Heska Corporation - Feltl and Company · 9/11/2012 · return multiplexed results in less than a minute (versus 8+ minutes for current state-of-the-art lateral flow and ELISA rapid

Healthcare- Diagnostic Equipment September 11, 2012

Please see important disclosures on pages 20 to 22.

Rev(mil) 2011A 2012E 2013E

Mar $19.5A $19.2A $21.2EJune $17.4A $18.3A $20.0ESept $17.6A $19.7E $20.9EDec $15.5A $19.0E $21.0E

FY $70.1A $76.1E $83.0E

P/Sales 0.6x 0.6x 0.5x

EPS 2011A 2012E 2013E

Mar $0.17A $0.11A $0.19EJune $0.09A $0.05A $0.12ESept $0.05A $0.07E $0.18EDec $0.09A $0.14E $0.18E

FY $0.40A $0.36E $0.67EP/E 20x 22x 12x

Price: $7.9952-Week Range: $13.00-$6.53Target: $13.50Rating: STRONG BUY

Shares Outstanding: 5.3 milMkt. Capitalization: $43 milAve. Volume: 35,000Instit. Ownership: 23%BV / Share: $9.15Debt / Tot. Cap.: 0%Est. LT EPS Growth: 15%

Feltl and Company Research Department 2100 LaSalle Plaza

800 LaSalle Avenue Minneapolis, MN 55402

1.866.655.3431 Ben C. Haynor, CFA

[email protected] | 612.492.8872

Company Description: Heska Corporation markets diagnostic instruments and consumables as well as develops, manufactures and markets vaccines, pharmaceuticals, and other biologicals targeted at the veterinary market. The company sells its products worldwide directly and through distributors. Heska was incorporated in 1988 and is based in Loveland, Colorado.

Heska Corporation

Severely undervalued – what the Heska? Initiating with STRONG BUY, $13.50 PT (HSKA - $7.99) STRONG BUY

Key Points

Financial Summary

Heska’s valuation compelling compared to peers.

Capital spending by veterinary offices set to return after secular decline.

New product introductions likely to spur growth.

Initiating with STRONG BUY rating and $13.50 price target (8x FY2013 EV/EBITDA).

Heska’s valuation is compelling compared to its peers. The company currently trades at 4.4x 2013 EV/EBITDA, a massive discount to other veterinary diagnostic firms at 17x 2013 EV/EBITDA, medical product distributors at 9.1x 2013 EV/EBITDA, and drug channel support firms at 8.1x 2013 EV/EBITDA. HSKA also trades below book value and offers a 5% dividend, attributes offered by none of its peers. Dynamics in the veterinarian industry served by Heska appear to be changing favorably. From 2004 through 2009, the number of practicing veterinarians grew ~30%, while the number of companion animals (pets) increased only ~5%, hurting the financial health of veterinary practices. In the last two years, however, this trend has modestly reversed as the number of veterinarians has stagnated while pet populations have grown, albeit modestly. We believe that the number of visits per veterinarian per week has likely bottomed and that as baby-boomer veterinarians retire and the economy improves, the financial health of the typical veterinary practice will improve. In addition, both IDEXX Laboratories (IDXX – HOLD) and VCA Antech (WOOF – not rated) have noted stabilization in practice visits the past two quarters after more than two years of declines. Management has noted that they plan on introducing several new products within the next few quarters. While they have been somewhat cagey as to what markets these products might compete in, we believe that these will help spur growth. We can understand the veiled stance due to the company’s past experiences with competitors preemptively attacking Heska products that were widely anticipated prior to introduction. However, the one product they have disclosed in alliance with Rapid Diagnostek is a potentially revolutionary piece of diagnostic equipment that can return multiplexed results in less than a minute (versus 8+ minutes for current state-of-the-art lateral flow and ELISA rapid assays). We believe this product will be available mid-2013 and will be very cost-competitive. Initiating coverage of Heska with a STRONG BUY rating and $13.50 price target, which represents 8x 2013 EV/EBITDA. HSKA’s current valuation of 4.4x 2013 EV/EBITDA values it at a significant discount to both veterinary diagnostic peers and lower-growth, lower-margin medical products distributors. Shares currently trade 10% below tangible book value and the company’s current share price offers a 5% dividend yield. Over the next several years the company should be able to grow revenue at ~10% and see more rapid bottom-line growth as operating expenses provide leverage opportunities. With this top-line growth, operating leverage, and new product introductions coming over the next twelve months, we do not believe Heska profiles as the “value trap” suggested by its present valuation.

September 11, 2012 rops Strong, Pricing Weak, Farm Profits Could Suffer

Feltl and Company Research Department Heska Corp. (HSKA) Page 2

INVESTMENT THESIS We believe that Heska is severely undervalued. It is exceedingly rare to find a company in the medical or veterinary space that trades under tangible book value, pays a 5% dividend, is growing both revenue and earnings while seeing operating leverage and plans to introduce a number of new products over the next twelve months. Even if we value HSKA at a discount to that of medical product distributors’ forward EV/EBITDA as opposed to more similar peers, we arrive at a price target of $13.50, or ~70% above current share prices. As such, we have assigned HSKA a STRONG BUY rating. Opportunities Valuation compelling. Heska is currently trading below its tangible book value of $8.91, carries no debt on its balance sheet, and pays a dividend amounting to ~5% per annum at current prices. The major publicly-traded veterinary diagnostic competitors trade at about ~17x our CY2013 EV/EBITDA estimates. Heska compares quite favorably in this respect, trading at only 4.4x our CY2013 EV/EBITDA estimate. Even if one assumes that Heska should be valued inline with medical distributors (as a large percentage of Heska’s revenue are dependent on selling third-party products), the company’s shares are attractively valued; on average drug channel support firms trade at 8.1x 2013 EV/EBITDA, medical product distributors trade at 9.1x 2013 EV/EBITDA, and veterinary diagnostic firms trade at 17x 2013 EV/EBITDA. Heska trades at only 4.4x 2013 EV/EBITDA presently Secular decline in veterinary market abating. The number of practicing veterinarians has grown ~30% since 2004, while the number of companion animals (pets) has grown only ~5%, hurting the financial health of veterinary practices. However, over the past several years, the number of veterinarians has stagnated while pet numbers have grown, albeit modestly. We believe that the number of visits per veterinarian per week has likely bottomed and that as baby-boomer veterinarians retire and the economy improves, the financial health of the typical veterinary practice will improve, leading to greater capital equipment sales and improved practice visit trends, ultimately resulting in increased consumable usage. New product introductions. Management has noted that they have several products in the hopper for introduction in the next year. While they remain secretive on what areas of the veterinary market these products will address, we believe that the product being developed with Rapid Diagnostek has the potential to be a game-changer. The Rapid Diagnostek platform (IntelliProbe Immunosensor) utilizes biosensors to perform quantitative immunoassays on bodily fluids to detect pathogens, proteins and other analytes within 60 seconds. The handheld system performs these tests with no need for reagents and uses disposable sensors. Heska believes that it can be commercialized midway through next year at a very competitive price point. Allergy testing and treatment leadership. Heska’s proprietary ALLERCEPT allergen panels and treatment sets may be a full product cycle ahead of competitors, in our view. The company’s chief competition in the allergy area is GREER Labs, which recently partnered with IDEXX to provide GREER’s serum allergy testing and immunotherapy through IDEXX veterinary laboratories. Veterinary allergy testing has improved over the years, but thanks to a number of “snake oil” products, some veterinarians remain skeptical. IDEXX exclusive nationwide distributor becoming nonexclusive. IDEXX recently announced that one of its exclusive nationwide distributors, MWI Veterinary Supply (MWIV – not rated) will open up to competing products come January 1, 2013. These exclusive agreements made it difficult for IDEXX’s competitors to reach veterinary practices through the distributor channel (most veterinary practices purchase from two distributors), causing them to focus on direct sales. Having access to MWI will help Heska reach accounts they formerly had difficulty accessing. Management believes there are a number of MWI accounts that currently utilize IDEXX instruments and consumables that are not completely satisfied with IDEXX and would be open to looking at Heska’s products. We have not modeled any contribution from MWI becoming nonexclusive up and believe the opportunities available will drive upside to our estimates. Economic recovery. It is well known that the recent economic slump has put a damper on physician office visits. A similar trend has also taken place in the veterinary space. An economic recovery would likely see the pet population grow as well as veterinary visits increase as new pets are acquired and pet owners who put off veterinary care in the past several years return. Since the economic downturn began, the pet population has aged, and, just as with humans, more aged pets have more lab tests conducted upon them, increasing the potential demand for Heska’s products.



Risks Much larger competitors. Both IDEXX Laboratories (IDXX – HOLD) and Abaxis (ABAX – BUY) in the veterinary diagnostics space are much larger than Heska. In the other vaccines, pharmaceuticals and products segment, Heska similarly competes with large players such as Merck, Novartis, Phizeer, Sanofi-Aventis, Bayer, Eli Lilly, CEVA Sante Animale, Vetoquinol, and Virbac. These companies have far larger sales forces and name recognition than Heska in most cases. Substantial portions of Heska’s revenue dependent on third parties. Heska relies on third parties for a majority of its revenue. On the veterinary diagnostics side of the business, the company has agreements with FUJIFILM, Boule Medical AB, Roche (RHHBY – not rated), and Quidel (QDEL – not rated) to supply instruments, consumables and technology. In other areas of the business, Heska relies on Merck (MRK – not rated) and Agri Laboratories, Ltd. to distribute certain vaccine and pharmaceutical products. IDEXX exclusive nationwide distributor becoming nonexclusive. The IDEXX agreement with MWI Veterinary Supply (MWIV – not rated) becoming nonexclusive on January 1, 2013 represents a double-edged sword to Heska. On one hand, they could theoretically gain greater access to a large, nationwide distributor to sell their products, but on the other, the risk that FUJIFILM, Boule AB, and/or Roche could decide that selling their products through MWI is preferable to manufacturing the products and allowing Heska to sell them under their own brand name. However, we believe this happening is unlikely for several reasons. First, Heska’s current contracts have multi-year consumable trailers, making it less attractive for these companies to attempt to go it alone. Second, distributors tend to focus more on consumable products and less on instruments so new installs may be tougher to come by without a direct sales force. Lastly, distributors are unlikely to provide the level of service and support required by customers. Ownership restrictions. In mid-2010, Heska’s restated certificate of incorporation was amended by stockholders. The amendment places restrictions on the transfer of HSKA shares that could harm Heska’s ability to utilize their domestic federal net operating loss (NOL) carryforward. This change prevents investors from becoming a 5-percent holder and additional stock acquisitions by existing 5-percent holders without the approval of the company’s board of directors. This amendment makes it more difficult for an acquirer to purchase the company and may prevent certain institutional investors from considering purchase of HSKA shares due to the transfer restriction. Additionally, investors may not view the ~$5/share in deferred tax assets as “tangible” when calculating book value. Veterinary practice roll-ups. In certain areas of human healthcare services, such as in the neonatal space, corporations and private equity have long been acquiring smaller practices, rolling them up into a larger entity to achieve scale. This has also been occurring in the veterinary space, with firms such as Banfield Pet Hospital, National Veterinary Associates, and VCA Antech (WOOF – not rated) acquiring practices and leveraging their scale to realize favorable pricing on instruments and consumables. Additionally, these firms tend to have their own reference laboratory services to which they send a large portion of their testing needs. Thoughts on Valuation Heska is a bit of an anomaly in the veterinary space, currently trading at ~4.4x our 2013 EV/EBITDA estimate. This represents a massive discount to its much larger peers in the space, IDEXX Laboratories and Abaxis, which trade at ~17x 2013 EV/EBITDA on average. Similarly, HSKA shares trade at a discount in terms of EV/sales as well, currently trading at 0.5x 2013 sales versus ~3.7x for both ABAX and IDXX shares. Consumables comprise a similar fraction of Heska’s revenue as their competitors. But, unlike the company’s competitors, Heska’s consumable sales are also comprised of vaccines, pharmaceuticals and allergy-related products, while its competitors’ consumable sales are nearly all diagnostic-related. We believe that some level of discount is warranted given Heska’s smaller market share and lower margins presently (due largely, we believe, to reliance on third parties for more than half of their revenue). Heska’s mid-40s gross margin is lower than its competitors, both of which boast gross margins in the mid-50s. That said, we believe the discount Heska receives due to these factors is far too severe, especially when one considers that the company also trades at a steep discount to medical supply distributors and drug channel support firms, as seen in the table below.



Veterinary DiagnosticsSymbol EV EBITDA Sales EBITDA margin EV/EBITDA EV/salesABAX 732$ 42$ 209$ 20.1% 17.4 3.5 IDXX 5,560$ 338$ 1,393$ 24.3% 16.4 4.0

Average 22.2% 16.9 3.7 Median 22.2% 16.9 3.7

Medical Products DistributorsSymbol EV EBITDA Sales EBITDA margin EV/EBITDA EV/salesMWIV 1,380$ 106$ 2,270$ 4.7% 13.1 0.6 HSIC 7,260$ 797$ 9,451$ 8.4% 9.1 0.8 PDCO 3,830$ 452$ 3,863$ 11.7% 8.5 1.0 PSSI 1,420$ 169$ 1,840$ 9.2% 8.4 0.8 OMI 1,800$ 274$ 9,312$ 2.9% 6.6 0.2

Average 7.4% 9.1 0.7 Median 8.4% 8.5 0.8

Drug Channel SupportSymbol EV EBITDA Sales EBITDA margin EV/EBITDA EV/salesCAH 13,790$ 2,407$ 100,978$ 2.4% 5.7 0.1 ABC 9,830$ 1,502$ 85,115$ 1.8% 6.5 0.1 MCK 22,490$ 3,288$ 127,332$ 2.6% 6.8 0.2 CTRX 8,650$ 622$ 15,033$ 4.1% 13.9 0.6 OCR 5,220$ 704$ 6,338$ 11.1% 7.4 0.8

Average 4.4% 8.1 0.4 Median 2.6% 6.8 0.2

HSKA 35$ 8$ 85$ 9.5% 4.4 0.4 Note: Sales and EBITDA estimates reflect each company’s fiscal year that comprises a majority of 2013.

While we believe that an argument can be made that HSKA shares should trade at multiples closer to similar veterinary diagnostics companies, we have chosen a conservative approach, valuing Heska at a discount to medical product distribution firms. To set our price target of $13.50, we have chosen to use 8x 2013 EV/EBITDA. This represents a discount to the 9.1x average forward EBITDA multiple that other medical distributors presently enjoy. We feel it prudent to factor in a discount due to the ownership restrictions placed on the company’s shares. Even if we became still more conservative and chose to value it on the medial multiple of drug channel support firms with razor-thin EBITDA margins, or 6.8x, this would equate to a target of ~$12.50 and would similarly warrant a STRONG BUY rating. Regardless, we think HSKA shares are severely undervalued. Key Model Assumptions For the remainder of 2012, we have built our model conservatively relative to the company’s guidance. Our 2012 estimates as compared with management guidance is shown in the table below. We have chosen to be conservative due to commentary by other industry participants stating that Q2 2012 weakened as the quarter progressed. We believe the company has over-accrued for income taxes so far this year, which may reverse in Q4 and provide upside to our $0.14 estimate for the quarter.

2012 Heska Guidance versus Feltl Estimates Quarter and Metric Guidance Feltl Estimate Q3 Revenue “a little over $20 million” $19.7 million Q3 Gross margin “approximately 42%” 42% Q3 Operating expenses “approximately $7.5 million” $7.7 million Q3 EPS “approximately $0.09” $0.07 Q4 Revenue $19.5 million (implied) $19.0 million Q4 Gross margin 44% (implied) 44% Q4 Operating expenses $7.0 million (implied) $7.1 million Q4 EPS $0.18 (implied) $0.14



Based upon our discussions with management as to strategies to grow the sales force, research and development projects, and other expectations, we have modeled EPS of $0.67 on revenue of $83.0 million for 2013. We believe that operating expenses will increase only modestly in 2013 as sales force additions will take place only as warranted by the market. We assume that gross margin can increase 50bps in 2013 to 44.6%, a modest improvement given the 9.1% top line growth we have modeled. For Heska’s OVP segment, we have modeled a constant $3 million per quarter in 2013. Going forward, we have assumed the share count will increase by 50,000 shares per quarter, due to their recently declared $0.10/quarter dividend offsetting the company’s ability to repurchase shares. Company Overview Company Brief Heska develops, manufactures, markets and sells veterinary products for companion animals in the United States and internationally. They report in two segments: Core Companion Animal Health (CCA) and Other Vaccines and Pharmaceuticals and Products (OVP). The Core Companion Animal Health segment is the largest segment in the company, including diagnostic instruments and supplies as well as a single use diagnostic and other tests, vaccines and pharmaceuticals. These products represent 82% of full year revenues, as seen in the chart below, with OVP making up the balance (18%). OVP revenues are generated from private label vaccine and pharmaceutical production. Heska faces three primary competitors in diagnostics - IDEXX Laboratories, Abaxis, and Synbiotics Corporation. A number of independent animal health companies and major pharmaceutical companies compete against Heska’s OVP segment.

Source: Company filings.

The company sells its products direct and through distributors. In the US, they sell their instruments direct to the end-user in most cases. Heska was founded in 1988 and is based in Loveland, Colorado. The company has several facilities worldwide, with a 60,000 square foot facility in Loveland, a 168,000 square foot facility in Des Moines, Iowa, and a facility in Fribourg, Switzerland. Product Overview Point-of-Care Veterinary Diagnostics Heska offers two models of chemistry analyzers, a hematology analyzer, and a blood gas and electrolyte analyzer for use in the veterinary practice. Their DRI-CHEM 4000 and DRI-CHEM 7000 chemistry analyzers rely on FUJIFILM slide technology and can test up to 25 parameters, shown in the table below, on an individual parameter basis or as part of a panel. Multiple slides can be stacked to create a custom panel or add additional tests to pre-packaged panels (up to 22 tests or 20 slides). The DRI-CHEM 7000 can run five comprehensive panels in 30 minutes or five pre-surgical panels in 16 minutes. Both



instruments offer automated dilution, consolidated printed reports, and the ability to eliminate pipetting from the centrifuge to the analyzer. Heska’s chemistry analyzers run slower than the latest generation of chemistry instruments available from Abaxis (~12 minutes) and IDEXX (~8 minutes for the CatalystDx). FUJIFILM provides both the instruments and test slides to Heska.

Source: Company marketing materials.

The company offers the HemaTrue hematology analyzer, shown below. The HemaTrue analyzer can provide a result in less than a minute using only one drop of blood, which is as fast or faster than competitors’ analyzers. Boule Medical AB provides the instruments and reagents to Heska.


Heska’s VitalPath blood gas and electrolyte analyzer, shown below, delivers results on 35 parameters in less than a minute. Roche provides the company with the instrument and related consumables. The product was launched in May 2010.




Rapid Assays The following table details Heska’s rapid assay offerings along with those offered by its larger competitors. Heska’s line is more limited than IDEXX’s and Abaxis’, but they offer the only in-clinic urine test to diagnose microalbuminuria which is used to assess and monitor the progression of kidney damage. This test is offered for both dogs and cats. Quidel provides Heska with the test strips for the heartworm diagnostic products.

Rapid Assays Offered by IDEXX, Abaxis and Heska

IDEXX Abaxis Heska Canine Heartworm Yes Yes Yes Ehrlichiosis Yes In Development No Lyme Disease Yes Yes No Canine Parvovirus Yes Yes No Anaplasmosis Yes No No Feline Heartworm Yes Yes Yes Feline Immunodeficiency Virus Yes No No Feline Leukemia Virus Yes No No Feline Pancreatitis Yes No No Canine Pancreatitis Yes No No Giardia Yes Yes No Parvovirus Yes Yes No Total T4 Yes Reagent Disc No Cortisol Yes No No Bile Acids Yes Reagent Disc No Bovine Viral Diarrhea Yes No No Foal Immunoglobulin G Yes No No Avian Flu No Yes No Microalbuminuria No No Yes

Rapid Diagnostek Product Last year, Heska announced a research, development and commercial agreement with Rapid Diagnostek to launch Rapid Diagnostek’s Intelliprobe Immunosensor platform (shown below) for companion animal diagnostics. This patented, proprietary platform can detect bacteria, viruses, spores, proteins, and other disease biomarkers in less than 60 seconds, which compares very favorably to current lateral flow or ELISA rapid assays which take eight minutes or more. The tests can be multiplexed and have the ability to utilize blood, urine, saliva and other bodily fluids. Management believes they will be able to launch the product midway through next year with a number of initial tests at a very cost-competitive price point. We would anticipate that the initial tests would be in the areas of heartworm, Lyme disease, and ehrlichia testing. Post-launch, the company intends on bringing additional tests to market over time. We believe this platform has the ability to be a game-changer for Heska; it stacks up very well versus lateral flow tests in single-test format and has the attributes to compete against IDEXX’s SNAP 4Dx ELISA-based tests in multiplexed format. We do not assume the initial tests offered on the platform will be multiplexed, however.



Source: Company website.

ALLERCEPT Allergy Treatment Heska currently offers ALLERCEPT Definitive Allergen panels for diagnosing pet allergies and ALLERCEPT Allergy Treatment Sets. The treatment sets are formulated specifically for each animal and contain only the allergens to which the animal has significant levels of IgE (Immunoglobulin E) antibodies. The prescriptions can be administered as a series of injections with increasing doses over several months (usually at the veterinarian’s office) or as sublingual immunotherapy (SLIT). SLIT delivers drops under the tongue of the animal twice a day and is generally administered by the pet owner, improving compliance. SLIT has been shown in studies to be ~60% effective. We estimate ALLERCEPT products account for 5%-8% of Heska’s revenue and are growing more rapidly than the company as a whole. Allergies are one of the main reasons pet owners visit the veterinarian and the most often reason pet owners switch veterinarians. Thus, it is reasonable to think that veterinarians have a strong incentive to administer quality allergy care. However, a number of companies have offered “solutions” (akin to “snake-oil” supplements in humans that promise to cure everything from AIDS to dyslexia) to allergy issues that have not been proven successful and have muddied the water of the allergy treatment market and disappointed a large number of veterinarians and pet owners. This has made the sale more difficult for companies like Heska. We believe Heska’s ALLERCEPT allergy treatment and tests are at the leading edge of allergy diagnostics and treatment. Veterinary allergy treatment is in the early stages of adoption; we estimate that relative to the potential market, allergy treatment of ALLERCEPT’s type is less than 5% penetrated. Estimates vary as to the number of dogs and cats that are affected by allergies, but it is generally thought to be in the 10%-15% range for both species. A Novartis survey of 1,269 pet owners conducted in spring 2012 placed allergy incidence at 18% for dogs and 14% for cats. Based upon these findings, approximately 14 million dogs and 12 million cats in the US suffer from allergies. However, the survey also found that ~80% of pet owners are unable to diagnose symptoms of allergies and, of those pets that do make it to the veterinarian, 70%-80% of the time the pet winds up on steroids or immunosuppressants. At an estimated $300-$500 per round of treatment, we estimate that the theoretical addressable market is between $300 million and $750 million. With continued pet owner and veterinarian education efforts and further market development, we believe Heska has the potential to reach $50-$75 million in ALLERCEPT sales over a five-year time horizon.

Pharmaceuticals, Vaccines, Supplements, and Other Biologicals Heska manufactures a number of pharmaceuticals, vaccines, supplements and other biologicals. The largest of which is the TRI-HEART Plus chewable tablets, a heartworm preventative which Heska has granted Schering-Plough Animal Health Corporation (a unit of Merck) distribution and marketing rights in the US and make up ~10% of Heska’s revenue. The company also sells THYROMED chewable tablets for treatment of hypothyroidism in dogs, a common endocrine disorder in older animals; this product is a daily supplement that is used for the life of the animal. They also sell FELINE ULTRANASAL FVRCP vaccine, a three-way modified live vaccine combination directed at preventing the three most common respiratory viruses in cats (calicivirus, rhnotracheitis virus, and panleukopenia virus); the vaccine is administered as a liquid preparation into the nostrils of cats to avoid injection site-associated side effects. Lastly, Heska sells a fatty acid



supplement, HESKA F.A. Granules containing a proprietary blend of fatty acids and vitamins and flavored for ease of administration. Other Core Companion Animal Health Products Heska also has several other products that fall under the Core Companion Animal Health (CCA) segment. In analyzers, they also offer the Accutrend Plus Lactate analyzer, a portable, handheld device for which Roche provides the instrument and consumables. Additionally, Heska offers the VET/IV 2.2 infusion pump, a compact IV pump used to deliver drugs or nutritional products manufactured by Caesarea Medical Electronics, Ltd. of Israel. Other Vaccines, Pharmaceuticals and Products (OVP) Segment The OVP segment consists of products sold by third parties under third party labels that are manufactured by Heska. The largest portion of revenue in this segment comes from a long-term agreement with Agri Laboratories, Ltd., which sells bovine vaccines licensed by the USDA under the Titanium and MasterGuard brands. Other offerings in this segment include research, production, packaging, and other services provided to third parties. The vast majority of these products are manufactured in Heska’s 168,000 square foot facility in Des Moines, Iowa. Veterinary Market Overview Approximately 61,000 veterinarians in roughly 30,000 veterinary clinics serve the companion and production animal veterinary care market in the U.S. A large number of veterinarians have entered the practice in the last decade, with practicing veterinarians growing by 30% from 2004 through 2009 while the number of cats and dogs increased only 5% over the same time period. This has placed a strain on veterinarian office income. Both the number of new clients a veterinarian obtains annually and the median active client population has declined steadily since 2001, as seen in the chart below. The financial strain placed upon vet offices has been exacerbated by the unsophisticated financial discipline of many practices; an American Veterinary Medical Association survey, done in conjunction with Pfizer (PFE – not rated), reported that 62% of practice owners don’t use financial concepts to manage their businesses. Additionally, veterinarians, as a whole, have the lowest profit margin of any independent medical practice, ~10%, and some of the lowest total earnings. Even chiropractors attain a higher profit margin and total earnings. The recent economic environment and lack of financial sophistication in veterinary clinic management, in our view, has suppressed investment in the practice, particularly in terms of capital equipment purchases.

Clients per Full-Time Veterinarian

1,299 1,278

1,1841,141

1,070271

250243

230

218800

900

1,000

1,100

1,200

1,300

1,400

2001 2003 2005 2007 2009

Med

ian

Act

ive

Cli

ents

200

225

250

275

300M

edia

n N

ew C

lien

ts

Median Active Clients per Veterinarian

Median New Clients per Veterinarian

Source: American Animal Hospital Association PulsePoints 2002-2010.



Over the past 25 years, the median number of visits per week per veterinarian has consistently stayed above 60. The metric peaked at 76 in 2000, but has declined to 66 visits per week per veterinarian in 2009. We believe the decline has largely been caused by the growth in practicing veterinarians (roughly 30% growth from 2004-2009) outstripping the growth in the companion animal population (~5% for dogs and cats from 2004-2009).

Patients/Veterinarian/Week

7576

73

68

66

60

65

70

75

80

1997 2000 2003 2006 2009

Source: 2009 DVM State of Profession Survey.

Another way of looking at the decline in visits is the ratio of companion animals per private practice veterinarian, shown below. The number of veterinarians has stayed consistent over the past several years, increasing by approximately 3%, likely due to baby boom generation veterinarians retiring. Based on this trend, we estimate that the visits per week per veterinarian stands at roughly 63 today, absent any economic effects. On the economic front, a late-2010 poll by NCVEI showed that over 70% of veterinary practices saw their number of veterinary visits stay stagnant or decline versus 2009, implying that veterinary visits continue to slow as well, being the number of practicing veterinarians has stayed relatively constant over the past few years. That being said, the stagnation in the growth of veterinary practitioners, combined with the slow growth in pet population should, in our view, soon lead to a bottoming out of the secular trend that has reduced the number of visits per veterinarian. We believe this will result in better financial health of veterinary practices, which, in turn, will lead to a rebound in capital equipment purchases (and resulting consumable volumes) in coming years.

Companion Animals per US Veterinarian

2,500

2,600

2,700

2,800

2,900

3,000

3,100

2005 2006 2007 2008 2009 2010

Source: American Pet Products Association, American Veterinary Medicine Association. Note: Intervening years interpolated using biennial data.



Workforce Needs in Veterinary Medicine In late May 2012, The National Academy of Science released a prepublication version of Workforce Needs in Veterinary Medicine, a five-year study of the future workforce needs in the veterinary industry through 2016. The publication was funded by the Association of American Veterinary Medical Colleges, the American Veterinary Medical Association, the American Animal Hospital Association, Bayer Animal Health and the Burroughs Welcome Fund. Please note that all of the charts contained within this section are sourced from this publication with attribution given as referenced in the prepublication version. Key Takeaways

The demand for new companion animal veterinarians is projected to outstrip the supply through 2016, although there is little evidence for widespread workplace shortages at present.

Entering veterinary medicine is not a high ROI decision for most practitioners. Veterinarian income has stagnated over the past five to seven years and tends to run in 10-15 year cycles of

growing versus stagnating income. Student debt acquired during vet school has grown far faster than incomes for graduating veterinarians. We believe a combination of the above factors will result in stronger practice economics for companion animal

veterinarians and the potential for increased spending on capital equipment and serves to support our thesis that the secular headwinds experienced by the veterinary industry over the past five to seven years are abating.

Supply and Demand for Companion Animal Veterinarians to 2016 The prepublication version of Workforce Needs in Veterinary Medicine attempted to forecast the supply and demand for companion animal veterinarians through 2016. The authors first estimated the number of pet visits per full-time equivalent veterinarian using 2006 data, which led to an estimate of 3,918 visits per Doctor of Veterinary Medicine (DVM) per year. Based upon this result, they forecast the range of visits per week and came up with 70-87 visits per week per DVM. They then estimated the number of pet visits per US resident and forecast this forward to 2016 based upon the Census Bureau’s population projections. This resulted in an anticipated demand for companion animal veterinarians in 2016 of 50,805 to 65,950 full-time equivalent (FTE) veterinarians. To forecast the supply of veterinarians, the committee looked at the current supply and demographics of practicing companion animal veterinarians. They assumed that vets less than 65 years old in 2016 would be working full time, those that were 65-70 would equate to 0.25 FTE each, and assumed an average career span of 35 years. This resulted in an estimate of 38,329 FTE veterinarians that are currently practicing that will still be practicing in 2016. To estimate the new supply of recently-graduated DVMs, they looked at enrollment trends in North American and worldwide accredited veterinary schools and projected the number of graduates that would practice in the US. By assuming that the number that would go into companion animal medicine on a full-time equivalent basis would stay constant with past relationships, they estimated 13,116 new companion animal DVMs would enter the market over this time frame. Together, this equates to a total supply of 51,445 full-time equivalent companion animal DVMs. Thus, if the National Academy of Sciences’ estimates prove correct, the US will experience a surplus of 640 or a deficit of 14,505 companion animal DVMs. Economics of Entering Veterinary Practice The report criticizes the veterinary profession for allowing the return on investment of a veterinary education to become unsustainable. The chart below illustrates the mean starting salary for new Doctor of Veterinary Medicine (DVM) graduates versus the student debt acquired to gain the degree. Student debt has risen nearly 40% over the 2006-2011 time period while starting salaries have increased only modestly over the period.



Student Debt and Mean Starting Salary for New DVM Graduates

Source: American Veterinary Medical Association.

Another way of looking at the value received for the cost of a DVM education is to calculate the rate of return on investment. Clearly, even if a starting salary is low and the amount of student debt acquired is high, the ROI may be fabulously positive if income in later years increases rapidly. Studies have calculated that the ROI for a baccalaureate degree as compared to a high school diploma is roughly 13% to 16% (using a real interest rate of 3%). This calculation becomes slightly more difficult due to differences in hours worked between male and female veterinarians; female vets generally work fewer hours than their male counterparts. The chart below shows the disparities in male and female vets whether they own their own practice or not.

Mean Incomes in Small-Animal Practice

Source: Calculated from American Veterinary Medical Association data 2007.

The National Academy of Sciences calculated a similar measure for the various genders and roles featured in the chart above. The results are shown in the table below and illustrate that the ROI generated by obtaining a DVM degree is positive, but not massively so, especially in the cases where a DVM remains in an associate role. The publication also notes that as national chains of veterinary clinics grow, the proportion of practicing veterinarians who are associates will increase as well.



Estimated Average Rate of Return for Obtaining a DVM

Source: Calculated from AVMA earnings data and AAVMC, 2009.

In comparison to other medical professions, becoming a veterinarian does not stack up well in terms of years of education to achieve a given level of income. The chart below shows a variety of other medical professions in these terms, illustrating that it may be likely that becoming a dental hygienist carries a higher lifetime ROI than becoming a veterinarian.

Source: Bureau of Labor Statistics, MGMA 2011.

Trends in Veterinarian Income We noted in our initiation that the number of practicing companion and production animal veterinarians increased ~30% over the 2004 through 2009 time period and that this has coincided with a decline in the number of pet visits per week per veterinarian as the pet population grew more slowly than the number of practicing veterinarians. The chart below shows trends in income for various groups of veterinarians over a longer time horizon. Veterinarian income looks to be somewhat cyclical, running in 10-15 year cycles. The 1980s were a rough decade for veterinarians as they experienced flat to declining incomes, which they recouped from the mid-1990s to early 2000s. If the cycle holds, and the National Academy of Sciences is correct that companion animal veterinarians should see demand outstrip supply over the coming years, we would expect veterinarian income to resume its previous uptrend in the next couple of years, assisting the financial health of the average vet practice.



Mean DVM Income in Private Practice (2006 dollars)

Source: AVMA annual compensation reports.

As one can see in the chart below, the sharply rising level of new DVM graduates likely affected the average income of a veterinarian throughout the 1980s and early 1990s as the market struggled to accelerating graduate population that took place throughout the 1970s through early 1980s. While the number of graduates continues to increase, the newly minted DVMs are replacing those that graduated prior to 1980 as the baby boom generation of vets begins to retire.

New DVM Graduates in the United States

Source: AVMA with extrapolation based on current enrollments

Recent Practice Visit Trends IDEXX is able to track practice visits and practice revenue for a subset of their Cornerstone practice management software customers. The quarterly practice visit and revenue metrics IDEXX has reported over the past several years suggest that this turn is beginning to occur, as practice visits saw their first positive print (+1.0%) in three years in Q4 2011. This is consistent with commentary from VCA Antech (WOOF – not rated), an operator of animal hospitals, which similarly noted positive same store sales growth in the second half of 2011. The first half of 2012 was much improved relative to the last several years, but certain players noted softness in the back half of Q2 2012.



Source: Company reports.

Veterinary Diagnostic Instruments, Consumables and Rapid Assays The following chart depicts the sales volume for the three publicly traded companies (Abaxis, Idexx Laboratories, and Heska Corporation) focused on the veterinary diagnostics market. IDEXX Laboratories is the largest firm in the industry in every segment. The fact that IDEXX has exclusive distribution contracts with the three largest veterinary health product distributors clearly has helped maintain their lead. However, IDEXX has announced its intentions to open up one of their formerly exclusive distributors, MWI Veterinary Supply (MWIV – not rated), beginning January 1, 2013. We believe Abaxis and Heska will be the largest beneficiaries; based upon industry commentary, it appears that most veterinary practices purchase the vast majority of their supplies from two chosen distributors, which are likely to be the large nationwide distributors IDEXX previously had locked up under exclusive agreements.

CY2011 Revenue by Category

0

100

200

300

400

500

600

IDXX ABAX HSKA

$ (m

illio

ns)

Instruments Consumables Rapid Tests

Source: Company reports, Feltl and Company estimates.

In terms of tests available on the each company’s instrument platform, the following table compares the analytes available as consumable tests on the chemistry side. Both Abaxis and IDEXX have analytes available for testing that Heska does not. However, Heska does not have any analyte tests available that either IDEXX or Abaxis are unable to test.



Analyte Tests Offered by Abaxis, IDEXX and Heska Test Method Abbreviation Abaxis IDEXX Heska Alanine aminotransferase ALT Yes Yes Yes Albumin ALB Yes Yes Yes Alkaline phophatase ALP Yes Yes Yes Ammonia NH3 No Yes No Amylase AMY Yes Yes Yes Aspartate aminotransferase AST Yes Yes Yes Bile acids BA Yes No No Calcium CA Yes Yes Yes Canine heartworm antigen CHW Yes No No Chloride CL- Yes Yes Yes Creatine kinase CK Yes Yes Yes Creatinine CRE Yes Yes Yes Gamma glutamyltransferase GGT Yes Yes Yes Glucose GLU Yes Yes Yes Lactate LAC No Yes No Lactate dehydrogenase LD Yes Yes Yes Lipase LIPA No Yes No Magnesium MG Yes Yes Yes Phosphorous PHOS Yes Yes Yes Potassium K+ Yes Yes Yes Sodium NA+ Yes Yes Yes Thyroxine T4 Yes Yes No Total bilirubin TBIL Yes Yes Yes Total carbon dioxide tCO2 Yes No Yes Total cholesterol CHOL Yes Yes Yes Total protein TP Yes Yes Yes Urea nitrogen BUN Yes Yes Yes Uric acid UA Yes Yes Yes

Source: Company sales literature. Rapid assays are used for testing for the presence of a biochemical, often as a part of annual screening for parasites such as heartworm, Lyme disease and Ehrlichiosis. IDEXX has a wide range of rapid assays available for the veterinary market, including several tests that combine several of the following individual tests. However, most rapid assays on the market screen for only one biochemical marker shown in the table below. Abaxis has several rapid assays in development and offers a couple of the substances IDEXX’s assays screen for on their reagent discs. As noted previously, Heska provides the only rapid assay to detect microalbuminuria.

Rapid Assays Offered by IDEXX, Abaxis and Heska IDEXX Abaxis Heska Canine Heartworm Yes Yes Yes Ehrlichiosis Yes In Development No Lyme Disease Yes Yes No Anaplasmosis Yes No No Feline Heartworm Yes Yes Yes Feline Immunodeficiency Virus Yes No No Feline Leukemia Virus Yes No No Feline Pancreatitis Yes No No Canine Pancreatitis Yes No No Giardia Yes Yes No Parvovirus Yes Yes No Total T4 Yes Reagent Disc No Cortisol Yes No No Bile Acids Yes Reagent Disc No Bovine Viral Diarrhea Yes No No Foal Immunoglobulin G Yes No No Avian Flu No Yes No Microalbuminuria No No Yes

Veterinary Reference Laboratory Market



The US veterinary reference laboratory market is essentially a duopoly at present, with VCA Antech and IDEXX being the dominant players as seen in the chart below. The market recently became more competitive as Abaxis entered in partnership with Kansas State University. While Abaxis’ reference lab business is still in its early stages, it is clear that the company is attempting to emulate IDEXX’s successful strategy of bundling reference laboratory services with instruments and consumables. Based upon Abaxis’ management commentary, they were willing to compete on price in an effort to gain customers for their recently launched effort. We believe there is risk of pricing pressure in the veterinary lab market with Abaxis and Heska attempting to emulate IDEXX’s strategy and by virtue of the fact that operating margins for veterinary reference labs with scale, such as VCA Antech’s and IDEXX’s, are roughly double that of human reference laboratories. For example, VCA Antech’s laboratory operating margin was 37.8% in 2011 compared to 13.3% for Quest Diagnostics (DGX – not rated) and 17.1% for Laboratory Corporation of America (LH – not rated).

Veterinary Laboratory US M arket Share 2011 Estim ated Total Market $750-780M

IDXX37%

WOOF41%

Other22%

IDXX WOOF Other

Source: Company filings, Feltl and Company estimates.

Management Robert B. Grieve, Ph.D. - Chairman and Chief Executive Officer Dr. Grieve was named Chief Executive Officer effective January 1, 1999, Vice Chairman effective March 1992 and Chairman of the Board effective May 2000. Dr. Grieve also served as Chief Scientific Officer from December 1994 to January 1999 and Vice President, Research and Development, from March 1992 to December 1994. He has been a member of Heska’s Board of Directors since 1990. Michael J. McGinley, Ph.D. - President and Chief Operating Officer Dr. McGinley was appointed President and Chief Operating Officer effective January 1, 2009. He previously served as Vice President, Global Operations from April through December 2008, Vice President, Operations and Technical Affairs and General Manager, Heska Des Moines from January 2002 to April 2008 and in other positions beginning in June 1997. Prior to joining Heska, Dr. McGinley held positions with Bayer Animal Health and Fort Dodge Laboratories. Jason A. Napolitano - Executive Vice President, Chief Financial Officer and Secretary Mr. Napolitano was appointed Executive Vice President and Chief Financial Officer in May 2002. He was appointed Secretary in February 2009. He also served as Secretary from May 2002 to December 2006. Prior to joining Heska, he was a financial consultant. From 1990 to 2001, Mr. Napolitano held various positions at Credit Suisse First Boston, an investment bank, including Vice President in health care investment banking and Director in mergers and acquisitions.



Joe Aperfine - Executive Vice President, Sales & Marketing Prior to joining Heska, Mr. Aperfine held positions with Banfield The Pet Hospital (“Banfield”), most recently as Chief Learning Officer. Mr. Aperfine was an officer of Banfield since September 2004. Mr. Aperfine was Chief Operating Officer at Merlin Digital Technology, a diagnostic imaging and telemedicine business which shared management and ownership with Banfield, from September 2004 until Merlin’s sale in March 2009. He was Vice President of Sales for Novartis Animal Health from May 2003 to September 2004. Mr. Aperfine was employed by IDEXX Laboratories, Inc. in various positions from March 1996 to May 2003.

September 11, 2012


Heska Corporation (HSKA) Ben Haynor, CFA612.492.8872

[email protected]

Income Statement 2010 Q1 Q2 Q3 Q4 2011 Q1 Q2 Q3E Q4E 2012E Q1E Q2E Q3E Q4E 2013ERevenue, net:Core companion animal health (CCA) 55.7 16.4 14.0 14.3 12.8 57.5 16.6 15.7 16.0 16.3 64.6 18.2 17.0 17.9 18.0 71.0

Y/Y growth -16.2% 4.1% 2.1% 0.8% 6.4% 3.3% 0.8% 12.0% 12.0% 28.0% 12.4% 10.0% 8.0% 12.0% 10.0% 10.0%Q/Q growth 37.1% -14.7% 1.7% -10.6% 30.0% -5.3% 1.7% 2.2% -71.8% -7.0% 5.5% 0.4%

Other vaccines, pharmaceuticals and products (OVP) 9.8 3.1 3.4 3.3 2.8 12.6 2.6 2.6 3.7 2.7 11.6 3.0 3.0 3.0 3.0 12.0Y/Y growth 6.1% 61.1% 148.8% -4.2% -9.1% 28.5% -15.3% -24.9% 10.6% -1.9% -8.1% 15.6% 16.7% -18.9% 11.1% 3.8%Q/Q growth 1.2% 11.7% -2.3% -17.8% -5.7% -1.0% 44.0% -27.0% -74.1% 0.0% 0.0% 0.0%

Total revenue 65.5 19.5 17.4 17.6 15.5 70.1 19.2 18.3 19.7 19.0 76.1 21.2 20.0 20.9 21.0 83.0Y/Y growth -13.5% 10.2% 15.5% -0.2% 3.3% 7.0% -1.7% 4.7% 11.7% 22.7% 8.7% 10.8% 9.2% 6.2% 10.2% 9.1%Q/Q growth 29.9% -10.6% 0.9% -11.9% 23.7% -4.7% 7.7% -3.3% -72.1% -6.0% 4.7% 0.3%

Cost of revenue 40.7 11.2 10.0 10.8 8.9 40.9 10.3 10.2 11.4 10.7 42.5 11.8 11.2 11.5 11.5 46.0

Gross profit 24.8 8.3 7.5 6.8 6.6 29.2 8.9 8.0 8.3 8.4 33.6 9.5 8.8 9.4 9.4 37.1Gross margin 37.9% 42.5% 42.8% 38.8% 42.5% 41.7% 46.5% 44.0% 42.0% 44.0% 44.1% 44.5% 44.0% 45.0% 45.0% 44.6%

Operating expenses:Selling and marketing 14.7 4.0 3.6 3.8 3.9 15.2 4.9 4.8 4.7 4.5 18.8 4.7 4.7 4.7 4.7 18.8

% of sales 22.5% 20.3% 20.5% 21.3% 25.0% 21.6% 25.5% 26.0% 23.9% 23.7% 24.7% 22.1% 23.6% 22.5% 22.4% 22.6%Research and development 1.6 0.3 0.7 0.3 0.3 1.7 0.3 0.2 0.3 0.3 1.0 0.3 0.3 0.3 0.3 1.2

% of sales 2.4% 1.7% 4.0% 1.8% 2.0% 2.4% 1.7% 1.1% 1.3% 1.3% 1.4% 1.4% 1.5% 1.4% 1.4% 1.4%General and administrative 8.1 2.5 2.3 2.4 2.0 9.1 2.6 2.7 2.7 2.3 10.3 2.7 2.7 2.7 2.7 10.8

% of sales 12.4% 12.6% 13.2% 13.4% 12.8% 13.0% 13.7% 14.8% 13.7% 12.1% 13.6% 12.7% 13.5% 12.9% 12.9% 13.0%

Total operating expenses 24.4 6.8 6.6 6.4 6.2 25.9 7.8 7.7 7.7 7.1 30.2 7.7 7.7 7.7 7.7 30.8

Operating income 0.4 1.5 0.9 0.4 0.4 3.2 1.1 0.4 0.6 1.3 3.4 1.8 1.1 1.7 1.7 6.3Operating margin 0.5% 7.9% 5.1% 2.3% 2.7% 4.6% 5.6% 2.1% 3.1% 6.9% 4.5% 8.2% 5.5% 8.1% 8.3% 7.6%

EBITDA 2.7 2.1 1.4 0.9 0.8 5.3 1.5 0.8 1.1 1.8 5.2 2.2 1.5 2.2 2.2 8.1EBITDA margin 4.1% 11.0% 8.0% 5.2% 5.4% 7.6% 7.8% 4.5% 5.4% 9.3% 6.8% 10.4% 7.7% 10.3% 10.4% 9.7%

Interest and other expense, net 0.3 0.0 0.1 -0.1 -0.2 -0.1 0.1 -0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 -0.1

Income before income taxes 0.1 1.5 0.7 0.5 0.6 3.4 0.9 0.4 0.6 1.3 3.4 1.8 1.1 1.7 1.8 6.4

Total income tax expense 0.1 0.6 0.3 0.2 0.1 1.2 0.4 0.2 0.3 0.5 1.3 0.7 0.4 0.7 0.7 2.5Tax rate 73.9% 39.6% 38.7% 39.0% 23.4% 36.3% 37.9% 40.5% 40.0% 40.0% 39.5% 40.0% 40.0% 40.0% 40.0% 40.0%

Net income 0.0 0.9 0.5 0.3 0.5 2.1 0.6 0.3 0.4 0.8 2.0 1.1 0.7 1.0 1.1 3.8Net margin 0.0% 4.7% 2.6% 1.6% 3.1% 3.1% 3.0% 1.4% 1.9% 4.2% 2.7% 5.0% 3.4% 5.0% 5.0% 4.6%

Basic EPS 0.00$ 0.18$ 0.09$ 0.05$ 0.09$ 0.41$ 0.11$ 0.05$ 0.07$ 0.15$ 0.38$ 0.20$ 0.12$ 0.19$ 0.19$ 0.70$ Diluted EPS 0.00$ 0.17$ 0.09$ 0.05$ 0.09$ 0.40$ 0.11$ 0.05$ 0.07$ 0.14$ 0.36$ 0.19$ 0.12$ 0.18$ 0.18$ 0.67$

Basic shares outstanding 5.2 5.2 5.2 5.2 5.2 5.2 5.3 5.3 5.4 5.4 5.3 5.4 5.4 5.5 5.5 5.5Diluted shares outstanding 5.3 5.3 5.4 5.4 5.3 5.3 5.4 5.6 5.6 5.7 5.6 5.6 5.7 5.7 5.8 5.7

Balance Sheet Cash and cash equivalents 5.5 5.6 5.7 7.5 6.3 6.3 6.0 7.6 5.2 4.4 4.4 5.9 9.3 9.5 11.3 11.3Total current assets 27.3 30.1 28.4 30.1 28.9 28.9 30.7 29.7 31.1 32.4 32.4 33.2 33.7 36.0 37.7 37.7Total assets 63.0 64.1 61.8 63.0 61.9 61.9 63.9 63.2 64.7 66.0 66.0 67.0 67.5 69.9 71.8 71.8

Line of Credit 3.1 3.4 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Total current liabilities 12.7 12.8 9.7 10.9 9.3 9.3 11.0 10.5 11.7 12.0 12.0 11.5 11.3 12.3 12.7 12.7Long- term debt, net of current portion and other 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Total liabilities 17.3 17.3 14.1 15.1 13.5 13.5 15.0 14.4 15.5 15.7 15.7 15.1 14.8 15.7 16.0 16.0

Total stockholders' equity 45.8 46.9 47.7 47.9 48.4 48.4 48.9 48.8 49.2 50.3 50.3 51.9 52.8 54.3 55.8 55.8

Cash per share 1.05$ 1.06$ 1.09$ 1.44$ 1.21$ 1.21$ 1.14$ 1.43$ 0.97$ 0.82$ 0.83$ 1.09$ 1.71$ 1.73$ 2.03$ 2.06$ Book value 8.77$ 8.96$ 9.12$ 9.15$ 9.24$ 9.25$ 9.30$ 9.15$ 9.15$ 9.27$ 9.41$ 9.61$ 9.68$ 9.87$ 10.05$ 10.19$

September 11, 2012


Analyst Certification

I, Ben Haynor, CFA, certify that the views expressed in this research report accurately reflect my personal views about the subject company and its securities. I also certify that I have not been, am not, and will not be receiving direct or indirect compensation related to the specific recommendations expressed in this report.

Important Disclosures: The analyst or a member of his/her household does not hold a long or short position, options, warrants, rights or futures of this security in their personal account(s). As of the end of the month preceding the date of publication of this report, Feltl and Company did not beneficially own 1% or more of any class of common equity securities of the subject company. There is not any actual material conflict of interest that either the analyst or Feltl and Company is aware of. The analyst has not received any compensation for any investment banking business with this company in the past twelve months and does not expect to receive any in the next three months. Feltl and Company has not been engaged for investment banking services with the subject company during the past twelve months and does not anticipate receiving compensation for such services in the next three months. Feltl and Company has not served as a broker, either as agent or principal, buying back stock for the subject company’s account as part of the company’s authorized stock buy-back program in the last twelve months. No director, officer or employee of Feltl and Company serves as a director, officer or advisory board member to the subject company. Feltl and Company Rating System: Feltl and Company utilizes a four tier rating system for potential total returns over the next 12 months.

Strong Buy: The stock is expected to have total return potential of at least 30%. Catalysts exist to generate higher valuations, and positions should be initiated at current levels. Buy: The stock is expected to have total return potential of at least 15%. Near term catalysts may not exist and the common stock needs further time to develop. Investors requiring time to build positions may consider current levels attractive. Hold: The stock is expected to have total return potential of less than 15%. Fundamental events are not present to make it either a Buy or a Sell. The stock is an acceptable longer-term holding. Sell: Expect a negative total return. Current positions may be used as a source of funds.

9/11/2012Ratings Distribution for Feltl and Company

------ Investment Banking ------ Number of Percent Number of Percent of

Rating Stocks of Total Stocks Rating categorySB/Buy 36 57% 0 0%Hold 25 40% 0 0%Sell 2 3% 0 0%

63 100% 0 0%

The above represents our ratings distribution on the stocks in the Feltl and Company research universe, together with the number in (and percentage of) each category for which Feltl and Company provided investment-banking services in the previous twelve months.

September 11, 2012


Date Nature of Report Rating Price Target

09/12/12 [email protected] StrongBuy $13.50

Feltl and Company does make a market in the subject security at the date of publication of this report. As a market maker, Feltl and Company could act as principal or agent with respect to the purchase or sale of those securities. Valuation and Price Target Methodology:

Our valuation is based upon an EV/EBITDA methodology. We have chosen 8x forward EV/EBITDA as the multiple on which to value Heska based upon comparable companies in the medical product distributor sector. Based on our 2013 estimates, this results in an enterprise value of $65 million from which we add current net cash of $7.6 million to arrive at $72 million, or ~$13.50 per share based upon 5.3 million shares outstanding at the end of Q2 2012.

Risks to Achievement of Estimates and Price Target:

Much larger competitors. Both IDEXX Laboratories (IDXX – HOLD) and Abaxis (ABAX – BUY) in the veterinary diagnostics space are much larger than Heska. In the other vaccines, pharmaceuticals and products segment, Heska similarly competes with large players such as Merck, Novartis, Phizeer, Sanofi-Aventis, Bayer, Eli Lilly, CEVA Sante Animale, Vetoquinol, and Virbac. These companies have far larger sales forces and name recognition than Heska in most cases.

Substantial portions of Heska’s revenue dependent on third parties. Heska relies on third parties for a majority of its revenues. On the veterinary diagnostics side of the business, the company has agreements with FUJIFILM, Boule Medical AB, Roche (RHHBY – not rated), and Quidel (QDEL – not rated) to supply instruments, consumables and technology. In other areas of the business, Heska relies on Merck (MRK – not rated) and Agri Laboratories, Ltd. to distribute certain vaccine and pharmaceutical products.

IDEXX exclusive nationwide distributor becoming nonexclusive. The IDEXX agreement with MWI Veterinary Supply (MWIV – not rated) becoming nonexclusive on January 1, 2013 represents a double-edged sword to Heska. On one hand, they could theoretically gain greater access to a large, nationwide distributor to sell their products, but on the other, the risk that FUJIFILM, Boule AB, and/or Roche could decide that selling their products through MWI is preferable to manufacturing the products and allowing Heska to sell them under their own brand

09/11/12 SB Target: $13.50

September 11, 2012


name. However, we believe this happening is unlikely for several reasons. First, Heska’s current contracts have multi-year consumable trailers, making it less attractive for these companies to attempt to go it alone. Second, distributors tend to focus more on consumable products and less on instruments so new installs may be tougher to come by without a direct sales force. Lastly, distributors are unlikely to provide the level of service and support required by customers.

Ownership restrictions. In mid-2010, Heska’s restated certificate of incorporation was amended by stockholders. The amendment places restrictions on the transfer of HSKA shares that could harm Heska’s ability to utilize their domestic federal net operating loss (NOL) carryforward. This change prevents investors from becoming a 5-percent holder and additional stock acquisitions by existing 5-percent holders without the approval of the company’s board of directors. This amendment makes it more difficult for an acquirer to purchase the company and may prevent certain institutional investors from considering purchase of HSKA shares due to the transfer restriction. Additionally, investors may not view the ~$5/share in deferred tax assets as “tangible” when calculating book value.

Veterinary practice roll-ups. In certain areas of human healthcare services, such as in the neonatal space, corporations and private equity have long been acquiring smaller practices, rolling them up into a larger entity to achieve scale. This has also been occurring in the veterinary space, with firms such as Banfield Pet Hospital, National Veterinary Associates, and VCA Antech (WOOF – not rated) acquiring practices and leveraging their scale to realize favorable pricing on instruments and consumables. Additionally, these firms tend to have their own reference laboratory services to which they send a large portion of their testing needs.

Other Disclosures:

The information contained in this report is based on sources considered to be reliable, but not guaranteed, to be accurate or complete. Any opinions or estimates expressed herein reflect a judgment made as of this date, and are subject to change without notice. This report has been prepared solely for informative purposes and is not a solicitation or an offer to buy or sell any security. The securities described may not be qualified for purchase in all jurisdictions. Because of individual requirements, advice regarding securities mentioned in this report should not be construed as suitable for all accounts. This report does not take into account the investment objectives, financial situation and needs of any particular client of Feltl and Company. Some securities mentioned herein relate to small speculative companies that may not be suitable for some accounts. Feltl and Company suggests that prior to acting on any of the recommendations herein, the recipient should consider whether such a recommendation is appropriate given their investment objectives and current financial circumstances. Past performance does not guarantee future results. Additional information is available upon request.

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Mark E. Smith (612) 492-8806

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Documents

Heska Corporation - Feltl and Company · 9/11/2012 · return multiplexed results in less than a minute (versus 8+ minutes for current state-of-the-art lateral flow and ELISA rapid