Earnings Call Transcript - IDXX Q2 2022

Operator, Operator

Good morning, and welcome to the IDEXX Laboratories Second Quarter 2022 Earnings Conference Call. As a reminder, today's conference is being recorded. Participating in the call this morning are Jay Mazelsky, President and Chief Executive Officer; Brian McKeon, Chief Financial Officer; and John Ravis, Vice President, Investor Relations. IDEXX would like to preface the discussion today with a caution regarding forward-looking statements. Listeners are reminded that our discussion during the call will include forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those discussed today. Additional information regarding these risks and uncertainties is available under the forward-looking statements notice in our press release issued this morning as well as in our periodic filings with the Securities and Exchange Commission, which can be obtained from the SEC or by visiting the Investor Relations section of our website, idexx.com. 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 measures is provided in our earnings release, which may also be found by visiting the Investor Relations section of our website. In reviewing our second quarter 2022 results, please note all references to growth, organic growth and comparable growth refer to growth compared to the equivalent period in 2021, unless otherwise noted. To allow broad participation in the Q&A, we ask that each participant limit their questions to one, with one follow-up as necessary. We appreciate you may have additional questions, so please feel free to get back into the queue and if time permits, we will take your additional questions. I would now like to turn the call over to Brian McKeon.

Brian McKeon, CFO

Good morning, and welcome to our second quarter earnings call. Today, I'll take you through our Q2 results and review our updated financial outlook for 2022. In terms of highlights, continued high levels of IDEXX execution drove solid organic revenue growth in Q2 compared to strong prior year results. Overall, IDEXX revenues increased 6.5% organically, supported by 7% organic growth in CAG diagnostic recurring revenues. Key execution metrics were excellent, reflected in an 18% gain in premium instrument placements, continued strong double-digit growth in veterinary software and service revenues, and a nearly 1,100 basis point U.S. CAG Diagnostics recurring revenue growth premium to same-store clinical visit levels. For the first half of 2022, overall organic growth was 7.2%, slightly below our expectations for first half growth at the low end of our 7.5% to 10% full year guidance range. These results reflect relatively increased headwinds from lower year-on-year U.S. clinical visit levels and increased macroeconomic impacts in international regions. Profit results were in line with our expectations, supported by sustained high gross margins. EPS was $1.56 per share in the quarter, including $0.72 of impact from discrete R&D investments and $0.06 of net year-on-year impact from the stronger U.S. dollar. As planned, EPS results reflected high operating expense growth, including the impact of $80 million in discrete R&D investments in the quarter and carryover effects from prior commercial investments. As we look forward to the second half of 2022, we're targeting continued solid organic revenue growth, building on the significant expansion of IDEXX's business through the pandemic. We've updated our full year overall organic growth outlook to 5.5% to 8% for 2022, reflecting 6.5% to 9% full year organic growth in CAG Diagnostic recurring revenues. The midpoint of this updated range reflects an outlook for continued solid organic gains in the second half, aided by strong IDEXX execution trends and benefits from incremental price increases. As we'll discuss, vet practices continue to work through capacity constraints and the lapping of high 2021 demand levels supported by the significant growth in new pets during the pandemic. Given these factors in a challenging global economic climate, our midpoint organic growth outlook incorporates expectations for continued pressure on clinical visit levels in the second half of 2022. At the low end of our updated growth range, we've also incorporated an additional 2.5% organic growth risk estimate in the second half related to higher potential macroeconomic impacts on demand. Our EPS outlook of $7.77 to $8.05 reflects our updated organic revenue growth estimates and new estimates for foreign exchange effects based on the continued strengthening of the U.S. dollar. It also reflects expectations for sustained strong full year operating margins flat to 50 basis points below prior year levels, adjusting for foreign exchange effects and $80 million in discrete R&D costs in 2022. We'll walk through the details of our updated P&L outlook later in my comments. Let's begin with a review of our second quarter results. Second quarter organic revenue growth of 6.5% was supported by 7% organic gains in our CAG business and 9% organic growth in our water business. These gains were moderated by a 5% organic decline in the LPD revenues, driven primarily by year-on-year impacts related to reduced African swine fever testing in China. CAG Diagnostic recurring revenues increased 7% organically in Q2, compared to strong prior year levels, reflecting 8% gains in the U.S. and 5% growth in international regions. Q2 CAG gains were also supported by 8% organic growth in CAG instrument revenues and 14% organic growth in veterinary software and diagnostic imaging revenues in addition to benefits from the ezyVet acquisition. In terms of U.S. CAG sector demand drivers, sustained healthy trends supporting increased utilization of diagnostics were moderated by relatively increased year-on-year pressure on clinical visit growth. In Q2, same-store clinical visits were an estimated 3.1% below strong prior year levels. This compares to an updated estimate of 1.4% declines in Q1 and 2.5% to 3% increases in the second half of 2021. Our analysis points to two primary factors driving the recent change in U.S. clinical visit growth trends: reduction in vet clinic capacity from peak pandemic levels and the continued lapping of the significant step-up in demand for pet health care during the pandemic, including benefits from the 10% increase in the pet population in 2020 and 2021. Historically, U.S. clinical visits per practice have grown at approximately 2% to 3% annually, supported by steady vet practice capacity expansion. Between Q1 2020 and Q1 2021, U.S. average clinical visits per practice jumped nearly 13%, and these higher absolute visit levels sustained through 2021. Extraordinary efforts by vets and their staff during the pandemic supported the significant increase in demand for clinical services, including diagnostics. In 2022, U.S. clinical visit capacity pulled back from these high levels, impacted by staffing challenges reflected in a 2% contraction in average clinical visit levels in the first half of 2022. This has brought implied vet clinic capacity metrics more in line with longer-term expansion trends, while still being below the strong demand in the sector implied by the pet population expansion. We see these specific dynamics improving over time. However, given the recent pullback in clinic capacity, which continues to be affected by near-term staffing challenges and the lapping of strong underlying demand levels throughout 2021, we believe it's appropriate to plan for continued year-on-year pressure on U.S. clinic visit growth in the second half of this year. Offsetting these near-term growth headwinds is the continued expansion of diagnostics revenue per visit at the clinic level, supported by IDEXX innovation and engagement. While year-on-year clinical visits declined 3% on a same-store basis in Q2, diagnostics revenue per visit expanded nearly 9%, consistent with strong Q1 trends. IDEXX's U.S. CAG Diagnostics organic recurring revenue growth of 7.6% in Q2 continues to outpace solid sector growth trends reflected in the 1,070 basis point premium to clinical visit gains. Jay will talk more about how we're driving sustained strong performance on this front in his comments. Globally, IDEXX achieved solid organic revenue gains across our modalities in the second quarter. IDEXX VetLab consumable revenues increased 8% organically, reflecting solid gains across U.S. and international regions. Consumable gains were supported by 15% year-on-year growth in our global premium instrument installed base, reflecting double-digit increases across our catalyst, premium hematology, and SediVue platforms. CAG premium instrument placements increased 18% in Q2, reflecting 8% gains in the U.S. and 25% growth internationally, as clinics showed continued confidence in investing towards support of increasing demand for diagnostics globally. The quality of instrument placements continues to be excellent, reflected in 9% growth in new and competitive Catalyst placements. ProCyte One momentum continues to build, supported by our global expansion efforts reflected in a 64% year-on-year increase in premium hematology placements in the quarter. Rapid assay revenues expanded solidly in Q2 compared to higher prior year demand levels. Global rapid assay revenues increased 6% organically, supported by solid volume gains in the U.S. and benefits from net price increases. Global Lab revenues increased 6% organically in Q2 as high single-digit growth in the U.S. was moderated by flat organic revenue growth in international regions, reflecting pressure on same-store clinic visit growth in Europe, including increased macroeconomic impacts. Reference Lab, new business momentum, and customer retention remain strong globally. We achieved continued solid net price gains in the quarter globally with an average 4% growth benefit to U.S. and worldwide CAG Diagnostic recurring revenues in the first half. Our updated outlook includes benefits from additional U.S. CAG price increases implemented in August, reflecting product and service enhancements and inflationary impacts. We estimate incremental price changes will provide an additional 1.5% to 2% growth benefit to worldwide CAG Diagnostic recurring revenues in the second half of 2022. In other areas of our CAG business, veterinary software and diagnostic imaging revenues increased 14% organically and 27% on a reported basis, including benefits from the ezyVet acquisition. Results were supported by double-digit organic gains in recurring software and digital imaging revenues and continued strong momentum in cloud-based software placements. Water revenues increased 9% organically in Q2, reflecting strong performance across regions, including benefits from net price improvements. Livestock, poultry and dairy revenue decreased 5% organically in Q2. Tough comparisons to high prior year revenue levels for African swine fever and core swine testing in China offset moderate overall organic revenue gains in other areas of our LPD business. We've now worked through these comparison impacts and are targeting positive growth in LPD in the second half of this year. Turning to the P&L. Q2 profit results were supported by solid gross profit gains. Gross profit increased 5% in the quarter as reported and 7% on a comparable basis. Gross margins were 59.7% in line with high prior year levels on a comparable basis. Benefits from net price gains, lab productivity initiatives and improvement in software service gross margins helped to offset inflationary effects and impacts from lower LPD revenues. Operating expenses increased 46% year-on-year as reported in the second quarter and 48% on a comparable basis, including a 35% OpEx growth impact related to $80 million in discrete R&D investments. Operating expense increases reflect carryover impacts from investments advanced in recent quarters related to our expanded global commercial capability. We're planning for moderated operating expense growth in the second half, particularly in the fourth quarter as we gain leverage from these investments and lap more favorable year-on-year comparisons. EPS was $1.56 per share, a decrease of 30% on a comparable basis including a 32% growth impact related to the discrete R&D investment. EPS results included tax benefits of $3 million or $0.03 per share related to share-based compensation, which was down $0.04 per share from high prior year levels. Foreign exchange reduced operating profits by $6 million and EPS by $0.06 per share in Q2, net of $6 million in hedge gains. Free cash flow was $36 million in the second quarter. On a trailing 12-month basis, our net income to free cash flow conversion rate was 66%. For the full year, we continue to estimate free cash flow conversion of 65% to 70%. This outlook reflects approximately 5% of free cash flow conversion impact from the discrete R&D investments, modestly higher inventory levels to sustain high levels of product availability, and higher deferred tax assets. We're maintaining our full year outlook for capital spending of $180 million, including approximately $50 million for our new manufacturing warehouse expansion project. Our balance sheet remains in a strong position. We ended the quarter with leverage ratios of 1.4 times gross and 1.3 times net of cash. We allocated $340 million of capital to repurchase 809,000 shares in Q2. We intend to continue to support our share repurchase program and leverage our strong balance sheet as appropriate. Our financial outlook assumes capital allocation to share repurchases aligned with the consistent net leverage ratio, supporting a projected 2% full year reduction in share count. Turning to our 2022 full year P&L outlook. We're lowering our full year organic revenue growth range by 2% to reflect first half performance, recent care sector trends, and to incorporate potential additional impacts from macroeconomic factors at the lower end of our guidance range. We're also adjusting our reported revenue growth outlook for the recent strengthening of the U.S. dollar and updating our EPS outlook to incorporate current expectations for foreign exchange impacts and projected changes in interest rates. Our updated full year revenue growth range of $3.305 billion to $3.385 billion reflects an $80 million to $85 million reduction compared to earlier estimates. This includes a $20 million adjustment related to the recent strengthening of the U.S. dollar. We now project foreign exchange will reduce year-on-year revenue growth by 3% to 3.5% for the full year with approximately 4.5% of year-on-year headwinds expected in Q3. As noted, we've updated the full year organic revenue growth outlook to 5.5% to 8%. This reflects a full year CAG Diagnostic organic recurring revenue growth outlook of 6.5% to 9%. Our updated CAG Diagnostic recurring revenue outlook implies second half organic gains of 5% to 10%. The midpoint of our outlook for H2 reflects CAG Diagnostic organic recurring revenue growth of 7.5% or 8% normalized for equivalent days effect, which we estimate will reduce Q3 revenue growth by approximately 1%. Supporting this outlook are benefits from price increases we are advancing in the second half of 2022, which we estimate will provide 1.5% to 2% of additional benefit to worldwide H2 CAG Diagnostic recurring revenue growth building on first half gains of approximately 4%. Net of this incremental price benefit, the midpoint growth outlook for the second half of 2022 is consistent with the global sector growth trends exiting Q2 and reflects expectations for sustained high IDEXX CAG growth premiums supported by continued strong IDEXX commercial execution. The lower end of our second half growth outlook factors in an additional 2.5% organic growth risk estimate related to higher potential macroeconomic impacts on demand. A 5% second half growth rate for CAG Diagnostic recurring revenues would align with the low end of growth impact seen in the last recessionary period. The higher end of our growth outlook for the second half targets improved 10% CAG Diagnostic recurring revenue growth supported by strong IDEXX execution and price increase benefits but will require an improvement in recent clinical visit growth trends. At our updated revenue growth rates, we're now planning for full year operating margins of 26.4% to 26.9%, an adjustment of approximately 50 basis points from our last outlook. This reflects a projected 210 to 260 basis point decrease on a reported basis compared to strong 2021 performance, including approximately 230 basis points of margin impact related to discrete R&D investments. Adjusted for the discrete R&D investments, and approximately 20 basis points of year-on-year net margin benefit from foreign exchange hedges, the high end of this outlook reflects updated goals for relatively flat operating margin gains in 2022 compared to strong prior year levels. The full year operating margin outlook is supported by goals to deliver solid comparable operating margin gains in H2. We're targeting flat to modest comparable operating margin increases in Q3 and higher levels of improvement in Q4 as we benefit from higher net price realization, cost management efforts, and the lapping of prior year stepped up investment levels. Our updated EPS outlook is $7.77 to $8.05 per share, including the $0.72 impact from the discrete R&D investments. This represents a decrease of $0.32 per share at midpoint, including $0.05 of impact from higher projected interest rates and $0.03 of additional headwind related to FX. For the full year at our midpoint outlook, we estimate foreign exchange will reduce full year operating profits by $23 million and EPS by $0.21 per share. This is net of an estimated $26 million or $0.23 per share benefit from projected 2022 hedge gains. We provided details on our updated estimates in the tables in our press release and earnings snapshot. That concludes our financial review. I'll now turn the call over to Jay for his comments.

Jay Mazelsky, CEO

Thank you, Brian, and good morning. IDEXX delivered another quarter of solid growth, supported by excellent execution by our global IDEXX teams. Demand for pet health care remains high, building on the step function in sector growth of pets and patient visits during the pandemic. IDEXX is a diagnostics and software partner of choice for veterinary clinicians. This was reflected in record second quarter premium instrument placements, continued high growth in cloud-based PIMS placements, and sustained IDEXX CAG Diagnostics recurring revenue growth premium to clinical visit growth. Our products support veterinarians by creating an integrated clinic-wide solution that helps them expand capacity and grow their businesses while providing diagnostic insights to support high levels of pet health care. The solid results that IDEXX delivered in the quarter, despite some headwinds from near-term clinical visit growth and international macro factors, reinforce our confidence in the durability and long-term growth potential of our business, aligned with increasing care standards for companion animals. Today, I'll discuss our performance and progress in the context of current sector trends and advancing key innovation and commercial initiatives that position us for continued solid growth and financial performance. Let me start by providing some updated context on trends in the companion animal sector. CAG sector trends continue to reflect strong global demand for veterinary services, building on a significant step-up in the number of pets and patient visits observed during the pandemic. U.S. diagnostics revenue per practice grew 6% during the second quarter against a very strong prior year base, as veterinarians use diagnostics to deliver the best care standards while benefiting from profitable clinical services growth. IDEXX grew U.S. CAG Diagnostics recurring revenue nearly 8%, two points faster, validating the value we bring with differentiated solutions and an excellent customer experience. Specifically, diagnostics remains one of the faster growing areas of the veterinary clinic, continuing to outpace both total practice revenue growth and clinical revenue growth on a same-store basis. U.S. diagnostics revenue growth per practice of 6% in the quarter, as noted, was once again driven by positive contributions from both diagnostic frequency and utilization. Diagnostics frequency and the utilization gains were both above pre-pandemic trends even at a much higher base. As highlighted in the earnings snapshot, critical use of diagnostics per visit expanded by revenue nearly 9% in the quarter, offsetting headwinds from lower clinical visits. We continue to make progress on initiatives that drive future diagnostics recurring revenue. We saw increased adoption of our U.S. preventive care program where we provide a turnkey diagnostic solution for wellness care, with approximately 225 new enrollments, the largest quarter of enrollment since late 2020. We're also seeing continued momentum across global regions related to the adoption of IDEXX platforms, reflected in 25% growth in international premium instrument placements, including the successful expansion of our ProCyte One platform. These strong areas of progress have been moderated by year-on-year pressure on clinical visit trends. This reflects a combination of impacts from pullback and capacity levels following a period of significant demand expansion, including the step-up in visits related to the 10% expansion of the pet population during the pandemic. In the U.S., for example, clinics were open around 50% of weekend days in Q2 compared to an average of almost 60% pre-pandemic. We're also seeing some impacts from macroeconomic pressures, particularly in Europe. We think it's prudent to plan for continued year-on-year growth impacts on these fronts in the second half of 2022. Recent research we performed in the U.S. and Germany shows that a majority of veterinarians indicate staff capacity is a major or moderate issue, while also indicating they see continued higher demand for appointments. As Brian indicated, we are well-positioned with clinics in working through these dynamics over time to address what is likely underserved demand for pet health care in a significantly expanded global pet population. As we work through these near-term headwinds, we're targeting solid organic growth overall in the second half, building momentum that will keep us on track towards our long-term growth goals. Let's now discuss our ongoing progress in key areas of our growth strategy. A key factor in enabling IDEXX to drive strong utilization of diagnostics within the sector is IDEXX’s decade-long focus on building and supporting a world-class commercial team to execute our high-touch model. These capabilities, along with significant new product introductions over the last several years, help our customers grow faster and continue to support strong commercial results. This is reflected in record instrument and software placements, strong EVI gains, and sustained solid net new business gains in very high customer retention levels. These results demonstrate the market development benefits of aligning commercial capabilities with highly relevant innovative products. Our sales professionals have shown an ability to maintain and leverage the deep relationships with customers to support these performance levels despite challenges related to staff capacity; U.S. account manager in-person visits are now over 70%, approaching desired end state goals. International access was also excellent at close to 70%, where international growth is a strategic priority, and we're applying the successful U.S. playbook to drive strong placements and new business gains. The second quarter represented continued progress against the strategy with solid year-over-year growth in customer adoption across modalities in Europe. Meanwhile, onboarding and integration of the six country-level commercial expansions have been completed and have gone extremely well. We look forward to ongoing future benefits from these expansions as we work through macro-driven headwinds in regions like Europe, which are constraining near-term organic gains. The international opportunity to drive diagnostics utilization is tremendous and largely underpenetrated; as shared in last year's Investor Day, our advancing global commercial capability and product innovations that fit the requirements of these regions are positioning us to realize significant opportunities over long horizons. Putting the right products and enhancing our capable sales professionals drives continued growth in instrument placements with the resulting highly profitable future consumable streams. Customers on a global basis have never been hungrier for technology that supports care, workflow optimization, excellent clinical performance, and ease of use. A key piece of our in-house analyzer portfolio is ProCyte One, the innovative customer-friendly hematology analyzer, which launched last year and has already surpassed an installed base of over 5,000 units. Reception and adoption of ProCyte One has been exceptional, particularly in international regions where many veterinarians were trained to run hematology diagnostics first when doing a basic workup on a patient. We had excellent growth in ProCyte One placements across regions for the second quarter and continued high levels of customer satisfaction and retention, supporting the expansion of our global premium hematology installed base aligned to the approximately 4,000 placements annually, as shared in last year's Investor Day. This progress is integral in addressing the estimated opportunity for 200,000 worldwide premium instrument placements. In addition to these targeted investments in enhanced commercial capabilities, technology, and product innovation is another key pillar of IDEXX's growth strategy as we endeavor to add value to our product and service offerings. In Q2, we announced three upcoming laboratory tests and service launches. We have a shared mission with our customers to deliver a higher standard of pet health care. And these new products and services support that care delivery with timely and highly accurate diagnostic insights. These innovations also enable our customers to achieve this efficiently by using the IDEXX reference lab as an extension of the veterinary clinic, which is a key benefit given the current capacity constraints within our sector. These innovations include: number one, expanding Fecal Dx antigen testing to include the detection of flea tapeworm, the most common type of tapeworm that infects dogs and cats. With this addition, IDEXX's Fecal Dx antigen test detects up to five times more common and prevalent parasites than fecal flotation alone and provides customers with earlier diagnostic insights. This will drive even greater progress towards the goal we shared at Investor Day in 2018 of an incremental $120 million in fecal antigen revenues by 2023. Number two, the addition of FGF-23, a kidney disease management biomarker that will provide clinicians, along with the use of SDMA, not only earlier diagnostic signs of chronic kidney disease but will deliver more confident recommendations for targeted therapy during earlier stages of chronic kidney disease. And number three, a new service of PCR direct testing, which reference U.S. reference lab customers will have crucial, timely access to next APCR results, enabled by a new PCR laboratory at our Louisville reference site. The addition of these tests and services supports our customers in delivering improved pet health care in ways in which an IDEXX partnership adds long-term increasing value for our customers. In addition to the development of highly relevant, accurate testing products, IDEXX's innovation focus is also on our broad portfolio of software services, including multiple cloud-native PIMS and a variety of tools to manage clinic workflow like Vet Radar, VetConnect PLUS, payment processing solutions, and Web PACS. When combined, these products create a powerful connected ecosystem within the veterinary clinic, which not only improves access to and communication of diagnostic insights but also provides efficiency benefits around the clinic and at each step of the patient visit process. The rapid uptake of IDEXX cloud-based solutions reflects this. Customers understand that modern software tools reduce manual work and increase capacity for clinic staff to focus on higher order patient center tasks. This higher standard of care is further supported by clinical decision support on VetConnect PLUS, which leverages machine learning to offer suggested next steps aligned with care protocols. A great example of this is our enhanced 4Dx Plus introduction, where we not only improved upon our gold standard in a plasma assay but added a vector-borne disease clinical decision support module and made significant enhancements to workflow by doubling product shelf life and room temperature storage. We are also seeing incremental follow-up tests for customers engaging with clinical decision support, and we'll share with you at the upcoming Investor Day promising early results. Customers clearly appreciate these benefits as we saw another quarter of record PIMS global placements, supported by continued strong demand for cloud-based offerings. ezyVet, in particular, continues to experience strong growth since joining the IDEXX software family. The second quarter placements are consistent with the prior quarter and 28% higher than the previous year. These cloud-based solutions enable customers to shift their focus from maintaining on-premise hardware to providing excellent patient care while also benefiting IDEXX through growth of a highly profitable recurring revenue stream in the future. We continue to be very pleased with the advancement of our long-term strategy to integrate diagnostics and software that help IDEXX customers grow faster. Underpinning our growing commercial and technology capabilities is a commitment to providing a world-class level of service to our customers, which is integral to earning our customers' business every day, especially given the high levels of demand within the sector. Strong execution against this commitment takes many forms, from consistently high product availability rates to reliable turnaround times at our reference labs. The high service level IDEXX delivered in the second quarter, including greater than 99% product availability demonstrates the benefit of our long-term focus on building supply chain capabilities and highly-scaled manufacturing centers. Our recently communicated U.S. mid-year price increase reflects higher costs to run the business, including investments in our supply chain to ensure excellent levels of product continuity and future network resiliency. Given this, IDEXX is well positioned to manage through supply chain and inflationary dynamics while building on our strong long-term financial performance. This concludes our review. IDEXX's execution levels remain strong and aligned towards our significant and enduring long-term growth potential. We're well positioned to deliver solid growth and financial results as we advance our mission to create a better future for animals, people, and our planet. I'm thankful for our more than 10,000 colleagues for their ongoing dedication to our efforts. They are integral in delivering strong financial performance for the company and creating long-term value while also supporting the advancement of animal care globally. To those listening in on the call, I'd like to extend heartfelt thanks for making a meaningful difference in the world. Before we open the line for Q&A, I'd like to remind you that my senior management team and I will provide more information on the IDEXX strategy and long-term potential at our upcoming Investor Day. After two years of holding the event virtually, we look forward to hosting the event at our global headquarters in Westbrook, Maine on Thursday, August 11, from 8:00 to noon. We're also live streaming and recording the event via idexx.com for those who cannot make it in person. Participating will be members of my senior management team, including Dr. Tina Hunt, Executive Vice President and GM for Point of Care Diagnostics and Worldwide Operations; Julie Godon, Vice President and GM for Global Rapid Assay; Mike Lane, Executive Vice President and GM for Reference Laboratories and Information Technology; Michael Schreck, Senior Vice President and GM of Veterinary Software and Services; Jim Polewaczyk, Executive Vice President and Chief Commercial Officer; and Brian McKeon, Executive Vice President and CFO. We're also excited to host a live customer conversation led by George Fennell, Senior Vice President and GM of Americas CAG Customer Facing Organization to discuss recent trends at the clinic level and how IDEXX has supported their business during these pandemic times. The event will last approximately four hours and we'll conclude with a Q&A session and an investor lunch with the extended management team. So with that, we'll end the prepared section of the call and open the line for Q&A.

Operator, Operator

Thank you. We will now begin our question-and-answer session. Our first question comes from Michael Ryskin with Bank of America.

Michael Ryskin, Analyst

Is that better? Hello?

Operator, Operator

Here we go. Thank you.

Michael Ryskin, Analyst

Okay. Great. Thanks. Sorry about that. I want to ask on the pricing side of things first, just because we've got a lot of questions on that. Am I understanding correctly that the incremental price you're taking is that you called out in August, the 1.5% to 2%. That's on top of the 4% you took in the first half. And then just sort of how much price do you think you can take until you start seeing a little bit of a pushback. Is this some price you're pulling forward from 2023 in a sense? Just wondering the dynamics there, especially as you talk about weak macro and just uncertain conditions elsewhere?

Brian McKeon, CFO

Thanks for the question, Mike. Just on the first part, that's correct. So we had approximately a 4% increase in the U.S. and worldwide in the first half, and the 1.5% to 2%, we anticipate it will be an incremental worldwide benefit, so that would imply 5.5% to 6% for the second half. I'll let Jay talk to the customer dimension.

Jay Mazelsky, CEO

Yeah. So qualitatively, as Brian indicated, the price increase was really, I think, a reflection of higher costs of running the business. And to your question around pet owner pushback, we don't think that that's been a driver to date. In fact, pet owners have traditionally prioritized pet health care spend relative to other things. It's a small percentage of total consumer expenditures. So it's a relatively small piece. And we know the human pet owner demand has been strong and growing, and we don't expect that to change.

Michael Ryskin, Analyst

Can I ask a follow-up about the growth in vet visits that you mentioned? We're all monitoring similar indicators, and we're comparing how Q2 performed against the first quarter. You discussed the improvements in vet visit capacity during 2020 and 2021. First, what is your expectation for vet visits for the remainder of the year? If I'm interpreting the numbers correctly, you're anticipating a gradual improvement from Q2 but still a decline in the second half of the year. Is that correct? By the end of this year, will we have returned to the levels we achieved in 2021, or will there be additional challenges in 2023? Are we at normal levels now and able to grow next year regarding vet visits, or is there still some capacity adjustment that needs to happen next year? Thank you.

Brian McKeon, CFO

So Mike, I will walk you through our analytical outlook and link it to the underlying sector trends. To start, in Q2, clinical visits decreased by 3% year-on-year. However, revenue per clinical visit was very strong, increasing by 8.5%, which we see as a positive sign to build upon. Nevertheless, clinical visit levels were somewhat lower compared to Q1, and we ended the quarter with a modest decrease. Looking at the midpoint for the second half, with a 7.5% midpoint on CAG Dx recurring, we anticipate a 1% headwind in Q3. Normalizing for that, we see an 8% growth. After accounting for an additional 1.5% to 2% pricing increase, we forecast growth between 6% and 6.5%. We believe that the underlying sector trends from Q2 will continue in the second half, along with some benefits from pricing. It's important to note that we are still managing the pullback in capacity that occurred with veterinary plans earlier this year. There was a significant increase from Q1 2020 to Q1 2021, which was about 13% and sustained throughout 2021, followed by a 2% decrease in average visit levels in the first half of this year. Due to ongoing staffing challenges, we expect to continue addressing these issues this year while still managing strong demand compared to last year, including advantages from the expanding pet population. In response to your latter question, we expect to tackle these headwinds throughout this year, with improvements expected as we move into 2023. However, we are being realistic about the near-term trends and headwinds given the dynamics observed through Q2, which we believe is accurately reflected in our outlook.

Jay Mazelsky, CEO

Yes. I would add that looking at the growth in pet visits during the pandemic, there appears to be an underserved demand with a 10% increase. If we consider the 2% to 3% trend in clinical visits we observed before the pandemic and factor in the growing pet population, clinical visits should logically be higher. As the profession addresses some of the capacity challenges we’ve discussed, I believe we will see a recovery from that point.

Operator, Operator

We have our next question from Chris Schott with JPMorgan.

Chris Schott, Analyst

Hi, great. Thanks so much. I was just trying to get a little bit of clarification on the guidance change as returning dissects, I guess this vet visit growth dynamic versus some of the softening demand you referenced in Europe. So can you just maybe quantify how much of the, I guess, 200 basis point or so change in organic guidance is from those two factors? And maybe just on elaborating on the macroeconomic side, where are you seeing the greatest impacts here? Is this kind of broadly across Europe, or are you seeing specific markets that are seeing greater pressures than elsewhere? Thanks so much.

Brian McKeon, CFO

Yes, Chris, thank you for your question. The adjustment we made mainly reflects the more recent trends we are observing in both the U.S. and Europe, particularly concerning visit trends. We believe our execution levels have remained strong, and we feel confident about that. The underlying dynamics of revenue per visit utilization, as shown in the metrics, are holding well, and we think we can build on that. However, the adjustment is primarily to align with the recent trends, which correspond more closely to the lower end of our outlook. Referring back to our earlier guidance, we had mentioned that the lower end accounts for ongoing pressures, and that's what we've experienced regarding visits through the second quarter. We believe we are adjusting for that correctly. We do see the full range suggesting some opportunities for improvement in the second half. To Jay's point, we believe there is underlying demand available, and if the clinics can adapt and enhance their capacity dynamics, this could be a positive development. Additionally, we want to emphasize that there may be some macro risks that are harder to quantify, and we are aware these could also play a role. Overall, we feel we are appropriately adjusting our outlook to reflect these recent trends.

Jay Mazelsky, CEO

Yes. Let me just maybe directly address your question around geographic balance. So we've done a number of different surveys, both in the U.S. and Germany as our largest country in Europe. And what we're seeing is the majority of veterinarians indicate that staffing capacity is a major or moderate issue. Not to say the macro effects, especially in Europe; we're seeing some impact from that, primarily more so in the reference labs than in-clinic testing. And not surprising when you consider some of the factors that our European sector and regions are dealing with in terms of inflation and energy and the Ukraine-Russian war is much closer to them.

Operator, Operator

Our next question is from Erin Wright with Morgan Stanley.

Erin Wright, Analyst

Great. Thanks. Another question on the macro. If I heard you correctly here, I guess, you mentioned that the lower end of the guidance embeds a growth expectation similar to what you experienced during the prior economic downturns here. But what the difference across your business now versus, for instance, 2008, 2009 that would make you, I guess, more or less insulated from a more challenging economic backdrop here? And as I think about what was going on during that time, for instance, the Catalyst Dx launch, those initiatives may be leaving you differently positioned than maybe you would going into a tougher economic backdrop, particularly here in the U.S.? Thanks.

Jay Mazelsky, CEO

Good morning, Erin. Thanks for the question. Yeah, I think we're in a much stronger position than we were back in 2008, 2009 on a couple of, I think, very important dimensions. Our sales channel, we worked through distributors over a decade ago, and now we have a direct presence in 99% plus from a revenue standpoint. So we have those direct relationships with customers; our portfolio from an innovation standpoint is much more robust across the board, both reference labs, in-clinic software, for example. So I think we offer veterinarians a lot more tools and technology to help manage their practices. I think, if anything, that pet bond has grown and is stronger than it was a decade ago. And I think the industry itself, the profession itself is more sophisticated in managing through cycles. I think they have adopted a number of, I think, business practices, whether it's individual practices or the corporately owned practices in terms of managing care. So I think we're overall in a much stronger position than we were.

Erin Wright, Analyst

Okay, great. Thanks. And then can you give us an update on innovation, and I'm sure we'll hear about this at the Investor Day. But how do you think about the recent discrete R&D investments that you made as well as the innovation that you called out in your prepared remarks here? And when will these efforts generate material contributions for you? And will this ultimately help bridge the gap between the macro capacity headwinds that you could see and continue to see in your historical long-term growth rates? Thanks.

Jay Mazelsky, CEO

From an innovation perspective, our productivity has reached new heights. Over the past few years, we've introduced a range of innovations in instrumentation, testing, services, and software. For example, ProCyte One has been an outstanding success, receiving excellent feedback from our customers who appreciate its user-friendliness, high performance, and competitive pricing. We've experienced significant growth in our international markets, especially in regions that prioritize hematology. Hematology is challenging but rewarding, and typically we sell our products alongside chemistry, particularly with SediVue in clinical suites. On the software side, many practices are grappling with issues related to workflow, staff productivity, and client communication. As a result, practices that have traditionally depended on on-premise software are now exploring modern cloud-based solutions to tackle these challenges. We've noticed a quick adoption of our cloud-based PIMS offerings, like ezyVet, in various international markets. Regarding testing, we have made several key advancements in our reference labs, particularly in fecal antigen testing for flea tapeworms, which is a rapidly growing segment. This testing is crucial for preventive care panels, as fecal tests are an essential component. We're enthusiastic about the in-licensing agreements we've established and will continue to provide updates on these developments, including during Investor Day. I look forward to discussing this further.

Operator, Operator

Thank you. Our next question comes from Jon Block with Stifel.

Jon Block, Analyst

Thanks, guys. Good morning. Both questions might be centered around price in some way. But when I think about the Dx recurring growth price, for 2022, it looks like it's shaking out around 300 bps. So in other words, the 8% CAG, the ex-recurring midpoint guidance, less roughly 500 basis points of full year price, Brian, if I've got that correct. And historically, you've been closer to 1,000 bps, give or take. You've been growing CAG Dx recurring around 12%. And price was closer to 200 to 300 bps. So maybe some color on that compression of, call it, growth ex-price. Is there anything to call out other than comps, such as less incremental contribution from innovation or maybe what you're even seeing from a market share perspective for that rate of compression?

Brian McKeon, CFO

Jon, I am trying to understand your calculations, but I don't believe we are indicating a fundamental decline in our underlying growth beyond the current visit levels, excluding price changes. This year, we have a significant advantage as we see about a 1,100 basis point premium in the U.S. during the first half, with 4% pricing suggesting that we are closer to the upper range of the 900 to 1,000 basis points we experienced before the pandemic. Our expectations for the year do not specifically include forecasts for clinical visit growth; instead, we observe trends from Q2 indicating consistently high levels, and we’re not signaling a decrease in that area. It’s crucial for us to execute well on this. There may be slight impacts from consumer trends, which we are mindful of, but our midpoint outlook suggests that we believe we can continue to perform well and gain additional benefits from pricing, supporting our strong numbers for the full year and the second half.

Jon Block, Analyst

Okay. Just to clarify, Brian, I’m not referring to the premium related to underlying clinical visits. I'm analyzing your CAG Dx recurring midpoints, which show around 8% growth with a 500 basis point contribution from price. If we exclude price, that puts CAG Dx growth at around 300 basis points, down from the previous 900 to 1,000 basis points. Your CAG Dx is currently growing at 12%, with price contributing 200 to 300 basis points. I’m curious why, when we remove the price contribution, the growth seems significantly lower this year compared to prior years. I suspect part of this is due to comps, but are there other factors at play, like a reduced incremental contribution from innovation or fewer market share gains? That’s what I wanted to clarify, and it might lead to the same answer so we can move on, but I hope I've asked a clearer question.

Brian McKeon, CFO

The main issue is the fluctuation in clinical visit growth; we saw a 3% increase and a 3% decline in Q3, resulting in a 600 basis point swing. Overall, our execution and delivery have been quite strong. The changes are due to two main factors: a reduction in clinic capacity after a significant expansion and retroactive clinics not being able to maintain their growth. We believe we can adapt to these changes over time. Additionally, we are experiencing a return to pre-pandemic levels after a surge in demand, including benefits from patient expansion. This context is vital for understanding the adjustments we're making to our full-year outlook for 2022. The key difference lies in the clinical visit growth trends compared to the latter half of 2021.

Jon Block, Analyst

That's helpful. I've got that swing of 400 basis points plus two to minus two and an ex-price compression of 600 to 700 basis points, but it gets me much closer, and I can follow up offline. That's why I was asking about market share innovation. Shifting gears, my second question is still about price. I'm curious, Brian, is it uniform across all your CAG modalities regarding consumables, lab, and rapids? More importantly, are your competitors adjusting their prices for both point of care and reference lab? If they aren't, what does that imply about your ability to implement the same rate of price increase and magnitude into 2023? Thanks.

Jay Mazelsky, CEO

Yeah. Jon, this was across consumables and reference not capital, and it was a primarily U.S. driven change.

Jon Block, Analyst

Sorry, Jay. I didn't ask about capital. In reference to point of care in the labs across all your CAG Dx modalities, have your competitors kept pace as far as you know? If they haven't, what does that indicate about your pricing power?

Jay Mazelsky, CEO

We don't have any insight in terms of what competitors or competitive landscape are up to.

Brian McKeon, CFO

It is reflective of the overall inflationary environment. So I think that that's a broader factor that I think everyone in the industry is dealing with.

Operator, Operator

We have our next question from Elliot Wilbur with Raymond James.

Elliot Wilbur, Analyst

Thanks. Good morning. I understand the granularity on ex-US visit trends is a little bit more difficult to attain. But just wondering if you could comment in general whether or not seeing the same level of deceleration in clinic visit trends ex-US versus US? Any perspective on that? And then more specifically on the performance or relative performance US versus ex US in the reference lab business, differential in growth rate is this purely just a function of difference in clinic visit trends, or are there other factors that continue to lead to the substantial over performance in the US versus international such as price and utilization? Thanks.

Brian McKeon, CFO

Yes, regarding international visibility, we don’t have the same size of PIMS installed base across different regions, which limits our accuracy compared to North America. However, we are observing similar trends based on other data. This reflects some of the capacity challenges in practices, as we experienced a pet boom in countries like the U.K., Germany, and Australia during the pandemic. In Europe, we notice macro impacts that affect reference labs more than point-of-care services. Notably, the wellness or preventive care business internationally isn't as significant, making up about 20% of visits, primarily in reference lab modalities. Therefore, we are encountering some headwinds related to these factors.

Operator, Operator

We have our last question from Ryan Daniels with William Blair.

Ryan Daniels, Analyst

Yes, thanks for taking the question, guys. I want to take a little bit of a different approach and get any insights you have on what type of IT investments you can make in the near or intermediate term to help your customers increase capacity. So I'm thinking things like digital intake platforms or self-service billing, et cetera. Is that a high priority for you? And do you think that's something that can actually help with throughput for your customers and alleviate some of this pressure?

Jay Mazelsky, CEO

Good morning, Ryan. We are observing a significant demand across both independent and corporate practices for IT tools, particularly PIM systems that include patient engagement modules. Practice owners have indicated that around 15% of their staff's time is dedicated to patient intake and administrative tasks, much of which can be automated or handled virtually, similar to other industries. The implementation of software tools for client communications and workflow optimization throughout the patient visit is a major focus for these practices. We have witnessed rapid growth in our software business as a result. Traditionally, practices have been reluctant to transition from PIM systems due to data familiarity and the reports they are accustomed to, but they are now more open to making that change because they recognize the advantages of modern software solutions. I anticipate that this trend will strengthen as we continue to tackle some of the capacity challenges.

Brian McKeon, CFO

Okay. And with that, I'd like to thank everybody on the phone for their participation this morning and to IDEXX employees listening, I'd like to just say thank you for your continued devotion to our purpose unwavering engagement enables us to continuously execute at a very high level and support our customers despite the unpredictable and evolving dynamics in our sector and around the world. Thankful for your excellent effort and I look forward to continuing our strong momentum through the rest of 2022. And so with that, we'll conclude the call. Thank you.

Operator, Operator

Thank you. Ladies and gentlemen, this concludes our conference. Thank you for participating. You may now disconnect.