Brian P. McKeon - IDEXX Laboratories, Inc. Jonathan W. Ayers - IDEXX Laboratories, Inc..

Jonathan Block - Stifel, Nicolaus & Co., Inc. Ryan S. Daniels - William Blair & Co. LLC Erin Wilson Wright - Credit Suisse Derik de Bruin - Bank of America Merrill Lynch Nicholas M. Jansen - Raymond James & Associates, Inc. David Westenberg - C.L. King & Associates, Inc..

Good morning and welcome to the IDEXX Laboratories Second Quarter 2017 Earnings Conference Call. As a reminder, today's conference is being recorded. Participating in the call this morning are Jon Ayers, Chief Executive Officer; Brian McKeon, Chief Financial Officer; and Kerry Bennett, Vice President, Investor Relations.

IDEXX would like to preface the discussion today with a caution regarding forward-looking statements.

Listeners are reminded that statements that members of IDEXX management may make on this call regarding IDEXX's future expectations, plans and prospects constitute forward-looking statements for purposes of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements can be identified by the use of words such as expects, may, anticipates, intends, would, will, plans, believes, estimates, should, and similar words and expressions. Such statements include, but are not limited to, statements regarding management's expectations for financial results for future periods.

Investors should be aware that any forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those discussed here today. These risk factors are explained in detail in the company's filings with the Securities and Exchange Commission.

Please refer to these filings for a more detailed discussion of forward-looking statements, and the risks and uncertainties of such statements.

All forward-looking statements are made as of today and except as required by law, the company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

Also during this call we will be discussing certain financial measures not prepared in accordance with Generally Accepted Accounting Principles, or GAAP. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP measure is provided in our earnings release, which can be found on our website, idexx.com.

In reviewing our second quarter 2017 results, please note all references to growth and organic growth refer to growth compared to the equivalent period in 2016, unless otherwise noted. In order to allow broad participation in the Q&A, we ask that each participant limit his or her questions to one, with one follow-up if necessary.

We appreciate you may have additional questions, so please feel free to get back into the queue and if time permits, we'll take your additional questions. I would now like to turn the call over to Brian McKeon..

Thanks, good morning everyone. IDEXX delivered excellent financial results in Q2, building on our strong start to 2017. In terms of highlights, Q2 revenues of $509 million reflected 10% organic revenue growth at the high-end of our expectations.

Our growth continues to be driven by expansion of recurring CAG Diagnostics revenues, which increased 13% organically in the quarter to $380 million or 75% of total revenues. These gains were driven by 14% organic growth in the U.S.

with strong gains across each of our modalities and 12% growth in international markets, despite a relatively tougher compare in Europe related to the later timing of the Easter holiday. Strong revenue growth supported another excellent quarter of profit performance.

Operating profit of $123 million, increased 19% on a constant currency basis, driven by a 180 basis point year-on-year improvement in gross margins, reflecting high recurring CAG Diagnostics growth, supported by moderate pricing gains and ongoing productivity improvement.

EPS for the quarter was $0.95 per share, an increase of 30% on a constant currency basis. These results included $0.08 per share or about 11% of EPS growth benefit from the adoption of new share-based compensation accounting guidance, which was also relatively higher than expected.

Reflecting our strong first half performance we're raising our full-year 2017 financial guidance today. We're increasing our 2017 revenue outlook by $17.5 million at midpoint to $1.945 billion to $1.965 billion.

This reflects an updated outlook for organic revenue growth of 10% to 11% and approximately $13 million of benefit from changes to FX rate assumptions, reflecting the recent strengthening of foreign currencies relative to the U.S. dollar.

We're raising our full-year EPS guidance to $3.12 to $3.22, an increase of $0.14 at midpoint, reflecting approximately $0.04 of operational improvement, $0.02 per share in benefit related to favorable FX changes, net of hedge affects and approximately $0.08 per share related to raised projections for 2017 benefits from stock compensation accounting changes.

Our updated EPS outlook reflects expectations for full-year operating margin gains of 100 basis points to 125 basis points as reported or 110 basis points to 135 basis points of improvement on a constant currency basis, while we advance incremental commercial, R&D and enabling IT investments to position us for sustained strong organic revenue growth.

We'll review our updated 2017 outlook in more detail later in my comments. Let's begin with the review of our Q2 performance by segment and region.

Q2 performance was again driven by our Companion Animal Group; global CAG revenues were $440 million, up 11% organically, supported by continued strong gains in recurring CAG Diagnostics revenues and solid growth in our veterinary software services and diagnostic imaging system businesses.

These gains offset relatively lower instrument revenues reflecting comparisons to strong prior year placement levels and impacts from our increased emphasis on high economic value placements, which resulted in lower year-on-year second Catalyst placements and hematology upgrades in the U.S.

Water revenues of $29 million grew 7% organically in Q2, supported by solid gains in Europe and Latin America including benefits from our go-direct initiative in Brazil.

Livestock, Poultry and Dairy revenues grew 4% organically to $34 million as we benefited from continued strong growth in China, improved performance in our herd health screening business and continued expansion of our recurring pregnancy testing franchise.

These gains offset moderately lower revenues related to successful Europe bovine disease eradication programs and in our Dairy business reflecting market demand impacts related to lower milk pricing. For the second half of 2017, we continue to target flat to modest growth in LPD overall. By region, U.S.

revenues were $360 million, up 10% driven by high growth in our CAG business. Recurring CAG Diagnostics revenues in the U.S. grew 14% organically in Q2, reflecting strong double-digit gains in consumables and lab revenues and continued solid growth in rapid assay.

Recurring CAG Diagnostics revenue gains continue to be primarily volume driven with overall net price gains trending at about 3% aided in the first half by some favorable year-on-year comparisons related to promotional activity. IDEXX's performance continues to significantly outpace solid U.S.

veterinary practice growth, reflected in our data set from approximately 5,000 clinics. In Q2, patient visits increased 2.8% and clinic revenues increased 6.8%, reflecting continued healthy market momentum.

International revenues in the second quarter were $193 million reflecting 10% organic growth driven by 12% recurring CAG Diagnostics revenue gains. Recurring CAG growth continues to benefit from robust consumable gains driven by expansion of our Catalyst instrument base and related increases in average test utilization.

These gains offset impacts from a later timing of the Easter holiday, which was in Q2 this year versus in Q1 last year, which moderated European CAG recurring revenue growth in the quarter as expected. For the first half overall, international recurring CAG Diagnostics revenues increased 15% organically, compared to the U.S.

at 13% with strong gains across modalities and major regions. In terms of segment performance, our Q2 results were supported by strong global gains across CAG Diagnostics testing modalities and continued expansion of our premium instrument base.

Globally, we placed 2,680 premium analyzers in Q2, including 1,191 Catalysts, 861 premium hematology instruments and 628 SediVues. We also placed 1,811 SNAP Pros in the quarter with accelerating momentum following our rollout of enhanced auto read capabilities.

We continue to achieve high levels of competitive Catalyst placements in North America benefiting from our expanded commercial organization and our focus on maximizing the economic value. In Q2, we placed 341 Catalysts at competitive or greenfield accounts, a growth of 14% year-over-year.

This represented 82% of total North American Catalyst placements. International Catalyst momentum also continues to be strong with close to half of these placements going to new and competitive accounts. As we in parallel support the expansion of SediVue in a wider range of international markets.

Globally our installed Catalyst instrument base increased 21% year-on-year in Q2, reflecting 11% year-on-year growth in North America and 37% year-on-year gains in international markets.

Global Instrument revenues for IDEXX were $28 million in Q2 down 13% organically, compared to strong prior year results, which included benefits from higher second Catalyst placements.

In Q2 of 2016, we placed a 131 second Catalysts in North America as part of the successful customer retention program, which declined to 48 units this Q2, creating a headwind to report an instrument revenue growth this quarter.

Note that while these second Catalyst placements contribute to instrument revenue, they do not on their own contribute meaningfully to incremental consumable revenue. Our emphasis on the economic value or EVI of placements in the U.S.

also shifted emphasis towards competitive Catalysts, SediVue and SNAP Pro placements, which resulted in relative declines in focus on hematology upgrades.

We continue to be very pleased with the execution of this new approach, which resulted in double-digit year-on-year increase in our EVI metric related to North America instrument placements in the quarter.

Growth in our instrument customer base supported by high retention levels and utilization benefits from the expansion of the Catalyst platform in international markets is driving continued strong momentum in consumable revenues. Instrument consumable revenues of $132 million in Q2 grew 17% organically.

These gains reflect continued high-teens organic growth in international markets and accelerated double-digit growth in the U.S. including benefits from the expansion of SediVue, which contributed 1.8% to global consumable gains in the quarter.

Reference laboratory and consulting services with revenues of $171 million, grew 13% organically in the second quarter, supported by higher growth in the U.S., which offset moderated international gains impacted by the later timing of the Easter holiday in Europe. Strong U.S.

lab trends reflect continued momentum from the differentiation provided by SDMA, which is increasing customer retention, as well as from high growth in test panels with proprietary IDEXX parasitology and Lab 4Dx Plus Tests. Rapid assay revenues also continued to trend very well with Q2 revenues of $60 million up 9% organically.

Rapid assay gains reflect continued strong growth in 4Dx and specialty tests and progress regaining share in first generation products in the U.S.

We expect rapid assay growth will moderate to the mid-single-digit growth range in the second half, as we begin to lap relatively stronger prior year performance levels and are impacted by select factors including fewer business days and less favorable year-on-year comparisons related to promotional activity.

Veterinary software, services and diagnostic imaging system revenues were $32 million in the quarter, up 9% organically. VSS gains continue to be driven by increased penetration of recurring services in our Cornerstone installed base.

Diagnostic imaging system revenues also increased solidly supported by growth in digital radiography-based placements and recurring services, including growth in our Web PACS platform.

Turning to the P&L, operating profit in Q2 was $123 million, up 18% as reported or 19% on a constant currency basis, with results driven by very strong profit gains in our CAG business.

Operating margins were 24.1%, up 180 basis points in the constant currency basis, driven by gross margin gains, reflecting continued strong momentum and expanding CAG recurring diagnostic revenues supported by moderate price gains and ongoing productivity improvement aided by volume leverage.

For the first half of 2017, we delivered approximately 220 basis points of operating margin improvement on a constant currency basis, building on the 170 basis points of adjusted constant currency improvement, delivered for the full year of 2016.

The new guidance we're providing today indicates we're on track towards 280 basis points to 305 basis points of adjusted constant currency operating margin improvement combined in 2016 and 2017, well ahead of our long-term goals.

We're delivering these results while advancing increased investments in certain areas, aligned with sustaining our accelerated revenue growth. These investments will moderate our year-on-year operating margin improvement in the second half of 2017 compared to our very strong first half gains.

We'll talk more about our second half outlook as we review our updated 2017 guidance. For Q2, reported gross profit was $293 million, up 12% or 14% on a constant currency basis. Foreign exchange hedge gains, which benefit gross profit, were $750,000 in Q2.

Operating expenses in Q2 were up 9%, driven primarily by higher investment in sales and marketing resources. Expense growth increased in Q2 as we began advancement of incremental investments in U.S.

commercial capability with some delay in the initial phasing – in the phasing of initial ramping costs, which created favorability in our Q2 results compared to our quarterly outlook. We expect to see higher levels of year-on-year operating expense growth in the low teens range in the second half of 2017 related to increased U.S.

commercial resources, enabling IT programs and R&D initiatives. We also recently announced the acquisition of rVetLink which will add an important dimension to our growing software and connectivity capability.

This acquisition and related development initiatives will add about $2 million to $3 million of incremental operating expense in H2 of 2017, including transition costs with limited initial incremental revenues. These costs are factored into our updated financial outlook.

EPS in Q2 was $0.95 per share, including $0.08 per share in benefit from adoption of new accounting guidance related to share-based compensation.

Tax benefits from share-based compensation continue to trend higher than originally projected, reflecting the significant recent appreciation of our stock price and higher levels of activity related to the expiration of specific stock compensation grants.

For the full-year, we now project benefits from adoption of the new accounting guidance in the range of $0.30 to $0.34 per share or about $0.08 per share higher than our last estimates.

This is obviously a dynamic area and higher levels of benefits in 2017 reflect timing of stock option grants and effects from the significant recent increase in our stock price.

As we'll discuss in clarifying our tax rate outlook, we projected about $13 million of the after tax benefit we expect to see in 2017 or about $0.15 per share will not flow through to future years.

Aside from the benefits from the new accounting adoption, Q2 EPS results were supported by share repurchases, which lowered year-on-year shares outstanding by 1% net of a 0.5% negative impact related to adoption of the new share-based compensation accounting guidance.

Our effective tax rate was 25.5% in Q2, including 6.2% of tax rate benefit from share-based compensation accounting adoption, foreign exchange net of hedge impacts in Q2 2016 and 2017, lower quarterly operating profit by $1.4 million and EPS by $0.01 per share.

Free cash flow was $95 million for 2017 in Q2, on track with our full-year outlook for free cash flow of approximately 95% of net income and projected full-year capital spending of $90 million.

Our outlook for continued strong free cash flow generation, aligned with our very strong business momentum, supports allocation of capital to share repurchases. In Q2, we deployed $114 million to repurchase 700,000 shares in the open market bringing year-to-date repurchases to $165 million for 1.1 million shares or an average price of $152 per share.

We ended Q2 with $1.309 billion in debt outstanding, $423 million in cash and investment balances and $145 million in borrowing capacity available under our revolving credit facility. Our leverage ratios as a multiple of adjusted EBITDA were 2.7 times gross and 1.8 times net of cash and investment balances. Turning to our 2017 outlook.

As noted, we're increasing our full-year revenue and EPS guidance ranges, we're raising our reported revenue guidance by $17.5 million at midpoint to $1.945 billion to $1.965 billion, reflecting our expectation for organic revenue growth of 10% to 11%, as well as about $13 million in revenue benefits from relatively more favorable foreign-exchange rate changes.

At the updated FX rates noted in our press release, we now project that our reported revenue growth will be reduced by about 0.5% in 2017, related to the year-on-year strengthening of the U.S. dollar.

In terms of our operating margin outlook, as noted, we're projecting annual improvement on a reported basis of 100 basis points to 125 basis points, which equates to 110 basis points to 135 annual basis point improvement on a constant-currency basis.

This higher constant-currency outlook reflects our strong first-half performance and momentum in growing CAG recurring diagnostic revenues.

For the second half, we expect operating margin gains will moderate as we lap strong prior-year gross margin performance and invest in expanding our regional customer-facing capability in the U.S., advance our R&D and enabling IT agenda and integrate the rVetLink acquisition.

In terms of EPS, we're raising our 2017 outlook to $3.12 to $3.22 per share or an increase from our previous $2.95 to $3.11 range or approximately $0.14 per share or higher at midpoint. This equates to 17% to 19% EPS growth adjusted for currency changes and share-based compensation accounting impacts, aligned with the long-term financial goals.

Our higher EPS outlook is driven by three factors; first, we're projecting $0.04 in operational benefit, related to our strong organic growth trends and our raised full year constant currency operating margin outlook. Note that this reflects about $0.06 of projected operating improvement offset by about $0.02 of impact from the rVetLink acquisition.

Second, favorable FX changes are projected to contribute $0.02 of benefit compared to our last guidance assumptions. At the rates assumed in our press release, FX changes are projected to reduce 2017 operating profit by $7 million and EPS by $0.03 per share, net of a projected $3 million or $0.03 per share benefit from hedges.

In terms of our 2017 outlook as a sensitivity to rates assumed in our press release, a 1% weakening of the dollar across our currencies would raise 2017 revenues by $3.5 million and operating profit by about $900,000 net of hedge impacts.

Please note that while not all of the favorable FX change year-to-date will benefit 2017 results given previously established hedge positions. These changes, if they hold, will benefit future years as hedge contracts expire.

Third, as noted, we expect $0.08 per share of incremental benefit from adoption of the new accounting guidance related to share-based compensation. On our last call, we had estimated that our effective tax rate for 2017 would be about 32% prior to these impacts, and we're maintaining that outlook.

In terms of benefits from reflecting the tax deductibility of share-based compensation in our P&L under the new accounting guidance, we're raising our expected tax rate benefits on these fronts for the full-year of 2017 to 7% to 8%.

This reflects in an updated estimated, in an updated estimate for our 2017 full year effective tax rate of 24% to 25% and this assumes an effective tax rate for the second half of 2017 of 26% to 27%, somewhat higher than the first half, reflecting accelerated option exercise activity earlier this year.

The projections for our effective tax rate in 2017, aligned with an estimated $27 million to $30 million benefit in tax reduction related to share-based compensation activity.

As noted, a portion of the tax rate benefit in 2017 is related to specific factors, including the timing of exercise of stock options which are not expect to carry over into future periods, based on our analysis of future vesting schedules and historical activity.

For future years, we estimate that the annual benefit from share-based compensation activity will be $14 million to $17 million, assuming our current share price and no change in U.S. corporate tax policy.

This is approximately $13 million below projections for 2017, which equates to about 3.5% of tax rate benefit in 2017 or $0.15 per share EPS benefit, which we do not anticipate will carry over into future periods.

Our outlook for share count in 2017 is for reduction in average shares outstanding from stock repurchases of approximately 1.5%, net of a 0.5% accounting impact. We're projecting net interest expense of approximately $33 million, assuming a relatively consistent current gross leverage ratio.

In terms of our third-quarter outlook in 2017, we expect Q3 reported revenue growth in the 9% to 10% range, reflecting organic gains of 9.5% to 10.5% offset by a modest FX headwind. As noted in earlier calls, we will see a 1% reduction in organic revenue growth in Q3 and Q4 of 2017 related to fewer business days, which is factored into our outlook.

Year-on-year operating margin improvement in Q3 is expected to be 0 to 50 basis points on a reported basis compared to the prior-year third quarter. This equates to 10 basis points to 60 basis points of constant-currency improvement.

While we're targeting continued solid operating margin improvement, Q3 gains will be moderated reflecting higher levels of operating expense growth, from our U.S. commercial expansion, R&D initiatives and acquisition integration, as noted.

We're targeting solid continued gross margin improvement, but also expected moderated level of year-on-year gross margin improvement for Q3, compared to very strong first half gains. That concludes the financial overview, let me turn the call over to Jon for this comments..

Okay, hey, thank you, Brian. Indeed a strong quarter with constant-currency revenue and EPS gains and an outlook for the year that is at the high end of our long-term growth goals.

This reflects continued strong market growth and outstanding execution by our teams with our highly impactful direct sales coverage model, driving an even higher growth for our business. Also the weaker dollar provides a tailwind as we're a net exporter of technology products.

Global CAG Diagnostics recurring revenue growth of 13% constant-currency benefited from exceptional performance from our U.S. commercial team, achieving 14% CAG Diagnostics recurring revenue growth.

Some notable accomplishments in North America, double-digit growth in the productivity of instrument placements using our economic value index, which measures the value of different instrument placements in contributing to recurring revenue growth and profitability.

Note that we didn't have a significant change in the field resources in place that are responsible for instrument placements over last year's quarter. So this is essentially all productivity. In Q3, we have in place the expansion of our U.S. sales organization.

Part of this EVI was contributed by 14% growth in competitive Catalyst placements year-over-year and SediVue placements continued to be strong. Reference lab growth in the U.S. pulled up the global average for this CAG Diagnostic modality.

And in rapid assay, our field professionals achieved tremendous momentum in placing SNAP Pro units at over 1,800 for Q2, the vast majority in North America, which grew 300% year-over-year.

SNAP Pro is giving our field professionals a great reason to talk about our highly differentiated rapid assay SNAP line, which saw another quarter of strong growth, led by SNAP 4Dx Plus in the North American market.

Clearly, even after 15 years in the market vector-borne disease testing, aka tick-borne disease, remains a developing market and by highlighting SNAP Pro and the SNAP line in general, our commercial organization is bringing new attention to the importance of vector-borne disease screening with 4Dx.

In fact, we just released a seminal analysis that uses big data to demonstrate a significant increased risk of chronic kidney disease with dogs exposed to the tick-borne diseases of Lyme or Ehrlichia. So, now we appreciate that testing for exposure to tick-borne disease is more important than ever.

We also appear to be continuing to recover the volumes in first-generation rapid assay sales that eroded during the transition to the fully direct in 2015. In Q3, we have put in place a 12% expansion of the sales force in the U.S. market with additional territories.

The hiring and training associated with this expansion is essentially complete and we have about 430 field-based professionals in place to start the new quarter. With the expansion we have both new reps to IDEXX and a U.S. territory reconfiguration that evolves about 8% of accounts with a change in IDEXX account professional.

We anticipate some moderation in U.S. growth in H2 over the very strong year-to-date performance as it typically takes at least a quarter for reps to settle into their new territories and we will be up against relatively tough compares in rapid assay that will moderate growth from the very strong first-half gains.

We also have about 1% of growth headwind with fewer business days. Having said that, our model of customer coverage has proven to be exceptionally successful in both growing the market for diagnostics for customers that use IDEXX, the expanded toolkit and also look forward to the benefits of this further-expanded U.S. commercial presence over time.

As we move into 2018 with this expansion fully settled into place, we'll also benefit from productivity initiatives such as fully leveraging our new customer relationship management system, up the EVI model for instrument placements, as well as more effective digital marketing support.

And of course, we will have significant new product introductions. Europe was solid in Q2 with CAG Diagnostics recurring revenue growth impacted by year-over-year timing of Easter, which is a major four-day holiday in Europe unlike the U.S. And as we indicated, this would be the case.

Asia-Pacific and Latin America continue to be our fastest-growing global regions. Global gains continue to be driven by the expansion of the Catalyst customer base generating high-teens year-over-year consumable gains with years of runway ahead.

We are seeing an increasing percentage of international Catalyst placements to new and competitive accounts, reaching almost 50% in the second quarter.

Overall, our CAG dynamics are very strong globally with a unique innovation driven growth, high and improving customer retention, strong pricing gains and high profit flow-through enabling us to support growth investments while delivering strong financial results. Let me turn to a couple of technology pipeline updates.

We are very pleased to add the rVetLink team to IDEXX in Q2. rVetLink is an exceptionally successful cloud-based application that solves the issue of communication and medical record sharing between the specialty referral hospitals and their referring DVM clients.

rVetLink adds an attractive recurring revenue business model to IDEXX that will also further add value to our practice information management systems offerings, including Cornerstone, DVMAX and Neo in North America.

All three of these practice information management systems are strategic product offerings that will also continue to be a development priority, including, but certainly not limited to embedding the rVetLink functionality. The rVetLink acquisition comes with a seasoned and talented leadership team.

We welcome them to the IDEXX family and their SaaS-based solutions to the IDEXX ecosystem. Of note, rVetLink is the seventh in a growing ecosystem of cloud-based offerings offered by IDEXX.

We also continue to see great opportunities to address our customer information technology needs with our ecosystem of products, including both client-server and cloud-based platforms by taking client-server applications to the cloud and through leveraging the data that is created by these systems.

These continue to be R&D investment priorities for IDEXX. We remain on track for two important product launches within the next year, as I referenced earlier, Catalyst SDMA and SNAP Fecal. Both products will generate direct revenues.

Importantly, they also add value to the entire IDEXX diagnostic offering and thus provide a multiplier effect on the growth of our core recurring diagnostic revenue. Let's take a look at each. Catalyst SDMA, a new slide for Catalyst, will contribute to instrument revenues directly, as it is a new test.

In addition, the new test makes Catalyst instrument even more unique, supporting the expansion of our in-house chemistry customer base.

Finally, by providing SDMA on Catalyst, we accelerate the growing recognition of SDMA as an essential parameter to the core chemistry panel, whether run at the point of care on an instrument or sent to the reference lab. We are on track to introduce Catalyst SDMA by the end of 2017 in the North American market.

As expected, with estimated annual revenue growing to roughly $50 million or more within five years for this one test alone on Catalyst. SNAP Fecal will become in time a major category of our rapid assay business, directly adding to the annual revenue growth with potential rapid assay revenue in five years, also of about $50 million or more.

SNAP Fecal also has a multiplier effect and that it adds value and attention to the SNAP family and makes SNAP Pro even more valuable as a device that assists in practices in running all SNAP products in the family, thus supporting our entire rapid assay product line.

SNAP Fecal also brings further attention to our unique Fecal antigen technology, which is used in SNAP Pro and also used at the reference lab, for those customers who prefer a send-out protocol for their Fecal testing and yet value the unprecedented accuracy advantage that antigen technology adds to traditional methods.

Again, we remain on track for the launch of SNAP Fecal in mid 2018 as expected. Both of these products are examples of how IDEXX innovation is uniquely driving profitable growth of veterinary diagnostics and thus IDEXX's CAG recurring revenues.

We are combining new and augmented technologies with evidence-based medical insight, increasing the clinical value of diagnostic testing and thus the motivation and justification to run more testing.

And we know that pet owners prioritize spending on their pets when the benefit to the health of their pet is apparent to them as it is with this medical-based insight that we're bringing to the market.

With this differentiated and augmented set of medical tools, it is no surprise that IDEXX's veterinary customers are growing their usage of diagnostics faster than the market as a whole to the benefit of the pet and the pet owner, the veterinary practice and to IDEXX.

This dynamic is one of the reasons we remain confident in the long-term target of 10% plus constant currency revenue growth for IDEXX as a whole. So, with those opening comments, we'll now open it up to Q&A..

Thank you. And our first question will come from the line of Jon Block form Stifel. Your line is open..

Great. Thanks, guys and good morning. Maybe two. The first one just your thoughts on international CAG recurring traction. I think it was plus 17% in the first quarter, still a robust 12%, but slowed to 12% in 2Q.

You guys certainly called out the timing of Easter, but just want to make sure anything else at play there, the step down from 17% to 12%, were there any markets in Europe that may have pulled back a little bit, maybe if you can just – can provide some overall color across the international landscape specific to CAG recurring? And then I've got a follow up..

Yeah, great. Thank you. It's a big holiday in Europe, Easter four-day holiday, and it was in the first quarter last year and then second quarter this year. So I think the best way to look at Europe is the first half growth and that sort – that normalizes for that. That was 15% recurring revenue growth internationally versus 13% for the U.S.

So that's that 200-basis-point delta that we typically see..

Yeah. If you adjust both quarters for that, Jon, it's a pretty consistent trend..

Okay, okay. Brian and then, of course, I got to push you a little bit on the leverage. The guidance implies a pretty big step-down in the amount of constant currency operating margin expansion in 2H relative to what we saw in 1H. Of course, Jon, you've alluded to the increased investments that you guys have made more recently.

Brian, I guess, maybe two things, how do we think about that leverage as we go into 2018? Maybe you can give us some details around the timing of it. In other words, do you absorb the heightened level of spend in 3Q and 4Q and then we go to a more normal cadence once we enter into 2018? Thanks guys..

We'll obviously provide more clarity on that as we get towards our preliminary guidance. But I think what we're signaling is that we're going to have low teens OpEx growth in the back half of this year and you would expect, just given lapping, Jon, some of that's going to carry over into the first half of 2018.

As we add the resources, we'll obviously have a higher level of resources that we have in the prior year. We're still confident that we can deliver good operating margin improvement. We do think it's going to be moderated because of that in the second half, along with just some relatively less favorable compares on the gross margin front.

But we feel good about being positioned to continue to deliver our 50 basis points to 100 basis points of annual operating margin improvement on a constant-currency basis which is our long-term goal, and we'll share more insight on that as we get closer to 2018..

Okay..

Jon, I just want to add to those appropriate comments by Brian. Obviously, the investments in the U.S. organization have generated a very attractive return in accelerating growth of the recurring diagnostic revenue that we've seen in the first half of this year, 13%, and the second quarter being 14%.

I think what we're finding is the more we call on customers the faster they adopt our more expanded toolkit of diagnostics, and it turns out when you have more tools you use them more frequently and they find more disease and this is a reinforcing dynamic.

And so while it takes a little while for this – it'll take a little bit while for this 12% expansion to settle in, as I mentioned in my prepared comments, we've got some very significant productivity initiatives that are already in play, that we're already seeing the benefits from, combined with some additional new product launches with the SDMA on Catalyst, which is going to be very, very big for us in the North America market, even in the global market.

And SNAP Fecal which will be very, very big for us in the North American market where Fecal testing is already an established protocol, mostly using in-house microscopy manual method. So we think these are proven to be very attractive ROI investments. But as Brian mentioned, they take a little time to kick in..

Understood. I'll follow up on the instruments offline. Thanks guys..

Thank you. Our next question comes from the line of Ryan Daniels with William Blair. Your line is open..

Yeah, good morning. Thanks for taking the questions. A couple of follow-ups on some of the investments you're making. I guess number one on the expansion in the customer facing units.

I'm curious, as you spend more time with vets and techs, if your teams are not only focusing on educating them on your products and product launches, but also how to increase overall lab utilization with pet owners, meaning wellness program initiatives, seasonal screenings, parasitic outbreaks et cetera that drive greater utilization at the point of care?.

Yeah. Ryan, actually it's a great question and we're seeing our customer grow faster whether they're growing – one of the drivers of reference lab growth is the same-store sales with our customers.

As Brian mentioned in his comments that's being driven in part by some of the technologies were being in the market, Fecal antigen testing is really taking off in the reference lab and driving same-store sales growth and 4Dx when customers choose to send that to the lab.

We also have some very successful programs to drive the growth in preventive care with our customers, which – and we're going to talk a little bit more about this at the Analyst Day, but the medical justification of running diagnostics in a preventive care across both dogs and cats and all ages is very, very strong and yet still really very, very underutilized.

So when our veterinarian – when our diagnostic or veterinary – VDCs, the veterinary diagnostic consultants engage with customers towards advancing a preventative care, we see a very dramatic growth in their usage of IDEXX diagnostics. This is a much higher growth and it really shows they're starting to kick in the gear.

And of course, one of our cloud-based offerings, Petly Plans, aids in the adoption of a preventive care plan, which, while it's not necessary can be helpful to growing a preventative care diagnostics in the customer.

So, all of these are trends we see were just starting to crack the code on this accelerated utilization, because we have unique tools, they find more disease, it's sort of a virtuous cycle, customers see the success, they see the clinical efficacy, they see that they are raising the standard of care, they're helping pet owners and pets find and treat these disease earlier.

Pets are living longer lives and so they want to do more of it. This virtuous cycle with the customers that are IDEXX customers is a very, very positive. And of course, then we're adding new customers that start to enter this virtuous cycle of utilization growth. It all happens over time, but these are enduring growth dynamics for us..

Great. That's very helpful color. And then as my follow-up one on the R&D spend.

I guess, can you talk a little bit more about how much of that is currently going towards commercialization or development of some of the products you've already announced, like moving SDMA on to Catalyst and the SNAP Fecal versus focusing on novel testing areas on the pure research front? Thank you..

Well, we have – it's really all of the above. We, of course, support existing products, for example, our – as I mentioned seven cloud-based offerings and our practice information management system, these are software offerings that are continuing to add a functionality.

We see the opportunity to leverage cloud technology with our client-server applications over time. So in the software area, it's not – it's new, but it's also really expansion and growing the value of that entire ecosystem and how it works together seamlessly to drive very, very attractive clinical and financial outcomes for our customers.

Of course, we've got the new products that we've announced SDMA on the slide, which is going to be really big for us and we're right on track for the launch at the end of the year. And then SNAP Fecal, which will be – the SNAP Fecal will be the most significant product launch since 3Dx in 2002.

And as I mentioned in my comments, 15 years later, we're still seeing growth in vector-borne disease testing. These are very, very long-enduring cycles and so we're going to start a whole – another long-enduring cycle with the SNAP Fecal.

Of course, we have other things in our pipeline that we haven't discussed yet because in many cases, these are a multiyear development efforts. But I'm going to tell you, what our commercial organization is very busy with our current and projected offerings. In some cases, Ryan, we have to hold things back. And so let me just give you an example.

We have a great new test on Catalyst called CRP. This is an inflammatory marker, chemistry marker. We launched in Europe because the European market appreciates – certain countries in the European market appreciate the benefit of CRP. The U.S. market is completely uneducated on CRP. We haven't even launched it in the U.S.

We don't want to – we're going to launch it eventually, but we just don't want to try to do too many things and each of them half done. And so, we are not gated by new – the innovation, we're more gated by the commercialization..

Great. Thank you for the color..

Thank you. Our next question comes from the line of Erin Wright with Credit Suisse. Your line is open..

Great. Thanks.

Can you speak to kind of how the incremental sales force in commercial investments that you've already made to-date are taking hold, I guess, what are you seeing quarter-to-date or the sales force that perhaps ramping up according to plan and how should we think about that influencing the quarterly progression as instrument placement trends in the next two quarters? Thanks..

Yeah, thank you. As I've mentioned, it's a 12% expansion and the vast majority of that is reducing the number of customers that a rep is servicing and thus increasing the intensity of the calls, creating a stronger relationship. So that involves some territory reconfiguration and about 8% of our accounts will therefore have a new rep.

Sometimes they're just – they're an existing rep, but they're new to that portion of the territory and of course other times it's a rep that's new to IDEXX. As we've done with the expansion in 2015, the added reps are very highly experienced and occasionally they also come from the very territory with some other animal health OEM.

But it does take time to learn our product line and it does take time to get settled in and we typically see that's going to be a quarter of investment and then they start to sort of begin to pay for themselves in the second quarter, but then we have a long period as they grow their relationships and their competency, where we see growing productivity.

But of course, we also have the benefit of ongoing relationships with the other 92% that aren't changing as a result of this expansion and we will be adding, as part of this expansion, we're adding in the second half year more professional service veterinarians which are highly appreciated by the customer and we've also added more of the field support reps, which are involved in the adoption of these protocol changes.

So it's a – we've seen that as we add intensity of coverage, we see very nice response with our customers who adopt diagnostic protocols faster, and it's such a deep market. Everything that suggests it's such a deep market that this has good ROI, Erin. Thank you..

Okay. Great.

And then on SediVue, can you speak to how the feedback has been in the field and placements were pretty strong, has there been any surprises from a consumable utilization standpoint per customer and can you speak to ways you could potentially enhance the utility of SediVue or potentially better leverage the algorithmic interpreted software? Thanks..

Well, thank you very much for that comment. We saw really nice customer response to the Neural Network 2.0 software offering, which as you know just gets launched behind the scenes, fully launched in the early part of second quarter. And that continued to advance the diagnostic algorithms.

That's not the last one, we're going to have another one in the first quarter of 2018, called Neural Network 3.0 that will continue to leverage the tens of millions of images that we're getting. I would say again everybody wants this to happen faster. We think that urine is underutilized.

We know that roughly 50% of the urine that is run on SediVue provides results that are medically significant, meaning, some kinds of observations in the urine that is very medically significant and helps rule in certain types of diseases. That's a very high rate, close to 50%.

We ran a free UA day, which we can do because of the pay per run, where they only pay when they run the analyzer. We say when you run the analyzer, this one day, you don't have to pay. And we saw over 600 customers run seven times the amount of urine that they would have run on a normal day.

And on the incremental results, we found over a third of those results provided remarkable diagnostic findings. This just shows underutilized urinalysis is. Our current projection is still 3,000 or 4,500 per year in recurring revenue per instrument placement. We hope to grow that gradually over time; we're around 1.1 runs per day on average.

Obviously, some customers are higher than that, other customers are lower. But the opportunity to run and the value of running urinalysis is still very, very significant and, of course, SediVue makes it easier to do so.

It's one of these protocol changes that allow customers to grow their diagnostic utilization without heavy load on the technician productivity..

Thank you. Our next question comes from the line of Derik de Bruin with Bank of America. Your line is open..

Hi, good morning..

Good morning..

Can you hear me?.

Yes..

Yeah, yes. Good morning..

Oh, great. Thank you. Sorry, I'm remote today. So, when you launch SDMA on the Catalyst, clearly an important product launch, how do we think about the incremental consumable pull through as we look into 2018? And what does that do, do you think to the consumable numbers, I'm just curious.

And then how do you look at – do you have any data on how many of people that are sending out to your services just do SDMA only and have Catalyst systems.

I'm just curious on potential utilization that way?.

There's all sorts of interesting good things that happen and yet they've all happened slowly over time, now when they – when a customer adds SDMA to a Chem CLIP that'll be an incremental roughly $7 for us. And so really the question is to what degree will we see customers adding the SDMA slide to the Chem CLIP over time.

And that'll be a gradual thing just like it was with when we launched the T4 on Catalyst and it adds a small amount, but every year it adds – continues to add more and more.

And so – but the other thing that we know is that we have a cohort of customers that have our full in house suite including Catalyst, but don't use us for the reference lab, but because they're in a contract they can't get out.

But they value SDMA and so we may see a shift towards more full panels being run in-house with this cohort of customers, again these are very difficult things to model, but we're really seeing very nice traction in SDMA being more and more viewed as an essential element of the routine chemistry panel and for those customers that have Catalyst, this will be – but don't – are don't have ready access to our reference labs, this will be a way that they can change to that protocol, so..

As Jon noted, we estimated over five years, we think they can build a $50 million and or more. So....

That would be $50 million in just Catalyst revenue associated with the SDMA slide, that's our estimate. That doesn't include the multiplier effect of growing utilization or growing the recognition of SDMA, or growing our reference lab or all the other things that we believe this will help..

Great. That's very helpful. And just one follow-up. I really appreciate the commentary on the SPC tax implication, that a lot of the other companies that are reporting these gains are calling out the fact that they're going to have headwinds in 2018 from this.

So I'm just curious, is there a general, is there any rule of thumb to think about incremental X amount of increase in the stock price, could potentially drive an incremental benefit from this, I know timing of these options is really hard to do, but I'm just wondering if there is any sort of rule of thumb we can use?.

Don't have that handy, I think that's something we can try to bring some clarity to over time because that obviously has one impact, and the other impact, that's harder predict, is how do people behave. So, I apologize we don't have that specifically....

Yeah..

We don't have that specifically, but that's a – as we continue to work on our PhD and stock share-based compensation impacts, we'll add some of that over time..

Yeah. Great. Thanks a lot. Appreciate the color..

No, problem..

Thank you. We will go to the line of Nicholas Jansen with Raymond James & Associates. Your line is open..

Hey, guys, congrats on another strong quarter. Just want to talk a little bit about margins in sales force density, as you look at your commercial infrastructure. At what point in time, do you think that we perhaps will level out there a bit more.

And then think about maybe accelerating the long-term guidance on margin improvement?.

I think the – we've gone through some phases on the increases in our sales and marketing capability. I think the history has shown, this has been a very high return area for investment, we're obviously focused on growing our core business.

We did a reset, if you will, once we went direct, and I think that you see the benefit of that playing out now and we've got a more modest reset here going on in the next few quarters.

I think over time, we do think we can get leverage out of sales and marketing, but we want to always leave the opportunity open to invest incrementally towards incremental growth, we're growing the market, we think this requires resources, and we'll continue to monitor that over time.

And that's all factored into our long-term view of the 50 basis points to 100 basis points of operating margin improvement. I think that there's potential to deliver more on that, but we want to balance that with always having an eye towards the significant long-term potential we see for growth in this company.

And we'll – as we move towards Investor Day, we're going to – we'll be spending more time on that and helping you understand the benefits of that approach..

Yeah, thanks for the comments, Nick. Just to add to that, margin expansion is a good thing, Brian mentioned with our new guidance we'll have 280 to 305 basis points on an adjusted constant currency basis over the combined two-year period, 2016-2017.

Margin expansion is a good thing, organic growth is a good thing, accelerating organic growth is a good thing. Some of that comes from incremental investments, of course, that also helps with gross margin expansion. I think it's a very favorable dynamic that we are – that we are working here..

Thanks for that color. And then just on the reference lab, certainly it's interesting to see your U.S. growth continue to accelerate relative to your peer group that's seeing some level of moderation.

So just maybe want to dig a little bit deeper into the share gains that you're seeing in the U.S.? And then more importantly, where are we in the cycle of your guys' gross margins within the reference lab as we think about that being a pretty big lever for growth longer-term in operating income? Thanks..

Yes. Thank you for those comments. I want to comment that our reference labs are doing very, very well in the U.S. market. A significant portion of that is the same-store sales growth from our customer base. And because they're adopting some of our unique differentiated offerings that aren't available to customers that don't use our reference lab.

And this really comes from the fact that our veterinary diagnostic consultants are – their commission is based on territory revenue growth. And that comes from any CAG recurring diagnostic growth including same-store sales and reference labs.

And so, we're really seeing a nice growth again in the Fecal antigen area, in the reference lab version of 4Dx and some of the specialty tests. And then, when we add a new customer – oh, by the way that growth also means that customers are adopting protocols that are only unique to IDEXX.

And it increases the retention of our IDEXX reference lab customers, and of course, the retention is increased as they appreciate that SDMA is an essential element of their routine chemistry panels. So, we're seeing gradually improving off of very strong retention ratios.

And then, as we add a new customer, what's really interesting is they start growing faster, with the reference lab utilization. And then, we're going to share this with – the results with – at Analyst Day, which I think investors know will be a Reg FD event, everybody will have the benefit of this.

We also note that actually customers that run more in-house diagnostics grow their reference lab business; they're higher reference lab growers. It turns out, and we're going to show this with big data. Testing begets testing. The more in-house testing that customers do, the more reference lab testing they do, it's an amazing dynamic.

These are our customers because these are all – a reinforcing integrated offering. I can't comment on with regard to customers that don't use us, because they don't have the tools, the toolset, the expanded toolset that we're providing. But it's an interesting dynamic.

One would normally think, hey, if I'm going to do more in-house, I do less reference lab. No, the more in-house you do, the more reference lab you do. And so that's another factor that's contributing to the growth in our reference lab business. And indeed, the expansion of the diagnostic market with customers who are using IDEXX expanded toolkit..

I'll leave it at two. Thanks, guys. Congrats again..

Thank you..

Thank you..

Thank you. And one moment please. Our next question will come from the line of David Westenberg with C.L. King. Your line is open..

Hey, guys. Thanks for taking the question and then, congrats on another good quarter..

Thank you..

Can you just give a little bit more color on the free SediVue utilization – the free SediVue utilization day in terms of what you might have saw afterwards.

Was there a spike, was there a continuous usage in those customers that used it? And if that is the case, is this something you might do on a regular basis, if testing begets testing in this particular case?.

Yeah. Thank you. It was an exceptionally successful market initiative that actually had very, very high ROI, because the foregone revenue and the marketing costs on it were relatively low. We're just now fully beginning to appreciate as a result of digging into the big data, how profound impact it had on the patient care.

But like everything in veterinary medicine, changes in clinic protocols, they happen slowly, they may happen with a subset of customers very rapidly. As I said, we have 600 to 700 customers, who really participated in the UA Day in such a way that they greatly expand their testing that day.

But, of course, that's a small fraction of our SediVue installed base in North America. But it is – it shows the power of the pay per run model and some of the creative marketing that we can do with that.

And I suspect that we'll continue to find ways to drive the utilization growth because the opportunity is so large in relation to the current standards. It's hard to parse all this out in terms of the impact that it's having because you've got seasonal factors. We've only been in the market for a year; we barely have year-over-year data.

Obviously, there's a little bit more testing that's run in the summer when practices are busier than run in the winter. And so, but it's got to be a good dynamic, as I said, we're right now about 1.1 runs per day, it's really shocking how low that is. And I think even vets themselves are shocked with how low that is.

So we see the opportunity to grow that. But I'm not going to say, it's going to change to 1.5 overnight, this takes time. And of course, we're continuing to grow the install base in the meantime..

Got it. Thank you. That's very helpful. And then just a very, very quick clarification question, you mentioned the slide pricing of SDMA being $7.

Was that up from $5 or was it always $7?.

We're just getting closer to launch and we're getting closer to what – this would be a bundled price if they buy it.

The list price for the SDMA slide will be $16 or $17, but we'll have a bundled discount when they buy it with a CLIP which should be the incremental price of the SDMA when you add it to a CLIP purchase, that will be about $7 and this is specific to U.S. These are U.S. numbers.

So we're just getting a little bit more specific on that as we get closer to the launch..

Fine..

I don't think we fully, we finalized it. But I think we're – that's pretty close to the neighborhood we're going to be in, in the bundled discount pricing which we would expect would be the majority of the slide-only purchases.

Of course, the majority of our customers also run T4 in combination with their panel and when they add SDMA to their T4, they will come at no incremental charge. But that's a very low, T4 which is just underutilized too. So less than 10% of Catalyst run in the U.S. add a T4.

So the vast majority of what we think will be the impact will be SDMA added to the CLIP without T4; although it may grow T4 utilization too. It's just a lot of moving parts, they're all good. We just don't know what degree they will move in and at what rate..

Perfect. Thank you very much and I look forward to seeing you in a couple of weeks and again congrats on a good quarter..

Thank you very much..

And our final question will come from the line of Mark Massaro with Canaccord Genuity. Your line is open..

Hi. This is Max, (01:04:48) on for Mark. Thanks for the question and congrats on the strong quarter.

So first, SediVue, can you speak to the number of countries you're launched in today? And perhaps could you add come color about where you're launched now and where you're expecting to launch later this year?.

Yeah. Thank you. Thank you very much for that question. We are, over the course of the first half of 2017, we launched in the major European countries, some of those were first quarter, some of those were second quarter and we're also launched in Australia.

And but I'm going to tell you what's interesting is SediVue is playing a nice role, but the big, big opportunities in these markets continue to the Catalyst placements, which are a lot for an individual instrument they have a higher impact on growth and recurring revenues of the consumable – the instrument consumables.

So in other words, they're EVI, the EVI of a Catalyst placement is still significantly higher than the EVI of a SediVue placement. So therefore SediVue plays a – what I would call a supporting role, but it's not a primary role.

It supports winning competitive customers, it supports advancing existing customers, filling out the suite, but really the primary objective for instrument placements internationally even more so in the U.S.

is continuing to take to upgrade or put in the Catalyst, which are, are what's generating that high teens VetLab consumable growth that we're seeing in the international markets. But we – it did contribute the international SediVue placements did contribute to meaningfully to the year-over-year growth in SediVue the 628 units that we place globally.

Thank you..

Great, thanks, and as a follow-up in terms of monetizing your patient data, I know it's an extremely small percentage of your business today.

Do you foresee any new verticals or areas where your lab data may be used to help some of your partners develop greater insights, whether it's in pet food or perhaps in new areas of pharmaceuticals?.

This is really very early days.

What we're really finding, right, and we – of course we do have a data business where we support some of the other players in the industry as you said on the pharmaceutical or diet side that appreciate their markets and support the execution of their marketing strategies, which are by the way very complementary to our strategies.

It helps grow the market and also a small revenue source for us. But what we're really – the larger impact we're seeing right now with this big data is these advanced medical insights.

I mean, I just mentioned the seminal work that used 850,000 patient data points that demonstrated that the length between exposure to Lyme Disease or Ehrlichiosis and increased risk of chronic kidney disease in the dog, which of course supports both our 4Dx product line as well as our kidney test to SDMA, which finds kidney disease earlier.

This is a phenomenal big data, evidenced-based work that we will published, we're out in the field, but it's only the beginning of what we see are the – medical insight. What we're showing here, and we're going to talk a little bit more about some of the work at Analyst Day is how underutilized diagnostics are in advancing care in the pet.

And we know the pet owner wants this. I mean, we know pet owners love their pets, we've talked about; we'll talk about that some more.

And so, we're really finding that through this evidence-based medicine, how powerful role diagnostic, how powerful role diagnostics played – plays when it is used to assess and monitor the health status of a patient and yet the utilization is still very, very low in relation to what would be medically justified.

And so, this is our Companion Animal business, and if we can have, even a couple points of impact on the growth of the Companion Animal business that will be lot of value creation for IDEXX shareholders, who come from our big data, well and doesn't preclude us from other ways that we can use the day.

I don't think there is any question that we're in the lead in the industry in using big data to provide insight to the industry on how to advance the standard of care..

Great. Thanks. And one more if I could.

On instruments, how should we think about your opportunity to place a second Catalyst in the clinics in either North America or beyond – and has the lion share of placing a second Catalyst – already taking place?.

Yeah, we're going to continue to place second Catalyst, when the customers need the throughput and – and that's – so that's still part of our standard program, it's is just a – I think we have some catch-up to do, and it really – it really, even with the growth, but the second Catalyst is more satisfying the customers need.

It doesn't generate it helps their capacity, but doesn't have any meaningful impact on the growth of their recurring revenues that we can deliver this over the short period of time, although it's certainly a good thing to do. So, it plays a role, but it's a minor role..

Great. Thanks for the question. And congrats on a great quarter..

Thanks..

Okay. Thanks..

And with that, Mr. Ayers, I'd like to turn it back over to you for any closing comments..

Well, thank you – thank you very much. I appreciate everybody joining on in the call. Again, I just want to congratulate the IDEXX team on really what was an exceptional quarter, the number of opportunities that we're finding to serve our customers is truly amazing.

And for investors, we look forward to sharing in more detail the opportunities we see for this market going forward at our Analyst Day which will be webcast and Reg FD for all of investors to benefit from. So with that, we'll conclude the call. Thank you very much..

Thank you. And ladies and gentlemen, that does conclude you conference call for today. Thank you for your participation and for using AT&T Executive TeleConference Service. You may now disconnect..