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Edited Transcript of CVET.OQ earnings conference call or presentation 13-Aug-19 1:00pm GMT

Q2 2019 Covetrus Inc Earnings Call

Aug 13, 2019 (Thomson StreetEvents) -- Edited Transcript of Covetrus Inc earnings conference call or presentation Tuesday, August 13, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Benjamin J. Shaw

Covetrus, Inc. - President, CEO & Director

* Christine T. Komola

Covetrus, Inc. - EVP & CFO

* Nicholas Michael Jansen

Covetrus, Inc. - VP of IR

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Conference Call Participants

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* David Michael Westenberg

Guggenheim Securities, LLC, Research Division - Analyst

* Erin Elizabeth Wilson Wright

Crédit Suisse AG, Research Division - Director & Senior Equity Research Analyst

* John Charles Kreger

William Blair & Company L.L.C., Research Division - Partner & Healthcare Services Analyst

* John Wilson Ransom

Raymond James & Associates, Inc., Research Division - MD of Equity Research & Director of Healthcare Research

* Jonathan David Block

Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst

* Kevin Kedra

G. Research, LLC - Research Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to Covetrus Second Quarter 2019 Earnings Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to turn the conference over to your host, Nicholas Jansen, Vice President, Investor Relations. You may begin.

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Nicholas Michael Jansen, Covetrus, Inc. - VP of IR [2]

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Thank you, Nicole. Good morning, and thank you for joining us for Covetrus' Q2 2019 Earnings Call. Joining me on today's call are Benjamin Shaw, our President and Chief Executive Officer; and Christine Komola, our Executive Vice President and Chief Financial Officer. Ben and Christine will begin with prepared remarks, and then we'll be happy to take your questions.

During this conference call, we anticipate making projections and forward-looking statements based on our current expectations. All statements other than statements of historical fact made during this conference call are forward-looking, including statements regarding management's expectations for future financial business, operational performance and operating expenditures. Forward-looking statements may be identified with words such as will, may, expect, plan, anticipate, upcoming, believe, estimate or similar terminology and the negative of these terms. Forward-looking statements are not promises or guarantees of future performance and are subject to a variety of risks and uncertainties, many of which are beyond our control, which could cause actual results to differ materially from those contemplated in these forward-looking statements. These risks and uncertainties include those under the heading risk factors in our most recent annual report on Form 10-K, quarterly report on Form 10-Q and other periodic reports filed with the Securities and Exchange Commission, which are available on the Investors section of our website at ir.covetrus.com and on the SEC's website at www.sec.gov. Forward-looking statements speak only as of the date hereof, and except as required by law, we undertake no obligation to update or revise these forward-looking statements.

During this presentation, we will also provide certain pro forma results for the 3 and 6 months ended June 30, 2019, and 2018 to help investors understand the underlying trends in the business as if the merger of the Animal Health Business of Henry Schein and Vets First Choice closed on December 31, 2017. Note, however, the historic combined financial statements do not necessarily reflect what the results of operations would have had we operated as a combined company as those results would depend on a number of factors, including the chosen organizational structure, what functions were outsourced and performed by employees and strategic decisions made in areas such as information technology and infrastructure.

You can find this morning's press release announcing our second quarter 2019 results and the slides referenced on the call on ir.covetrus.com. We will continue to use our site to distribute important and time-critical information.

The slides and the press release also contain further information about the non-GAAP financial measures that we will discuss during this call. These non-GAAP financial measures exclude certain noncash or nonrecurring items such as costs directly associated with the spinoff and merger and the ongoing integration process, including certain infrastructure investment expenses, from our GAAP financial results. We believe that in order to properly understand our short-term and long-term financial trends, investors may wish to consider the impact of these items as a supplement to financial performance measures determined in accordance with GAAP. Please refer to this morning's press release announcing our second quarter 2019 results for a reconciliation of these non-GAAP performance measures to our GAAP financial results.

With that, I will now turn it over to Ben to provide the highlights.

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [3]

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Thanks, Nick, and good morning, everyone. Today, I'll begin with some observations on our second quarter of 2019, which is our first full quarter as Covetrus. I'll discuss our progress on our strategic growth drivers, provide perspectives on near-term market dynamics and outline investments we're making to successfully complete the separation from Henry Schein.

Covetrus is a powerful new platform that empowers veterinary customers across the globe to unlock new health and financial outcomes. The integration of our market-leading practice management software, prescription and appointment management capabilities, along with our inventory management and supply chain services is a compelling value proposition for the veterinary market. Our platform promises to streamline workflow, improve client engagement, accelerate sales and improve practice performance on a global basis and all at a time when customers are increasingly demanding a new way to engage the channel and to meet changing client expectations. Covetrus has been very well received by customers and manufacturer partners, as evidenced by our strong customer engagement, new customer acquisition and improved customer satisfaction scores over the last couple of months, and we look forward to building on that momentum.

As we think about our transformation, we are measuring success during this period based on: first, completing our separation from Henry Schein and exiting TSAs in a seamless manner; second, delivering on our brand promise and enhanced value proposition for our global veterinary community that puts veterinarians at the center of everything we do; third, leveraging our strong market position to accelerate adoption of our platform in North America, Europe and APAC; and lastly, driving innovation and deeper integration in our platform, putting us in a position to unlock new value for our customers and manufacturer partners over the long term.

As I reflect on Q2, which is summarized on Slide 5, we made significant early progress in executing against all of these objectives, and we're delivering on our vision for an integrated ecosystem of capabilities and services. We aligned our commercial teams and corporate culture across the organization, and we've started the process of integrating the combined infrastructure to accelerate our ability to unlock the power of this platform. As an example, we made significant investments in Q2 to enhance our practice management software and our prescription management capabilities for the immediate benefit of customers. We also delivered on early value capture work and remain on pace to unlock more than $100 million of run rate EBITDA by the end of year 3. Our technology platform is gaining momentum in the market, and we're confident in our ability to drive new growth and value for our customers globally.

That said, Q2 was impacted by challenges in North America and the U.K. In the U.S., we saw moderating foot traffic in veterinary practices and declining sales of veterinary products purchased through distribution and resold to their clients. We also saw unusual inventory activity in the U.K. related to Brexit. At the same time, Covetrus has significantly accelerated investments tied to our separation from Henry Schein and the build-out of infrastructure that supports completion of the carve-out. These dynamics are offsetting the good progress we have made to date and are creating a delay in the transformation time line we previously discussed. Christine will discuss our updated outlook later in her prepared remarks.

Our conviction in our strategy remains extremely high as the rapid evolution of the market is accelerating the need for our platform and our integrated value proposition. Our technology platform, which includes Vets First Choice and our practice management software portfolio, witnessed faster pro forma year-over-year sales growth in Q2 versus Q1. Our platform now represents more than 9% of the company's net sales as compared to 7% of pro forma sales in the prior year. These sales are growing much faster than the rest of our business year-to-date as we leverage the expanded sales force, larger customer base and deliver significant new enhancements that further differentiate our capabilities. We're in the early innings of this Covetrus journey. The strong growth in our -- in new customers, the accelerating pace of engagement of users on our platform gives us great confidence in the long-term opportunity.

Turning to progress on our long-term value-creation plan, beginning on Slide 6. We successfully exited another 11 TSAs in Q2 and are on track with the remaining 9 TSAs for 2019. Our team has done a great job of identifying the right strategies to navigate the transition process, and we're accelerating certain investments to pull forward the time line for several high-priority TSAs. Although these actions are resulting in Covetrus having additional infrastructure expense and duplicative costs in the near term as we create replacement functions, we continue to believe these efforts will result in enhanced service levels, improved operational effectiveness and will result in the successful wind-down of our reliance on these TSAs.

From a commercial perspective, our global teams are now aligned and coordinating their go-to-market efforts. This alignment has already helped us win new business and results in the expansion of a number of key new relationships through Q2. These wins are projected to serve as a tailwind entering 2020 as these customers ramp engagement.

Turning to Slide 7. Our North American commercial team remains extremely focused on driving the rapid adoption of our proactive prescription and appointment management platform and our practice management software. This has been our top priority since day 1, and we're seeing momentum across all leading indicators.

Enrollments on our prescription management platform increased nearly 20% sequentially as we benefit from early efforts by our combined North America sales team that now represent the combined value proposition. We ended Q2 with more than 8,700 practices on our prescription management platform and enjoy a healthy pipeline of addition new practice partners we expect to enroll in the second half of this year. Importantly, the quality of these new enrollments under our prescription platform in the first half of the year supports our enthusiasm for the opportunity that lies ahead. We're experiencing faster sales activation times with the support of our expanded account management team, that is the shortening of the onboarding time from enrollment to sales generation.

Quarterly activations increased by more than 40% sequentially during Q2, faster than the sequential enrollment growth in the quarter as we've accelerated our efforts in not only driving new enrollments but also converting these accounts to sales-generating accounts more efficiently. Of note, 2019 accounts that have a full quarter of sales in the platform and were signed up by our expanded account management team generated 50% higher sales in the first 90 days versus our historical cohorts.

For example, one of our many success stories thus far is a practice in the Southeast of the U.S., which was onboarding in late first quarter as a result of strong long-term legacy supply chain relationships. The account has generated more than $60,000 in net sales since launch, highlighting the magnitude of the opportunity within the large and growing customer base. Another example is a practice in the Midwest of the U.S. that our supply chain team converted from a competing online pharmacy service. The first 2 months of net sales by this practice averaged approximately $10,000 per month utilizing our platform as compared to less than $5,000 in the competitor service for all of 2018. As a last example, a small group practice that signed up in Q1 in Texas generated more than $25,000 in net sales in the first full quarter out of the gate of the platform while, at the same time, growing their in-office sales for the benefit of our supply chain relationship. These and multiple other customer success stories are highlighting the power of our platform, the significant competitive differentiation we enjoy in the market and ability to drive insights, deeper client engagement, improved service, better practice workflow, versus the competitive peer group.

As a reminder, once a veterinary practice has been onboarded to our prescription management platform, there's a predictable ramp-up in utilization. As these customers create new active recommendations, those prescriptions are filled and refilled and pet owners clients subscribe to AutoShip services, and then veterinarians can renew those prescriptions in subsequent periods, like year 2, year 3, year 4. With this in mind, we believe we are well positioned to see the ramp in utilization and top line sales acceleration planned for these newly onboarded practices. We reiterate our guidance to deliver more than 3,000 prescription management practice enrollments for 2019 and to end the year with greater than 10,000 practices on our prescription management platform.

Looking beyond 2019, we're working towards the international launch of our prescription management platform, which is progressing as planned and is a top priority.

In addition to driving new enrollments, we're keenly focused on accelerating proactive prescription management activity from existing customers. New initiated therapies grew 57% year-over-year in Q2, an acceleration versus Q1 year-over-year growth rates, which will empower customers to drive new active recommendations for prescription medications. This increased focus on proactive client engagements enable us to drive sustainable double-digit growth from existing veterinary customers enrolled in 2017 or earlier, which is akin to same-store sales.

Same-store sales growth was 16% year-over-year in Q2, which exceeded expectations. Total prescription platform net sales increased 46% year-over-year in Q2, which is also 22% growth above our record Q1 2019 net sales. We're really pleased by this trajectory and expect to maintain strong momentum heading into the second half of this year. Faster sales growth and the broadening scale of our high-margin technology platform is contributing to underlying profitability gains and gross margin expansion.

We also made great progress in growing the number of customers using our portfolio of practice management software systems. The number of net new customers added during the second quarter under our cloud-based practice management software increased 20% versus the same quarter last year. Currently, our cloud-based installation base represents 8.2% of our total PIMS customers, which is an increase of more than 200 basis points year-over-year and 70 basis points sequentially.

We also continue to see strong growth in our legacy client/server customer base as well. Importantly, we delivered major signature enhancements to legacy client/server software in Q2, including our market-leading AVImark and ImproMed practice management systems, which really strengthened our competitive position while improving system performance and enhancing workflow. We're excited to bring even more innovation to the market in the second half of this year.

We believe our leadership position in practice management software has strategic implications as we seek to deliver new coordinated prescription, appointment and inventory management solutions in 2019 and beyond. Deep integration with PIMS and leveraging insights to improve medical and service compliance is a core focus as we continue to unlock new category growth, improve practice profitability and further differentiate Covetrus from its competitors.

Turning to value capture, which is presented on Slide 9. We exited Q2 with a $4 million of incremental EBITDA run rate largely tied to our initial procurement activities. Importantly, we expect that our new shipping contract, which was signed in Q2 and goes into effect in Q3, will deliver more than $25 million in savings over a multiyear contract. Work is also under way on our global supply chain capabilities as we seek to optimize our logistics network worldwide in support of 2020 value capture objectives.

We're also in the process of building out pharmacy capabilities inside our North American distribution centers. I think this is a really great example of how we intend to leverage our combined capabilities in fixed infrastructure to both reduce costs and improve service levels. Such initiatives, combined with the robust year-to-date enrollments, put us on track to achieve our run rate value capture targets by the end of this year. In total, we remain committed on delivering the anticipated $100 million in run rate value capture by the end of the third year of Covetrus.

Now turning to Slide 10. While we have made progress on a number of items since early February, it is clear that a slowdown in the North American animal health market is undermining early gains from our transformation efforts. Slowing patient visits to the veterinary practice and increased competition has put incremental pressure on our in-office supply chain business in North America relative to our initial expectations of mid-single-digit industry growth as we've seen in 2017 and 2018. Our manufacturer partners are also reporting decelerating growth in the U.S. in Q2. And market data of nearly 5,000 practices confirm sales growth of products purchased through distribution and resold by veterinarians to their clients declined 1.2% year-over-year in Q2, which is 50 basis points lower than the growth rate those practices experienced in Q1 and the positive 2.3% in Q2 last year. Please note that Covetrus does not sell to customers outside the veterinary channel in North America, which impacts comparisons to the data published by some of our competitors and some manufacturers.

While we expect the rapid growth of technology services and our differentiated value proposition to continue to support an above-market growth trajectory for Covetrus in North America long term, we believe it's prudent to reset our near-term growth outlook in the second half of this year based on the recent trends. Long term, we remain very bullish on the overall health of the channel, the role the veterinarian will continue to play globally and our strong market leadership position. Notwithstanding market dynamics, we're focused on new customer acquisition, enhancing our account management capabilities and accelerating market penetration for our differentiated technology platform. We continue to believe our platform is well aligned with where the veterinary market is headed in North America and around the world, and we expect to increase our share of wallet and to expand the category overall as we help drive compliance.

With that, I'll turn it over to Christine to review our 2Q '19 results and provide additional color on our updated guidance for this year.

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Christine T. Komola, Covetrus, Inc. - EVP & CFO [4]

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Thanks, Ben. Good morning, everyone, and thank you for joining us today. I'd like to echo the comments made by Ben that we remain encouraged by the progress made thus far on driving our long-term Covetrus transformation and the strength of our technology platform in the second quarter, which remains our strategic long-term driver of accelerated net sales growth and margin expansion. While market dynamics and infrastructure investments are creating a delay in the timing of the transformation, we remain confident in our value proposition and our ability to execute against our long-term priorities, which, in turn, should drive sustainable growth and shareholder value creation over time.

Now turning to the second quarter financials. Slides 11 and 12 provide details on our GAAP results as well as the adjustments we made to arrive at our non-GAAP results. I will focus my comments on our adjusted measures to provide insights into the underlying trends of our business. Please refer to today's press release for a detailed description of the year-over-year changes in our GAAP results.

Looking at Slide 13. Total Covetrus net sales were slightly over $1 billion in Q2. On a pro forma basis, which includes Vets First Choice in the prior year, net sales declined 4% in Q2, of which foreign exchange effects were a 3% headwind. Non-GAAP pro forma organic net sales declined 1%.

As Ben mentioned in his comments, net sales growth this quarter was affected by the market slowdown in North America and Brexit-related disruption in the U.K., which was partially offset by strength in our prescription management platform. Results also include the impact from the previously announced customer loss in North America prior to the formation of Covetrus and the impact in APAC tied to the manufacturer moving to a direct sales model in Q4 2018. Normalizing for these, underlying pro forma organic growth, it would've been 2% in Q2 and 3% year-to-date.

Our GAAP gross margin was 19.8% in Q2 versus 18.2% in the prior year. If Vets First Choice was included in the prior year period, gross margin as a percentage of sales would have improved 40 basis points year-over-year. The improvement in the quarter was driven by sales mix, the increased contribution from our higher prescription management software and specialty businesses.

Our GAAP selling, general and administrative expenses were $205 million during the second quarter of 2019. Pro forma corporate expenses ramped up in Q2 due to infrastructure investment timing and our efforts to accelerate the exit from the certain transition services agreements, which resulted in certain duplicative costs being incurred. Specifically, such expenses were redundant with the TSA agreements as we prepared to transition responsibility to our internal team, which has the short-term effect of a double-paying for the same service. As we get further and further into the transformation over the next 12 months, we expect to see a reduction in the duplicative expenses captured in the P&L today.

It is worth noting that our Q2 results also include $4 million of operating expense, $2 million of which are recurring, tied to our infrastructure investments, which were expenses were previously not contemplated in our prior outlook and were instead included in the estimated $100 million onetime infrastructure investment discussed at our Covetrus Capital Markets Day.

Adjusted EBITDA, which excludes special items and share-based compensation, was $53 million versus $62 million in the prior year on a pro forma basis. The year-over-year decline was driven by continued investments in the platform and a top line shortfall we discussed earlier. Changes in foreign exchange also impacted EBITDA by $2 million year-over-year. As we discussed in our Q1 earnings call, our results did include a step-up in R&D, which impacted our year-over-year comparison.

While Q2 adjusted EBITDA improved sequentially, similar to as we discussed on our last quarter's call, the magnitude of that improvement fell short of our internal expectations due to the North America slowdown, Brexit-related disruption and the higher spend on infrastructure investments and TSA exits, some of which is timing. Notwithstanding, we were encouraged by the improvement in profitability by our technology platform as these operations continue to accelerate their growth and their contribution.

Turning to the rest of the income statement. We had approximately $14 million in net interest expense, which was primarily interest on our $1.2 billion term loan, offset by interest income from our cash deposits. Our GAAP net loss was $10 million or a loss of $0.09 per diluted earnings per share. Pro forma adjusted net income, as seen on our non-GAAP reconciliation, was a positive $14 million.

Moving to our business segment performance on Slide 14. North America pro forma organic net sales were flat year-over-year. As previously announced, loss of a customer weighed heavily on organic growth in Q2 by 3%. Sequentially, higher year-over-year growth for prescription management, including our specialty pharmacy business, was offset by the U.S. market slowdown. We expect our rapid growth in prescription management to continue in the second half of 2019 as we are aided by increased visibility into growth in AutoShip services, activated enrollments, and we are encouraged by the number of new corporate account wins in Q2, which should help us continue to outpace overall market growth.

Turning to our European segment on Slide 15. While pro forma organic net sales was impacted by Brexit-related dynamics in the quarter, we are optimistic about our market position and the enthusiasm for the launch of our platform in this market in 2020. Specifically, pro forma organic net sales in Europe declined 1% in Q2, with the U.K. down year-over-year 4% as the pre-Brexit inventory buildup by our veterinarian practice customers unwound more significantly than expected during the quarter.

Outside of the U.K., we saw good organic growth in most European markets, including solid performance from our businesses operating in Ireland, Belgium and the Czech Republic. Importantly for the segment, we recently secured a new multiyear contract with one of the largest corporate groups in Europe. We believe our strategic position as the only pan-European player in the market creates a compelling value proposition and competitive advantage for us. This specific contract should drive an acceleration in organic growth in Europe in the second half of 2019.

We also continue to see strong results from our specialty businesses and were particularly pleased with our instrument placements at scil, which is our veterinarian diagnostic business that generates approximately $80 million in annual sales. We are continuously looking to drive increased adoption of our proprietary brands, not only throughout our European customer base but also across our business operations in North America and APAC and the Emerging Markets.

As seen on Slide 16, APAC and Emerging Markets business experienced a 1% decline in pro forma organic net sales in Q2. However, it is important to remember that a manufacturer went to a direct sales model in this market in Q4 last year, which negatively impacted our business' sales growth by 8% year-over-year. Normalizing for this, this segment grew at the high single digits, an acceleration from last quarter as our team has quickly replaced the business with new sales opportunities. Our success has been aided by new customers, a new exclusive manufacturer partnership and the cross-selling of our software business. We expect our overall value proposition within the market to further accelerate with the launch of prescription management in the upcoming years.

Turning to the balance sheet and cash flow metric. Covetrus generated $3 million in cash from operations during the first 6 months of 2019 and negative $18 million in non-GAAP free cash flow when subtracting net purchases of fixed assets of $21 million. For the full year, we expect $50 million to $60 million in capital expenditures, including our infrastructure investments. We ended Q2 with $55 million in cash and cash equivalents on the balance sheet, $1.2 billion in long-term debt and no borrowings against our $300 million revolving credit facility.

Our leverage ratio, as defined by our credit agreement, stood at 4.3x for the trailing 12 months ending June 30, 2019, as our credit agreement permits adjustments to EBITDA for certain special items as well as considering our value capture that we expect to realize over the next 12 months. As a reminder, we remain committed to deleveraging in addition to the mandatory $15 million quarterly long-term amortization payment that begin in the first quarter of 2020.

On 17 Slide, I want to provide an update on the previously disclosed infrastructure investments tied to TSA exits and standardizing certain core functions. Significant work has been completed to redefine planned infrastructure investments that are associated with certain TSA exit strategies, which include detailed business requirements, RFP processes, et cetera. Based on this work, we reiterate our expectation for approximately $100 million onetime spend over the next 3 years, and we now estimate that $40 million of this spending will occur in 2019. This spending also reflects $10 million to $15 million in reoccurring operating expenses, $2 million of which we have incurred in Q2 that will now become part of our adjusted EBITDA presentation on a go-forward basis.

Finally, turning to our full year guidance on Slide 18. We now project non-GAAP pro forma organic net sales growth of low single digits versus our previous 3% to 5% growth expectation and the 1% growth rate we have achieved year-to-date. The update in our pro forma organic net sales growth guidance reflects the reduction of our market growth rate assumption in North America and the Brexit-related disruption to our U.K. business. We continue to believe that the rapid growth in our prescription management platform and the momentum in the number of new customer wins will enable Covetrus to outperform market growth rates in 2019. Note that the expected impacts from the previously disclosed loss of a customer in North America and the impacts of one manufacturer moving to a direct sales model in APAC in October 2018 remains unchanged at more than 2% in 2019.

Also, foreign exchange fluctuations could result in an approximately 2% headwind to reported non-GAAP pro forma net sales growth for 2019 should rates remain unchanged from the year -- from the end of Q2.

Given the market headwinds on forecasted net sales growth and the infrastructure investments previously discussed, we now project 2019 non-GAAP pro forma adjusted EBITDA to be at least $200 million. This compares to a range of $235 million to $250 million of non-GAAP pro forma adjusted EBITDA previously announced. Importantly, our forecasted value capture remains on track for the run rate targets that we've discussed earlier. As we reiterate our guidance for more than 3,000 enrollments onto our prescription management platform, as I've mentioned before, we will continuously look for ways to improve free cash flow conversion, and we remain committed to deleveraging the balance sheet as previously discussed.

I will now turn it back over to Ben for some brief closing remarks.

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [5]

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Thanks, Christine. In summary on Slide 19, we're pleased with key aspects achieved so far of this large-scale transformation into a global industry leader and with how we are tracking toward strategic objectives. We're encouraged by the accelerated growth in platform enrollments and continue to believe our combined capabilities are compelling to veterinary customers in context of what is becoming a more challenging market environment for their practices. These are early days in our multiyear transformation process, and we're very enthusiastic for our prospects. I'm confident that our team of more than 5,500 employees can deliver on our promise in the years ahead. And I'd like to personally thank each of our team members for all the efforts to manage through a complex transaction, drive new innovation for our evolving industry marketplace and help establish core infrastructure to support long-term growth aspirations. Our collective passion for the veterinary community and our ability to unlock significant value for our customers, their clients and manufacturer partners puts us in a unique position to drive long-term shareholder value creation.

This concludes our prepared remarks. I'd now like to turn over to Nick to moderate Q&A discussions.

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Nicholas Michael Jansen, Covetrus, Inc. - VP of IR [6]

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Thanks, Ben. (Operator Instructions) So Nicole, please provide instructions for the Q&A session, and we are then ready to take the first question.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from John Kreger from William Blair.

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John Charles Kreger, William Blair & Company L.L.C., Research Division - Partner & Healthcare Services Analyst [2]

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Christine, can you maybe just sort of break down the -- so you've roughly, I think, taken your expectations for '19 EBITDA down by about $40 million. Can you just sort of break that down? How much of that is accelerated spending versus a more cautious view on the U.S. versus a more cautious view on the U.K. or anything else I might have missed?

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Christine T. Komola, Covetrus, Inc. - EVP & CFO [3]

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Sure. As we looked at the results that came in, the majority of it is based on the drive -- the market down in North America. That's the primary driver. There is definitely overhead costs which are increasing and duplicative costs. That is also factored into it as well as, we mentioned, the IT infrastructure investments of between $10 million to $15 million. But the stress in the marketplace that we've seen is the primary driver in North America.

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John Charles Kreger, William Blair & Company L.L.C., Research Division - Partner & Healthcare Services Analyst [4]

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And Ben, as you look at the more granular results out of North America, can you just give us a little bit more input on what you think is really going on? I mean to what degree is this maybe a shift to other e-commerce channel versus just less traffic in the practice versus anything else?

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [5]

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Yes. Well, for several quarters in a row, we've seen a slowdown relative to historical trends. We've seen a slowdown in the number of visits to veterinary practices, which has impacted product sales out of a practice. We see continued and strong competition from alternative channels, which give consumers a lot more options. And we also see manufacturer support for a broadening range of channels. But we -- I think the core issue is we saw market -- we saw the market growth within clinic sales of veterinary products purchased and resold to pet owners decline for the third consecutive quarter. And that's a surprise relative to a really strong finish in Q1 and a good start to Q2, but that trend did continue from Q4, Q1 and now into Q2.

Maybe a last comment would just be that we saw the impact across the board. So not just in dispensed medications. We saw it in equipment sales, we saw it in a variety of products that are sold to practices. I just want to be clear that this was not just for dispensed medications, but we saw a slowdown in growth for visits, which impacted all classes of products and services in the veterinary practice.

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Operator [6]

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And our next question comes from Erin Wright from Crédit Suisse.

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Erin Elizabeth Wilson Wright, Crédit Suisse AG, Research Division - Director & Senior Equity Research Analyst [7]

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Okay. A follow-up to that last question. In terms of kind of the pressure you mentioned in North America, it's seemingly somewhat of a disconnect from other industry constituents. And I was just curious if there was any sort of share shift going on amongst the distributors. Or can you speak to some of the changes in the competitive landscape that may be unique to you, whether it be manufacturers establishing direct relationships with the alternative channels, how that can impact you longer term? And then can you remind us where the Vets First Choice platform can be positioned in all of this and help vets as an alternative and how quickly that can resonate with your customers or how quickly you can have an offset to this pressure?

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Nicholas Michael Jansen, Covetrus, Inc. - VP of IR [8]

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Erin, this is Nick. I'll provide a brief perspective on just kind of the overall industry dynamic that we saw. Other third-party market data would suggest that veterinary clinics did decelerate Q1 -- Q2 to Q1, so I don't think this is necessarily something that was specific to us. And some of the manufacturers also reported a slowing trend in the U.S. in Q1 -- or excuse me, in Q2 relative to Q1. I'll let Ben discuss kind of the competitive dynamics. Ben?

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [9]

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We feel like our value proposition -- the Covetrus value proposition is resonating very well in the market. We have strong new customer wins. We feel like we're in a share-gaining mode. We described that not only in our online channels but in software and in our supply chain businesses. I really think that there's never been a greater need for veterinarians for our prescription management capabilities and the integration that we've achieved -- we're achieving with practice management software. This is giving veterinarians the tools they need to respond to changing market pressures and changing client expectations. And so we're seeing a big call to action for enrollment onto the platform and we think that's going to continue to be a source of momentum going into the second half of this year. We feel like we're ideally suited in the market to be able to help veterinarians respond to these pressures.

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Erin Elizabeth Wilson Wright, Crédit Suisse AG, Research Division - Director & Senior Equity Research Analyst [10]

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Okay. And then in terms of your guidance, what does your guidance now assume in terms of underlying realized synergies for 2019? And how should we be thinking about the -- over the next couple of years here how those synergies and the timing thereon in terms of realization of those?

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Christine T. Komola, Covetrus, Inc. - EVP & CFO [11]

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I will take that one. We actually continue to feel very confident in our value capture momentum. As you heard earlier, we exited with a $4 million run rate this quarter. We are on target for a $20 million run rate by the end of this year and fully committed to the $100 million by the end of year 3, so no change to that.

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [12]

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Maybe I'll just add to it that I did acknowledge that we signed a multiyear new shipping contract that will generate $25 million of value capture over a multiple year contract. And that our enrollments and the strong same-store sales growth experienced, which exceeded our expectations, are contributing to our bullish views on value capture.

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Operator [13]

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And our next question comes from Jon Block from Stifel.

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Jonathan David Block, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [14]

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This may build on the prior 1 or 2 questions. But Ben or Christine, just on long-term growth targets of double-digit adjusted EBITDA growth. So is that still intact off, call it, the much lower 2019 adjusted EBITDA base? Or how should we think about that target in the out years with some of the moving parts to end market demand? And then I've got a follow-up.

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Christine T. Komola, Covetrus, Inc. - EVP & CFO [15]

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Jon, we actually haven't changed our outlook at this point. We feel confident that those numbers still make sense. We are committed to them and we haven't changed anything for our long-term outlook.

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Nicholas Michael Jansen, Covetrus, Inc. - VP of IR [16]

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And Jon, just as a follow-up. As you can imagine, the value capture, as we've previously communicated, builds in 2020 into 2021 serving as a tailwind. And the prescription management platform will become a bigger piece of the overall pie as will our practice software assets, which all come with a higher margin profile relative to the supply chain business.

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [17]

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Yes. Just contributing to that then. Not only stronger-than-expected same-store sales growth in the platform, but we also discussed that enrollments grew 20% sequentially. But activations of accounts grew 40% sequentially. And we're really encouraged by the strong performance in the market by our expanded account management base, being able to drive enrollments and activations and achieve higher-than-expected -- historically expected first quarter full sales from new accounts. So that is going to continue to provide strong organic growth in -- particularly impressive given the backdrop of low single-digit market growth.

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Jonathan David Block, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [18]

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Perfect. And that's actually a good segue to the second question, which -- I hope some of these numbers are right, but it looks like the number of North American practices joining the prescription management platform was roughly 700 for the quarter. I believe 1,200 for the first half of the year, but I think you reiterated 3,000 for all of '19. So can you talk to the ramp implied in the back part of 2019? If there was any seasonality that may have weighed on some of the figures in 2Q '19?

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Nicholas Michael Jansen, Covetrus, Inc. - VP of IR [19]

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Yes. I'll provide some perspective on just historical numbers, and then -- and Ben can talk about the future. But as you saw in our registration statement last year, we ended 2017 with 5,100 practices on the platform. And we said at the end of Q2 that we are at roughly 6,000. And so if you do that 900 incremental relative to the 2,400 that we did last year, it was about a 40% in the first half of the year and we're on track with that same type of dynamic with the 1,200 we discussed. But Ben can talk about the enrollments in terms of our account management team.

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [20]

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Yes. Remember, this is our first full quarter operating as Covetrus. We stood up and aligned our North America commercial organization. We have really strong execution on both enrollments and activations in the second quarter, and I think that set us up really well in the second half to continue to drive significant enrollment activity. We have a lot of confidence. We're seeing outperformance in that model, and the success stories that our account managers have now witnessed has given everyone a lot of confidence about what this looks like. The overall backdrop of strong competition from online and alternative channels is just fueling the need for our platform and I think is going to continue to support a strong enrollment activity. So we'd reiterate that we're really confident in that 3,000 enrollment target for this year.

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Operator [21]

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And our next question comes from Kevin Kedra from G. Research.

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Kevin Kedra, G. Research, LLC - Research Analyst [22]

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Throughout kind of the spin and the IPO process, we've seen kind of the performance management ratio -- the EBITDA outlook kind of shift downward over time. We're seeing another shift down with the outlook today. So how can you reassure investors and give us that confidence that the company has kind of hit a bottom or a point of stabilization in this outlook for the full year and this is a point of growth from this current level? And then secondly, on AutoShip, did you -- I don't know if I missed it, but did you guys give kind of a number, kind of percentage of pet owners or pet parents that are using AutoShip? And where do you think that percentage can go? And is that a valuable metric in looking at where the business is going?

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Christine T. Komola, Covetrus, Inc. - EVP & CFO [23]

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Kevin, it's Christine. Let me start with our kind of EBITDA guidance. As we said, the market really has a stress point right now. I don't think that this long-term market is at this low. I think that we will continue to gain share as we've been talking about with our platform and the technology businesses and the veterinarian opportunities. So I think as we look forward, this is really just a 2019 guidance. We feel confident in the numbers and the expectation, really focusing in on where the gaps are within the North America businesses.

As you heard earlier, Europe and APAC continue to have strong, solid, good momentum within each one of those businesses. The veterinarian practices in each one of those businesses continue to kind of gain share and momentum across the categories, and they've got a multi-strategy in terms of gaining that customer relationship. So feel really good about those businesses. I'll turn it over to Ben to talk more strategically about some of your specific questions on activation.

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [24]

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Just maybe one comment on the first piece, just also at this point in the year, we have great visibility to the nature of our infrastructure investments. We exited 21 TSAs this year. We had 9 in the second half. And we're at a point where we have detailed plans and understanding of the level of infrastructure investment we need to make and how those costs break out in terms of onetime infrastructure investments and the recurring operating expense. So we just have a lot greater visibility and more detailed plans that we're now in an implementation mode, and I think that gives us a lot of -- more confidence than where we were in January, providing a approximately $100 million estimate on IT infrastructure investments. So I think that's also important to your question.

I think you asked about AutoShip. And I think AutoShip can be a very useful measure to understand within our prescription management business. It affords a lot of predictability and a sense of recurring revenue. It helps us understand how we can be more planful and faster to service those customers. We have very high rates of AutoShip. A number of products we dispense are not AutoShip-eligible. And so if we look at AutoShip-eligible products, those continue to be very, very high rates of subscription, north of 70%. As a part of the growth we've experienced year-over-year, more than 70% of that growth are from transactions that are on AutoShip.

But just a reminder, not all of the medications that we dispense are AutoShip-eligible orders. Some of them are, for example short-course antibiotics or acute care products that really do not have a refill profile. So that's going to be more akin to some of our food, therapeutic diets, preventatives, maintenance and chronic medications where you're going to see higher rates of AutoShip.

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Operator [25]

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And our next question comes from John Ransom from Raymond James.

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John Wilson Ransom, Raymond James & Associates, Inc., Research Division - MD of Equity Research & Director of Healthcare Research [26]

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Just want to clarify the G&A. The $10 million to $15 million, is that basically an accounting change, especially on what you thought going in? And doesn't represent a change in cash, but would affect the P&L? I just want to make sure we understand that.

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Christine T. Komola, Covetrus, Inc. - EVP & CFO [27]

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Sure, John. It is actually not a change in cash. So that much I can confirm back. If you recall at our Capital Market Day, we identified the need for about $100 million over 3 years to invest into our infrastructure and to plan for the TSA. So the -- as Ben mentioned just a few minutes ago, it really is focused on now understand the components, the specific plan, what needs to happen. We've done business cases to define what should be onetime -- truly onetime, what would be reoccurring and what will be capital for the prudent 2019 plan.

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [28]

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So yes, it's kind of an accounting clarification on how those expenses would be realized in the P&L.

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John Wilson Ransom, Raymond James & Associates, Inc., Research Division - MD of Equity Research & Director of Healthcare Research [29]

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Right. So as we -- I know you aren't giving guide on '20 and '21, but as we think about trying to project G&A with all of these moving parts, using 2019 as a base, could you at least give us a little bit of help in terms of how to think about G&A in the next 2 years?

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Christine T. Komola, Covetrus, Inc. - EVP & CFO [30]

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We haven't given, as you said, specific guidance on it. But I think it's fair to say across that these reoccurring expenses as a percentage of the total is probably reasonable estimate. We'll continue to provide more as we see more into the 2020 plan, but I think it's reasonable as the -- as approximate read.

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Nicholas Michael Jansen, Covetrus, Inc. - VP of IR [31]

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And John, as Ben mentioned in our prepared remarks, we're obviously looking to drive more efficiencies in our business as we think about just the market overall and some of the value capture activities we're exploring. And so those are other things to consider as you think about the G&A buildup for 2020 and beyond.

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [32]

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Yes. And of the spirit of this, these investments with strong business cases supporting them, we think, in many cases, we'll be able to lower cost and improve service. And so the yield on those investments we expect to be attractive.

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John Wilson Ransom, Raymond James & Associates, Inc., Research Division - MD of Equity Research & Director of Healthcare Research [33]

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Okay. My second question is I think as we think about the legacy vet source business and the sales ramp from here, has anything changed in your view in terms of the cohort data onboarding of revenue? I mean we think about it as kind of $10,000 in the first year and $50,000 in the fifth year coming in at a high-20s, low-30s contribution margin. Has anything -- with this new -- you've signed up so many accounts recently. Have you seen anything in the data that says this new batch of customers looks any different than your historical cohorts?

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [34]

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If anything, we're seeing some really positive signals there. The answer to your question is no, I don't see anything fundamentally different. But we did mention that accounts enrolled year-to-date activated much faster. So we saw a 20% sequential growth in enrollments, about a 40% sequential growth in activation. So the time from enrollment to first revenue has improved materially as a function of our go-to market.

And the second point being that the quarterly revenue growth from the first full [month of] quarter from newly enrolled accounts by our expanded sales team had 50% higher growth in the first quarter than it did in prior historical cohorts. So 2019 cohort is off to a very good start, well above historical expectations. And I think that we exceeded our expectations for same-store sales growth in Q2 despite what was a difficult overall market. So we're really confident in the fundamentals of growth in new initiated therapies, the platform performance in refills and renewals and overall yield on prescriptions under management. We're really comfortable with enrollment to activation activity. And we're liking what we're seeing in terms of first quarter revenue from first -- from new cohort relative to historical averages. So overall across the board, very consistent, very healthy and in some cases, better than what we had seen in the past.

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John Wilson Ransom, Raymond James & Associates, Inc., Research Division - MD of Equity Research & Director of Healthcare Research [35]

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Okay. I guess what's odd to us is that you're clearly taking share in this channel, but it looks like your growth is -- and I know there's one-off things with APAC and with losing an account. But it's odd that you cite that customers are more willing to -- less willing to buy through the distribution channel at the same time while you're taking share in the Vets First platform. So those are the 2 -- I guess it looks a little noisy to us, kind of outside looking in, why those 2 things would be occurring at the same time.

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [36]

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Well, I think what we're seeing is that traffic into the office has slowed and that's now a multi-quarter pattern. And the need -- our ability to be very proactive in the way we attack gaps in care, both for dispensed medications and for in-office services, is coming at a time when veterinarians need help driving incremental revenues and addressing declining foot traffic. So I think that the platform is demonstrating that its ability is to drive new category growth to improve on compliance levels seen in the practice. And it's coming at a time when they really need this level of support and engagement. So I feel like in a lot of ways, the market dynamics have created a lot of urgent need for our prescription management and appointment management capabilities.

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Christine T. Komola, Covetrus, Inc. - EVP & CFO [37]

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And John, I just want to add, like in that, we look at the visits. I mean, this isn't just our visits. This is several thousand third-party resources that have identified this trend of the slowing business. It's not specific to us or anything like that. So just to be clear, that trend is from external forces.

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Operator [38]

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And our last question comes from David Westenberg from Guggenheim Securities.

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David Michael Westenberg, Guggenheim Securities, LLC, Research Division - Analyst [39]

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So we're starting to hear companies like PetMeds and Chewy also talking about compliance. Just -- do you believe that their -- it's a response to you? And do you think that's a sustainable kind of a business model or a business strategy given the fact that it's not necessarily through the veterinary channel?

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [40]

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So I don't think that unless you have the trust of the veterinarians, you really understand the days on therapy for an individual patient, for an individual medications and you're able to understand both the online dispensing and in-office services. We are positioned to really completely picture about what compliance for a patient looks like. And I think that's why our strong partnership with veterinarians and our ability to have great insights to the state of care, both in-office and online, for any individual patient is allowing us to have accuracy and being able to improve the impact of proactivity relative to driving days on therapy. I think that AutoShip as a sort of predictor of possible compliance gains, in our experience, is tricky. I think it's more relevant for a food-type services. I'm not really sure that clients are stopped -- are going to stop feeding their dogs just because they're not on AutoShip. So I'm not sure AutoShip in the food context is really a great predictor of improvement in compliance.

But I think in order to be able to make claims regarding medical compliance, you really have to be in a position to have the raw data, have a 3-year view of patient care and to be able to study and understand both in-office dispensing and online capabilities. That's why I think our deep integration with PIMS, the high trust relationships we form with veterinarians allows us a position to create those insights and to document the impact that services are having across a wide variety of types of medical compliance, both for dispensed products as well as for in-office services. So we're really confident in the way in which we track that information. It's very transparent and very clear to veterinarians what that is. Many manufacturers have studied that. We've put out many white papers and third-party-reviewed studies that have demonstrated the impact of our platform on driving compliance. But no, I don't believe that AutoShip alone is a fair study of medical compliance benefit.

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David Michael Westenberg, Guggenheim Securities, LLC, Research Division - Analyst [41]

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And if I could ask a mandatory question on Zoetis' Triple. It does represent kind of a channel shifting event or at least maybe a change in prescription from legacy BRAVECTO and NexGard. So do you see this as an opportunity to be -- or a threat right now in terms of where prescriptions are at given the fact that it probably does represent a channel shopping event?

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [42]

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I'm not -- I don't think we're in a position to comment about what the impact of that -- those -- these future products will be in the category. We certainly have very strong relationships with these manufacturers. We believe that our platform is capable of driving strong engagement, both online and in-office. And that as a long-time trust partner, we believe a multichannel strategy to support both in-office visits and driving in-office care but also to drive client engagement and click-to-buy capabilities are really going to be a powerful capability set, not just for veterinarians but for manufacturers. So I think it's too early to talk about future programs and how that might impact it. It's something we'll be glad to follow up on in future discussion.

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David Michael Westenberg, Guggenheim Securities, LLC, Research Division - Analyst [43]

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If I could just squeeze in one more on the distribution business. Did you give any metrics around growth ex that customer loss? And just generally speaking, is there any way it changes in the way -- with slower volumes in the last couple of quarters, just is there any change in the way you think about the distribution business generally, just the macro generally in distribution? If there is any change in the way you think about distribution, is there maybe opportunities for pivots? And I realize I took a little bit more than my allotted questions. I apologize for that.

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Benjamin J. Shaw, Covetrus, Inc. - President, CEO & Director [44]

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No. We think the business is very stable. We think we have very good relationships. We think that the integration of our supply chain and inventory management capabilities with practice management software is going to be a really important value proposition to customers. Being able to have better ordering and receiving capabilities and to streamline workflow in the practice, we think, is a really significant benefit. And as we've started to roll out those capabilities, as we announced in Q2, we think that that's a really great differentiator in that business. But we're really confident in the long-term outlook of what that looks like. We think that we provide a terrific value to small business-owning veterinary practices, they manage very complex inventory management needs. And so we feel like our share -- we're building on our share position. We feel like we can offer a very competitive value proposition and very differentiated in our abilities to manage both online, in-office and with the PIMS connectivity. So we feel really confident in our market share position. Albeit, we earn that business every day. It's a services business. We have high-quality competitors in the market and we earn it every day, all day to make sure that we're delivering on right service levels, great account management, that our veterinarians have choices and we appreciate their loyalty to our offer.

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Christine T. Komola, Covetrus, Inc. - EVP & CFO [45]

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And David, I would add, there hasn't been any fundamental changes in any customers or any of the rest of the business itself. So in terms of metrics, there hasn't any fundamental change, in many ways, the distribution channel is also benefiting from the value capture results that we've had. So nothing fundamentally different in the models that we have today.

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Operator [46]

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Thank you. And this does conclude today's question-and-answer session. Ladies and gentlemen, thank you for your participation in today's Covetrus conference call. This does conclude today's program. You may all disconnect. Everyone, have a great day.