UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549 
FORM 10-Q  
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the quarterly period ended March 31, 2010
 
OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the transition period from _______________ to _______________.

COMMISSION FILE NUMBER: 0-19271

IDEXX LABORATORIES, INC.
(Exact name of registrant as specified in its charter)

DELAWARE
01-0393723
(State or other jurisdiction of incorporation
 or organization)
(IRS Employer Identification No.)
   
ONE IDEXX DRIVE, WESTBROOK, MAINE
04092
(Address of principal executive offices)
(ZIP Code)
 
207-556-0300
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer   x
  
Accelerated filer
o
Non-accelerated filer     o
(Do not check if a smaller reporting company)
Smaller reporting company
o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. The number of shares outstanding of the registrant’s Common Stock, $0.10 par value, was 57,652,045 on April 19, 2010.
 
 
 
 
 
 
 
 
 
 
 

IDEXX LABORATORIES, INC.
Quarterly Report on Form 10-Q
Table of Contents

Item No.
  
Page
     
 
PART I—FINANCIAL INFORMATION
  
Item 1.
Financial Statements (unaudited)
  
 
Condensed Consolidated Balance Sheets as of March 31, 2010 and December 31, 2009
3
 
Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2010 and 2009
4
 
Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2010 and 2009
5
 
Notes to Condensed Consolidated Financial Statements
6
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
17
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
26
Item 4.
Controls and Procedures
27
 
PART II—OTHER INFORMATION
  
Item 1A.
Risk Factors
28
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
34
Item 6.
Exhibits
35
Signatures
  
36
Exhibit Index
  
37
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
2
 

PART I — FINANCIAL INFORMATION
Item 1.     Financial Statements.

IDEXX LABORATORIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
(Unaudited)
 
   
March 31,
    
December 31,
  
     
2010
      
2009
  
                 
ASSETS
                
Current Assets:
                
Cash and cash equivalents
  
 $
106,354
    
 $
106,728
  
Accounts receivable, net of reserves of $2,384 in 2010 and $2,331 in 2009
    
130,519
      
115,107
  
Inventories, net
    
122,384
      
110,425
  
Deferred income tax assets
    
22,872
      
25,188
  
Other current assets
    
16,240
      
18,890
  
Total current assets
    
398,369
      
376,338
  
Long-Term Assets:
                
Property and equipment, net
    
197,063
      
199,946
  
Goodwill
    
146,534
      
148,705
  
Intangible assets, net
    
61,304
      
63,907
  
Other long-term assets, net
    
21,014
      
19,631
  
Total long-term assets
    
425,915
      
432,189
  
TOTAL ASSETS
  
 $
824,284
    
 $
808,527
  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
                
Current Liabilities:
                
Accounts payable, principally trade accounts
  
 $
24,104
    
 $
19,133
  
Accrued liabilities
    
94,616
      
104,959
  
Line of credit
    
157,388
      
118,790
  
Current portion of long-term debt
    
825
      
813
  
Current portion of deferred revenue
    
12,234
      
12,610
  
Total current liabilities
    
289,167
      
256,305
  
Long-Term Liabilities:
                
Deferred income tax liabilities
    
17,795
      
18,283
  
Long-term debt, net of current portion
    
4,070
      
4,281
  
Long-term deferred revenue, net of current portion
    
4,421
      
3,813
  
Other long-term liabilities
    
11,699
      
11,266
  
Total long-term liabilities
    
37,985
      
37,643
  
Total liabilities
    
327,152
      
293,948
  
                 
Commitments and Contingencies (Note 12)
                
                 
Stockholders’ Equity:
                
Common stock, $0.10 par value: Authorized: 120,000 shares;
    Issued: 96,794 and 96,334 shares in 2010 and 2009, respectively
    
9,679
      
9,633
  
Additional paid-in capital
    
593,924
      
580,797
  
Deferred stock units: Outstanding: 127 and 117 units in 2010 and 2009, respectively
    
4,753
      
4,301
  
Retained earnings
    
857,282
      
824,256
  
Accumulated other comprehensive income
    
6,543
      
10,341
  
Treasury stock, at cost: 39,258 and 38,118 shares in 2010 and 2009, respectively
    
(975,061
)
    
(914,759
)
Total IDEXX Laboratories, Inc. stockholders’ equity
    
497,120
      
514,569
  
Noncontrolling interest
    
12
      
10
  
Total stockholders’ equity
    
497,132
      
514,579
  
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
  
 $
824,284
    
 $
808,527
  

The accompanying notes are an integral part of these condensed consolidated financial statements
 
 
3
 

IDEXX LABORATORIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(Unaudited)
 
   
For the Three Months Ended
March 31,
  
     
2010
      
2009
  
                 
Revenue:
                
Product revenue
  
 $
176,761
    
 $
155,895
  
Service revenue
    
91,764
      
80,560
  
Total revenue
    
268,525
      
236,455
  
Cost of Revenue:
                
Cost of product revenue
    
68,634
      
59,267
  
Cost of service revenue
    
57,530
      
52,755
  
Total cost of revenue
    
126,164
      
112,022
  
Gross profit
    
142,361
      
124,433
  
                 
Expenses:
                
Sales and marketing
    
44,416
      
40,985
  
General and administrative
    
32,808
      
29,068
  
Research and development
    
16,709
      
15,939
  
Income from operations
    
48,428
      
38,441
  
Interest expense
    
(365
)
    
(640
)
Interest income
    
53
      
244
  
Income before provision for income taxes
    
48,116
      
38,045
  
Provision for income taxes
    
15,088
      
11,974
  
Net income
    
33,028
      
26,071
  
Less: Net income attributable to noncontrolling interest
    
2
      
-
  
Net income attributable to IDEXX Laboratories, Inc. stockholders
  
 $
33,026
    
 $
26,071
  
                 
Earnings per Share:
                
Basic
  
 $
0.57
    
 $
0.44
  
Diluted
  
 $
0.55
    
 $
0.43
  
Weighted Average Shares Outstanding:
                
Basic
    
58,033
      
59,172
  
Diluted
    
60,029
      
60,606
  

The accompanying notes are an integral part of these condensed consolidated financial statements.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
4
 

IDEXX LABORATORIES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)

   
For the Three Months Ended
March 31,
  
     
2010
      
2009
  
                 
Cash Flows from Operating Activities:
                
Net income
  
 $
33,028
    
 $
26,071
  
Adjustments to reconcile net income to net cash provided by operating activities:
                
Depreciation and amortization
    
11,246
      
12,556
  
Loss on disposal of property and equipment
    
1,092
      
491
  
Increase (decrease) in deferred compensation liability
    
101
      
(100
)
Provision for uncollectible accounts
    
385
      
246
  
Provision for deferred income taxes
    
769
      
1,465
  
Share-based compensation expense
    
3,344
      
2,930
  
Tax benefit from exercises of stock options and vesting of restricted stock units
    
(3,318
)
    
(161
)
Changes in assets and liabilities, net of acquisitions:
                
Accounts receivable
    
(17,393
)
    
(6,072
)
Inventories
    
(12,179
)
    
(8,067
)
Other assets
    
1,441
      
179
  
Accounts payable
    
5,081
      
(4,315
)
Accrued liabilities
    
(4,916
)
    
(12,394
)
Deferred revenue
    
524
      
(205
)
Net cash provided by operating activities
    
19,205
      
12,624
  
Cash Flows from Investing Activities:
                
Purchases of property and equipment
    
(7,789
)
    
(9,114
)
Proceeds from disposition of pharmaceutical product lines
    
-
      
1,377
  
Proceeds from sale of property and equipment
    
27
      
1,046
  
Acquisitions of equipment leased to customers
    
(684
)
    
(188
)
Acquisitions of intangible assets
    
(144
)
    
-
  
Net cash used by investing activities
    
(8,590
)
    
(6,879
)
Cash Flows from Financing Activities:
                
Borrowings on revolving credit facilities, net
    
38,523
      
15,019
  
Payment of other notes payable
    
(200
)
    
(190
)
Purchase of treasury stock
    
(57,728
)
    
(14,986
)
Proceeds from exercises of stock options and employee stock purchase plans
    
6,483
      
3,281
  
Tax benefit from exercises of stock options and vesting of restricted stock units
    
3,318
      
161
  
Net cash provided (used) by financing activities
    
(9,604
)
    
3,285
  
Net effect of changes in exchange rates on cash
    
(1,385
)
    
(1,603
)
Net increase (decrease) in cash and cash equivalents
    
(374
)
    
7,427
  
Cash and cash equivalents at beginning of period
    
106,728
      
78,868
  
Cash and cash equivalents at end of period
  
 $
106,354
    
 $
86,295
  
                 
Supplemental Disclosures of Cash Flow Information:
                
Interest paid
  
 $
373
    
 $
1,105
  
Income taxes paid
  
 $
3,790
    
 $
3,337
  

The accompanying notes are an integral part of these condensed consolidated financial statements
 
 
 
 
 
 
 
 
5
 

IDEXX LABORATORIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1.         BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION

The accompanying condensed consolidated financial statements of IDEXX Laboratories, Inc. (“IDEXX,” the “Company,” “we” or “our”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the requirements of Regulation S-X, Rule 10-01 for financial statements required to be filed as a part of Form 10-Q.

The accompanying condensed consolidated financial statements include the accounts of IDEXX Laboratories, Inc. and our wholly-owned and majority-owned subsidiaries. All material intercompany transactions and balances have been eliminated in consolidation.

The accompanying condensed consolidated financial statements reflect, in the opinion of our management, all adjustments necessary for a fair presentation of our financial position and results of operations. All such adjustments are of a recurring nature. The consolidated balance sheet data at December 31, 2009 was derived from audited financial statements, but does not include all disclosures required by U.S. GAAP. The results of operations for the three months ended March 31, 2010 are not necessarily indicative of the results to be expected for the full year or any future period. These condensed consolidated financial statements should be read in conjunction with this Quarterly Report on Form 10-Q for the three months ended March 31, 2010, and our Annual Report on Form 10-K for the year ended December 31, 2009 filed with the Securities and Exchange Commission.

NOTE 2.         ACCOUNTING POLICIES

Significant Accounting Policies

The significant accounting policies used in preparation of these condensed consolidated financial statements for the three months ended March 31, 2010 are consistent with those discussed in Note 3 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2009, except for the adoption of new accounting standards during the three months ended March 31, 2010 as discussed below.

Recent Accounting Pronouncements

On January 1, 2010, we adopted amendments to authoritative literature that modifies the revenue recognition guidance for establishing separate units of accounting in a multiple element arrangement and requires the allocation of arrangement consideration to each deliverable in the arrangement based on relative selling price of the elements. The selling price for each deliverable is based on vendor-specific objective evidence ("VSOE") if available, third-party evidence ("TPE") if VSOE is not available, or best estimate of selling price ("BESP") if neither VSOE nor TPE is available. BESP must be determined in a manner that is consistent with that used to determine the price to sell the specific elements on a standalone basis. The authoritative literature permits prospective or retrospective adoption, and we elected prospective adoption. The adoption of these amendments did not have a significant impact on our financial position, results of operations, or cash flows for the three months ended March 31, 2010, nor do we anticipate a significant impact for the year ended December 31, 2010.

On January 1, 2010, we adopted amendments to authoritative literature that modifies the revenue recognition guidance for the sale of tangible products that contain software that is more than incidental to the functionality of the product as a whole. More specifically, the revised accounting guidance indicates that when a product has tangible and software components that function together to deliver the essential functionality of the product as a whole, that product should be excluded from the scope of software revenue accounting guidance, as opposed to the previous accounting guidance where such an instrument would be subject to the rules detailed in the software revenue guidance. The authoritative literature permits prospective or retrospective adoption, and we elected prospective adoption. Certain sales of our instruments are subject to these amendments. However, the adoption of these amendments did not have a significant impact on our financial position, results of operations, and cash flows for the three months ended March 31, 2010, nor do we anticipate a significant impact for the year ended December 31, 2010.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
6
 

Our updated revenue recognition policy in its entirety reflecting the adoption of these amendments is provided in the following discussion.

Revenue Recognition

We recognize revenue when four criteria are met: (i) persuasive evidence that an arrangement exists; (ii) delivery has occurred or services have been rendered; (iii) the sales price is fixed or determinable; and (iv) collectability is reasonably assured. Revenue-generating transactions generally fall into one of the following categories of revenue recognition:

 
·
We recognize revenue at the time of shipment to U.S. distributors for substantially all products sold through distributors because title and risk of loss pass to the distributors on delivery to the common carrier. Our distributors do not have the right to return products. We recognize revenue for the remainder of our customers when the product is delivered to the customer, except as noted below.
 
 
·
We recognize revenue from the sales of instruments, non-cancelable software licenses and hardware systems upon installation (and completion of training if applicable) and the customer’s acceptance of the instrument or system as we have no significant further obligations after this point in time.
 
 
·
We recognize service revenue at the time the service is performed.
 
 
·
We recognize revenue associated with extended maintenance agreements (“EMAs”) over the life of the contracts using the straight-line method, which approximates the expected timing in which applicable services are performed. Amounts collected in advance of revenue recognition are recorded as a current or long-term liability based on the time from the balance sheet date to the future date of revenue recognition.
 
 
·
We recognize revenue on certain instrument systems under rental programs over the life of the rental agreement using the straight-line method. Amounts collected in advance of revenue recognition are recorded as a current or long-term liability based on the time from the balance sheet date to the future date of revenue recognition.
 
 
·
We recognize revenue on practice information management systems sales either by allocating the revenue to each element of the sale based on relative fair values of the elements, including post-contract support when fair value for all elements is available, or by use of the residual method when only the fair value of the post-contract support is available. We recognize revenue for the system on installation and customer acceptance and recognize revenue equal to the fair value of the post-contract support over the support period.
 
 
·
Shipping costs reimbursed by the customer are included in revenue.

Multiple element arrangements (“MEAs”). Arrangements to sell products to customers frequently include multiple deliverables. Our most significant MEAs include the sale of one or more of the instruments from the IDEXX VetLab® suite of analyzers or digital radiography systems, combined with one or more of the following products: extended maintenance agreements; consumables; laboratory diagnostic and consulting services; and practice management software. Practice management software is frequently sold with postcontract customer support and implementation services. Delivery of the various products or performance of services within the arrangement may or may not coincide. Delivery of our IDEXX VetLab® instruments, digital radiography systems, and practice management software generally occurs at the onset of the arrangement. EMAs, consumables, and laboratory diagnostic and consulting services generally are delivered over a period of one to five years. In certain arrangements revenue recognized is limited to the amount invoiced or received that is not contingent on the delivery of future products and services.

When arrangements outside of the scope of software revenue recognition guidance include multiple elements, we allocate revenue to each element based on the relative selling price and recognize revenue when the elements have standalone value and the four criteria for revenue recognition have been met for each element. We establish the selling price of each element based on VSOE if available, TPE if VSOE is not available, or BESP if neither VSOE nor TPE is available. We generally determine selling price based on amounts charged separately for the delivered and undelivered elements to similar customers in standalone sales of the specific elements. When arrangements outside of the scope of software revenue recognition guidance include an EMA, we recognize revenue related to the EMA at the stated contractual price on a straight-line basis over the life of the agreement.
 
 
 
 
 
 
 
 
 
 
7
 
 
When arrangements within the scope of software revenue recognition guidance include multiple elements, we allocate revenue to each element based on relative fair value when VSOE exists for all elements or residual fair value when there is VSOE for the undelivered elements but no such evidence for the delivered elements. When allocating revenue based on residual fair value, the fair value of the undelivered elements is deferred and the residual revenue is allocated to the delivered elements. Revenue is recognized on any delivered elements when the four criteria for revenue recognition have been met for each element. If sufficient VSOE does not exist for the allocation of revenue to the various elements of the arrangement, all revenue from the arrangement is deferred until the earlier of the point at which such sufficient VSOE does exist or all elements of the arrangement have been delivered. We generally determine fair value based on amounts charged separately for the delivered and undelivered elements to similar customers in standalone sales of the specific elements.

Customer programs. We record estimated reductions to revenue in connection with customer marketing programs and incentive offerings that may give customers rebates or award points, or provide other incentives. Award points granted under our IDEXX Points customer programs may be applied to trade receivables owed to us and/or toward future purchases of our products or services. We establish accruals for estimated revenue reductions attributable to customer programs and incentive offerings for each program. Revenue reductions are recorded quarterly based on issuance of credits, points earned but not yet issued, and estimates of credits and points to be earned in the future based on current revenue. As points are redeemed we recognize the benefit of points expected to expire, or breakage, using historical forfeiture rates. On November 30 of each year, unused points granted before January 1 of the prior year expire and any variance from the breakage estimate is accounted for as a change in estimate.

Within our overall IDEXX Points program, our two most significant customer programs are Practice Developer® and SNAP® up the Savings™ (“SUTS”), both of which are offered only to North American customers. Our Practice Developer® program is a Companion Animal Group (“CAG”) awards program that permits customers to earn points by purchasing quarterly minimums in certain product and service categories, including IDEXX Reference Laboratories services, Catalyst Dx® and VetTest® slides, SNAPShot Dx® Analyzer and VetTest® SNAP® Reader reagents, LaserCyte® and VetAutoread™ tubes, and service and maintenance agreements. For the Practice Developer® program, the accrued revenue reduction is calculated each quarter based on sales to end users during the quarter by either us or our distributors and on our estimate of future points to be issued upon sale of applicable product inventories held by distributors at the end of the quarter. SUTS is our volume incentive program for selected SNAP® tests that provides customers with benefits in the form of (1) discounts off invoice at the time of purchase and (2) points under the IDEXX Points program awarded and paid out quarterly throughout the SUTS program year (which ends on August 31) based on total purchase volume of qualified SNAP® products during the given quarter.

Doubtful accounts receivable. We recognize revenue only in those situations where collection from the customer is reasonably assured. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We base our estimates on a detailed analysis of specific customer situations and a percentage of our accounts receivable by aging category. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be required. Account balances are charged off against the allowance when we believe the receivable will not be recovered.

NOTE 3.         SHARE-BASED COMPENSATION

The fair value of options, restricted stock units, deferred stock units with vesting conditions, and employee stock purchase rights awarded during the three months ended March 31, 2010 and 2009 totaled $15.0 million and $15.1 million, respectively. Share-based compensation expense for the three months ended March 31, 2010 and 2009 was $3.3 million and $2.9 million, respectively. The total unrecognized compensation expense for unvested awards outstanding at March 31, 2010 was $36.5 million, net of approximately $2.8 million related to estimated forfeitures. The weighted average remaining expense recognition period at March 31, 2010 was approximately 2.3 years.
 
 
 
 
 
 
 
 
 
 
 
 
8
 

Options

We determine the assumptions used in the valuation of option grants as of the date of grant. Differences in the stock price volatility, terms of options granted to different segments of employees, or risk-free interest rates may necessitate distinct valuation assumptions at those grant dates. As such, we may use different assumptions during the fiscal year if we grant options at different dates or with varying terms. Option awards are granted to employees with an exercise price equal to not less than the closing market price of our common stock at the date of grant. We have never paid any cash dividends on our common stock and we have no present intention to pay a dividend; therefore, we assume that no dividends will be paid over the expected terms of option awards. The weighted averages of the valuation assumptions used to determine the fair value of each option grant on the date of grant and the weighted average estimated fair values were as follows:

   
For the Three Months Ended
March 31,
   
2010
  
2009
             
Expected stock price volatility
     31 %     30 %
Expected term, in years
     4.9       4.8  
Risk-free interest rate
     2.3 %     1.6 %
                 
Weighted average fair value of options granted
    $ 16.53      $ 9.97  

NOTE 4.         INVENTORIES

Inventories include material, labor and overhead, and are stated at the lower of cost (first-in, first-out) or market. The components of inventories were as follows (in thousands):

   
March 31,
    
December 31,
  
     
2010
      
2009
  
                 
Raw materials
  
 $
28,331
    
 $
28,426
  
Work-in-process
    
15,448
      
17,761
  
Finished goods
    
78,605
      
64,238
  
   
 $
122,384
    
 $
110,425
  

NOTE 5.         GOODWILL AND OTHER INTANGIBLE ASSETS

The changes in goodwill and the cost of intangible assets other than goodwill during the three months ended March 31, 2010 resulted primarily from changes in foreign currency exchange rates.

NOTE 6.         ACCRUED LIABILITIES

Accrued liabilities consisted of the following (in thousands):

   
March 31,
2010
    
December 31,
2009
  
                 
Accrued expenses
  
 $
28,387
    
 $
33,094
  
Accrued employee compensation and related expenses
    
31,790
      
44,497
  
Accrued taxes
    
15,702
      
9,980
  
Accrued customer programs
    
18,737
      
17,388
  
   
 $
94,616
    
 $
104,959
  

NOTE 7.         WARRANTY RESERVES

We provide for the estimated cost of instrument warranties in cost of product revenue at the time revenue is recognized based on the estimated cost to repair the instrument over its warranty period. As we develop and sell new instruments, our provision for warranty expense increases. Cost of revenue reflects not only estimated warranty expense for the systems sold in the current period, but also any changes in estimated warranty expense for the installed base that results from our quarterly evaluation of service experience. Our actual warranty obligation is affected by instrument performance in the customers’ environment and costs incurred in servicing instruments. Should actual service rates or costs differ from our estimates, which are based on historical data and projections of future costs, revisions to our estimated warranty liability would be required.
 

 
9
 
 
The following is a summary of changes in accrued warranty reserves during the three months ended March 31, 2010 and 2009 (in thousands):

   
For the Three Months Ended
March 31,
  
     
2010
      
2009
  
                 
Balance, beginning of period
  
 $
3,086
    
 $
2,837
  
Provision for warranty expense
    
1,082
      
1,264
  
Change in estimate
    
(478
)
    
(69
)
Settlement of warranty liability
    
(1,076
)
    
(926
)
Balance, end of period
  
 $
2,614
    
 $
3,106
  

NOTE 8.         TREASURY STOCK

We primarily acquire shares by means of repurchases in the open market. We also acquire shares that are surrendered by employees in payment for the minimum required withholding taxes due on the exercise of stock options, the vesting of restricted stock units and the settlement of deferred stock units, and in payment for the exercise price of stock options.

Information about our treasury stock purchases and other receipts for the three months ended March 31, 2010 and 2009 (in thousands, except per share amounts):

   
For the Three Months Ended
March 31,
  
   
2010
    
2009
  
             
Shares acquired
     1,140       499  
Total cost of shares acquired
    $ 60,302      $ 16,058  
Average cost per share
    $ 52.89      $ 32.20  

NOTE 9.         INCOME TAXES

Our effective income tax rates were 31.4% and 31.5% for the three months ended March 31, 2010 and 2009, respectively. The decrease in the effective tax rate was due primarily to tax benefits related to U.S. manufacturing activities that were fully phased-in effective January 1, 2010, partly offset by the expiration of federal research and development tax incentives that were available during the three months ended March 31, 2009. 

NOTE 10.       COMPREHENSIVE INCOME

The following is a summary of comprehensive income for the three months ended March 31, 2010 and 2009 (in thousands):

   
For the Three Months Ended
March 31,
  
     
2010
      
2009
  
                 
Net income
  
 $
33,028
    
 $
26,071
  
Less: Net income attributable to noncontrolling interest
    
2
      
-
  
Net income attributable to IDEXX Laboratories, Inc. stockholders
    
33,026
      
26,071
  
Other comprehensive income (loss) attributable to IDEXX Laboratories, Inc. stockholders:
                
Foreign currency translation adjustments
    
(5,548
)
    
(7,093
)
Change in fair value of foreign currency contracts classified as hedges, net of tax
    
2,275
      
(1,287
)
Change in fair value of interest rate swaps classified as hedges, net of tax
    
(582
)
    
(213
)
Change in fair market value of investments, net of tax
    
57
      
(63
)
Comprehensive income attributable to IDEXX Laboratories, Inc. stockholders
  
 $
29,228
    
 $
17,415
  
 
 
 
 
 
 
 
 
10
 

NOTE 11.       EARNINGS PER SHARE

Basic earnings per share is computed by dividing net income by the weighted average number of shares of common stock and vested deferred stock units outstanding during the year. The computation of diluted earnings per share is similar to the computation of basic earnings per share, except that the denominator is increased for the assumed exercise of dilutive options and other potentially dilutive securities using the treasury stock method, unless the effect is anti-dilutive.

The following is a reconciliation of shares outstanding for basic and diluted earnings per share (in thousands):

   
For the Three Months Ended
March 31,
  
   
2010
    
2009
  
             
Shares Outstanding for Basic Earnings per Share:
            
Weighted average shares outstanding
  
57,911
    
59,064
  
Weighted average vested deferred stock units outstanding
  
122
    
108
  
   
58,033
    
59,172
  
             
Shares Outstanding for Diluted Earnings per Share:
            
Shares outstanding for basic earnings per share
  
58,033
    
59,172
  
Dilutive effect of options issued to employees and directors
  
1,821
    
1,386
  
Dilutive effect of restricted stock units issued to employees and directors
  
170
    
41
  
Dilutive effect of unvested deferred stock units issued to directors
  
5
    
7
  
   
60,029
    
60,606
  

Vested deferred stock units outstanding are included in shares outstanding for basic and diluted earnings per share because the associated shares of our common stock are issuable for no cash consideration, the number of shares of our common stock to be issued is fixed and issuance is not contingent.

Certain options to acquire shares and restricted stock units have been excluded from the calculation of shares outstanding for dilutive earnings per share because they were anti-dilutive. The following table presents information concerning those anti-dilutive options and restricted stock units (in thousands, except per share amounts):

   
For the Three Months Ended
March 31,
  
     
2010
    
2009
  
               
Weighted average number of shares underlying anti-dilutive options
    
605
    
1,432
  
               
Weighted average exercise price per underlying share of anti-dilutive options
  
 $
54.85
  
 $
44.60
  
               
Weighted average number of shares underlying anti-dilutive restricted stock units
    
-
    
302
  

The following table presents additional information concerning the exercise prices of vested and unvested options outstanding at the end of the period (in thousands, except per share amounts):

   
March 31,
  
   
2010
    
2009
  
                 
Closing price per share of our common stock
  
 $
57.55
    
 $
34.58
  
                 
Number of shares underlying options with exercise prices below the closing price
    
4,882
      
4,382
  
Number of shares underlying options with exercise prices equal to or above the closing price
    
-
      
1,104
  
Total number of shares underlying outstanding options
    
4,882
      
5,486
  
 
 
 
 
 
11
 

NOTE 12.       COMMITMENTS, CONTINGENCIES AND GUARANTEES

Significant commitments, contingencies and guarantees at March 31, 2010 are consistent with those discussed in Note 12 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2009.

NOTE 13.       SEGMENT REPORTING

The accounting policies of the segments are consistent with those discussed in Notes 1 and 13 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2009. Intersegment revenues, which are not included in the table below, were not significant for the three months ended March 31, 2010 and 2009.

Segment performance for the three months ended March 31, 2010 and 2009 is as follows (in thousands):

   
For the Three Months Ended March 31,
  
   
CAG
    
Water
    
Production
Animal
Segment
    
Other
    
Unallocated
Amounts
    
Consolidated
Total
  
2010
                                    
Revenue
    $ 221,417      $ 17,864      $ 19,941      $ 9,303      $ -      $ 268,525  
                                                 
Income (loss) from operations
    $ 39,767      $ 7,123      $ 4,734      $ 260      $ (3,456 )    $ 48,428  
Interest expense, net
                                             312  
Income before provision for income taxes
                                             48,116  
Provision for income taxes
                                             15,088  
Net income
                                             33,028  
Net income attributable to noncontrolling interest
                                             2  
Net income attributable to IDEXX Laboratories, Inc. stockholders
                                            $ 33,026  
                                                 
2009
                                                
Revenue
    $ 193,692      $ 15,851      $ 18,266      $ 8,646      $ -      $ 236,455  
                                                 
Income (loss) from operations
    $ 29,079      $ 7,312      $ 4,950      $ 129      $ (3,029 )    $ 38,441  
Interest expense, net
                                             396  
Income before provision for income taxes
                                             38,045  
Provision for income taxes
                                             11,974  
Net income
                                             26,071  
Net income attributable to noncontrolling interest
                                             -  
Net income attributable to IDEXX Laboratories, Inc. stockholders
                                            $ 26,071  

Revenue by product and service category was as follows (in thousands):

   
For the Three Months Ended
March 31,
  
     
2010
    
2009
  
CAG segment revenue:
              
Instruments and consumables
  
 $
83,382
  
 $
72,235
  
Rapid assay products
    
39,443
    
37,677
  
Laboratory diagnostic and consulting services
    
79,840
    
68,692
  
Practice information systems and digital radiography
    
18,752
    
15,034
  
Pharmaceutical products
    
-
    
54
  
CAG segment revenue
    
221,417
    
193,692
  
               
Water segment revenue
    
17,864
    
15,851
  
Production animal segment revenue
    
19,941
    
18,266
  
Other segment revenue
    
9,303
    
8,646
  
               
Total revenue
  
 $
268,525
  
 $
236,455
  
 
 
12
 

NOTE 14.       FAIR VALUE MEASUREMENTS

U.S. GAAP defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. U.S. GAAP also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs, where available, and minimize the use of unobservable inputs when measuring fair value.

There are three levels of inputs that may be used to measure fair value:
 
Level 1
Quoted prices in active markets for identical assets or liabilities.
   
Level 2
Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Foreign currency exchange contracts and interest rate swaps classified as derivative instruments are valued utilizing third-party pricing services.
   
Level 3
Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. At March 31, 2010 and December 31, 2009, we had no Level 3 assets or liabilities.

Assets and liabilities measured at fair value are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability. We did not have any significant nonfinancial assets or nonfinancial liabilities which required remeasurement during the three months ended March 31, 2010 or during the year ended December 31, 2009. We did not have any transfers between Level 1 and Level 2 measurements during the three months ended March 31, 2010.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
13
 

The following tables set forth our assets and liabilities that were measured at fair value on a recurring basis at March 31, 2010 and at December 31, 2009 by level within the fair value hierarchy (in thousands):

As of March 31, 2010
  
Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
    
Significant
Other
Observable
Inputs
(Level 2)
    
Significant
Unobservable
Inputs
(Level 3)
    
Balance at
March 31, 2010
  
                         
Assets
                        
Money market funds(1)
    $ 59,014      $ -      $ -      $ 59,014  
Equity mutual funds(2)
     1,993       -       -       1,993  
Liabilities
                                
Foreign currency exchange contracts(3)
     -       926       -       926  
Deferred compensation(4)
     1,993       -       -       1,993  
Interest rate swaps(5)
     -       1,515       -       1,515  

As of December 31, 2009
  
Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
    
Significant
Other
Observable
Inputs
(Level 2)
    
Significant
Unobservable
Inputs
(Level 3)
    
Balance at
December 31, 2009
  
                         
Assets
                        
Money market funds(1)
    $ 47,021      $ -      $ -      $ 47,021  
Equity mutual funds(2)
     1,891       -       -       1,891  
Liabilities
                                
Foreign currency exchange contracts(3)
     -       4,221       -       4,221  
Deferred compensation(4)
     1,891       -       -       1,891  
Interest rate swaps(5)
     -       595       -       595  
 
(1)
Money market funds are included within Cash and cash equivalents.
(2)
Equity mutual funds relate to a deferred compensation plan that was assumed as part of a previous business combination. This amount is included within Other long-term assets, net. See item 4 below for a discussion of the related deferred compensation liability.
(3)
Foreign currency exchange contracts are included within Accrued liabilities.
(4)
Deferred compensation plans are included within Other long-term liabilities. The fair value of our deferred compensation plan is indexed to the performance of the underlying equity mutual funds discussed in item 1 above.
(5)
Interest rate swaps are included within Accrued liabilities.

The estimated fair value of certain financial instruments, including cash and cash equivalents, investments, accounts receivable, derivative instruments, interest rate swap agreements, accounts payable, lines of credit, and notes payable approximate carrying value due to their short maturity. The estimated fair value of long-term debt approximates the carrying value based on current market prices for similar debt issues with similar remaining maturities.

Financial instruments that potentially subject us to concentrations of credit risk are principally cash and cash equivalents, investments and accounts receivable. To mitigate such risk, we place our cash and cash equivalents and investments in highly-rated financial institutions and money market funds invested in government securities. Concentration of credit risk with respect to accounts receivable is limited to certain customers to whom we make substantial sales. To reduce risk, we routinely assess the financial strength of our customers and closely monitor their amounts due to us and, as a consequence, believe that our accounts receivable credit risk exposure is limited. We maintain an allowance for doubtful accounts, but historically have not experienced any significant losses related to an individual customer or group of customers in any particular industry or geographic area.

NOTE 15.       DERIVATIVE INSTRUMENTS AND HEDGING

Disclosure within this footnote is presented to provide transparency about how and why we use derivative instruments, how the instruments and related hedged items are accounted for, and how the instruments and related hedged items affect our financial position, results of operations, and cash flows. Derivative instruments are recognized on the balance sheet as either assets or liabilities at fair value with a corresponding offset to other comprehensive income (“OCI”), which is net of tax.
 
 
 
14
 

We are exposed to certain risks related to our ongoing business operations. The primary risks that we manage by using derivative instruments are foreign currency exchange risk and interest rate risk. Our subsidiaries enter into foreign currency exchange contracts to manage the exchange risk associated with their forecasted intercompany inventory purchases for the next year. From time to time, we may also enter into foreign currency exchange contracts to minimize the impact of foreign currency fluctuations associated with specific, significant transactions. Interest rate swaps are entered into to manage interest rate risk associated with $80 million of our variable-rate debt.

The primary purpose of our foreign currency hedging activities is to protect against the volatility associated with foreign currency transactions. We also utilize natural hedges to mitigate our transaction and commitment exposures. Our corporate policy prescribes the range of allowable hedging activity. We enter into exchange contracts with large multinational financial institutions, and we do not hold or engage in transactions involving derivative instruments for purposes other than risk management. Our accounting policies for these contracts are based on our designation of such instruments as hedging transactions. Market gains and losses are deferred in OCI until the contract matures, which is the period when the related obligation is settled. We primarily utilize forward exchange contracts with durations of less than 24 months.

Cash Flow Hedges

We have designated our forward currency exchange contracts and variable-to-fixed interest rate swaps as cash flow hedges. For derivative instruments that are designated as hedges, changes in the fair value of the derivative are recognized in OCI and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. We de-designate derivative instruments from hedge accounting when the probability of the hedged transaction occurring becomes less than probable, but remains reasonably possible. For de-designated instruments, the gain or loss from the time of de-designation through maturity of the instrument is recognized in earnings. Any gain or loss in other comprehensive income at the time of de-designation is reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. We did not de-designate any instruments from hedge accounting treatment during the three months ended March 31, 2010 or 2009. We immediately record in earnings the extent to which a hedge is not effective in achieving offsetting changes in fair value of the hedged item. Gains or losses related to hedge ineffectiveness recognized in earnings during the three months ended March 31, 2010 and 2009 were not material. At March 31, 2010, the estimated net amount of losses that are expected to be reclassified out of accumulated other comprehensive income and into earnings within the next 12 months is $0.6 million if exchange rates do not fluctuate from the levels at March 31, 2010.

We enter into currency exchange contracts for amounts that are less than the full value of forecasted intercompany sales. Our hedging strategy related to intercompany inventory purchases is to employ the full amount of our hedges for the succeeding year at the conclusion of our budgeting process for that year, which is complete by the end of the preceding year. Quarterly, we enter into contracts to hedge incremental portions of anticipated foreign currency transactions for the current and following year. Accordingly, our risk with respect to foreign currency exchange rate fluctuations may vary throughout each annual cycle.

Under our current credit facility agreement, the applicable interest rates on our unsecured short-term revolving credit facility (“Credit Facility”) generally range from 0.375 to 0.875 percentage points (“Credit Spread”) above the London interbank offered rate or the Canadian Dollar-denominated bankers’ acceptance rate, dependent on our consolidated leverage ratio. In March 2009, we entered into two forward fixed interest rate swap agreements to manage the economic effect of variable interest obligations on amounts borrowed under the terms of our Credit Facility. Under these agreements, beginning on March 31, 2010 the variable interest rate associated with $80 million of borrowings outstanding under the Credit Facility has effectively become fixed at 2% plus the Credit Spread through March 30, 2012. The critical terms of the interest rate swap agreements match the critical terms of the underlying borrowings, including notional amounts, underlying market indices, interest rate reset dates and maturity dates.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
15
 
The notional amount of foreign currency exchange contracts to hedge forecasted intercompany sales consisted of the following (in thousands):

Currency Sold
  
U.S. Dollar Equivalent
   
March 31,
    
December 31,
    
March 31,
   
2010
    
2009
    
2009
                 
Euro
    $ 49,882      $ 53,091      $ 48,843
British Pound
     19,017       19,238       23,541
Canadian Dollar
     18,095       18,849       24,740
Australian Dollar
     6,863       7,086       6,414
Japanese Yen
     9,040       9,795       7,253
     $ 102,897      $ 108,059      $ 110,791

Currency Purchased
  
U.S. Dollar Equivalent
   
March 31,
    
December 31,
    
March 31,
   
2010
    
2009
    
2009
                 
Swiss Franc
    $ 8,425      $ 8,808      $ 7,306

The notional amount of forward fixed interest rate swap agreements to manage variable interest obligations consisted of the following (in thousands):

   
U.S. Dollar Equivalent
   
March 31,
    
December 31,
    
March 31,
   
2010
    
2009
    
2009
                 
Interest rate swap
    $ 80,000      $ 80,000      $ 80,000

The fair values of derivative instruments and their respective classification in the condensed consolidated balance sheet consisted of the following (in thousands):

   
Liability Derivatives
           
   
March 31, 2010
    
December 31, 2009
   
Balance Sheet
Classification
    
Fair Value
    
Balance Sheet
Classification
    
Fair Value
                           
Derivatives designated as hedging instruments
                          
Foreign currency exchange contracts
  
Accrued expenses
    
 $
926
    
Accrued expenses
    
 $
4,221
Interest rate swaps
  
Accrued expenses
      
1,515
    
Accrued expenses
      
595
Total derivative instruments
        
 $
2,441
          
 $
4,816

The effect of derivative instruments designated as cash flow hedges on the condensed consolidated balance sheet for the three months ended March 31, 2010 and 2009 consisted of the following (in thousands):

     
Gain (Loss) Recognized in OCI on
Derivative Instruments (Effective Portion)
  
     
For the Three Months Ended
March 31,
  
Derivative instruments
      
2010
      
2009
  
                   
Foreign exchange contracts, net of tax
    
 $
2,275
    
 $
(1,287
)
Interest rate swaps, net of tax
      
(582
)
    
(213
)
Total loss, net of tax
    
 $
1,693
    
 $
(1,500
)
 
 
 
 

 
16
 

The effect of derivative instruments designated as cash flow hedges on the condensed consolidated statement of operations for the three months ended March 31, 2010 and 2009 consisted of the following (in thousands):

       
Gain (Loss) Reclassified from Accumulated
OCI into Income (Effective Portion)
  
   
Classification of Gain (Loss)
Reclassified from OCI into
  
For the Three Months Ended
March 31,
  
Derivative instruments
  
Income (Effective Portion)
  
2010
    
2009
  
                 
Foreign exchange contracts
  
Cost of revenue
    $ (411 )    $ 4,818  

Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations.

This Quarterly Report on Form 10-Q contains statements which, to the extent they are not statements of historical or present fact, constitute “forward-looking statements.” Such forward-looking statements about our business and expectations within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, include statements relating to future revenue growth rates, earnings and other measures of financial performance, the effect of economic downturns on our business performance, demand for our products, realizability of assets, future cash flow and uses of cash, future repurchases of common stock, future levels of indebtedness and capital spending, warranty expense, share-based compensation expense, and competition. 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. These forward-looking statements are intended to provide our current expectations or forecasts of future events; are based on current estimates, projections, beliefs, and assumptions; and are not guarantees of future performance. Actual events or results may differ materially from those described in the forward-looking statements. These forward-looking statements involve a number of risks and uncertainties as more fully described under the heading “Part II, Item 1A. Risk Factors” in this Quarterly Report on Form 10-Q. The risks and uncertainties discussed herein do not reflect the potential impact of any mergers, acquisitions or dispositions. In addition, any forward-looking statements represent our estimates only as of the day this Quarterly Report was first filed with the Securities and Exchange Commission (“SEC”) and should not be relied upon as representing our estimates as of any subsequent date. From time to time, oral or written forward-looking statements may also be included in other materials released to the public. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our estimates or expectations change.

■ Business Overview

Operating segments. We operate primarily through three business segments: diagnostic and information technology products and services for the veterinary market, which we refer to as our Companion Animal Group (“CAG”), water quality products (“Water”) and products for production animal health, which we refer to as our Production Animal Segment (“PAS”). We also operate two smaller operating segments that comprise products for dairy quality (“Dairy”) and products for the human point-of-care medical diagnostics market (“OPTI Medical”). Financial information about the Dairy and OPTI Medical operating segments and other licensing arrangements are combined and presented in an “Other” category because they do not meet the quantitative or qualitative thresholds for reportable segments. See Note 13 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for financial information about our segments.

CAG develops, designs, manufactures and distributes products and performs services for veterinarians, primarily related to diagnostics and information management. Water develops, designs, manufactures and distributes products to detect contaminants in water. PAS develops, designs, manufactures and distributes products to detect disease in production animals. Dairy develops, designs, manufactures and distributes products to detect contaminants in dairy products. OPTI Medical develops, designs, manufactures and distributes point-of-care electrolyte and blood gas analyzers and related consumable products for the human medical diagnostics market and also manufactures our VetStat® electrolyte and blood gas analyzer and electrolyte consumables used with our Catalyst Dx® analyzer sold in the veterinary market.
 
 
 
 
 
 
 
 
 
 
 
 
 
17
 

Items that are not allocated to our operating segments are comprised primarily of corporate research and development expenses that do not align with one of our existing business or service categories, a portion of share-based compensation expense, interest income and expense, and income taxes. We estimate our share-based compensation expense for the year and allocate the estimated expense to the operating segments. This allocation differs from the actual expense and consequently yields a difference between the total allocated share-based compensation expense and the actual expense for the total company, resulting in an unallocated amount reported under the caption “Unallocated Amounts.” We maintain active research and development programs, some of which may materialize into the development and introduction of new technology, products or services. Research and development costs incurred that are not specifically allocated to one of our existing business or service categories are reported under the caption “Unallocated Amounts.”

Use of Distributors. Because the instrument consumables and rapid assay products in our CAG segment are sold in the U.S. and certain other geographies by distributors, distributor purchasing dynamics have an impact on our reported sales of these products. Distributors purchase products from us and sell them to veterinary practices, who are the end users. Distributor purchasing dynamics may be affected by many factors and may be unrelated to underlying end-user demand for our products. As a result, fluctuations in distributors’ inventories may cause reported results in a period not to be representative of underlying end-user demand. Therefore, we believe it is important to track distributor sales to end users and to distinguish between the impact of end-user demand and the impact of distributor purchasing dynamics on reported revenue growth.

Where growth rates are affected by changes in end-user demand, we refer to the impact of practice-level sales on growth. Where growth rates are affected by distributor purchasing dynamics, we refer to the impact of changes in distributors’ inventories. If during the comparable period of the prior year, distributors’ inventories grew by more than those inventories grew in the current year, then changes in distributors’ inventories have a negative impact on our reported sales growth in the current period. Conversely, if during the comparable period of the prior year, distributors’ inventories grew by less than those inventories grew in the current year, then changes in distributors’ inventories have a positive impact on our reported sales growth in the current period.

Currency Impact. Approximately 25% of our revenue is derived from products manufactured in the U.S. and sold internationally in local currencies. Strengthening of the rate of exchange for the U.S. dollar relative to other currencies has a negative impact on our international revenues and on profits of products manufactured in the U.S. and sold internationally. In addition, to the extent that the U.S. dollar is stronger in future periods relative to the exchange rates in effect in the corresponding prior periods, our growth rate will be negatively affected. The impact of foreign currency denominated operating expenses, foreign currency denominated supply contracts and the impact of foreign currency hedge contracts in place partly offset this exposure. See also the section of this Quarterly Report on Form 10-Q under the heading “Part 1, Item 3. Quantitative and Qualitative Disclosures About Market Risk.”

Effect of Economic Conditions. We believe that our financial results in the first quarter of 2010 continued to be negatively impacted by weakened economic conditions. We believe that a weak economy has caused patient visits to U.S. and European veterinary clinics for routine screening, preventive care and elective procedures to remain depressed. As a result, the growth rate of sales of rapid assay tests, instrument consumables, and laboratory diagnostic and consulting services in our CAG segment has been negatively affected. In addition, we believe that the rate of growth of sales of our instruments, which are larger capital purchases for veterinarians, has been negatively affected by increased caution among veterinarians regarding economic prospects. Weaker economic conditions also increased the sensitivity of our customers to the pricing of our products and services, resulting in lower growth from price increases for certain products over the course of the first quarter of 2010 relative to the comparable period for the prior year.

Beyond our companion animal business, we are also seeing the weaker economy impact certain customer groups in our Water and PAS businesses. Lower water testing volumes in the non-regulated segments of the business have been driven by a decline in new home construction and reduced consumer willingness to spend on certain luxury items, such as vacation cruises. Lower PAS testing volumes have been driven by a reduction in non-regulated producer and laboratory testing, as a measure to reduce operating costs, and by a reduction in testing associated with some government mandated eradication programs, due to lower government funding.

While we expect these trends to continue in the near term, we believe the fundamental drivers of demand in the markets we serve will remain intact and that growth rates will improve as major world economies stabilize.
 
 
 
 
 
 
 
 
 
 
 
 
 
18
 

■ Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. The significant accounting policies used in preparation of these condensed consolidated financial statements for the three months ended March 31, 2010 are consistent with those discussed in Note 3 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2009, except as discussed in Note 2 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q. The critical accounting policies and the significant judgments and estimates used in the preparation of our condensed consolidated financial statements for the three months ended March 31, 2010 are consistent with those discussed in our Annual Report on Form 10-K for the year ended December 31, 2009 in the section under the heading “Part 2, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates.”

■ Results of Operations

Three Months Ended March 31, 2010 Compared to Three Months Ended March 31, 2009

Revenue

Total Company. The following table presents revenue by operating segment:

For the Three Months Ended March 31,
Net Revenue
(dollars in thousands)
  
2010
    
2009
    
Dollar
Change
    
Percentage
Change
    
Percentage
Change from
Currency (1)
    
Percentage
Change from
Acquisitions/
Divestitures (2)
    
Percentage
Change Net of 
Acquisitions/
Divestitures
and Currency
Effect
                                         
CAG
    $ 221,417      $ 193,692      $ 27,725       14.3%        3.6%        0.8%        9.9% 
Water
     17,864       15,851       2,013       12.7%        5.2%        -            7.5% 
PAS
     19,941       18,266       1,675       9.2%        4.7%        -            4.5% 
Other
     9,303       8,646       657       7.6%        1.5%        -            6.1% 
Total
    $ 268,525      $ 236,455      $ 32,070       13.6%        3.8%        0.6%       9.2% 
 
(1)
Represents the percentage change in revenue attributed to the effect of changes in currency rates from the three months ended March 31, 2009 compared to the three months ended March 31, 2010.
(2)
Represents the percentage change in revenue during the three months ended March 31, 2010 compared to the three months ended March 31, 2009 attributed to incremental revenues from businesses acquired or revenues lost from businesses divested or discontinued subsequent to December 31, 2008.

The following revenue analysis and discussion reflects the results of operations net of the impact of currency exchange rates on sales outside the U.S. and net of incremental sales from businesses acquired or revenues lost from divisions divested subsequent to December 31, 2008.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
19
 

Companion Animal Group. The following table presents revenue by product and service category for CAG:

For the Three Months Ended March 31,
  
Net Revenue
(dollars in thousands)
  
2010
    
2009
    
Dollar
Change
    
Percentage
Change
  
Percentage
Change from
Currency (1)
  
Percentage
Change from
Acquisitions/
Divestitures (2)
  
Percentage
Change Net of 
Acquisitions/
Divestitures
and Currency
Effect
                                           
Instruments and consumables
    $ 83,382      $ 72,235      $ 11,147       15.4 %      3.8 %      -       11.6 % 
Rapid assay products
     39,443       37,677       1,766       4.7 %     1.3 %     -       3.4 %
Laboratory diagnostic and consulting services
     79,840       68,692       11,148       16.2 %     5.1 %     2.1 %      9.0 %
Practice information management systems and digital radiography
     18,752       15,034       3,718       24.7 %     1.9 %     0.6 %     22.2 %
Pharmaceutical products
     -       54       (54 )     (100.0 %)     -       (100.0 %)     -  
Net CAG revenue
    $ 221,417      $ 193,692      $ 27,725       14.3 %     3.6 %     0.8 %     9.9 %
 
(1)
Represents the percentage change in revenue attributed to the effect of changes in currency rates from the three months ended March 31, 2009 compared to the three months ended March 31, 2010.
(2)
Represents the percentage change in revenue during the three months ended March 31, 2010 compared to the three months ended March 31, 2009 attributed to incremental revenues from businesses acquired or revenues lost from businesses divested or discontinued subsequent to December 31, 2008.

The increase in instruments and consumables revenue was due to higher sales volumes, partly offset by lower average unit sales prices. Higher sales volumes were driven primarily by sales of consumables that are sold for use in our chemistry analyzers. The impact from changes in distributors’ inventory levels increased reported instruments and consumables revenue growth by 5%. Higher sales volumes were also attributable to sales of our Catalyst Dx® Analyzer and, to a lesser extent, our SNAPShot Dx® Analyzer and our IDEXX VetLab® Station. Instrument service and accessories revenue also contributed to revenue growth as our active installed base of instruments continued to increase. These favorable impacts were partly offset by lower average unit prices for our LaserCyte® instruments, resulting from discounts associated with customer purchase programs.

The increase in rapid assay revenue was due to the favorable impact from changes in distributors’ inventory levels, which increased reported rapid assay revenue growth by 12%. This favorable impact was partly offset by lower practice-level sales. The decrease in practice-level sales was due primarily to lower volumes of canine combination test products purchased in connection with customer programs as a result of changes in program design from the prior year, and to a lesser extent, lower sales volumes of feline combination test products in the U.S.

The increase in laboratory diagnostic and consulting services revenue resulted primarily from the impact of higher testing volume and price increases. Higher testing volume was the result of growth in our customer base.

The increase in practice information management systems and digital radiography revenue resulted primarily from higher sales volumes of companion animal radiography systems. Increased service revenue also contributed to revenue growth as our active installed base of systems continued to increase.

Water. The increase in Water revenue resulted primarily from higher Colilert® product sales volume. This favorable impact was partly offset by higher relative sales in geographies where products are sold at lower average unit sales prices.

Production Animal Segment. The increase in PAS revenue resulted primarily from higher sales volume of certain bovine tests. This favorable impact was partly offset by lower average unit sales prices.

Other. The increase in Other revenue was due primarily to higher sales volumes of OPTI Medical and Dairy products. Higher OPTI Medical sales volume was primarily attributable to sales of consumables used with our OPTI Medical instruments. Higher Dairy volume was primarily attributable to sales of our Dairy SNAP® residue test for detection of melamine.
 
 
 
20
 

Gross Profit

Total Company. The following table presents gross profit and gross profit percentages by operating segment:

For the Three Months Ended March 31,
  
Gross Profit (dollars in thousands)
  
2010
    
Percent of
Revenue
  
2009
    
Percent of
Revenue
  
Dollar
Change
    
Percentage
Change
                                     
CAG
    $ 113,330       51.2 %    $ 96,442       49.8 %    $ 16,888       17.5 %
Water
     11,214       62.8 %     11,156       70.4 %     58       0.5 %
PAS
     13,474       67.6 %     13,108       71.8 %     366       2.8 %
Other
     4,153       44.6 %     3,548       41.0 %     605       17.0 %
Unallocated amounts
     190       N/A       179       N/A       11       6.4 %
Total Company
    $ 142,361       53.0 %    $ 124,433       52.6 %    $ 17,928       14.4 %

Companion Animal Group. Gross profit for CAG increased due to higher sales volumes in all CAG product and service lines and an increase in the gross profit percentage to 51% from 50%. The increase in gross profit percentage was attributable to reduced overall spending on service and manufacturing and lower depreciation on our VetLab® instruments placed at customer sites under usage agreements, as we have reduced this type of placement activity and an increasing number of prior placements have become fully depreciated. Gross profit percentage was also favorably impacted by lower costs of service and higher selling prices in our laboratory and consulting services business. These favorable impacts were partly offset by the unfavorable impact of foreign currency hedge contracts and the unfavorable impact of exchange rates on foreign currency denominated expenses, net of the favorable impact that weakening of the U.S. dollar had on sales denominated in foreign currencies. Gross profit percentage also was negatively affected by higher relative sales of lower margin instruments and reference laboratory services.

Water. Gross profit for Water increased slightly as higher sales volumes were predominantly offset by a decrease in the gross profit percentage to 63% from 70%. The decrease in the gross profit percentage was due to higher overall manufacturing costs; the unfavorable impact of foreign currency hedge contracts and the unfavorable impact of exchange rates on foreign currency denominated expenses, net of the favorable impact that weakening of the U.S. dollar had on sales denominated in foreign currencies; and lower average unit sales prices. The gross profit percentage of 63% is relatively consistent with full year 2008 and 2009 results.

Production Animal Segment. Gross profit for PAS increased due to higher sales volumes, partly offset by a decrease in the gross profit percentage to 68% from 72%. The decrease in the gross profit percentage was due to the unfavorable impact of foreign currency hedge contracts and the unfavorable impact of exchange rates on foreign currency denominated expenses, net of the favorable impact that weakening of the U.S. dollar had on sales denominated in foreign currencies. To a lesser extent, gross profit percentage was unfavorably impacted by higher overall manufacturing costs and lower average unit sales prices. These unfavorable impacts were partly offset by higher relative sales of higher margin products.

Other. Gross profit for Other operating units increased due to higher sales volume and an increase in the gross profit percentage to 45% from 41%. The increase in the gross profit percentage was due to lower overall manufacturing costs and higher relative sales of higher margin products.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
21
 

Operating Expenses and Operating Income

Total Company. The following tables present operating expenses and operating income by operating segment:

For the Three Months Ended March 31,
Operating Expenses
(dollars in thousands)
  
2010
  
Percent of
Revenue
  
2009
  
Percent of
Revenue
  
Dollar
Change
  
Percentage
Change
                                     
CAG
  
 $
73,563
  
33.2
%
  
 $
67,363
  
34.8
%
  
 $
6,200
  
9.2
%
Water
    
4,091
  
22.9
%
    
3,844
  
24.3
%
    
247
  
6.4
%
PAS
    
8,740
  
43.8
%
    
8,158
  
44.7
%
    
582
  
7.1
%
Other
    
3,893
  
41.8
%
    
3,419
  
39.5
%
    
474
  
13.9
%
Unallocated amounts
    
3,646
  
N/A
      
3,208
  
N/A
      
438
  
13.7
%
Total Company
  
 $
93,933
  
35.0
%
  
 $
85,992
  
36.4
%
  
 $
7,941
  
9.2
%

Operating Income
(dollars in thousands)
  
2010
  
Percent of
Revenue
  
2009
  
Percent of
Revenue
  
Dollar
Change
  
Percentage
Change
                                     
CAG
  
 $
39,767
  
18.0
%
  
 $
29,079
  
15.0
%
  
 $
10,688
  
36.8
%
Water
    
7,123
  
39.9
%
    
7,312
  
46.1
%
    
(189
)
(2.6
%)
PAS
    
4,734
  
23.7
%
    
4,950
  
27.1
%
    
(216
)
(4.4
%)
Other
    
260
  
2.8
%
    
129
  
1.5
%
    
131
  
101.3
%
Unallocated amounts
    
(3,456
)
N/A
      
(3,029
)
N/A
      
(427
)
(14.1
%)
Total Company
  
 $
48,428
  
18.0
%
  
 $
38,441
  
16.3
%
  
 $
9,987
  
26.0
%

Companion Animal Group. The following table presents CAG operating expenses by functional area:

For the Three Months Ended March 31,
Operating Expenses
(dollars in thousands)
  
2010
  
Percent of
Revenue
  
2009
  
Percent of
Revenue
  
Dollar
Change
  
Percentage
Change
                                     
Sales and marketing
  
 $
37,759
  
17.1
%
  
 $
34,844
  
18.0
%
  
 $
2,915