On the surface, IDEXX Laboratories's (NASDAQ:IDXX) third quarter wasn't the kind of outstanding report we've come to expect from the animal-testing company, which narrowed its revenue guidance for the year. But dig a little deeper, and the revenue issues weren't that big of a deal.

The hurricanes hurt sales a little. And less testing of cattle is hurting the company's farm-animal testing business, although that's a relatively small fraction of sales. Finally, IDEXX increased the use of programs that result in placements of its instruments, but don't necessarily translate to immediate revenue recognition in the quarter in which they're placed -- which hurts short-term revenue, but should benefit long-term profits.

IDEXX Laboratories results: The raw numbers

Metric

Q3 2017

Q3 2016

Year-Over-Year Change

Revenue

$492 million

$448 million

10%

Income from operations

$100.4 million

$88.5 million

14%

Earnings per share

$0.79

$0.62

27%

Data source: IDEXX Laboratories.

What happened with IDEXX Laboratories this quarter?

  • Sales for the companion animal group (CAG) were up 10%, with diagnostic tests and veterinary software services leading the way. Revenue from instruments fell, partially because the year-ago quarter was so strong, with a backlog order fulfillment for the SediVue instrument, but also because of the aforementioned deferred revenue recognition.
  • Despite the decrease in revenue from instruments, the company placed 2,738 premium analyzers during the quarter -- more than the year-ago quarter -- including 1,385 of its workhorse Catalyst instrument, with 80% of the placements in North America going to competitive accounts where IDEXX hadn't previously had a strong relationship with the veterinarian office. Now that IDEXX has a foot in the door, those new accounts should drive future sales.
  • IDEXX's two smaller segments had mixed results, with water testing up 11% year over year and tests for farm animals down 5%, as lower milk prices in Europe have decreased the use of antibiotic residue testing, pregnancy testing, and herd health screening for dairy cattle.
  • IDEXX was able to increase operating income faster than revenue through increases in gross margins as it sells more high-margin diagnostic tests, and through increases in operating efficiency as fixed costs get shared by larger gross profits.
  • Earnings per share grew even faster because of lower taxes, which investors shouldn't expect to continue to boost earnings growth in the years ahead.
Veterinarian using a Catalyst instrument

Image source: IDEXX Laboratories

What management had to say

Jonathan Ayers, IDEXX Laboratories' chairman, president, and CEO, explained how a move toward bundled sales that results in revenue from CAG instruments being recognized over five or six years, as well as rental programs in emerging markets, might hurt revenue in the short term, but benefits the company's profits in the long term:

The primary purpose of instrument placements is to drive the very profitable recurring revenue, that's not only instrument consumables, but of course, can apply also to reference labs and Rapid Assay -- all components of the CAG Diagnostic recurring revenue. That -- so instruments is a means toward an end and that end is profitable.

Ayers also highlighted the SDMA test that will be available on the Catalyst instrument in the next few months as a driver for future growth:

The enthusiasm from our Catalyst customers for SDMA is exceptionally high as we continue to build the franchise for this unique and proprietary kidney function marker as an essential element of the chemistry panel, whether run in-house on Catalyst or sent out to the IDEXX reference labs. SDMA has the benefit of a growing number of third-party studies and the impact of almost 12 million patient samples run in our reference labs over the past two-plus years.

Looking forward

Management increased 2017 earnings-per-share guidance to $3.22 to $3.26, which is $0.07 higher than the midpoint of the previous guidance, although about $0.05 of that will come from the aforementioned tax benefits. The company also released preliminary guidance for 2018, which has revenue increasing 9.5% to 11.5% year over year, with earnings per share increasing 8% to 12%, as reported, or 15% to 19% on a comparable constant-currency basis, as IDEXX plans to increase operating margins by 75 to 125 basis points.

Brian Orelli has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Idexx Laboratories. The Motley Fool has a disclosure policy.