Description

I recommend taking a short position in Idexx Labs, a provider of veterinary products and services. The company trades at 28x ltm EPS on the expectation of returning to double-digit revenue growth, after having grown revenues in the mid-single digit range for several years. Almost half the expected growth of 13% is expected to come from a new diagnostic instrument called LaserCyte. I expect that LaserCyte sales will fall far short of expectations. The product’s value proposition is weak and the economics to veterinarians are not compelling; IDXX faces serious manufacturing issues resulting in inconsistent test results; and even if successful, LaserCyte is cannibalizing IDXX’ existing sales, making it difficult to meet forecasts.

IDXX is a leading provider of diagnostic products and services to veterinarians. The company’s most important products include Immunoassays - single-use disease test kits - as well as in-clinic diagnostic instruments for blood chemistry and hematology. Other products include diagnostic lab services and practice mgmt software for vets as well as water and dairy testing products.
For the last 3 years, IDXX has managed to grow revenues by 3 – 7% annually to $413m in 02. Operating margin has grown from 13.1% in 99 to 15.9% in 02. At $36, the stock is trading at 28 times 02 EPS of $1.30 and 24 times the Street’s estimate of $1.52 for 03. The market cap is $1.2b and with net cash of $146m, EV is at $1.1b. On the aggregate, IDXX’ business is fairly stable and the company’s recent results are not depressed.
Despite the modest revenue growth evidenced in recent years, IDXX has managed to keep the expectation of growth alive and its multiple elevated. Investors’ hopes are pinned on IDXX’s new LaserCyte hematology instrument, which was introduced in October 2002, after repeatedly postponing the launch for more than a year. After selling 114 units in 4Q02, IDXX is guiding for 1,500 LaserCyte units at an average price of around $15,500 each for a total of $23m. Taking into consideration the $1.9m in LaserCyte revenues in 2002, LaserCyte is expected to contribute 5 pts to its 03 revenue growth of 13%.
The potential from Nitazoxanide, IDXX’s second largest hope for growth appears to be fairly limited. According to the 2002 10K, IDXX expects FDA approval for this drug in late 2003, with annual revenue potential for IDXX of $13 – 20m ($50m market potential with a 25 – 40% market share) achieved within 4 years. This translates into 3 – 5% of 2002 revenue by 2007. Nitazoxanide is an equine drug for the treatment of a disease called EPM.
My short thesis revolves around LaserCyte, which I think will disappoint along several dimensions. In short, I believe that 1) the LaserCyte’s value proposition is very weak, 2) the economics to vets are not compelling, 3) IDXX has yet to prove that it can manufacture LaserCytes that produce consistent and accurate results, and 4) the cannibalization of IDXX’s existing hematology offering isn’t reflected in analysts’ models.
The LaserCyte is intended to offer an upgrade to IDXX’ existing hematology instrument called VetAutoRead. With the VetAutoRead, IDXX has a dominant market share of around 80%. According to IDXX there are around 42,000 veterinary clinics large enough to justify an in-clinic hematology instrument worldwide. Half these clinics currently have a hematology instrument. IDXX introduced the first in-clinic hematology instrument roughly 10 years ago and the company sold up to 4,000 instruments in the early years. Sales have slowed to ~1,000 units by 02.
After talking to IDXX, its competitors, several vets and an academic, I am convinced that LaserCyte’s benefits relative to the VetAutoRead are only marginal. The additional cells that the LaserCyte detects are much less frequent than the cells the VetAutoRead detects, and even if present, their count is not time-sensitive. Vets have satisfactory alternatives both in-clinic as well as outside. In the next paragraph, I will take you through the value proposition in detail. If you prefer not to bother with the medical details, feel free to skip this paragraph.
Hematology instruments provide a count of different types of white blood cells (WBCs) that give indications of infections etc. The VetAutoRead provides a count of each of the 3 most important WBC types. The LaserCyte provides counts for the remaining 2 WBC types in addition to the existing 3. The 2 additional WBCs are called basophils and eosinophils. Basophils are of no interest to vets but eosinophils help vets diagnose parasites and allergies. While vets are always keen to have more information, the importance of eosinophils seems limited. The vets I spoke with indicated they would run only up to 10% more samples if they had an in-clinic instrument that allowed an eosinophil count, compared to the 3-part machine. IDXX claims that usage would increase from 8 samples to 15 samples a week. Eosinophil counts are not required before surgery or otherwise time-sensitive. Furthermore, vets have 2 alternatives in analyzing eosinophils. A vet or lab technician can look at a blood smear through a microscope (takes a few minutes) or send a sample to a reference lab, which will typically return results on the same day or next day. Both alternatives provide more information than the LaserCyte and include an interpretation of the results. A professor for veterinary pathology told me it would be best practice for vets to use the microscope for an eosinophil count even if a machine count was available, though not all vets would do that.
While the benefits of owning a LaserCyte are marginal, the additional expense is substantial. LaserCytes sell for $15,000 – 18,000 compared to $7,000 – 10,000 for a VetAutoRead. The average VetAutoRead customer runs around 8 tests a week, incurring $4.25 in costs for consumables and charging $25 to the client. This translates into an annual contribution of $8,600 (excluding labor etc.). Sending a sample to a reference lab costs around $9. From the perspective of an existing VetAutoRead owner, it would take a clinic something like 13 years to pay back the initial investment (assuming a salvage value of $3,500 for the VetAutoRead, $15,000 for the LaserCyte, 10% more samples, and the same revenue and cost per consumable as for the VetAutoRead). I asked a large clinic vet whether he would invest $15,000 in a LaserCyte, he laughed out loud and told me “Frankly, eosinophils are not that important”
IDXX has a history of manufacturing and quality control problems with the LaserCyte that have yet to fixed. IDXX has outsourced the major manufacturing steps for VetAutoRead and its other instruments. The LaserCyte is the first Instrument that is manufactured in house. It’s an ambitious project. The human equivalent of this machine costs upward of $50,000. IDXX Investor Relations told me that getting the specs right has proven very cumbersome, as the software has to be re-written every time there are small adjustments to the physical design. This has led to repeated delays in the product launch, as the prototypes’ result were inaccurate. At the time the product was launched in October 02, management stood with their backs against the wall and was eager not to disappoint the Street again with another delay. The LaserCyte does not require FDA approval.
In 4Q02, IDXX sold 114 LaserCytes, exceeding their guidance of 100. The backlog stood at more than 230. I assume that after 2 years of marketing and delayed launches there is enough initial demand. Interestingly, IDXX lowered its LaserCyte expectation for 1Q03 from 300 to 200 units, less than the backlog. Furthermore, IDXX’ gross margin came in 1 pt below guidance, which the company attributed to the scale-up and launch of the LaserCyte. IR told me after the call that customers are comparing results from their LaserCyte with reference lab results as well as results from their 3-part instruments and find that some of the results are different. One of our sources talked to 8 clinics that have bought a LaserCyte. Out of these, not one is still working on their original LaserCyte. One has stopped using the LaserCyte altogether in frustration and another is on its 5th machine. Furthermore, our source has obtained data from an IDXX competitor that tested the LaserCyte with a vet. According to a 3rd party veterinary lab, the correlation of the LaserCyte’s results with control tests is only at 0.82. The lab considers correlations below 0.93 - 0.94 unacceptable.
Even if IDXX sells as many LaserCytes as it has guided for, it appears that analysts are modeling the additional revenues from LaserCySte to be incremental to IDXX total sales. However, LaserCyte’s success would come at the expense of VetAutoRead sales and IDXX’s reference lab services. The 2002 10K notes that 02 VetAutoRead sales have decreased by $1.2m “primarily due to a shift in marketing and customer focus to the LaserCyte”. LaserCyte revenues were $1.9m in 2002.
Finally, while I do not think IDXX is a short because of major accounting or free cash flow issues, there have been some smaller signs of stress. The company has repeatedly lowered its tax rate from 38% in 99 to 34% in 02. 03 guidance is at 33.5%. Allowance for doubtful accounts relative to gross accounts receivables has declined and contributed 2c in 02. Also, the 10K reveals a swing in currency from a loss of $0.6m in 01 to a gain of $0.3m in 02, which also contributed 2c. Other current assets (excl. deferred taxes) also increased as a percentage of revenue. If this was used to capitalize expenses that should have been expensed, then this boosted EPS by another 2c.
There were filings by insiders to sell stock in February: 4,700 shares by the VP Finance / Treasurer, and 103,000 shares by the Chief Scientific(!) Officer. Short interest is modest at around 5%.

Catalyst

My expectation is that IDXX’ revenue growth contribution from LaserCyte in the next few quarters will disappoint. After the 4Q02, IDXX already pushed back revenue and EPS growth into the second half of 03. A sizeable revenue miss should lead to a multiple contraction, as investors increasingly realize that this is not a fast growing company that merits a 28x multiple of ltm EPS. 15x 03 consensus estimate of $1.52 would get us a target of $23. With continued cannibalization and gross margin deterioration related to the manufacturing difficulties and free product replacement, there is additional upside from a significant EPS miss. I estimate that IDXX could miss EPS by 10c. This assumes that IDXX only sells 50% as many LaserCytes as guided, of which 50% replace VetAutoRead sales. This would get us a target of 15x $1.42 = $21.