pasteur.

At the same time, the dehydrated culture medias are used to produce useful products. They're used to grow --for vaccine production and things like that. So, that business is strategic and has been. It is important in what we have in the US that we serve the world.

But then we acquired the Lab M operations. It's been about a year ago, hasn't it, guys? Just a little over a year ago. Again, that's a middle England operation near Manchester. And that has helped expand what we're doing with the sale of the dehydrated culture media products.

Some of that is [port] plates where it goes out to companies, they have the petri dishes, they streak them, and decide whether anything's there. It is all an important part of our criteria. As we've grown, maybe, in an effort to improve transparency, we might have put them in the same bucket with some other things that might have been a bit misleading, so I apologize for that.

Brian, the biggest thing that I should have mentioned right out of the gate was the two acquisitions, the Quat-Chem and Rogama acquisitions, are also running through that. When I was giving you the earlier color it was more on the continuing business but then those acquisitions are also what goosed those numbers, as well.

I think we need to look at that when we report those. We got that base in Brazil mixed up with vaccine production in England, something is wrong. Thanks, Brian.

No problem. I had another question on the rodenticides and the insecticides and disinfectants. I know you had the vole outbreak last year. But just the trend line on that, it seems like net-net it was sitting at about $19 million last quarter, down a few million sequentially here.

So, can you talk about the sequential change in that line? Is this a more normal type of revenue trajectory that we should be thinking about from here? Just remind us if there was anything last quarter that was unique there.

It feels okay. I'm not sure what -- it feels good. It's growing. I'm not sure what the year-to-year difference in reporting is Steve.

Brian, if you are talking sequential change, we don't focus specifically on that. But the third quarter of the year for particularly those businesses is our lowest revenue quarter. And then we talked a little bit, the rodenticide business is a little bit soft with the vole outbreak subsiding. And then the insecticide business did about what we thought they were going to do but a little bit lower than last year.

So, as Jim said, there's no issues in the businesses. I think there was some explanations that made sense to us. And we think that the fourth quarter those businesses will rebound a little bit.

It certainly is looking good going forward. We're right in the middle, particularly when you look outside the US, we are strongly in the middle of mosquito control. I don't need to tell people how important mosquito control is to human disease spread and what those problems are. There's a lot of mosquitoes that grow in stock tanks where cows drink, too. So, there is good opportunities for this insecticide business.

It's heavily influenced by the weather. Everybody is wondering now did we get a cold enough winter to kill insects off or how fast are they going to come back. Our guys are in the process of trying to plan that because you can't start making them overnight.

I think the insecticide side of our business, it fits right in with the strategy. There will be some seasonality, as Steve pointed out, and some issues based on weather, but in the long term it is a strong place. And we're not overburdened by competition there.

Going back to the first question that was asked, the one on operating margin, can you talk about specific things that you think your team is able to do to drive gross margins higher in the short term? Are you willing to expand on any of those specific items and what you guys are doing to drive, other than integrating acquisitions and getting more maturity into some of these markets, but specific steps that you guys are doing about the gross and the operating margin side? Can you be more specific?

I think from two standpoints, one way to improve your margins is to increase prices. I think we've got into a position now that we are in a better spot to increase prices as we look at where we stand with competition. And we're looking at pricing, not just flat pricing but if we do something for our customer that saves him money or makes him money, can we charge him more for that.

Our people have been pretty creative on a couple of significant areas there where I think we're going to have an opportunity to increase prices. We have not nailed anything to the wall on that yet, but as we are starting to do our budgeting process I think that is there.

It is there because we do offer things other than -- we're not in a commodity auction, who can make it, who can sell it the cheapest. As we've gotten bigger, the economies of scale are coming in, so they are clearly helping and are going to continue to help our cost.

As it relates to that, raw materials, we're continually on the hunt for more economical raw materials. On our animal safety side that is the chief cost.

And our direct labor costs are good. We're not squeezing money out of our employees that makes great. But, as we've been able to automate, we've been able to, what might have been 8% or 9% direct cost, is down 1% or 2% now because of the effect of automation. That is helping us.

We've got a fixed amount of overhead and administrative costs. We don't have to have but one Rick Calk and one Steven Quinlan, and the more dollars we can divide them over, the better off we look there.

There are a lot of things working for us, the economies of scale and ability to increase prices. It is too early to say what I think the margins are going to look like for next year because we're just beginning to get into that process. But what I have seen so far looks pretty promising.

Great. Thank you very much.

Charles Haff, Craig-Hallum Capital Group.

Thank you for taking my questions. The first question I had, Steve, you mentioned a $440,000 gain. Was that foreign currency or can you just explain that a little bit?

Sure, Charles. That is a couple of pieces. We have our hedging program is in those numbers. And then it's really the difference between what we collect when we actually collect a receivable and what we actually invoiced it at. So, the difference in the currencies in that time period is where we recognize that other income and expense, down in that line.

We just happen to have fairly significant activity in the UK where they sell, in some cases, dollar-denominated sales, and then the dollar actually improved against the pound in that period so we had some pick up there. That is really what's inside of that $440,000. It is the Brazil, the Mexican, the pound, the euro all as compared to the dollar in those markets. And then there is offsets to that or additions to that with our hedging program.

Okay. Thanks for that. And then for D&A revenues which were classified in food safety this quarter, what were those?

The absolute amount?

Yes, in the food safety segment. And then also forensic kits, if you have it.

Forensics is spread across. We've got forensic products going into Asia and Europe, forensic products that are part of our Lexington operations. And then because some of that now going to Brazil, some of that gets recorded in Brazil even though the product might have been an intercompany transfer out of Lexington.

I am not sure we have done a consolidated forensic. That's not been too important for us to look at. Maybe we ought to do that. I know it is better but I don't think we could get you a number on that right off, Charles.

Genomics is about 2.7[%], Charles.

Okay, great. Thanks, Steve. And then, Jim, when you think about your international distribution infrastructure, obviously you have a lot of opportunity internationally. You mentioned about two-thirds of your total opportunity there.

How do you view your current international distribution? I know you did an acquisition of a Chinese distributor a couple years ago. What other things, pockets, do you see that need to be filled going forward in the next couple of years?

That's a good question, Charles, thanks. First of all, if you look at food safety and animal safety a little bit separate, the distribution system on the animal safety side is a bit different. There, we are dealing with larger products, we are delivering by pallet load, by 50 gallon drum, whatever.

So, you need trucks and warehouses. That means you need to be a part of what is already a very efficient existing distribution system. So, regardless of where we are in the world, a big part of those products move through the distribution system to the people who are going to get it to the end users.

Now, to support that, we've got a group in the field that are calling on particularly the major protein producers, be they dairymen or chickens, pigs, whatever, that are saying -- when you place your order ask for Neogen. And that same group, then, is also able to sell things like our dairy heifer replacement program where you don't have to have trucks and warehouses. That is a hybrid system on the animal side.

We are in the process of expanding. We are in good shape there with the US. I think we've got everybody that we need in the US and they're properly addressed. We're not in that good of shape in the rest of the world. There are some countries in which we are in good shape, we're expanding.

Then, if you look over at the food safety side, there are a lot fewer customers. You don't have as many ranchers and farmers scattered around the world as you do the Nabiscos or the Nestles of the world that are running processing plants. There, we are able more to go direct.

In the US, Canada and Mexico we have our own feet on the ground. 90% of all that business is brought in from our salespeople who write orders.

When we get outside of the US, we rely on distributors. We are in 110 countries, I think, now, and we rely on distributors in some of those.

However, on the food safety side, we have our own sales force that's covering the UK. That is Scotland, England, Northern Ireland and Ireland And then we've got our own sales force in Germany, our own sales force in France, and our own sales force in the Netherlands.

So, from that standpoint we have our own sales group. We've got our own sales force in Brazil covering the food safety business. So, I think, as we depend upon what we're doing and where it is, we will expand distribution through distributors as we avail ourselves of some of those international distributors that we don't have today for animal safety.

There will be some other opportunities, like the China opportunity that you talked about. In fact, that is how we started Neogen Europe. We had a good distributor in Scotland. We liked each other and we bought that business and the rest of that story is history.

I think from the food safety standpoint we will continue to look at opportunities where we can annex those countries. I don't want to get in a place where I've got foreign corrupt practices act or somebody got to bribe somebody or whatever. But I think there is going to be opportunities for us to continue to expand our food safety distribution through some of the places today where we perhaps are working with distributors.

Okay. I am just trying to understand. You are putting up very strong growth in these countries. You are in Europe, as well, but I am thinking more about Brazil, China, India, Mexico. You're putting up very strong growth in those countries and I'm just wondering if distribution becomes a constraint at some point, or do you have a pretty good line of sight for the next couple of years and it's not going to be a constraint for you?

I think the latter is true. UPS and FedEx moves a lot of our food safety products around. They are cigar-sized boxes that contain test kits. It is much easier to move those around.

But in most of the countries where we are, there is an established, what some people would refer to as an animal health distributor business. And our products fit well there. We work with a couple of major producers.

Merck is sort of a partner of ours. And working on the animal genomics area because that gives their people who are selling vaccines and pharmaceuticals something else to sell when they go to the field. I think we are okay.

Okay. And then the last for me, Steve, on animal safety, organic growth or reported growth for the fourth quarter, you've got a lot of cross-currents going on here. It was about flat this quarter. And I'm just trying to figure out how to model animal safety growth in the fourth quarter. Is there any assistance you can give me there in terms of my inputs and how I think about that?

Charles, Rick talked a little bit about ThyroKare. That's going to be a $1.8 million or so hole in the fourth quarter we have to make up. And I think we will make that up but any time you are trying to recover $1.8 million in a quarter it's going to make your organic growth look fairly sluggish.

Maybe we can talk after the call. I don't know that I can give you much except to say that the markets are still strong. And there's a lot of pieces and parts that are moving in there. But I can't give you anything specific, no.

That business is growing good. I mentioned the casualty because of LANXESS. There is probably $1 million worth of product there that we would have sold that belonged to LANXESS that they have taken away from us that we would have normally gotten in the fourth quarter. But we are bringing on instead, though, more than that by adding the Preserve acquisition which came on this year.

And Quat-Chem

Yes, and Quat-Chem, too.

Okay, great. Thanks guys.

(Operator Instructions)

David Stratton, Great Lakes Review.

Thank you for taking the questions. Really quick, can you dive in a little bit on the dairy genomics -- huge growth this quarter -- and just what you see going forward, and maybe how big of a business that is right now to give some color around that growth?

It is an easy place to be able to determine the value of genomics. If I can take a day-old dairy calf, little black and white holstein heifer cat, in Inner Mongolia, China, and I can pull a dozen hairs out of her tail and put it in a card and send it to Lincoln, Nebraska, and they can come back in 10 days and give you a prediction that says how good of a milk producer she is going to be, what kind of feed conversion you might expect, how quick will she breed back, what kind of mama will she make, those are truly game-changing things and that's really where we are.

The milk production around the world is competitive based on supply and demand. The successful dairymen are going to be those that are making sure they are saving the right genetic stock and that is exactly what our program does. It allows them to, from a group of females, select the ones they want to keep for replacement heifers.

That has become even more helpful or important as we move along and it has now become pretty well established that I can do sex semen. I can go through and take the semen from the bull and through a process eliminate those that would have provided male calves and inseminate those cows only with the female-producing semen. So, now I've got a large population of day-old heifers to select from. The selection process makes it even better.

That is almost a parable and not a story but I don't know whether that helps you or not, but that is the importance of what we see. The dairy business around the world is important and always has been important.

That is why we are there with diagnostics to be able to detect the presence of antibiotic residues in milk. It is important going into the diets of infants and children and I think always will be. So, anything that can happen to be able to improve the cost production of milk or the safety of that milk is going to continue to be important.

All right. And then when we get into disinfectants, you mentioned veterinary disinfectants. Can you give just a little bit of color around that? Is that included in the veterinary instruments line item or is that with the other bio-security things?

I'm going to let Steve answer where he puts it on the statement.

That would fall in the cleaners and disinfectants area. That instruments is pure vet instruments.

All right. And then along the line of disinfectants, are you seeing any early indications of people stepping up their disinfectant purchasing due to the bird flu in Tennessee, early signs of that? I know it's only maybe a few weeks old but wondering if you are seeing anything there yet.

Probably. I can't pinpoint exact gallons and where but, of course, that is where our products come in is, number one, not just when you get an emergency but on a regular basis. My story of putting a clean animal in a clean house and keeping it clean, you've got to start with a clean house and clean confinement, whatever that might be.

This was a situation in Tennessee where, I guess it's no secret, the largest poultry producer in the world had a breeder flock that broke -- I don't think we know how the avian flu got there. But the systems being such as they were, they found it pretty quick. They, as near as I can tell, they quarantined it, they destroyed that flock.

They will go back in after they clean out, they will go back in with one of our disinfectant products. We got a couple that will kill avian influenza. They will make sure they've got good, clean before they go right back with the next flock of birds.

It is not as widespread as it was a year ago when waterfowl carried it across the upper Midwest and hit all the egg production areas up there. But it is waiting to happen anytime. We don't know where it comes from. Sometimes it is a fighting rooster that came over from Mexico in somebody's coat pocket that had it, or it's a goose brought in from somewhere.

But it's always going to be an issue. And as we continue to raise more animals on the same confined space and try to run them through the same kind of processing facilities, it will just require more and more safeguards. Anything we can do to get a safer product through that farm gate is going to be a big help, and I think the world recognizes that.

All right, thank you.

Kurt Kemper, Hilliard Lyons.

Thank you for taking the questions. I got kicked off the call for a second so sorry if any of these are repeats. Steve, could you give me the revenue contribution from Quat-Chem and Rogama in the quarter?

It is about $4 million combined.

Okay. And then I noticed allergens and toxin sales were pretty strong and the category is up about 10%. Did you give any color on how drug residues did?

Drug residues were down. And that's a business that we have a very strong presence in Europe. We think we've lost a little bit of share there. We have a number of new products that we're working on that are due to be introduced near future.

But in that category, the allergens were up, I think Rick talked 14%. Mycotoxins were very strong. Those were up 29%. And then the drug residue or dairy residues were down.

Okay. And then last question, could you broadly speak about the margin profile of some of your acquisition targets? Is it generally lower margin in emerging markets or higher-margin in developed? Any color around that?

We really are not focused on emerging markets much. Our product line is probably still a bit sophisticated for the emerging market. We are focused on those more developed markets.

You could say China and India are emerging markets, I suppose, but they are also where we've got huge middle classes that are developing, that are already demanding safer higher-quality food. So, to that extent, I think we're doing good.

Where our margins -- we don't look, and you probably remember that story, we try to focus on operating profits, not gross margins. I can have a product that is not all that attractive in gross margins but if I can run it through the same sales force and don't have any big sales and marketing costs, and it is already fully developed and I don't need to spend 10% on R&D, and it's truly a bolt-on, then I can get a big part of the gross margin all the way through to the net operating. That is the reason we prefer to look at net operating because as you look back even at the acquisitions I talked about this morning, they are all essentially bolt-ons.

We've got three rules when we look at acquisitions. Number one, do we understand the technology? Number two, could we manufacture it if we wanted to? And, number three, do we have access to the marketplace? In all of those they fit that category.

Okay. Thank you for taking my questions.

[Peter Boyle], private investor

Good morning, gentlemen, or I should say afternoon. I will not take too much of your time because I know you are getting hungry and it's chow time. I have one question concerning, are you receiving any feedback yet about pushback of federal regulations for your products, either food safety or animal?

I think the answer is no. Nobody wants to mess with food safety. If we're going to rebuild America we can't rebuild America with unsafe food. I think that is around the world.

Will there be some changes over at EPA? Likely. Most people think that is one of the first places where maybe there could be some relaxation of current places. But if they relax it, it will make it easier for us to get products approved.

But there's certainly not going to be any changes in having to kill insects or something that will take care of killing the microorganisms or the viruses that cause animal diseases. Whatever the game is, we'll play the hand, but I don't think you're going to see anything that, at this point, is going to be a big concern.

That sounds good. I am impressed with your 100th quarter of revenue increase.

Thank you, Peter. You have been your through most of them. We appreciate that.

I'm getting a little tired of having to say it for the 100th time, but, again, good luck, and keep up the good work. Thank you.

Don't ever get tired of saying it because we're going to give you the opportunity to continue.

I will now turn the call back over to Mr. Herbert for closing comments.

Thank you very much. Thank you for your time this morning and your questions and your continued interest. I think you can tell from the comments here today, and hopefully our answers, that we continue to be really excited about where we are and where we are going.

We are going into the fourth quarter now and will be wrapping up the year, and we won't be back to you quite as quick next time as we get the year end closed. I think the next scheduled conference call to you will be sometime mid July.

In the meantime, those that are looking, don't ever hesitate to contact Terry as it relates to anything having to do with investor work. Terry does a great job on top of that, those of us that work with him. And obviously Steve and his team -- we don't make forecasts and they won't give you forecasts but they can help you develop your own model probably.

So, thank you all once again and have a good week. We're off.

Thank you. And thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating You may now disconnect.