Unassociated Document

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 June 30, 2011

OR

¨
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
(IRS Employer Identification No.)
or organization)
 
   
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 ¨

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 x No ¨

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
¨
       
Non-accelerated filer
¨ (Do not check if a smaller reporting company)
Smaller reporting company
¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ 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 56,844,037 on July 15, 2011.
 
 
1

 
 
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 June 30, 2011 and December 31, 2010
 
3
 
Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2011 and 2010
 
4
 
Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2011 and 2010
 
5
 
Notes to Condensed Consolidated Financial Statements
 
6
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
16
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
32
Item 4.
Controls and Procedures
 
32
PART II—OTHER INFORMATION
Item 1A.
Risk Factors
 
32
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
39
Item 6.
Exhibits
 
40
Signatures
   
41
Exhibit Index
     
 
 
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)

   
June 30,
   
December 31,
 
   
2011
   
2010
 
             
ASSETS
           
Current Assets:
           
Cash and cash equivalents
  $ 159,398     $ 156,915  
Accounts receivable, net of reserves of $3,187 in 2011 and $2,828 in 2010
    149,314       120,080  
Inventories, net
    133,934       127,885  
Deferred income tax assets
    26,891       26,203  
Other current assets
    24,034       29,508  
Total current assets
    493,571       460,591  
Long-Term Assets:
               
Property and equipment, net
    210,163       201,725  
Goodwill
    154,191       149,112  
Intangible assets, net
    53,044       55,752  
Other long-term assets, net
    39,606       29,964  
Total long-term assets
    457,004       436,553  
TOTAL ASSETS
  $ 950,575     $ 897,144  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current Liabilities:
               
Accounts payable
  $ 29,888     $ 22,669  
Accrued liabilities
    121,898       118,598  
Line of credit
    132,548       128,999  
Current portion of long-term debt
    890       863  
Current portion of deferred revenue
    12,913       13,983  
Total current liabilities
    298,137       285,112  
Long-Term Liabilities:
               
Deferred income tax liabilities
    21,152       18,661  
Long-term debt, net of current portion
    2,966       3,418  
Long-term deferred revenue, net of current portion
    6,555       4,627  
Other long-term liabilities
    12,954       11,045  
Total long-term liabilities
    43,627       37,751  
Total liabilities
    341,764       322,863  
                 
Commitments and Contingencies (Note 13)
               
                 
Stockholders’ Equity:
               
Common stock, $0.10 par value: Authorized: 120,000 shares; Issued: 98,835 and 97,968 shares in 2011 and 2010, respectively
    9,884       9,797  
Additional paid-in capital
    680,093       641,645  
Deferred stock units: Outstanding: 119 and 118 units in 2011 and 2010, respectively
    4,622       4,433  
Retained earnings
    1,050,809       965,540  
Accumulated other comprehensive income
    26,468       13,467  
Treasury stock, at cost: 42,004 and 40,657 shares in 2011 and 2010, respectively
    (1,163,102 )     (1,060,647 )
Total IDEXX Laboratories, Inc. stockholders’ equity
    608,774       574,235  
Noncontrolling interest
    37       46  
Total stockholders’ equity
    608,811       574,281  
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
  $ 950,575     $ 897,144  

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
June 30,
   
For the Six Months Ended
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Revenue:
                       
Product revenue
  $ 203,502     $ 179,813     $ 391,887     $ 356,574  
Service revenue
    114,360       101,669       218,647       193,433  
Total revenue
    317,862       281,482       610,534       550,007  
Cost of Revenue:
                               
Cost of product revenue
    77,457       72,063       151,162       140,697  
Cost of service revenue
    66,372       60,135       130,414       117,665  
Total cost of revenue
    143,829       132,198       281,576       258,362  
Gross profit
    174,033       149,284       328,958       291,645  
                                 
Expenses:
                               
Sales and marketing
    50,974       44,167       101,959       88,583  
General and administrative
    33,140       33,076       65,736       65,884  
Research and development
    18,621       17,206       36,433       33,915  
Income from operations
    71,298       54,835       124,830       103,263  
Interest expense
    (782 )     (689 )     (1,510 )     (1,054 )
Interest income
    419       138       788       191  
Income before provision for income taxes
    70,935       54,284       124,108       102,400  
Provision for income taxes
    22,281       17,087       38,848       32,175  
Net income
    48,654       37,197       85,260       70,225  
Less: Net (loss) income attributable to noncontrolling interest
    (3 )     4       (9 )     6  
Net income attributable to IDEXX Laboratories, Inc. stockholders
  $ 48,657     $ 37,193     $ 85,269     $ 70,219  
                                 
Earnings per Share:
                               
Basic
  $ 0.85     $ 0.64     $ 1.49     $ 1.21  
Diluted
  $ 0.83     $ 0.62     $ 1.45     $ 1.17  
Weighted Average Shares Outstanding:
                               
Basic
    57,276       57,747       57,366       57,890  
Diluted
    58,727       59,646       58,934       59,875  

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 Six Months Ended
June 30,
 
   
2011
   
2010
 
             
Cash Flows from Operating Activities:
           
Net income
  $ 85,260     $ 70,225  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    23,343       22,632  
Loss on disposal of property and equipment
    326       1,442  
Increase (decrease) in deferred compensation liability
    71       (71 )
Provision for uncollectible accounts
    683       596  
Provision for (benefit of) deferred income taxes
    2,392       (112 )
Share-based compensation expense
    7,501       6,602  
Tax benefit from exercises of stock options and vesting of restricted stock units
    (10,854 )     (9,372 )
Changes in assets and liabilities, net of acquisitions:
               
Accounts receivable
    (24,213 )     (16,544 )
Inventories
    (5,692 )     (12,977 )
Other assets
    7,293       (1,634 )
Accounts payable
    7,002       4,308  
Accrued liabilities
    (5,171 )     7,432  
Deferred revenue
    369       2,558  
Net cash provided by operating activities
    88,310       75,085  
Cash Flows from Investing Activities:
               
Purchases of property and equipment
    (26,173 )     (17,437 )
Proceeds from disposition of pharmaceutical product lines
    3,000       -  
Proceeds from sale of property and equipment
    218       64  
Acquisitions of intangible assets
    -       (144 )
Net cash used by investing activities
    (22,955 )     (17,517 )
Cash Flows from Financing Activities:
               
Borrowings on revolving credit facilities, net
    3,486       15,099  
Payment of notes payable
    (425 )     (400 )
Repurchases of common stock
    (98,419 )     (83,724 )
Proceeds from exercises of stock options and employee stock purchase plans
    19,367       16,446  
Tax benefit from exercises of stock options and vesting of restricted stock units
    10,854       9,372  
Net cash used by financing activities
    (65,137 )     (43,207 )
Net effect of changes in exchange rates on cash
    2,265       (3,114 )
Net increase in cash and cash equivalents
    2,483       11,247  
Cash and cash equivalents at beginning of period
    156,915       106,728  
Cash and cash equivalents at end of period
  $ 159,398     $ 117,975  

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 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, 2010 was derived from audited financial statements, but does not include all disclosures required by U.S. GAAP. The results of operations for the three and six months ended June 30, 2011 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 quarter ended June 30, 2011 and our Annual Report on Form 10-K for the year ended December 31, 2010 filed with the Securities and Exchange Commission.

Certain reclassifications have been made to the prior year condensed consolidated financial statements to conform to the current year presentation. Reclassifications had no material impact on previously reported results of operations, financial position or cash flows.

NOTE 2.        ACCOUNTING POLICIES

Significant Accounting Policies

The significant accounting policies used in preparation of these condensed consolidated financial statements for the six months ended June 30, 2011 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, 2010.

Recent Accounting Pronouncements

There were no new accounting pronouncements adopted or enacted during the three and six months ended June 30, 2011 that had, or are expected to have, a material impact on our financial statements.

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 and six months ended June 30, 2011 totaled $2.4 million and $23.5 million, respectively, compared to $0.4 million and $15.4 million for the three and six months ended June 30, 2010, respectively.

The total unrecognized compensation expense, net of estimated forfeitures, for unvested share-based compensation awards outstanding at June 30, 2011 was $35.1 million, which will be recognized over a weighted average of approximately 2.1 years.

Options

We determine the assumptions used in the valuation of option awards as of the date of grant. Differences in the stock price volatility, expected term or risk-free interest rate may result in distinct valuation assumptions at each grant date. As such, we may use different assumptions for options granted throughout the year. Option awards are granted with an exercise price equal to 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 award on the date of grant and the weighted average estimated fair values were as follows:
 
 
6

 
 
   
For the Six Months Ended
June 30,
 
   
2011
   
2010
 
             
Expected stock price volatility
    33 %     31 %
Expected term, in years
    4.8       4.9  
Risk-free interest rate
    2.3 %     2.3 %
                 
Weighted average fair value of options granted
  $ 24.87     $ 16.56  

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):

   
June 30,
   
December 31,
 
     
2011
     
2010
 
                 
Raw materials
 
$
30,176
   
$
26,758
 
Work-in-process
   
14,097
     
13,790
 
Finished goods
   
89,661
     
87,337
 
   
$
133,934
   
$
127,885
 

NOTE 5.        GOODWILL AND INTANGIBLE ASSETS

The increase in goodwill during the six months ended June 30, 2011 resulted from changes in foreign currency exchange rates. The decrease in intangible assets other than goodwill during the six months ended June 30, 2011 resulted from the continued amortization of our intangible assets, partly offset by the impact of changes in foreign currency exchange rates.

NOTE 6.        OTHER NONCURRENT ASSETS

Other noncurrent assets consisted of the following (in thousands):

   
June 30,
   
December 31,
 
     
2011
     
2010
 
                 
Investment in long-term product supply arrangements
 
$
12,452
   
$
12,120
 
Customer acquisition costs, net
   
13,229
     
5,470
 
Other assets
   
13,925
     
12,374
 
   
$
39,606
   
$
29,964
 

NOTE 7.        ACCRUED LIABILITIES

Accrued liabilities consisted of the following (in thousands):

   
June 30,
2011
   
December 31, 
2010
 
                 
Accrued expenses
 
$
41,388
   
$
36,150
 
Accrued employee compensation and related expenses
   
39,328
     
47,914
 
Accrued taxes
   
11,242
     
12,320
 
Accrued customer programs
   
29,940
     
22,214
 
   
$
121,898
   
$
118,598
 
 
7

 
 
NOTE 8.        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 sell new instruments, our provision for warranty expense increases. Cost of product 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. The liability for warranties is included in accrued liabilities in the accompanying condensed consolidated balance sheets.

The following is a summary of changes in accrued warranty reserves for the three and six months ended June 30, 2011 and 2010 (in thousands):

   
For the Three Months Ended
June 30,
   
For the Six Months Ended
June 30,
 
     
2011
     
2010
     
2011
     
2010
 
                                 
Balance, beginning of period
 
$
1,763
   
$
2,614
   
$
2,196
   
$
3,086
 
Provision for warranty expense
   
711
     
1,020
     
1,233
     
1,941
 
Change in estimate, balance beginning of period
   
(146
)
   
(90
)
   
(237
)
   
(570
)
Settlement of warranty liability
   
(653
)
   
(947
)
   
(1,517
)
   
(1,860
)
Balance, end of period
 
$
1,675
   
$
2,597
   
$
1,675
   
$
2,597
 

NOTE 9.        REPURCHASES OF COMMON STOCK

The following is a summary of our open market common stock repurchases for the three and six months ended June 30, 2011 and 2010 (in thousands, except per share amounts):

   
For the Three Months Ended
June 30,
   
For the Six Months Ended
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Shares repurchased
    759       422       1,297       1,513  
Total cost of shares repurchased
  $ 58,479     $ 25,996     $ 98,419     $ 83,724  
Average cost per share
  $ 77.08     $ 61.66     $ 75.89     $ 55.32  

We primarily acquire shares by means of repurchases in the open market. However, we also acquire shares that are surrendered by employees in payment for the minimum required withholding taxes due on the vesting of restricted stock units and the settlement of deferred stock units, otherwise referred to herein as employee surrenders. Shares acquired through employee surrenders were not significant for the three months ended June 30, 2011 and for the same period of the prior year. We acquired 53,015 shares at a total cost of $4.1 million in connection with such employee surrenders for the six months ended June 30, 2011 compared to 48,662 shares at a total cost of $2.6 million for the same period of the prior year. Employee surrenders are generally most significant during the first quarter of each year in connection with the annual vesting of restricted stock unit awards.

In 2011, we began issuing shares of treasury stock upon the vesting of certain restricted stock units. The number of shares of treasury stock issued during the three and six months ended June 30, 2011 was not significant.

NOTE 10.      INCOME TAXES

Our effective income tax rates were 31.4% and 31.3% for the three and six months ended June 30, 2011 compared to 31.5% and 31.4% for the three and six months ended June 30, 2010. The decrease in our effective income tax rate was due primarily to federal research and development tax incentives that were available during the three and six months ended June 30, 2011 but not available during the same period of the prior year, partly offset by higher relative earnings subject to domestic tax rates that are higher than international tax rates.
 
 
8

 

NOTE 11.      COMPREHENSIVE INCOME

The following is a summary of comprehensive income for the three and six months ended June 30, 2011 and 2010 (in thousands):

   
For the Three Months Ended
June 30,
   
For the Six Months Ended
June 30,
 
     
2011
     
2010
     
2011
     
2010
 
                                 
Net income
 
$
48,654
   
$
37,197
   
$
85,260
   
$
70,225
 
Less: Net (loss) income attributable to noncontrolling interest
   
(3
)
   
4
     
(9
)
   
6
 
Net income attributable to IDEXX Laboratories, Inc. stockholders
   
48,657
     
37,193
     
85,269
     
70,219
 
Other comprehensive income attributable to IDEXX Laboratories, Inc. stockholders:
                               
Foreign currency translation adjustments
   
5,438
     
(7,339
)
   
13,579
     
(12,887
)
Change in fair value of foreign currency contracts classified as hedges, net of tax
   
1,276
     
4,020
     
(976
)
   
6,295
 
Change in fair value of interest rate swaps classified as hedges, net of tax
   
177
     
(191
)
   
353
     
(773
)
Change in fair value of investments, net of tax
   
(10
)
   
(109
)
   
45
     
(52
)
Comprehensive income attributable to IDEXX Laboratories, Inc. stockholders
 
$
55,538
   
$
33,574
   
$
98,270
   
$
62,802
 

NOTE 12.      EARNINGS PER SHARE

Basic earnings per share is computed by dividing net income attributable to IDEXX Laboratories, Inc. stockholders by the weighted average number of shares of common stock and vested deferred stock units outstanding during the period. 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. 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 assumed issuance of unvested restricted stock units and unvested deferred stock units 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 for the three and six months ended June 30, 2011 and 2010 (in thousands):

   
For the Three Months Ended
June 30,
   
For the Six Months Ended
June 30,
 
     
2011
     
2010
     
2011
     
2010
 
                                 
Shares outstanding for basic earnings per share
   
57,276
     
57,747
     
57,366
     
57,890
 
                                 
Shares outstanding for diluted earnings per share:
                               
Shares outstanding for basic earnings per share
   
57,276
     
57,747
     
57,366
     
57,890
 
Dilutive effect of share-based payment awards
   
1,451
     
1,899
     
1,568
     
1,985
 
     
58,727
     
59,646
     
58,934
     
59,875
 

Certain options to acquire shares have been excluded from the calculation of shares outstanding for diluted earnings per share because they were anti-dilutive. The following table presents information concerning those anti-dilutive options for the three and six months ended June 30, 2011 and 2010 (in thousands):

   
For the Three Months Ended
June 30,
   
For the Six Months Ended
June 30,
 
     
2011
     
2010
     
2011
     
2010
 
                                 
Weighted average number of shares underlying anti-dilutive options
   
617
     
547
     
513
     
624
 
 
9

 

NOTE 13.      COMMITMENTS, CONTINGENCIES AND GUARANTEES

As discussed in our Annual Report on Form 10-K for the year ended December 31, 2010, in January 2010, we received a letter from the U.S. Federal Trade Commission (“FTC”), stating that it was conducting an investigation to determine whether we or others have engaged in, or are engaging in, unfair methods of competition in violation of Section 5 of the Federal Trade Commission Act (“FTC Act”) through pricing or marketing policies for companion animal veterinary products and services, including but not limited to exclusive dealing or tying arrangements with distributors or end-users of those products or services. The letter stated that the FTC has not concluded that we or anyone else has violated Section 5 of the FTC Act. In April 2010, we received a subpoena from the FTC requesting that we provide the FTC with documents and information relevant to this investigation. We are cooperating fully with the FTC in its investigation.

In November 2010, we received notification that the United Kingdom Office of Fair Trading (“OFT”) was conducting an investigation to determine whether we had engaged in, or are engaging in, practices foreclosing the supply of companion animal diagnostic testing services in violation of the United Kingdom Competition Act of 1998.  We have provided the OFT with documents and information relevant to this investigation as requested and we are cooperating fully with the OFT on this matter.
 
We believe that our marketing and sales practices for companion animal veterinary products and services do not violate the antitrust laws of the U.S., U.K., or any other country. At this time, we cannot predict whether government investigations will lead to enforcement proceedings, or what the outcomes of those proceedings will be, including whether those outcomes will involve the payment of fines or penalties. As such, we have not recognized a loss contingency as potential losses related to either investigation are neither probable nor can they reasonably be estimated through the date of the filing of this Quarterly Report on Form 10-Q for the three and six months ended June 30, 2011.

Significant commitments, contingencies and guarantees at June 30, 2011 are consistent with those discussed in Note 14 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2010.

NOTE 14.      SEGMENT REPORTING

We operate primarily through three business segments: diagnostic and information technology-based products and services for the veterinary market, which we refer to as our Companion Animal Group (“CAG”), water quality testing products (“Water”) and products for livestock and poultry health, which we refer to as Livestock and Poultry Diagnostics (“LPD”). We also operate two smaller operating segments that comprise products for testing milk quality (“Dairy”) and products for the human point-of-care medical diagnostics market (“OPTI Medical”). Financial information about our Dairy and OPTI Medical operating segments is combined and presented with one of our remaining pharmaceutical product lines and our out-licensing arrangements in an “Other” category because they do not meet the quantitative or qualitative thresholds for reportable segments.

The accounting policies of the segments are consistent with those discussed in Notes 1 and 15 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2010, except for the change in our measure of segment profitability during the three months ended March 31, 2011 as discussed below. Intersegment revenues, which are not included in the table below, were not significant for the three and six months ended June 30, 2011 and 2010.

During the three months ended March 31, 2011, we changed the measure of profitability for our reportable segments. As a result of this change, a portion of corporate support function expenses and personnel-related expenses, certain manufacturing costs and certain foreign currency exchange gains and losses are no longer allocated to our reportable segments and, instead, are reported under the caption “Unallocated Amounts.” Similar to our treatment of share-based compensation expense, we estimate corporate support function expenses and certain personnel-related costs and allocate the estimated expense to the operating segments. This allocation differs from the actual expense and consequently yields a difference that is now reported under the caption “Unallocated Amounts.”  With respect to manufacturing costs, the costs reported in our operating segments include our standard cost for products sold and any variances from standard cost for products purchased or manufactured within the period. We capitalize these variances for inventory on hand at the end of the period to record inventory in accordance with U.S. GAAP. We then record these costs as cost of product revenue as that inventory is sold. The impact to cost of product revenue resulting from this variance capitalization and subsequent expense recognition is now reported within the caption “Unallocated Amounts.” Prior to the three months ended March 31, 2011, “Unallocated Amounts” included primarily corporate research and development expenses that did not align with one of our existing business or service categories and the difference between estimated and actual share-based compensation expense. The segment income (loss) from operations discussed within this report for the three and six months ended June 30, 2010 have been restated to conform to our new measure of segment profitability. This change in measure of segment profitability did not have a material impact on the results of operations for any of our individual segments. There was no change to the business composition of our reportable segments. 
 
 
10

 
 
The following is a summary of segment performance for the three and six months ended June 30, 2011 and 2010 (in thousands):

   
For the Three Months Ended June 30,
 
   
CAG
   
Water
   
LPD
   
Other
   
Unallocated
Amounts
   
Consolidated
Total
 
2011
                                   
Revenue
  $ 259,734     $ 21,510     $ 25,367     $ 11,251     $ -     $ 317,862  
                                                 
Income (loss) from operations
  $ 58,270     $ 8,401     $ 7,176     $ 309     $ (2,858 )   $ 71,298  
Interest expense, net
                                            (363 )
Income before provision for income taxes
                                            70,935  
Provision for income taxes
                                            22,281  
Net income
                                            48,654  
Net (loss) attributable to noncontrolling interest
                                            (3 )
Net income attributable to IDEXX  Laboratories, Inc. stockholders
                                          $ 48,657  
                                                 
2010
                                               
Revenue
  $ 232,320     $ 19,448     $ 19,160     $ 10,554     $ -     $ 281,482  
                                                 
Income (loss) from operations
  $ 47,140     $ 8,150     $ 4,549     $ 638     $ (5,642 )   $ 54,835  
Interest expense, net
                                            (551 )
Income before provision for income taxes
                                            54,284  
Provision for income taxes
                                            17,087  
Net income
                                            37,197  
Net income attributable to noncontrolling interest
                                            4  
Net income attributable to IDEXX  Laboratories, Inc. stockholders
                                          $ 37,193  

   
For the Six Months Ended June 30,
 
   
CAG
   
Water
   
LPD
   
Other
   
Unallocated
Amounts
   
Consolidated
Total
 
2011
                                   
Revenue
  $ 500,323     $ 40,475     $ 49,306     $ 20,430     $ -     $ 610,534  
                                                 
Income (loss) from operations
  $ 101,242     $ 15,348     $ 14,326     $ (241 )   $ (5,845 )   $ 124,830  
Interest expense, net
                                            (722 )
Income before provision for income taxes
                                            124,108  
Provision for income taxes
                                            38,848  
Net income
                                            85,260  
Net (loss) attributable to noncontrolling interest
                                            (9 )
Net income attributable to IDEXX  Laboratories, Inc. stockholders
                                          $ 85,269  
                                                 
2010
                                               
Revenue
  $ 453,737     $ 37,312     $ 39,101     $ 19,857     $ -     $ 550,007  
                                                 
Income (loss) from operations
  $ 87,962     $ 15,662     $ 9,127     $ 1,188     $ (10,676 )   $ 103,263  
Interest expense, net
                                            (863 )
Income before provision for income taxes
                                            102,400  
Provision for income taxes
                                            32,175  
Net income
                                            70,225  
Net income attributable to noncontrolling interest
                                            6  
Net income attributable to IDEXX  Laboratories, Inc. stockholders
                                          $ 70,219  
 
 
11

 
 
The following is a summary of revenue by product and service category for the three and six months ended June 30, 2011 and 2010 (in thousands):

   
For the Three Months Ended
June 30,
   
For the Six Months Ended
June 30,
 
     
2011
     
2010
     
2011
     
2010
 
CAG segment revenue:
                               
Instruments and consumables
 
$
98,603
   
$
86,455
   
$
192,490
   
$
169,837
 
Rapid assay products
   
44,193
     
40,481
     
82,810
     
79,924
 
Reference laboratory diagnostic and consulting services
   
99,087
     
86,048
     
188,215
     
165,888
 
Practice management systems and digital radiography
   
17,851
     
19,336
     
36,808
     
38,088
 
CAG segment revenue
   
259,734
     
232,320
     
500,323
     
453,737
 
                                 
Water segment revenue
   
21,510
     
19,448
     
40,475
     
37,312
 
LPD segment revenue
   
25,367
     
19,160
     
49,306
     
39,101
 
Other segment revenue
   
11,251
     
10,554
     
20,430
     
19,857
 
                                 
Total revenue
 
$
317,862
   
$
281,482
   
$
610,534
   
$
550,007
 

NOTE 15.      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 that the entity has the ability to access at the measurement date.
 
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 classified as derivative instruments are valued based on the present value of the forward rate less the contract rate multiplied by the notional amount. The product of this calculation is then adjusted for counterparty risk. Interest rate swaps classified as derivative instruments are valued utilizing a discounted cash flow analysis based on the terms of the contract and the interest rate curve and adjusted for counterparty risk.
 
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 June 30, 2011 and December 31, 2010, 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 six months ended June 30, 2011. We did not have any transfers between Level 1 and Level 2 measurements during the six months ended June 30, 2011.

The following tables set forth our assets and liabilities that were measured at fair value on a recurring basis at June 30, 2011 and at December 31, 2010 by level within the fair value hierarchy (in thousands):
 
 
12

 
 
As of June 30, 2011
 
Quoted Prices
in Active
Markets for
Identical Assets
(Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
   
Balance at
June 30, 2011
 
                         
Assets
                       
Money market funds(1)
  $ 67,029     $ -     $ -     $ 67,029  
Equity mutual funds(2)
    2,299       -       -       2,299  
Foreign currency exchange contracts(3)
    -       2,892       -       2,892  
Liabilities
                               
Foreign currency exchange contracts(3)
    -       6,538       -       6,538  
Deferred compensation(4)
    2,299       -       -       2,299  
Interest rate swaps(5)
    -       1,051       -       1,051  

As of December 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
December 31, 2010
 
                         
Assets
                       
Money market funds(1)
  $ 67,025     $ -     $ -     $ 67,025  
Equity mutual funds(2)
    2,222       -       -       2,222  
Liabilities
                               
Foreign currency exchange contracts(3)
    -       2,234       -       2,234  
Deferred compensation(4)
    2,222       -       -       2,222  
Interest rate swaps(5)
    -       1,611       -       1,611  
  

(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 number (4) below for a discussion of the related deferred compensation liability.
(3)
Foreign currency exchange contracts are included within other current assets; other long-term assets, net; accrued liabilities; or other long-term liabilities depending on the gain (loss) position and anticipated settlement date.
(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 number (2) above.
(5)
Interest rate swaps are included within accrued liabilities.

The estimated fair value of certain financial instruments, including cash and cash equivalents, accounts receivable, accounts payable, and the current portion of notes payable approximate carrying value due to their short maturity.

Based on current market conditions, we believe that we could obtain an unsecured short-term revolving credit facility similar to our current unsecured short-term revolving credit facility (“Credit Facility”) at prevailing market rates. Applicable interest rates on borrowings under the Credit Facility generally range from 0.375 to 0.875 percentage points (“Credit Spread”) above the London interbank rate or the Canadian Dollar-denominated bankers’ acceptance rate, dependent on our leverage ratio. We believe that the Credit Spread on a new facility would most likely range from 0.875 to 1.250. As a result, the fair value of our current Credit Facility would be approximately $132 million as of June 30, 2011, assuming the amounts outstanding at June 30, 2011 remained consistent for the duration of the Credit Facility.

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, cash equivalents, accounts receivable, investments and derivatives. To mitigate such risk with respect to cash, cash equivalents and investments, we place our cash with highly-rated financial institutions, in non-interest bearing accounts that are fully insured by the U.S. government 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 most significant customers and monitor the amounts owed to us, taking appropriate action when necessary. As a result, we believe that 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. To mitigate concentration of credit risk with respect to derivatives we enter into transactions with highly-rated financial institutions, enter into master netting arrangements with the counterparties to our derivative transactions and frequently monitor the credit worthiness of our counterparties.
 
 
13

 
 
NOTE 16.      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 presented net of tax.

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 and sales 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. We have entered into interest rate swaps to manage interest rate risk associated with $80 million of our variable-rate debt through March 30, 2012.

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. We present our derivative assets and liabilities on the balance sheet on a gross basis.

Cash Flow Hedges

We have designated our foreign 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 OCI at the time of de-designation is reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. 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.

We did not de-designate any instruments from hedge accounting treatment during the three and six months ended June 30, 2011 or 2010. Gains or losses related to hedge ineffectiveness recognized in earnings during the three and six months ended June 30, 2011 and 2010 were not material. At June 30, 2011, the estimated net amount of losses, net of tax, that are expected to be reclassified out of OCI and into earnings within the next 12 months is $3.1 million if exchange and interest rates do not fluctuate from the levels at June 30, 2011.

We enter into foreign currency exchange contracts for amounts that are less than the full value of forecasted intercompany inventory purchases and sales. Our hedging strategy related to intercompany inventory purchases and sales 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. As a result, the notional value of foreign currency exchange contracts outstanding may be higher throughout the year in comparison to the amounts outstanding at the end of the year. Accordingly, our risk with respect to foreign currency exchange rate fluctuations may vary throughout each annual cycle.

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 became effectively 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.

 
14

 
 
The notional amount of foreign currency exchange contracts to hedge forecasted intercompany inventory purchases and sales consisted of the following (in thousands):
 
Currency Sold
 
U.S. Dollar Equivalent
 
   
June 30,
   
December 31,
 
   
2011
   
2010
 
             
Euro
  $ 73,707     $ 59,360  
British Pound
    25,108       21,144  
Canadian Dollar
    26,118       21,776  
Australian Dollar
    9,091       7,930  
Japanese Yen
    12,286       10,427  
    $ 146,310     $ 120,637  

Currency Purchased
 
U.S. Dollar Equivalent
 
   
June 30,
   
December 31,
 
   
2011
   
2010
 
             
Swiss Franc
  $ 20,615     $ 12,542  

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
 
   
June 30,
   
December 31,
 
   
2011
   
2010
 
             
Interest rate swaps
  $ 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):

    
Asset Derivatives
 
   
June 30, 2011
 
December 31, 2010
 
   
Balance Sheet
Classification
 
Fair Value
 
Balance Sheet
Classification
 
Fair Value
 
                       
Derivatives designated as hedging
instruments
                     
Foreign currency exchange contracts
 
Other current assets
 
$
2,199
 
Other current assets
 
$
-
 
Foreign currency exchange contracts
 
Other long-term assets, net
   
693
 
Other long-term assets, net
   
-
 
Total derivative instruments
     
$
2,892
     
$
-
 

    
Liability Derivatives
 
   
June 30, 2011
 
December 31, 2010
 
   
Balance Sheet
Classification
 
Fair Value
 
Balance Sheet
Classification
 
Fair Value
 
                       
Derivatives designated as hedging
instruments
                     
Foreign currency exchange contracts
 
Accrued expenses
 
$
5,682
 
Accrued expenses
 
$
2,234
 
Foreign currency exchange contracts
 
Other long-term liabilities
   
856
 
Other long-term liabilities
   
-
 
Interest rate swaps
 
Accrued expenses
   
1,051
 
Accrued expenses
   
1,611
 
Total derivative instruments
     
$
7,589
     
$
3,845
 
 
 
15

 
 
The effect of derivative instruments designated as cash flow hedges on the condensed consolidated balance sheet for the three and six months ended June 30, 2011 and 2010 consisted of the following (in thousands):

   
Gain (Loss) Recognized in OCI on Derivative Instruments (Effective Portion)
 
   
For the Three Months Ended
June 30,
   
For the Six Months Ended
June 30,
 
Derivative instruments
 
2011
   
2010
   
2011
   
2010
 
                         
Foreign currency exchange contracts, net of tax
  $ 1,276     $ 4,020     $ (976 )   $ 6,295  
Interest rate swaps, net of tax
    177       (191 )     353       (773 )
Total derivative instruments, net of tax
  $ 1,453     $ 3,829     $ (623 )   $ 5,522  

The effect of derivative instruments designated as cash flow hedges on the condensed consolidated statement of operations for the three and six months ended June 30, 2011 and 2010 consisted of the following (in thousands):
 
    
Classification of
Gain (Loss)
   
Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)
 
   
Reclassified from
OCI into Income
   
For the Three Months Ended
June 30,
   
For the Six Months Ended
June 30,
 
Derivative instruments
 
(Effective Portion)
   
2011
   
2010
   
2011
   
2010
 
                                       
Foreign currency exchange contracts
 
Cost of revenue
    $ (2,286 )   $ 846     $ (3,577 )   $ 435  
Interest rate swaps
 
Interest expense
      (358 )     (345 )     (699 )     (345 )
          $ (2,644 )   $ 501     $ (4,276 )   $ 90  

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 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 conditions 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; interest expense; 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 and Trends

Operating segments. We operate primarily through three business segments: diagnostic and information technology-based products and services for the veterinary market, which we refer to as our Companion Animal Group (“CAG”), water quality testing products (“Water”) and products for livestock and poultry health, which we refer to as Livestock and Poultry Diagnostics (“LPD”). We also operate two smaller operating segments that comprise products for testing milk quality (“Dairy”) and products for the human point-of-care medical diagnostics market (“OPTI Medical”). Financial information about our Dairy and OPTI Medical operating segments is combined and presented with one of our remaining pharmaceutical product lines and our out-licensing arrangements in an “Other” category because they do not meet the quantitative or qualitative thresholds for reportable segments. See Note 14 to the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for financial information about our segments and the section entitled “Description of Business by Segment” under the heading “Item 1. Business” in our Annual Report on Form 10-K for the year ended December 31, 2010 for additional description of our segments.
 
 
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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 a range of products used in the detection of various microbiological parameters in water. LPD develops, designs, manufactures and distributes diagnostic tests and related instrumentation that are used to detect a wide range of diseases and to monitor health status in livestock and poultry. Dairy develops, designs, manufactures and distributes products to detect contaminants in milk. 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. Further, OPTI Medical manufactures our VetStat® Electrolyte and Blood Gas Analyzer, a component of our Catalyst Dx® Analyzer and electrolyte consumables used with our Catalyst Dx® Analyzer.

During the three months ended March 31, 2011, we changed the measure of profitability for our reportable segments. As a result of this change, a portion of corporate support function expenses and personnel-related expenses, certain manufacturing costs and certain foreign currency exchange gains and losses are no longer allocated to our reportable segments and, instead, are reported under the caption “Unallocated Amounts.” Similar to our treatment of share-based compensation expense, we estimate corporate support function expenses and certain personnel-related costs and allocate the estimated expense to the operating segments. This allocation differs from the actual expense and consequently yields a difference that is now reported under the caption “Unallocated Amounts.” With respect to manufacturing costs, the costs reported in our operating segments include our standard cost for products sold and any variances from standard cost for products purchased or manufactured within the period. We capitalize these variances for inventory on hand at the end of the period to record inventory in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). We then record these costs as cost of product revenue as that inventory is sold. The impact to cost of product revenue resulting from this variance capitalization and subsequent expense recognition is now reported within the caption “Unallocated Amounts.” Prior to the three months ended March 31, 2011, “Unallocated Amounts” included primarily corporate research and development expenses that did not align with one of our existing business or service categories and the difference between estimated and actual share-based compensation expense. The segment income (loss) from operations discussed within this report for the three and six months ended June 30, 2010 have been restated to conform to our new measure of segment profitability. This change in measure of segment profitability did not have a material impact on the results of operations for any of our individual segments. There was no change to the business composition of our reportable segments. 

Effects of Certain Factors on Results of Operations

Distributor Purchasing and Inventories. The instrument consumables and rapid assay products in our CAG segment are sold in the U.S. and certain other geographies by third party distributors, who purchase products from us and sell them to veterinary practices, which are the end users. As a result, distributor purchasing dynamics have an impact on our reported sales of these products. Distributor purchasing dynamics may be affected by many factors and may be unrelated to underlying end-user demand for our products. Consequently, reported results may reflect fluctuations in distributors’ inventories and not necessarily reflect changes in 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.

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 on growth. If during the current year, distributors’ inventories grew by less than those inventories grew in the comparable period of the prior year, then changes in distributors’ inventories have a negative impact on our reported sales growth in the current period. Conversely, if during the current year, distributors’ inventories grew by more than those inventories grew in the comparable period of the prior year, then changes in distributors’ inventories have a positive impact on our reported sales growth in the current period.

At the end of a quarter, we believe that our U.S. CAG distributors typically hold inventory equivalent to approximately four weeks of our anticipated end-user demand for instrument consumables and rapid assay products.
 
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Currency Impact. For both the three and six months ended June 30, 2011, approximately 26% of our revenue was derived from products manufactured in the U.S. and sold internationally in local currencies compared to 25% for both the three and six months ended June 30, 2010. Strengthening of the rate of exchange for the U.S. dollar relative to other currencies has a negative impact on our revenues derived in currencies other than the U.S. dollar and on profits of products manufactured in the U.S. and sold internationally, and a weakening of the U.S. dollar has the opposite effect. Similarly, to the extent that the U.S. dollar is stronger in current or future periods relative to the exchange rates in effect in the corresponding prior periods, our growth rate will be negatively affected. The impacts of foreign currency denominated operating expenses and foreign currency denominated supply contracts partly offset this exposure.

The impact on revenue from changes in foreign currency exchange rates is a non-U.S. GAAP financial measure, which is a numerical measure the components of which do not align with the most directly comparable measure calculated and presented in accordance with U.S. GAAP. This particular measure is calculated by applying the differences between the average exchange rates during the current year period and the comparable previous year period to foreign currency denominated revenues for the current year period.

During the three months ended June 30, 2011, as compared to the three months ended June 30, 2010, changes in foreign currency exchange rates increased total company revenue by approximately $13.4 million, due primarily to the weakening of the U.S. dollar against the Euro and, to a lesser extent, the Australian dollar, British pound, Japanese yen and Canadian dollar.

During the six months ended June 30, 2011, as compared to the six months ended June 30, 2010, changes in foreign currency exchange rates increased total company revenue by approximately $16.6 million, due primarily to the weakening of the U.S. dollar against the Euro and, to a lesser extent, the Australian dollar, Japanese yen, Canadian dollar and British pound.

These changes in foreign currency exchange rates impacted the revenues generated by each of our individual operating segments in a manner similar to the impact on the company as a whole.

Effect of Economic Conditions. Demand for many of our products and services has been negatively affected by economic conditions since approximately mid-2008. In our CAG segment, we believe that low economic growth and relatively high unemployment have led to negative or cautious consumer sentiment, which has affected the number of patient visits to veterinary clinics. Since the beginning of the economic slowdown, patient visits have been flat to slightly down in each year-over-year period. We continued to observe this trend during the three and six months ended June 30, 2011 relative to the same periods in 2010. We believe the essentially flat patient visits have had a slightly negative impact on the growth rate of sales of rapid assay tests, instrument consumables and reference laboratory diagnostic and consulting services. In addition, we believe the rate of growth of sales of our instruments and digital radiography systems, which are larger capital purchases for veterinarians, has been negatively affected by continued caution among veterinarians regarding economic conditions. Weaker economic conditions have also caused our customers to remain sensitive to the pricing of our products and services resulting in lower growth due to limited price increases for certain products.

We also believe that current economic conditions have affected purchasing decisions by certain customer groups in our Water business. Lower water testing volumes have resulted from a decline in discretionary testing.

We believe that the diversity and innovative nature of our products and services, and the geographic diversity of our markets, have and will continue to partially mitigate the effects of the slow economic growth and negative consumer sentiment. However, until we see improvements in broad factors that measure the economic climate both in the United States and Europe, we expect our growth rates will continue to be negatively affected.

■ 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 U.S. GAAP. 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 and six months ended June 30, 2011 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, 2010. The critical accounting policies and the significant judgments and estimates used in the preparation of our condensed consolidated financial statements for the three and six months ended June 30, 2011 are consistent with those discussed in our Annual Report on Form 10-K for the year ended December 31, 2010 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.”
 
 
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Results of Operations

Three Months Ended June 30, 2011 Compared to Three Months Ended June 30, 2010

Revenue

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

For the Three Months Ended June 30,
 
Net Revenue
(dollars in thousands)
 
2011
   
2010
   
Dollar
Change
   
Percentage
Change
   
Percentage
Change from
Currency (1)
   
Percentage 
Change from
Acquisitions (2)
   
Organic
Revenue
Growth(3)
 
                                           
CAG
  $ 259,734     $ 232,320     $ 27,414       11.8 %     4.3 %     0.1 %     7.4 %
Water
    21,510       19,448       2,062       10.6 %     4.7 %     -       5.9 %
LPD
    25,367       19,160       6,207       32.4 %     11.1 %     -       21.3 %
Other
    11,251       10,554       697       6.6 %     3.1 %     -       3.5 %
     Total Company
  $ 317,862     $ 281,482     $ 36,380       12.9 %     4.8 %     -       8.1 %
 

(1)
The percentage change from currency is a non-U.S. GAAP measure. It represents the percentage change in revenue resulting from the difference between the average exchange rates during the three months ended June 30, 2011 and the same period of the prior year applied to foreign currency denominated revenues for the three months ended June 30, 2011.
(2)
Represents the percentage change in revenue during the three months ended June 30, 2011 compared to the three months ended June 30, 2010 attributed to incremental revenues from acquisitions subsequent to March 31, 2010.
(3)
Organic revenue growth is a non-U.S. GAAP measure and represents the percentage change in revenue during the three months ended June 30, 2011 compared to the three months ended June 30, 2010 net of acquisitions and the effect of changes in foreign currency exchange rates.

The following revenue analysis and discussion reports on organic revenue growth. Organic revenue growth should be considered in addition to, and not as a replacement for or as superior to, revenues reported in accordance with U.S. GAAP, and may not be comparable to similarly titled measures reported by other companies. Management believes that reporting organic revenue growth provides useful information to investors by facilitating easier comparisons of our revenue performance with prior and future periods and to our peers. We exclude the effect of changes in foreign currency exchange rates because changes in foreign currency exchange rates are not under management’s control, are subject to volatility and can obscure underlying business trends. We exclude the effect of acquisitions and divestitures because the nature, size and number of acquisitions can vary dramatically from period to period and therefore can also obscure underlying business trends.
 
 
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Companion Animal Group. The following table presents revenue by product and service category for CAG:

For the Three Months Ended June 30,
 
Net Revenue
(dollars in thousands)
 
2011
   
2010
   
Dollar
Change
   
Percentage
Change
   
Percentage
Change from
Currency (1)
   
Percentage 
Change from
Acquisitions (2)
   
Organic
Revenue
Growth(3)
 
                                           
Instruments and consumables
  $ 98,603     $ 86,455     $ 12,148       14.1 %     5.2 %     -       8.9 %
Rapid assay products
    44,193       40,481       3,712       9.2 %     2.3 %     -       6.9 %
Reference laboratory diagnostic and consulting services
    99,087       86,048       13,039       15.2 %     5.3 %     0.1 %     9.8 %
Practice management  systems and digital radiography
    17,851       19,336       (1,485 )     (7.7 %)     0.5 %     -       (8.2 %)
Net CAG revenue
  $ 259,734     $ 232,320     $ 27,414       11.8 %     4.3 %     0.1 %     7.4 %
 

(1)
The percentage change from currency is a non-U.S. GAAP measure. It represents the percentage change in revenue resulting from the difference between the average exchange rates during the three months ended June 30, 2011 and the same period of the prior year applied to foreign currency denominated revenues for the three months ended June 30, 2011.
(2)
Represents the percentage change in revenue during the three months ended June 30, 2011 compared to the three months ended June 30, 2010 attributed to incremental revenues from acquisitions subsequent to March 31, 2010.
(3)
Organic revenue growth is a non-U.S. GAAP measure and represents the percentage change in revenue during the three months ended June 30, 2011 compared to the three months ended June 30, 2010 net of acquisitions and the effect of changes in foreign currency exchange rates.

Instruments revenue was $21.1 million and $19.0 million for the three months ended June 30, 2011 and 2010, respectively. Consumables revenue was $66.2 million and $57.5 million for the three months ended June 30, 2011 and 2010, respectively. Instrument service and accessories revenue was $11.0 million and $9.7 million for the three months ended June 30, 2011 and 2010, respectively. The remaining sources of revenue are not significant to overall instruments and consumables revenue. The $2.1 million increase in instruments revenue was due primarily to sales of our ProCyte® Dx instrument, the hematology analyzer that we began shipping during the third quarter of 2010, partly offset by lower sales volumes of our other instruments as some of our sales focus has shifted to ProCyte Dx® and, to a lesser extent, lower average unit sales prices.  Lower average unit sales prices were due, in part, to discounts associated with customer purchase programs. The $8.7 million increase in consumables revenue was due primarily to higher sales volumes of consumables used with our Catalyst Dx® instrument, partly offset by lower sales of consumables used with our VetTest® chemistry instrument as customers continue to upgrade from VetTest® and other chemistry instruments to Catalyst Dx® instruments. Sales of consumables used with our ProCyte Dx® instrument also contributed to the increase in consumables revenue. The $1.3 million increase in instrument service and accessories revenue was primarily a result of the increase in our active installed base of instruments. The impact from changes in distributors’ inventory levels contributed 1% to instruments and consumables growth.

The increase in rapid assay revenue was due primarily to the favorable impact from changes in distributors’ inventory levels and, to a lesser extent, an increase in U.S. practice-level sales of our canine heartworm and canine combination test products and sales of our feline pancreatitis test product that we began shipping during the second quarter of 2011. Changes in distributors’ inventory levels increased revenue growth by 5%. These favorable impacts were partly offset by a decrease in U.S. practice-level sales of our feline combination test products as we continue to see a negative trend in feline visits to the veterinarian.

The increase in reference laboratory diagnostic and consulting services revenue resulted primarily from the impact of higher testing volume and, to a lesser extent, price increases. Higher testing volume was driven by the acquisition of new customers due in part to geographic expansion and customer acquisition related programs in which customers are provided incentives in the form of IDEXX points or cash in exchange for agreements to purchase services in future periods.

The decrease in practice management systems and digital radiography revenue resulted primarily from a decrease in sales of our digital radiography systems, partly offset by higher service and support revenue. Revenue generated from sales of digital radiography systems decreased in the second quarter of 2011 due to fewer system placements, combined with an increase in placement activity under customer acquisition related programs for which the consideration and related revenue is received and recognized over future periods.
 
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Water. The increase in Water revenue resulted primarily from higher Colilert® product sales volume. This favorable impact was partly offset by higher relative sales of Colilert® products in geographies where products are sold at lower average unit sales prices.

Livestock and Poultry Diagnostics. The increase in LPD revenue resulted primarily from higher sales volumes of certain bovine tests and, to a lesser extent, higher sales volumes of certain swine tests. The timing of revenue recognized related to a customer where revenue is recognized on the cash basis of accounting due to uncertain collectibility also contributed to the increase in revenue. The increased sales volume of certain bovine tests was due, in part, to sales in Germany where we have won several government tenders for testing in connection with a country-wide eradication program for a virus impacting beef and dairy production yields. These increases were partly offset by lower average unit sales prices of Bovine Spongiform Encephalopathy (“BSE” or “mad cow disease”) tests due to increasing competitive pressures. Effective January 1, 2009, the age at which healthy cattle to be slaughtered are required to be tested for BSE in the European Union was increased from 30 months to 48 months, which reduced the population of cattle to be tested. Effective July 1, 2011, the age has been further increased to 72 months, which will likely further reduce the population of cattle tested for this disease.

Other. The increase in Other revenue was primarily attributable to higher sales volumes of our OPTI Medical instruments and consumables, partly offset by lower sales volumes of our Dairy SNAP® Beta Lactam test used for the detection of antibiotic residue in milk.

Gross Profit

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

For the Three Months Ended June 30,
 
Gross Profit
(dollars in thousands)
 
2011
   
Percent of
Revenue
   
2010
   
Percent of
Revenue
   
Dollar
Change
   
Percentage
Change
 
                                     
CAG
  $ 138,332       53.3 %   $ 120,125       51.7 %   $ 18,207       15.2 %
Water
    12,968       60.3 %     12,328       63.4 %     640       5.2 %
LPD
    17,335       68.3 %     13,275       69.3 %     4,060       30.6 %
Other
    4,742       42.2 %     4,610       43.7 %     132       2.9 %
Unallocated amounts
    656       N/A       (1,054 )     N/A       1,710       N/A  
Total Company
  $ 174,033       54.8 %   $ 149,284       53.0 %   $ 24,749       16.6 %

Companion Animal Group. Gross profit for CAG increased due to higher sales and an increase in the gross profit percentage to 53% from 52%. The increase in gross profit percentage was due primarily to higher relative sales of higher margin consumables used with our IDEXX VetLab® instruments and reduced overall manufacturing costs associated with our IDEXX VetLab® instruments. These favorable impacts were partly offset by the net unfavorable impact of currency as the favorable impact from changes in foreign currency exchange rates was more than offset by the impact of increased hedging losses.

Water. Gross profit for Water increased as higher sales were partly offset by a decrease in the gross profit percentage to 60% from 63%. The decrease in the gross profit percentage was due primarily to lower average unit sales prices of our Colilert® products, higher freight costs as a result of rising fuel prices and the net unfavorable impact of currency as the favorable impact from changes in foreign currency exchange rates was more than offset by the impact of increased hedging losses. These unfavorable impacts were partly offset by the timing of certain manufacturing costs and, to a lesser extent, higher relative sales of our Colilert® products that yield higher margins.

Livestock and Poultry Diagnostics. Gross profit for LPD increased as higher sales were partly offset by a decrease in the gross profit percentage to 68% from 69%. The decrease in the gross profit percentage was due primarily to the net unfavorable impact of currency as the favorable impact from changes in foreign currency exchange rates was more than offset by the impact of increased hedging losses and higher relative sales of products that yield lower margins coupled with lower average unit sales prices for our BSE tests due to competitive pressures. These unfavorable impacts were partly offset by lower manufacturing costs and the timing of revenue recognized related to a customer where revenue is recognized on the cash basis of accounting due to uncertain collectibility. The decrease in manufacturing costs was due primarily to benefits achieved from economies of scale as a result of an increase in sales volume.
 
 
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Other. Gross profit for Other operating units increased as higher sales were partly offset by a decrease in the gross profit percentage to 42% from 44%. The decrease in the gross profit percentage was due primarily to higher freight and distribution costs in our Dairy business as a result of rising fuel prices and higher relative sales of lower margin products.  These unfavorable items were partly offset by lower overall manufacturing costs due primarily to benefits achieved from economies of scale as a result of an increase in sales and manufacturing volume in our OPTI Medical line of business.
 
Unallocated amounts. Gross profit for Unallocated increased due primarily to the favorable impact of certain manufacturing costs. See the subsection above titled “Business Overview and Trends” under the heading “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Quarterly Report on Form 10-Q for the three and six months ended June 30, 2011 for further information regarding the nature of these manufacturing costs.
 
Operating Expenses and Operating Income

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

<
For the Three Months Ended June 30,
 
Operating Expenses
(dollars in thousands)
 
2011
   
Percent of
Revenue
   
2010
   
Percent of
Revenue
   
Dollar
Change
   
Percentage
Change
 
                                     
CAG
  $ 80,062       30.8 %   $ 72,985       31.4 %   $ 7,077       9.7 %
Water
    4,567       21.2 %     4,178       21.5 %     389       9.3 %
LPD
    10,159       40.1 %     8,726       45.5 %