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 September 30, 2019

or

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________________ to _______________________

Commission file number: 0-22427

HESKA CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	77-0192527
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
3760 Rocky Mountain Avenue Loveland, Colorado	80538
(Address of principal executive offices)	(Zip Code)
Registrant's telephone number, including area code: (970) 493-7272

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Trading Symbol	Name of each exchange on which registered
Common stock, $0.01 par value	HSKA	The Nasdaq Stock Market LLC

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

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).  Yes x  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company.  See the definitions of "large accelerated filer," "accelerated filer", "smaller reporting company" and "emerging growth company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer o	Accelerated filer x
Non-accelerated filer o	Smaller Reporting Company ¨
	Emerging growth company o

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If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

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

7,828,358 shares of the Registrant's Public Common Stock, $.01 par value, were outstanding at November 5, 2019.

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TABLE OF CONTENTS

 

			Page
PART I - FINANCIAL INFORMATION
	Item 1.	Financial Statements	1
		Condensed Consolidated Balance Sheets	1
		Condensed Consolidated Statements of Income	2
		Condensed Consolidated Statements of Comprehensive Income	3
		Condensed Consolidated Statements of Stockholders' Equity	4
		Condensed Consolidated Statements of Cash Flows	5
		Notes to Condensed Consolidated Financial Statements	6
		Note 1, Operations and Summary of Significant Accounting Policies	6
		Note 2, Revenue	10
		Note 3, Acquisitions and Related Party Items	12
		Note 4, Investments in Unconsolidated Affiliates	14
		Note 5, Income Taxes	15
		Note 6, Leases	15
		Note 7, Earnings Per Share	17
		Note 8, Goodwill and Other Intangibles	18
		Note 9, Property and Equipment, Net	19
		Note 10, Inventories, Net	19
		Note 11, Accrued Liabilities	20
		Note 12, Capital Stock	20
		Note 13, Accumulated Other Comprehensive Income	23
		Note 14, Commitments and Contingencies	23
		Note 15, Interest and Other Income, Net	25
		Note 16, Convertible Notes and Credit Facility	25
		Note 17, Segment Reporting	29
	Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	31
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	39
	Item 4.	Controls and Procedures	39
PART II - OTHER INFORMATION
	Item 1.	Legal Proceedings	39
	Item 1A.	Risk Factors	39
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	57
	Item 6.	Exhibits	57
		Signatures	58

HESKA, ALLERCEPT, HemaTrue, Solo Step, Element DC, Element HT5, Element POC, Element i, Element COAG, Element DC5X and Element RC are registered trademarks of Heska Corporation. DRI-CHEM is a registered trademark of FUJIFILM Corporation. TRI-HEART is a registered trademark of Intervet Inc., d/b/a Merck Animal Health, formerly known as Schering-Plough Animal Health Corporation ("Merck Animal Health"), which is a unit of Merck & Co., Inc., in the United States and is a registered trademark of Heska Corporation in other countries. This quarterly report on Form 10-Q also refers to trademarks and trade names of other organizations.

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

HESKA CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)

		September 30,				December 31,
		2019				2018
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	80,505			$	13,389
Accounts receivable, net of allowance for doubtful accounts of $170 and $245, respectively		13,715				16,454
Inventories, net		26,215				25,104
Net investment in leases, current, net of allowance for doubtful accounts of $89 and $40, respectively		3,593				2,989
Prepaid expenses		3,028				1,533
Other current assets		2,695				2,938
Total current assets		129,751				62,407
Property and equipment, net		14,623				15,981
Operating lease right-of-use assets		5,870				—
Goodwill		27,216				26,679
Other intangible assets, net		9,206				9,764
Deferred tax asset, net		6,634				14,121
Net investment in leases, non-current		13,515				11,908
Investments in unconsolidated affiliates		7,563				8,018
Other non-current assets		9,633				7,574
Total assets		$	224,011			$	156,452
LIABILITIES, MEZZANINE EQUITY AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable		$	5,524			$	7,469
Due to related parties		—				226
Accrued liabilities		5,302				10,142
Current operating lease liabilities		1,714				—
Current portion of deferred revenue, and other		2,687				2,526
Total current liabilities		15,227				20,363
Convertible note, long-term, net		43,823				—
Deferred revenue, net of current portion		6,183				7,082
Line of credit		—				6,000
Non-current operating lease liabilities		4,578				—
Other liabilities		217				598
Total liabilities		70,028				34,043
Commitments and contingencies (Note 14)
Redeemable non-controlling interest and mezzanine equity		300				—
Stockholders' equity:
Preferred stock, $.01 par value, 2,500,000 and 2,500,000 shares authorized, respectively, none issued or outstanding		—				—
Common stock, $.01 par value, 10,250,000 and 10,250,000 shares authorized, respectively, none issued or outstanding		—				—
Public common stock, $.01 par value, 10,250,000 and 10,250,000 shares authorized, 7,823,802 and 7,675,692 shares issued and outstanding, respectively		78				77
Additional paid-in capital		288,181				257,034
Accumulated other comprehensive income		140				277
Accumulated deficit		(134,716		)		(134,979		)
Total stockholders' equity		153,683				122,409
Total liabilities, mezzanine equity and stockholders' equity		$	224,011			$	156,452

See accompanying notes to condensed consolidated financial statements.

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HESKA CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share amounts)

(unaudited)

		Three Months Ended September 30,								Nine Months Ended September 30,
		2019				2018				2019				2018
Revenue:
Core companion animal		$	26,339			$	27,190			$	75,771			$	80,652
Other vaccines and pharmaceuticals		4,898				3,765				13,123				12,729
Total revenue, net		31,237				30,955				88,894				93,381
Cost of revenue		17,573				16,161				50,275				52,215
Gross profit		13,664				14,794				38,619				41,166
Operating expenses:
Selling and marketing		6,709				6,215				20,457				18,299
Research and development		2,532				935				6,137				2,165
General and administrative		4,230				11,239				12,473				20,223
Total operating expenses		13,471				18,389				39,067				40,687
Operating income (loss)		193				(3,595		)		(448		)		479
Interest and other expense (income), net		927				(50		)		932				37
(Loss) income before income taxes and equity in losses of unconsolidated affiliates		(734		)		(3,545		)		(1,380		)		442
Income tax (benefit) expense:
Current income tax expense		40				27				112				56
Deferred income tax benefit		(570		)		(1,902		)		(2,078		)		(1,997		)
Total income tax benefit		(530		)		(1,875		)		(1,966		)		(1,941		)
Net (loss) income before equity in losses of unconsolidated affiliates		(204		)		(1,670		)		586				2,383
Equity in losses of unconsolidated affiliates		(147		)		—				(455		)		—
Net (loss) income after equity in losses of unconsolidated affiliates		(351		)		(1,670		)		131				2,383
Net loss attributable to redeemable non-controlling interest		(41		)		—				(132		)		—
Net (loss) income attributable to Heska Corporation		$	(310	)		$	(1,670	)		$	263			$	2,383
Basic (loss) earnings per share attributable to Heska Corporation		$	(0.04	)		$	(0.23	)		$	0.04			$	0.33
Diluted (loss) earnings per share attributable to Heska Corporation		$	(0.04	)		$	(0.23	)		$	0.03			$	0.30
Weighted average outstanding shares used to compute basic (loss) earnings per share attributable to Heska Corporation		7,501				7,289				7,461				7,194
Weighted average outstanding shares used to compute diluted (loss) earnings per share attributable to Heska Corporation		7,501				7,289				7,960				7,820

 

See accompanying notes to condensed consolidated financial statements.

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HESKA CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands) 

(unaudited)

		Three Months Ended September 30,								Nine Months Ended September 30,
		2019				2018				2019				2018
Net (loss) income after equity in losses of unconsolidated affiliates		$	(351	)		$	(1,670	)		$	131			$	2,383
Other comprehensive (loss) income:
Foreign currency translation		(158		)		15				(137		)		(16		)
Comprehensive (loss) income		(509		)		(1,655		)		(6		)		2,367
Comprehensive loss attributable to redeemable non-controlling interest		(41		)		—				(132		)		—
Comprehensive (loss) income attributable to Heska Corporation		$	(468	)		$	(1,655	)		$	126			$	2,367

 

See accompanying notes to condensed consolidated financial statements.

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HESKA CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

(in thousands) 

(unaudited)

		Common Stock							Additional Paid-in Capital				Accumulated Other Comprehensive Income				Accumulated Deficit				Total Stockholders' Equity
Three Months Ended September 30, 2018 and 2019		Shares			Amount
Balances, June 30, 2018		7,498			$	75			$	246,422			$	201			$	(136,776	)		$	109,922
Net loss attributable to Heska Corporation		—			—				—				—				(1,670		)		(1,670		)
Issuance of common stock, net of shares withheld for employee taxes		55			1				1,927				—				—				1,928
Stock-based compensation		—			—				1,406				—				—				1,406
Other comprehensive income		—			—				—				15				—				15
Balances, September 30, 2018		7,553			$	76			$	249,755			$	216			$	(138,446	)		$	111,601
Balances, June 30, 2019		7,794			$	78			$	256,952			$	298			$	(134,406	)		$	122,922
Net loss attributable to Heska Corporation		—			—				—				—				(310		)		(310		)
Issuance of common stock, net of shares withheld for employee taxes		30			—				213				—				—				213
Stock-based compensation		—			—				1,246				—				—				1,246
Convertible notes, equity		—			—				29,770												29,770
Other comprehensive loss		—			—				—				(158		)		—				(158		)
Balances, September 30, 2019		7,824			$	78			$	288,181			$	140			$	(134,716	)		$	153,683
Note: Excludes amounts related to redeemable non-controlling interests recorded in mezzanine equity.

		Common Stock							Additional Paid-in Capital				Accumulated Other Comprehensive Income				Accumulated Deficit				Total Stockholders' Equity
Nine Months Ended September 30, 2018 and 2019		Shares			Amount
Balances, December 31, 2017		7,303			$	73			$	243,598			$	232			$	(143,463	)		$	100,440
Adoption of accounting standards		—			—				—				—				2,634				2,634
Balances, January 1, 2018, as adjusted		7,303			73				243,598				232				(140,829		)		103,074
Net income attributable to Heska Corporation		—			—				—				—				2,383				2,383
Issuance of common stock, net of shares withheld for employee taxes		250			3				2,383				—				—				2,386
Stock-based compensation		—			—				3,774				—				—				3,774
Other comprehensive loss		—			—				—				(16		)		—				(16		)
Balances, September 30, 2018		7,553			$	76			$	249,755			$	216			$	(138,446	)		$	111,601
Balances, December 31, 2018		7,676			$	77			$	257,034			$	277			$	(134,979	)		$	122,409
Net income attributable to Heska Corporation		—			—				—				—				263				263
Issuance of common stock, net of shares withheld for employee taxes		148			1				(2,248		)		—				—				(2,247		)
Stock-based compensation		—			—				3,625				—				—				3,625
Convertible notes, equity		—			—				29,770												29,770
Other comprehensive loss		—			—				—				(137		)		—				(137		)
Balances, September 30, 2019		7,824			$	78			$	288,181			$	140			$	(134,716	)		$	153,683
Note: Excludes amounts related to redeemable non-controlling interests recorded in mezzanine equity.

See accompanying notes to condensed consolidated financial statements.

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HESKA CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

		Nine Months Ended September 30,
		2019				2018
Cash flows from operating activities:
Net income after equity in losses from unconsolidated affiliates		$	131			$	2,383
Adjustments to reconcile net income to cash (used in) provided by operating activities:
Depreciation and amortization		3,759				3,473
Non-cash impact of operating leases		1,126				—
Deferred income tax benefit		(2,078		)		(1,997		)
Stock-based compensation		3,625				3,774
Equity in losses of unconsolidated affiliates		455				—
Amortization of debt discount and issuance costs		282				30
Other losses (gains)		340				(32		)
Changes in operating assets and liabilities (net of the effect of acquisitions):
Accounts receivable		2,808				2,102
Inventories		(438		)		3,935
Due from related parties		—				1
Lease receivable, current		(605		)		(708		)
Other current assets		(892		)		(451		)
Accounts payable		(2,491		)		(5,092		)
Due to related parties		(226		)		(1,422		)
Accrued liabilities and other		(6,528		)		6,076
Lease receivable, non-current		(1,551		)		(1,906		)
Other non-current assets		(65		)		(843		)
Deferred revenue and other		(928		)		(2,865		)
Net cash (used in) provided by operating activities		(3,276		)		6,458
Cash flows from investing activities:
Investment in subsidiary, net of cash acquired		(622		)		—
Investments in unconsolidated affiliates		—				(8,089		)
Purchases of property and equipment		(722		)		(1,061		)
Proceeds from disposition of property and equipment		—				24
Net cash (used in) investing activities		(1,344		)		(9,126		)
Cash flows from financing activities:
Borrowings on line of credit		6,750				3,000
Repayments of line of credit borrowings		(12,750		)		(3,000		)
Payment of debt issuance costs		(3,072		)		—
Convertible debt proceeds		86,250				—
Proceeds from issuance of common stock		1,233				3,627
Repurchase of common stock		(3,480		)		(1,241		)
Distributions to non-controlling interest members		—				(126		)
Repayments of other debt		(1,164		)		(5		)
Net cash provided by financing activities		73,767				2,255
Foreign exchange effect on cash, cash equivalents and restricted cash		(31		)		(10		)
Net increase (decrease) in cash, cash equivalents and restricted cash		69,116				(423		)
Cash, cash equivalents and restricted cash, beginning of period		13,389				9,659
Cash, cash equivalents and restricted cash, end of period		$	82,505			$	9,236
Supplemental disclosure of cash flow information:
Non-cash transfers of equipment between inventory and property and equipment, net		$	1,118			$	1,019
Accrued debt issuance costs		$	105			$	—

See accompanying notes to condensed consolidated financial statements.

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.    OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Heska Corporation and its wholly-owned subsidiaries ("Heska", the "Company", "we" or "our") sell veterinary and animal health diagnostic and specialty products. Our offerings include Point of Care diagnostic laboratory instruments and supplies; digital imaging diagnostic products, software and services; vaccines; local and cloud-based data services; allergy testing and immunotherapy; and single-use offerings such as in-clinic diagnostic tests and heartworm preventive products. Our core focus is on supporting veterinarians in the canine and feline healthcare space.

Basis of Presentation and Consolidation

In the opinion of management, the accompanying unaudited Condensed Consolidated Financial Statements contain all adjustments, consisting of normal, recurring adjustments, necessary to present fairly the financial position of the Company as of September 30, 2019 and December 31, 2018, the results of our operations and statements of stockholders' equity for the three and nine months ended September 30, 2019 and 2018, and cash flows for the nine months ended September 30, 2019 and 2018.

The unaudited Condensed Consolidated Financial Statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") have been condensed or omitted pursuant to such rules and regulations. Our unaudited Condensed Consolidated Financial Statements include our accounts and the accounts of our wholly-owned subsidiaries since their respective dates of acquisitions. All intercompany accounts and transactions have been eliminated in consolidation. Where our ownership of a subsidiary is less than 100%, the non-controlling interest is reported on our Condensed Consolidated Balance Sheets. The non-controlling interest in our consolidated net income is reported as "Net loss attributable to redeemable non-controlling interest" on our Condensed Consolidated Statements of Income. These unaudited Condensed Consolidated Financial Statements should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2018 and other financial information filed with the SEC.

Reclassification

To maintain consistency and comparability, certain amounts in the financial statements have been reclassified to conform to current year presentation.

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates are required when establishing the allowance for doubtful accounts and the net realizable value of inventory; determining future costs associated with warranties provided; determining the period over which our obligations are fulfilled under agreements to license product rights and/or technology rights; evaluating long-lived and intangible assets and investments for estimated useful lives and impairment; estimating the useful lives of instruments under leasing arrangements; determining the allocation of purchase price under purchase accounting; estimating the expense associated with the granting of stock; determining the need for, and the amount of a valuation allowance on deferred tax assets; determining the value of the non-controlling interest in a business combination; and determining the fair value of the liability component associated with the issuance of convertible debt.

Critical Accounting Policies

Our accounting policies are described in our audited Consolidated Financial Statements and Notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2018, and other than the recently adopted accounting pronouncements, restricted cash, and fair value measurement of convertible senior notes discussed below, have not changed materially since such filing.

Restricted Cash

The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported within the condensed consolidated balance sheets to the same amounts shown in the condensed consolidated statements of cash flows.

	September 30, 2019				December 31, 2018
Cash and cash equivalents	$	80,505			$	13,389
Restricted cash in other non-current assets	2,000				—
Total cash, cash equivalents, and restricted cash shown in the statement of cash flows	$	82,505			$	13,389

Restricted cash relates to cash deposited in a blocked collateral account held by Chase (as defined below) to secure the Company's obligations under the Amendment to the Credit Facility discussed in Note 16.

Fair Value of Financial Instruments

Our policies for the fair value measurement of cash and cash equivalents, short-term trade receivables and payables and the Company's revolving line of credit have not changed from the policies described in our Annual Report on Form 10-K for the year ended December 31, 2018.

The estimated fair value of the convertible senior notes disclosed at each reporting period is evaluated through consideration of quoted market prices in less active markets. The fair value measurement is classified as Level 2 in the fair value hierarchy, which is defined in ASC 820 as inputs other than quoted prices in active markets that are either directly or indirectly observable. For additional information regarding the Company's accounting treatment for the issuance of the convertible senior notes, including the fair value measurement of the liability component, refer to Note 16 - Convertible Notes and Credit Facility.

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Adoption of New Accounting Pronouncements

Effective January 1, 2019, we adopted Accounting Standard Update ("ASU") 2018-07, Compensation – Stock Compensation (Topic 718), Improvements to Non-employee Share-Based Payment Accounting. This ASU is intended to simplify aspects of share-based compensation issued to non-employees by making the guidance consistent with accounting for employee share-based compensation. Guidance related to the stock compensation granted to employees is followed for non-employees, including the measurement date, valuation approach and performance conditions. The expense is recognized in the same period as though cash were paid for the good or service, ratably over the service period. The adoption of this ASU did not have an impact on our consolidated financial statements but did have a minimal impact on our related disclosures.

Effective January 1, 2019, we adopted ASU 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. The ASU permits companies to elect a reclassification of the disproportionate tax effects in accumulated other comprehensive income ("AOCI") caused by the Tax Cuts and Jobs Act of 2017 to retained earnings. As of September 30, 2019, the Company does not have any disproportionate income tax effects in AOCI to reclassify. However, if the Company did have disproportionate income tax effects in AOCI in the future, it would reclassify them to retained earnings.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which supersedes ASC 840, Leases. This update requires lessees to recognize a right-of-use (“ROU”) asset and a lease liability for all leases, including operating leases, with terms greater than 12 months on its balance sheet. The update also expands the required quantitative and qualitative disclosures by lessees and lessors about the amount, timing and uncertainty of cash flows arising from leases. The accounting for lessors does not fundamentally change except for changes to conform and align guidance to the lessee guidance as well as to the new revenue recognition guidance in ASU 2014-09, Revenue from Contracts with Customers (Topic 606). Subsequent to the issuance of Topic 842, the FASB clarified the guidance through several ASUs; hereinafter the collection of lease guidance is referred to as “ASC 842”.

The Company adopted ASC 842 on January 1, 2019, using the modified retrospective approach for all lease arrangements at the beginning of the period of adoption. Results for reporting periods beginning January 1, 2019 are presented under ASC 842, while prior period amounts were not adjusted and continue to be reported in accordance with the Company’s historic accounting under ASC 840, Leases. For leases that commenced before the effective date of ASC 842, the Company elected the permitted practical expedients to not reassess the following: (i) whether any expired or existing contracts contain leases; (ii) the lease classification for any expired or existing leases; and (iii) initial direct costs for any existing leases. The Company also elected to exclude leases with a term of 12 months or less from the recognized ROU assets and lease liabilities.

Adoption of the standard did not have a material net impact in our Condensed Consolidated Balance Sheets, Condensed Consolidated Statements of Income or Condensed Consolidated Statements of Cash Flows. The most significant impact was the recognition of ROU assets and lease liabilities for the operating leases, of which we are the lessee. As a result of the cumulative impact of adopting ASC 842, the Company recorded operating lease ROU assets of $6.5 million and operating lease liabilities of $6.9 million as of January 1, 2019, primarily related to building, vehicle, and office equipment leases, based on the present value of the future lease payments on the date of adoption. As a lessor, accounting for our subscription agreements will remain substantially unchanged. Refer to Note 6 for additional disclosures required by ASC 842.

The Company determines if an arrangement is a lease at inception based on whether control of an identified asset is transferred. For leases where the Company is the lessee, ROU assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent an obligation to make lease payments arising from the lease. ROU assets and lease liabilities are recognized at the lease commencement date based

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

on the present value of lease payments over the lease term. As most of the Company’s leases do not provide an implicit interest rate, the Company uses its incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. The lease terms used to calculate the ROU asset and related lease liability include options to extend or terminate the lease when it is reasonably certain that the Company will exercise that option. Lease expense for operating leases is recognized on a straight-line basis over the lease term as an operating expense while the expense for finance leases is recognized as amortization expense and interest expense. The Company has lease agreements which require payments for lease and non-lease components and has elected to account for these as a single lease component for our building and office equipment leases, but as separate components for our vehicle leases.

Our revenue under subscription agreements relates to both operating-type lease (“OTL”) arrangements and sales-type lease (“STL”) arrangements. Determination of an OTL or STL is primarily determined as a result of the length of the contract as compared to the estimated useful life of the instrument, among other factors. A STL results in earlier recognition of instrument revenue. The cost of the customer-leased instruments is removed from inventory and recognized in the Consolidated Statements of Income. There is no residual value taken into consideration as it does not meet our capitalization requirements. Instrument lease revenue for OTL agreements is recognized on a straight-line basis over the life of the lease and included with the predominant non-lease components in consumable revenue. The costs of customer-leased instruments are recorded within property and equipment in the accompanying Consolidated Balance Sheets and depreciated over the instrument’s estimated useful life. The depreciation expense is reflected in cost of revenue in the accompanying Consolidated Statements of Income. The OTLs and STLs are not cancellable until after an initial term and include an option to renew.

For lease arrangements with lease and non-lease components where the Company is the lessor, the Company allocates the total contract consideration to the lease and non-lease components on a relative standalone selling price basis using the Company’s best estimate of the standalone selling price of each distinct product or service in the contract. The primary method used to estimate standalone selling price is the price observed in standalone sales to customers of a prior period. Changes in these values can impact the amount of consideration allocated to each component of the contract. When prices in standalone sales are not available, we may use a cost-plus margin approach. Allocation of the transaction price is determined at the inception of the lease arrangement. The Company’s leases consist of leases with fixed and variable lease payments. For those leases with variable lease payments, the variable lease payment is typically based upon purchase of consumables used with the leased instruments and included in consumable revenue.

Accounting Pronouncements Not Yet Adopted

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326), which requires that financial assets measured at amortized cost be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset to present the net carrying value at the amount expected to be collected. The income statement reflects the measurement of credit losses for newly recognized financial assets, as well as the increases or decreases of expected credit losses that have taken place during the period. The measurement of expected credit losses is based upon historical experience, current conditions and reasonable and supportable forecasts that affect the collectability of the reported amount. Subsequent to the issuance of ASU 2016-13, the FASB issued ASU 2018-19, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, in November 2018. This ASU clarifies that receivables from operating leases are accounted for using the lease guidance and not as financial instruments. In April 2019, the FASB issued ASU 2019-04, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments, which further clarifies and improves guidance related to accounting for credit losses. In May 2019, the FASB issued ASU 2019-05, Financial Instruments - Credit Losses (Topic

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326). This ASU provides relief to certain entities adopting ASU 2016-13. The amendment provides entities with an option to irrevocably elect the fair value option for certain financial assets. These amendments are effective for fiscal years beginning after December 15, 2019 and interim periods within those annual periods. We are currently evaluating the amended guidance and the impact on our consolidated financial statements and will adopt the provisions in the first quarter of 2020.

2.     REVENUE

We separate our goods and services among two reportable segments, Core companion animal ("CCA") and Other vaccines and pharmaceuticals ("OVP"). The CCA segment consists of revenue generated from the following:

•	Point of Care laboratory products including instruments, consumables and services;

•	Point of Care imaging products including instruments, software and services;

•	Single use pharmaceuticals, vaccines and diagnostic tests primarily related to companion animals; and

•	Other vaccines and pharmaceuticals.

The OVP segment consists of revenue generated from the following:

•	Contract manufacturing agreements; and

•	Other license, research and development revenue.

The following table summarizes our CCA revenue (in thousands):

	Three Months Ended September 30,								Nine Months Ended September 30,
	2019				2018				2019				2018
Point of Care laboratory revenue:	$	17,524			$	14,584			$	49,605			$	43,277
Consumables	14,021				11,598				39,545				33,942
Sales-type leases	1,587				1,228				4,821				4,559
Outright instrument sales	1,547				1,382				4,122				3,528
Other	369				376				1,117				1,248
Point of Care imaging revenue:	5,337				5,326				15,976				15,759
Outright instrument sales	4,479				4,453				13,431				13,157
Service revenue	544				590				1,663				1,689
Operating type leases and other	314				283				882				913
Other CCA revenue:	3,478				7,280				10,190				21,616
Other pharmaceuticals, vaccines and diagnostic tests	3,400				7,176				9,927				21,278
Research and development, license and royalty     revenue	78				104				263				338
Total CCA revenue	$	26,339			$	27,190			$	75,771			$	80,652

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

The following table summarizes our OVP revenue (in thousands):

	Three Months Ended September 30,								Nine Months Ended September 30,
	2019				2018				2019				2018
Contract manufacturing	$	4,747			$	3,540			$	12,741			$	12,218
License, research and development	151				225				382				511
Total OVP revenue	$	4,898			$	3,765			$	13,123			$	12,729

Remaining Performance Obligations

Remaining performance obligations represent the aggregate transaction price allocated to performance obligations with an original contract term greater than one year which are fully or partially unsatisfied at the end of the period. Remaining performance obligations include noncancelable purchase orders, the non-lease portion of minimum purchase commitments under long-term supply arrangements, extended warranty, service and other long-term contracts. Remaining performance obligations do not include revenue from contracts with customers with an original term of one year or less, revenue from long-term supply arrangements with no minimum purchase requirements, revenue expected from purchases made in excess of the minimum purchase requirements, or revenue from instruments leased to customers. While the remaining performance obligation disclosure is similar in concept to backlog, the definition of remaining performance obligations excludes leases and contracts that provide the customer with the right to cancel or terminate for convenience with no substantial penalty, even if historical experience indicates the likelihood of cancellation or termination is remote. Additionally, the Company has elected to exclude contracts with customers with an original term of one year or less from remaining performance obligations.

As of September 30, 2019, the aggregate amount of the transaction price allocated to remaining minimum performance obligations was approximately $94.1 million. As of September 30, 2019, the Company expects to recognize revenue as follows (in thousands):

Year Ending December 31,	Revenue
2019 (remaining)	$	6,409
2020	23,605
2021	19,858
2022	16,831
2023	13,453
Thereafter	13,993
	$	94,149

Contract Balances

The timing of revenue recognition, billings and cash collections results in billed accounts receivable, unbilled receivables (contract assets) and deferred revenue, and customer deposits and billings in excess of revenue recognized (contract liabilities) on the Condensed Consolidated Balance Sheets. In addition, the Company defers certain costs incurred to obtain contracts (contract costs).

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Contract Receivables

Certain unbilled receivable balances related to long-term contracts for which we provide a free term to the customer where revenue has been recognized are recorded in other current and other non-current assets. We have no further performance obligations related to these receivable balances and the collection of these balances occurs over the term of the underlying contract. The balances as of September 30, 2019 were $1.0 million and $3.6 million for current and non-current assets, respectively, shown net of related unearned interest. The balances as of December 31, 2018 were $0.9 million and $3.3 million for current and non-current assets, respectively, shown net of related unearned interest.

Contract Liabilities

The Company receives cash payments from customers for licensing fees or other arrangements that extend for a specified term. These contract liabilities are classified as either current or long-term in the Condensed Consolidated Balance Sheets based on the timing of when the Company expects to recognize revenue. As of September 30, 2019 and December 31, 2018, contract liabilities were $8.7 million and $9.6 million, respectively, and are included within "Current portion of deferred revenue, and other" and "Deferred revenue, net of current portion" in the accompanying Condensed Consolidated Balance Sheets. The decrease in the contract liability balance during the nine-month period ended September 30, 2019 is approximately $2.1 million of revenue recognized during the period, offset by approximately $1.2 million of additional deferred sales in 2019.

Contract Costs

The Company capitalizes certain direct incremental costs incurred to obtain customer contracts, typically sales-related commissions, where the recognition period for the related revenue is greater than one year. Contract costs are classified as current or non-current, and are included in "Other current assets" and "Other non-current assets" in the Condensed Consolidated Balance Sheets based on the timing of when the Company expects to recognize the expense. Contract costs are generally amortized into selling and marketing expense with a certain percentage recognized immediately based upon placement of the instrument with the remainder recognized on a straight-line basis (which is consistent with the transfer of control for the related goods or services) over the average term of the underlying contracts, approximately 6 years. Management assesses these costs for impairment at least quarterly on a portfolio basis and as “triggering” events occur that indicate it is more-likely-than-not that an impairment exists. The balance of contract costs as of September 30, 2019 and December 31, 2018 was $2.6 million and $2.5 million, respectively. Amortization expense for the nine-month period ended September 30, 2019 was approximately $0.7 million, offset by approximately $0.9 million of additional contract costs capitalized.

Contract liabilities are reported on the accompanying Condensed Consolidated Balance Sheets on a contract-by-contract basis whereas contract costs are calculated and reported on a portfolio basis.

3.    ACQUISITIONS AND RELATED PARTY ITEMS

Optomed

On February 22, 2019, Heska acquired 70% of the equity of Optomed, a French-based endoscopy company, in exchange for approximately $0.2 million in cash and the assumption of approximately $0.4 million in debt. As part of the purchase, Heska entered into put and call options on the remaining 30% minority interest. The written put options can be exercised based on the achievement of certain financial conditions over a specified period of time for a fixed amount. The options are not currently exercisable at the acquisition date or the

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

reporting date. The estimated value of the non-controlling interest is inclusive of the probability weighted outcome of the options described herein. As of September 30, 2019, the purchase price allocation is final. As part of the purchase agreement, Heska has committed to purchase from the minority interest holder, by the end of the fiscal year, real estate in the amount of approximately $1.0 million, which is currently under lease by Optomed. The Company prepaid approximately $0.6 million of the real estate purchase price during the quarter ended September 30, 2019 and paid the remainder of the purchase price on November 4, 2019 to complete the transaction.

Cuattro Veterinary Acquisitions

In February 2013, the Company acquired a majority interest in Cuattro Veterinary USA, LLC, which was owned by Kevin S. Wilson, among other members. The subsidiary was subsequently renamed Heska Imaging US, LLC ("US Imaging"). The remaining minority position in US Imaging was subject to purchase by Heska under a performance-based put option which was exercised in March 2017. In May 2017, we purchased the remaining minority interest position in US Imaging.

In May 2016, the Company closed a transaction to acquire Cuattro Veterinary, LLC ("International Imaging"), which was owned by Kevin S. Wilson, among other members. International Imaging is a provider to international markets of digital radiography technologies for veterinarians. As a leading provider of advanced veterinary diagnostic and specialty products, we made the acquisition in an effort to combine International Imaging's global reach with our domestic success in the imaging and laboratory markets in the United States.

In June 2017, the Company consolidated its assets and liabilities in the US Imaging and International Imaging companies into Heska Imaging, LLC ("Heska Imaging"). Cuattro, LLC ("Cuattro") is owned by Kevin S. Wilson, the CEO and President of the Company in addition to Mrs. Wilson and trusts for the benefit of Mr. and Mrs. Wilson's children and family. Steven M. Asakowicz and Rodney A. Lippincott, members of Cuattro Veterinary USA, LLC and Cuattro International prior to the acquisitions, each serve as Executive Vice President, Companion Animal Health Sales for the Company.

Purchase Agreement for Certain Assets

On December 21, 2018, the Company closed a transaction (the "Asset Acquisition") to acquire certain assets from Cuattro, all related to the CCA segment. Pursuant to the Asset Acquisition, dated November 26, 2018, the Company issued 54,763 shares of the Company's common stock, $0.01 par value per share (the "Common Stock"), to Cuattro on the closing date, at an aggregate value equal to approximately $5.4 million based on the adjusted closing price per share of the Common Stock as reported on the Nasdaq Stock Market on the Asset Acquisition agreement date. These shares were issued to Cuattro in a private placement in reliance upon an exemption from the registration requirements of the Securities Act pursuant to Section 4(a)(2) thereof and the safe harbor provided by Rule 506 of Regulation D promulgated thereunder. In addition to the Common Stock, the Company paid cash in the amount of $2.8 million to Cuattro as part of the transaction. The total purchase price was determined based on a valuation report from an independent third party. Part of the Asset Acquisition was an agreement to terminate the supply and license agreement that Heska had been operating under since the acquisition of Cuattro Veterinary USA, LLC.

The Company evaluated the acquisition of the purchased assets under ASC 805, Business Combinations and ASU 2017-01, Business Combinations (Topic 805) and concluded that as substantially all of the fair value of the gross assets acquired is concentrated in an identifiable group of similar assets, the transaction did not meet the requirements to be accounted for as a business combination and therefore was accounted for as an asset acquisition. Accordingly, the purchase price of the purchased assets was allocated entirely to an identifiable intangible asset. In addition to the software assets acquired, Cuattro is obligated, without further

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

compensation, to assist the Company with the implementation of a third-party image hosting platform and necessary data migration.

Other Related Party Activities

Cuattro charged Heska Imaging $6.0 thousand and $3.1 million during the nine months ended September 30, 2019 and 2018, respectively. The charge in 2019 relates to minor inventory purchases as the Company transitions the digital imaging software assets away from Cuattro. The charge in 2018 was primarily for digital imaging products, pursuant to an underlying supply contract which was terminated in December 2018.

The Company had no receivables from or payables to Cuattro as of September 30, 2019. Heska Imaging owed Cuattro $0.2 million as of December 31, 2018, which is reported in "Due to related parties" on the Company's Condensed Consolidated Balance Sheets.

4.    INVESTMENTS IN UNCONSOLIDATED AFFILIATES

The carrying values of investments in unconsolidated affiliates, categorized by type of investment, is as follows (in thousands):

	September 30, 2019				December 31, 2018
Equity method investment	$	4,545			$	5,000
Non-marketable equity security investment	3,018				3,018
	$	7,563			$	8,018

Equity Method Investment

On September 24, 2018, we invested $5.1 million, including costs, in exchange for a 28.7% interest of a business as part of our product development strategy. In connection with the investment, the Company entered into a Manufacturing Supply Agreement that grants the Company global exclusivity to specified products to be delivered under the agreement for a 15-year period that begins upon the Company's receipt and acceptance of an initial order under the agreement. The Company accounts for this investment using the equity method of accounting. Under the equity method, the carrying value of the investment is adjusted for the Company's proportionate share of the investee's reported earnings or losses with the corresponding share of earnings or losses reported as Equity in losses of unconsolidated affiliates, listed below Net income before equity in losses of unconsolidated affiliates within the Condensed Consolidated Statements of Income.

Non-Marketable Equity Security Investment

On August 8, 2018, the Company invested $3.0 million, including costs, in MBio Diagnostics, Inc. ("MBio"), in exchange for preferred stock, representing a 6.9% interest in MBio. The Company’s investment in MBio is a non-marketable equity security, recorded using the measurement alternative of cost minus impairment, if any, plus or minus changes resulting from qualifying observable price changes.

As part of the agreement, the Company entered into a Supply and License Agreement with MBio, which provides that MBio produce and commercialize products that will enhance the Company's diagnostic portfolio. As part of this agreement, the Company made an upfront payment to MBio of $1.0 million related to a worldwide exclusive license agreement over a 20-year period, recorded in both short and long-term other assets. In addition, the agreement provides for an additional contingent payment from Heska to MBio of $10.0 million, relating to the successful achievement of sales milestones. This potential future milestone payment has not yet been accrued as it is not deemed by the Company to be probable at this time.

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Both parties in this arrangement are active participants and are exposed to significant risks and rewards dependent on the commercial success of the activities of the collaboration. The parties are actively working on developing and testing the product as well as funding the research and development. Heska classifies the amounts paid for MBio's research and development work within the CCA segment research and development operating expenses. Expense is recognized ratably when incurred and in accordance with the development plan.

5.    INCOME TAXES

Our total income tax benefit for our (loss) income before income taxes were as follows (in thousands):

		Three Months Ended September 30,								Nine Months Ended September 30,
		2019				2018				2019				2018
(Loss) income before income taxes and equity in losses of unconsolidated affiliates		$	(734	)		$	(3,545	)		$	(1,380	)		$	442
Total income tax benefit		(530		)		(1,875		)		(1,966		)		(1,941		)

        

There were cash payments of $1 thousand and cash refunds, net of payments, of $114 thousand, respectively, for income taxes for the three and nine months ended September 30, 2019. There were $0 thousand and $30 thousand in cash payments for income taxes, net of refunds, for the three and nine months ended September 30, 2018. The Company’s tax benefit decreased to $0.5 million and $2.0 million for the three and nine months ended September 30, 2019, respectively, compared to the tax benefit of $1.9 million for the three months ended September 30, 2018 and tax benefit of $1.9 million for the nine months ended September 30, 2018. The decrease in tax benefits is due to the lower financial loss. The Company recognized $0.1 million in excess tax benefits related to employee share-based compensation for the three months ended September 30, 2019 compared to $0.8 million recognized for the three months ended September 30, 2018. The Company recognized $1.5 million in excess tax benefits related to employee share-based compensation for the nine months ended September 30, 2019 compared to $2.1 million recognized for the nine months ended September 30, 2018.

As more fully described in Note 16, the Company accounted for the issuance of the 3.750% Convertible Senior Notes due 2026 (the "Notes") by separating the Notes into liability and equity components. The portion of the proceeds allocated to equity created a basis difference associated with the liability component and resulted in a temporary taxable difference for tax purposes. The Company recognized a $9.7 million net deferred tax liability for the temporary difference between the carrying value and the tax basis of the Notes, which was recorded as an adjustment to additional paid-in-capital.

6.    LEASES

Lessee Accounting

The Company leases buildings, office equipment, and vehicles. The Company’s finance leases were not material as of September 30, 2019 and for the three and nine month periods then ended. ROU assets arising from finance leases are included in Property and equipment, net in the accompanying Condensed Consolidated Balance Sheets. The current portion of the finance lease liabilities are included in Current portion of deferred revenue, and other and the non-current portion of the finance lease liabilities are included in Other liabilities in the accompanying Condensed Consolidated Balance Sheets.

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

For the three and nine months ended September 30, 2019, operating lease expense was approximately $0.6 million and $1.8 million, respectively, including immaterial variable lease costs.

Supplemental cash flow information related to the Company's operating leases for the nine months ended September 30, 2019 was as follows (in thousands):

Cash paid for amounts included in the measurement of operating lease liabilities	$	1,344
ROU assets obtained in exchange for operating lease obligations	498

The following table presents the weighted average remaining lease term and weighted average discount rate related to the Company's operating leases as of September 30, 2019:

Weighted average remaining lease term	3.9 years
Weighted average discount rate	4.44	%

The following table presents the maturity of the Company's operating lease liabilities as of September 30, 2019 (in thousands):

Remainder of 2019	$	727
2020	1,633
2021	1,439
2022	1,328
2023	1,766
Total operating lease payments	6,893
Less: imputed interest	601
Total operating lease liabilities	$	6,292

Lessor Accounting

 

In our CCA segment, primarily related to our Point of Care laboratory products, the Company enters into sales-type leases as part of our subscription agreements. The following table presents the maturity of the Company's undiscounted lease receivables as of September 30, 2019 (in thousands):

Year Ending December 31,
Remainder of 2019	$	799
2020	3,788
2021	3,797
2022	3,455
2023	2,698
Thereafter	2,571
	$	17,108

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

7.    EARNINGS PER SHARE

Basic earnings per share ("EPS") is computed by dividing net income attributable to the Company by the weighted-average number of common shares outstanding during the period. The computation of diluted EPS is similar to the computation of basic EPS except that the numerator is increased to exclude charges that would not have been incurred, and the denominator is increased to include the number of additional common shares that would have been outstanding (using the if-converted and treasury stock methods), if securities containing potentially dilutive common shares such as stock options converting to common shares, and if such assumed conversion is dilutive.

The following is a reconciliation of the weighted-average shares outstanding used in the calculation of basic and diluted EPS for the three and nine months ended September 30, 2019 and 2018 (in thousands, except per share data):

	Three Months Ended September 30,								Nine Months Ended September 30,
	2019				2018				2019				2018
Net (loss) income attributable to Heska Corporation	$	(310	)		$	(1,670	)		$	263			$	2,383
Basic weighted-average common shares outstanding	7,501				7,289				7,461				7,194
Assumed exercise of dilutive stock options and restricted shares	—				—				499				626
Diluted weighted-average common shares outstanding	$	7,501			$	7,289			$	7,960			$	7,820
Basic (loss) earnings per share attributable to Heska Corporation	$	(0.04	)		$	(0.23	)		$	0.04			$	0.33
Diluted (loss) earnings per share attributable to Heska Corporation	$	(0.04	)		$	(0.23	)		$	0.03			$	0.30

The following stock options and restricted shares were excluded from the computation of diluted EPS because they would have been anti-dilutive (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
Stock options and restricted shares	273			675			272			190

As more fully described in Note 16, our Notes are convertible under certain circumstances, as defined in the indenture, into a combination of cash and shares of our common stock. Potential dilution upon conversion of the Notes occurs when the market price per share of our common stock is greater than the conversion price of the Notes of $86.63. The Company intends to settle the principal value of the Notes in cash and issue shares of our common stock to settle the intrinsic value of the conversion feature. The Company will use the treasury stock method when calculating the potential dilutive effect of the conversion feature on earnings per share, if any. The average price of our common stock during the three and nine months ended September 30, 2019 did not exceed the conversion price of the Notes; therefore, under the net share settlement method, there are no potential shares issuable under the Notes to be used in the calculation of diluted EPS.

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

8.    GOODWILL AND OTHER INTANGIBLES

The following summarizes the change in goodwill during the nine months ended September 30, 2019 (in thousands):

Carrying amount, December 31, 2018	$	26,679
Goodwill attributable to acquisitions	547
Foreign currency adjustments	(10		)
Carrying amount, September 30, 2019	$	27,216

Other intangibles consisted of the following (in thousands):

	September 30, 2019												December 31, 2018
	Gross Carrying Amount				Accumulated Amortization				Net Carrying Amount				Gross Carrying Amount				Accumulated Amortization				Net Carrying Amount
Developed technology	$	8,200			$	(615	)		$	7,585			$	8,200			$	—			$	8,200
Customer relationships and other	3,726				(2,105		)		1,621				3,303				(1,739		)		1,564
Total intangible assets	$	11,926			$	(2,720	)		$	9,206			$	11,503			$	(1,739	)		$	9,764

Amortization expense relating to other intangibles was as follows (in thousands):

	Three Months Ended September 30,								Nine Months Ended September 30,
	2019				2018				2019				2018
Amortization expense	$	346			$	97			$	953			$	291

Estimated amortization expense related to intangibles for each of the five years from 2019 (remaining) through 2023 and thereafter is as follows (in thousands):

Year Ending December 31,
2019 (remaining)	$	322
2020	1,295
2021	1,291
2022	1,275
2023	926
Thereafter	4,097
	$	9,206

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

9.    PROPERTY AND EQUIPMENT, NET

Property and equipment, net, consisted of the following (in thousands):

	September 30, 2019				December 31, 2018
Land	$	377			$	377
Building	2,978				2,978
Machinery and equipment	30,039				33,087
Office furniture and equipment	1,699				1,687
Computer hardware and software	4,318				4,704
Leasehold and building improvements	10,545				9,953
Construction in progress	747				1,274
	50,703				54,060
Less accumulated depreciation	(36,080		)		(38,079		)
Total property and equipment, net	$	14,623			$	15,981

Depreciation expense was $0.9 million and $1.0 million for the three months ended September 30, 2019 and 2018, respectively, and $2.8 million and $3.2 million for the nine months ended September 30, 2019 and 2018, respectively.

The Company has subscription agreements whereby its instruments in inventory may be placed at a customer's location on a rental basis. The cost of these instruments is transferred to machinery and equipment and depreciated, typically over a 5 to 7 year period depending on the circumstance under which the instrument is placed with the customer. Our cost of instruments under operating leases as of September 30, 2019 and December 31, 2018, was $9.2 million and $10.8 million, respectively, before accumulated depreciation of $5.1 million and $6.1 million, respectively.

10.    INVENTORIES, NET

Inventories, net, consisted of the following (in thousands):

	September 30, 2019				December 31, 2018
Raw materials	$	15,292			$	15,000
Work in process	2,959				3,592
Finished goods	9,145				8,085
Allowance for excess or obsolete inventory	(1,181		)		(1,573		)
Total inventory, net	$	26,215			$	25,104

Inventories are measured on a first-in, first-out basis and stated at lower of cost or net realizable value.

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

11.    ACCRUED LIABILITIES

Accrued liabilities consisted of the following (in thousands):

	September 30, 2019				December 31, 2018
Accrued settlement (see Note 14)	$	—			$	6,750
Accrued payroll and employee benefits	1,189				759
Accrued property taxes	510				632
Accrued purchase orders	1,957				699
Other	1,646				1,302
Total accrued liabilities	$	5,302			$	10,142

Other accrued liabilities consists of items that are individually less than 5% of total current liabilities.

12.    CAPITAL STOCK

Stock Option Plans

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions for options granted in the three and nine months ended September 30, 2019 and 2018.

	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
Risk-free interest rate	1.53%		2.80%		1.66%		2.66%
Expected lives	4.7 years		4.9 years		4.7 years		4.9 years
Expected volatility	40%		40%		40%		40%
Expected dividend yield	0%		0%		0%		0%

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

A summary of our stock option plans is as follows:

	Nine Months Ended September 30,							Year Ended December 31,
	2019							2018
	Options			Weighted Average Exercise Price				Options			Weighted Average Exercise Price
Outstanding at beginning of period	620,553			$	40.741			630,847			$	29.312
Granted at market	35,200			$	72.271			153,700			$	75.244
Forfeited	(664	)		$	98.660			(18,978	)		$	53.010
Expired	(234	)		$	98.660			(896	)		$	65.414
Exercised	(153,227	)		$	16.583			(144,120	)		$	25.740
Outstanding at end of period	501,628			$	50.230			620,553			$	40.741
Exercisable at end of period	321,229			$	36.493			386,176			$	21.214

The total estimated fair value of stock options granted during the nine months ended September 30, 2019 and 2018 was computed to be approximately $0.9 million and $4.4 million, respectively. The amounts are amortized ratably over the vesting periods of the options. The weighted average estimated fair value of options granted during the nine months ended September 30, 2019 and 2018 was computed to be approximately $26.05 and $28.74, respectively. The total intrinsic value of options exercised during the nine months ended September 30, 2019 and 2018 was $11.8 million and $6.6 million, respectively. The cash proceeds from options exercised during the nine months ended September 30, 2019 and 2018 was $0.5 million and $3.0 million, respectively.

The following table summarizes information about stock options outstanding and exercisable at September 30, 2019:

		Options Outstanding									Options Exercisable
Exercise Prices		Number of Options Outstanding at September 30, 2019			Weighted Average Remaining Contractual Life in Years		Weighted Average Exercise Price				Number of Options Exercisable at September 30, 2019			Weighted Average Exercise Price
$ 4.96 - $ 7.36		90,852			3.38		$	6.988			90,852			$	6.988
$ 7.37 - $ 32.21		78,374			4.55		$	15.964			78,374			$	15.964
$ 32.22 - $ 62.50		57,533			6.31		$	39.797			51,945			$	39.740
$ 62.51 - $ 69.77		130,000			8.43		$	69.770			43,337			$	69.770
$ 69.78 - $ 108.25		144,869			8.19		$	82.494			56,721			$	83.719
$ 4.96 - $ 108.25		501,628			6.60		$	50.230			321,229			$	36.493

As of September 30, 2019, there was approximately $4.2 million in total unrecognized compensation cost related to outstanding stock options. That cost is expected to be recognized over a weighted average period of 1.28 years, with all cost to be recognized by the end of February 2023, assuming all options vest according to the vesting schedules in place at September 30, 2019. As of September 30, 2019, the aggregate intrinsic value of outstanding options was approximately $12.0 million and the aggregate intrinsic value of exercisable options was approximately $11.8 million.

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

The Company issues new shares upon share option exercise, which may be netted or withheld to meet strike price or related tax obligations.

Employee Stock Purchase Plan (the "ESPP")

For the three months ended September 30, 2019 and 2018, we issued 3,032 and 1,942 shares under the ESPP, respectively. For the nine months ended September 30, 2019 and 2018, we issued 8,401 and 7,396 shares under the ESPP, respectively.

For the three and nine months ended September 30, 2019 and 2018, we estimated the fair values of stock purchase rights granted under the ESPP using the Black-Scholes pricing model. The weighted average assumptions used for the periods presented were as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
Risk-free interest rate	1.94%		2.04%		2.16%		1.39%
Expected lives	1.1 years		1.1 years		1.1 years		1.2 years
Expected volatility	39%		42%		39%		43%
Expected dividend yield	0%		0%		0%		0%

For the three months ended September 30, 2019 and 2018, the weighted-average fair value of the purchase rights granted was $16.62 and $23.44 per share, respectively. For the nine months ended September 30, 2019 and 2018, the weighted-average fair value of the purchase rights granted was $18.03 and $17.85 per share, respectively.

Restricted Stock Issuances

We have granted non-vested restricted stock awards (“restricted stock” or "RSAs") to management and non-employee directors pursuant to the Company's amended and restated Stock Incentive Plan. The restricted stock awards have varying vesting periods, but generally become fully vested between one and four years after the grant date, depending on the specific award, performance targets met for performance-based awards granted to management, and vesting periods for time based awards. Management performance-based awards are granted at the target amount of shares that may be earned. We valued the restricted stock awards related to service and/or company performance targets based on grant date fair value and expense over the period when achievement of those conditions is deemed probable. For restricted stock awards related to market conditions, we utilize a Monte Carlo simulation model to estimate grant date fair value and expense over the requisite period. We recognize forfeitures as they occur. There were no modifications that affected our accounting for restricted stock awards in the nine months ended September 30, 2019 or 2018.

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

The following table summarizes restricted stock transactions for the nine months ended September 30, 2019:

	RSAs			Weighted-Average Grant Date Fair Value Per Award
Non-vested as of December 31, 2018	259,430			$	74.26
Granted	42,567			70.00
Vested	(4,230	)		85.09
Forfeited	(1,400	)		80.90
Non-vested as of September 30, 2019	296,367			$	73.50

The weighted average grant date fair value of awards granted was $71.84 and $98.41 for the three months ended September 30, 2019 and 2018, respectively. The weighted average grant date fair value of awards granted was $70.00 and $71.77 for the nine months ended September 30, 2019 and 2018, respectively. No restricted stock awards vested during the three months ended September 30, 2019 and 2018. Fair value of restricted stock vested was $0.3 million and $4.4 million for the nine months ended September 30, 2019 and 2018, respectively.

As of September 30, 2019, there was approximately $2.6 million of total unrecognized compensation cost related to restricted stock with market and time vesting conditions. The Company expects to recognize this expense over a weighted average period of 1.1 years. As of September 30, 2019, we reviewed each of the underlying corporate performance targets and determined that approximately 193,000 of shares of common stock were related to company performance targets in which we did not deem achievement probable. No compensation expense had been recorded at any period prior to September 30, 2019.

13.    ACCUMULATED OTHER COMPREHENSIVE INCOME

Accumulated other comprehensive income (loss) consisted of the following (in thousands):

	Minimum Pension Liability				Foreign Currency Translation				Total Accumulated Other Comprehensive Income
Balances at December 31, 2018	$	(419	)		$	696			$	277
Current period other comprehensive loss	—				(137		)		(137		)
Balances at September 30, 2019	$	(419	)		$	559			$	140

14.    COMMITMENTS AND CONTINGENCIES

Royalty Agreements

The Company holds certain rights to market and manufacture products developed or created under certain research, development, and licensing agreements with various entities. In connection with such agreements, the Company has agreed to pay the entities royalties on net product sales. In each of the three months ended September 30, 2019 and 2018, royalties of $0.1 million became payable under these agreements. In each of the nine months ended September 30, 2019, and 2018, royalties of $0.3 million became payable under these agreements.

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Warranties

The Company's current terms and conditions of sale include a limited warranty that its products and services will conform to published specifications at the time of shipment and a more extensive warranty related to certain products. The Company also sells a renewal warranty for certain of its products. The typical remedy for breach of warranty is to correct or replace any defective product, and if not possible or practical, the Company will accept the return of the defective product and refund the amount paid. Historically, the Company has incurred minimal warranty costs. The Company's warranty reserve was $0.2 million at both September 30, 2019 and December 31, 2018.

Litigation

From time to time, the Company may be involved in litigation relating to claims arising out of its operations. The Company records accruals for outstanding legal matters when it believes it is probable that a loss will be incurred, and the amount can be reasonably estimated.

On October 10, 2018, we reached an agreement in principle to settle the complaint that was filed against the Company by Shaun Fauley on March 12, 2015 in the U.S. District Court Northern District of Illinois (the "Court") alleging our transmittal of unauthorized faxes in violation of the federal Telephone Consumer Protection Act of 1991, as amended by the Junk Fax Prevention Act of 2005, as a class action (the "Fauley Complaint"). The settlement, which received the Court's approval on February 28, 2019 and was not subsequently appealed by a class member, required us to make available a total of $6.8 million to pay class members, as well as to pay attorneys' fees and expenses to legal counsel to the class. The Company recorded the loss provision in the third quarter of 2018 in connection with the settlement agreement and does not have insurance coverage for the Fauley Complaint. The payment in respect of the settlement was made in full on April 3, 2019, and all activity related to the Fauley Complaint has ceased.

As of September 30, 2019, the Company was not a party to any other legal proceedings that were expected, individually or in the aggregate, to have a material adverse effect on its business, financial condition, or operating results.

Off-Balance Sheet Commitments

The Company has contractual obligations with suppliers for unconditional annual minimum inventory purchases in the amounts of $17.0 million as of September 30, 2019.

The Company also committed to purchase real estate in the amount of approximately $1.0 million from Optomed's minority interest holder within a reasonable amount of time from acquisition date of the French company. Approximately half of the $1.0 million commitment was prepaid in the quarter ended September 30, 2019 and the remainder was paid on November 4, 2019.

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

15.    INTEREST AND OTHER EXPENSE, NET

Interest and other expense, net, consisted of the following (in thousands):

	Three Months Ended September 30,								Nine Months Ended September 30,
	2019				2018				2019				2018
Interest income	$	(141	)		$	(66	)		$	(365	)		$	(186	)
Interest expense	494				89				718				231
Other expense (income), net	574				(73		)		579				(8		)
Total interest and other expense (income), net	$	927			$	(50	)		$	932			$	37

Cash paid for interest for the three months ended September 30, 2019 and 2018 was $224 thousand and $58 thousand, respectively. Cash paid for interest for the nine months ended September 30, 2019 and 2018 was $351 thousand and $143 thousand, respectively.

16.    CONVERTIBLE NOTES AND CREDIT FACILITY

Convertible Notes

On September 17, 2019, the Company issued $86.25 million aggregate principal amount of 3.750% Convertible Senior Notes due 2026, which included the exercise in full of an $11.25 million purchase option, to certain financial institutions as the initial purchasers of the Notes (the "Initial Purchasers"). The Notes are senior unsecured obligations of the Company. The Notes were issued pursuant to an Indenture, dated September 17, 2019 (the “Indenture”), between the Company and U.S. Bank National Association, as trustee.

The net proceeds from the sale of the Notes were approximately $83.7 million after deducting the initial purchasers’ discounts and the offering expenses payable by the Company. The Company used approximately $12.8 million of the net proceeds from the Notes to repay all outstanding indebtedness on its existing Credit Facility, and an additional $2.0 million to fully fund a cash collateralized, letter of credit facility under the new Credit Facility as amended by the Amendment (as defined below). The Company expects to use the remainder of the net proceeds from the sale of the Notes to fund our intended expansion efforts, including through acquisitions of complementary businesses or technologies or other strategic transactions, and for working capital and other general corporate purposes.

The Notes are senior unsecured obligations of the Company and will rank senior in right of payment to any of our indebtedness that is expressly subordinated in right of payment to the Notes; equal in right of payment to any of our unsecured indebtedness that is not so subordinated; effectively junior in right of payment to any of our secured indebtedness (including any letters of credit issued under our Credit Facility) to the extent of the value of assets securing such indebtedness; and structurally junior to all indebtedness and other liabilities (including trade payables) of our subsidiaries.

The Company pays interest on the Notes semiannually in arrears at a rate of 3.750% per annum on March 15 and September 15 of each year. The Notes are convertible based upon an initial conversion rate of 11.5434 shares of the Company’s common stock per $1,000 principal amount of Notes (equivalent to a conversion price of approximately $86.63 per share of common stock). The Notes would convert in full into 995,618 shares of common stock based on the initial conversion rate. The conversion rate will be subject to standard anti-dilution adjustments upon the occurrence of certain events but will not be adjusted for accrued and unpaid interest. The interest rate on the Notes may be increased by up to 0.50% upon the occurrence of certain events of default or non-timely filings until such matter has been cured.

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

The Indenture includes customary covenants, but no financial or operating covenants or restrictions on the payments of dividends, the incurrence of indebtedness or the issuance or repurchase of securities, and sets forth certain events of default after which the Notes may be declared immediately due and payable, and sets forth certain types of bankruptcy or insolvency events of default involving the Company after which the Notes become automatically due and payable. The Company can settle any conversions of the Notes in cash, shares of the Company’s common stock or a combination thereof, with the form of consideration determined at the Company’s election. The Company intends to settle the principal value of the Notes in cash and issue shares of the Company’s common stock to settle the intrinsic value of the conversion feature. There can be no guarantee, however, that any settlement will be effected by the Company as currently intended, and the timing and other factors of any settlement, many of which may be outside the Company's control, could impact the actual amounts to be settled in either cash or common stock.

The Notes will mature on September 15, 2026, unless earlier repurchased, redeemed or converted. Prior to March 15, 2026, holders may convert all or a portion of their Notes only under the following circumstances: (1) during any calendar quarter commencing after the calendar quarter ending on December 31, 2019 (and only during such calendar quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on, and including, the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day; (2) during the 5 business day period after any 5 consecutive trading day period (the "Notes measurement period") in which the trading price per $1,000 principal amount of Notes for each trading day of the Notes measurement period was less than 98% of the product of the last reported sale price of the Company’s common stock and the conversion rate on each such trading day; (3) with respect to any Notes called for redemption by the Company, at any time prior to the close of business on the scheduled trading day immediately preceding the redemption date; or (4) upon the occurrence of specified corporate events. On and after March 15, 2026 until the close of business on the scheduled trading day immediately preceding the maturity date, holders may convert their Notes at any time, regardless of the foregoing circumstances. Holders of Notes who convert their Notes in connection with a notice of a redemption or a make-whole fundamental change (each as defined in the Indenture) may be entitled to a premium in the form of an increase in the conversion rate of the Notes.

The Company may not redeem the Notes prior to September 20, 2023. On or after September 20, 2023, the Company may redeem for cash all or part of the Notes if the last reported sale price of the Company’s common stock equals or exceeds 130% of the conversion price then in effect for at least 20 trading days (whether or not consecutive) during any 30 consecutive trading day period (including the last trading day of such period) ending on, and including, the trading day immediately preceding the date on which the Company provides notice of the redemption. The redemption price will be 100% of the principal amount of the Notes to be redeemed, plus accrued and unpaid interest, if any. No sinking fund is provided for the Notes.

Upon the occurrence of a fundamental change (as defined in the Indenture), holders may require the Company to repurchase all or a portion of their Notes for cash at a price equal to 100% of the principal amount of the Notes to be repurchased plus any accrued but unpaid interest to, but excluding, the fundamental change repurchase date.

In accounting for the issuance of the Notes, the Company separated the Notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component, representing the conversion option, which does not meet the criteria for separate accounting as a derivative as it is indexed to the Company's own stock, was determined by deducting the fair value of the liability component from the par value of the Notes. The difference between the principal amount of the Notes

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

and the liability component represents the debt discount, which is recorded as a direct deduction from the related debt liability in the consolidated and condensed balance sheet and amortized to interest expense using the effective interest method over the term of the Notes. The effective interest rate of the Notes is 10.8%. The equity component of the Notes of approximately $39.5 million, net of allocated issuance costs, is included in additional paid-in capital in the consolidated and condensed balance sheet and is not remeasured as long as it continues to meet the conditions for equity classification. The Company allocated transaction costs related to the Notes using the same proportions as the proceeds from the Notes. Transaction costs attributable to the liability component were recorded as a direct deduction from the related debt liability in the consolidated and condensed balance sheet and amortized to interest expense over the term of the Notes, and transaction costs attributable to the equity component were netted with the equity component in shareholders’ equity.

In addition, the Company determined that the additional interest that could be due to the holders of the Notes upon an event of default or non-timely filing represented an embedded derivative feature that should be bifurcated from the Notes. The Company concluded that the fair value of this embedded derivative feature was de minimis upon the issuance of the Notes and at September 30, 2019.

	September 30, 2019
Carrying amount of equity component	$	39,508
Principal amount of the Notes	86,250
Unamortized debt discount	(42,427		)
Net carrying amount	$	43,823

Interest expense related to the Notes for the quarter ended September 30, 2019 was $337 thousand, which is comprised of the amortization of debt discount and debt issuance costs and the contractual coupon interest as follows:

	Three and Nine Months Ended
	September 30, 2019
Interest expense related to contractual coupon interest	$	117
Interest expense related to amortization of the debt discount	220
	$	337

As of September 30, 2019, the remaining period over which the unamortized discount will be amortized is 83.5 months.

The estimated fair value of the Notes was $95.3 million as of September 30, 2019, determined through consideration of quoted market prices in less active markets. The fair value measurement is classified as Level 2 in the fair value hierarchy, which is defined in ASC 820 as inputs other than quoted prices in active markets that are either directly or indirectly observable. The if-converted value of the Notes did not exceed the principal value as of September 30, 2019.

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Credit Facility

We entered into a Credit Agreement, dated July 27, 2017, as amended in May 2018, December 2018 and July 2019 (the "Credit Agreement"), with JPMorgan Chase Bank, N.A. ("Chase") which provided for a revolving credit facility up to $30.0 million (the "Credit Facility"). The Credit Facility provided us with the ability to borrow up to $30.0 million although the amount of the Credit Facility may have been increased by an additional $20.0 million up to a total of $50.0 million subject to receipt of additional lender commitments and other conditions. Any interest on borrowings due was to be charged at either the (i) rate of interest per annum publicly announced from time to time by Chase as its prime rate in effect at its principal offices in New York City, subject to a floor, minus 1.65%, or (ii) the interest rate per annum equal to (a) LIBOR for the interest period in effect multiplied by (b) Chase's Statutory Reserve Rate (as defined in the Credit Agreement), plus 1.10% and payable monthly. There was an annual minimum interest charge of $60 thousand under the Credit Agreement. Chase held first right of priority over all other liens, if any were to exist.

In September 2019, we entered into an amendment to the Credit Agreement (the “Amendment”), which among other things, reduced and limited the Credit Facility to a $2.0 million, cash collateralized, letter of credit facility and eliminated a majority of the negative covenants previously contained in the Credit Facility, including any covenants that could have prohibited the issuance of any Notes and the Company's ability to pay cash upon conversion, repurchase or redemption of any Notes issued. The Company was required to repay in full the approximately $12.8 million of indebtedness outstanding under the Credit Facility and fully fund the $2.0 million collateral account to be held by Chase to secure the Company's obligations under the Amendment to the Credit Facility in connection with the issuance of the Notes. The maturity date of the Credit Facility, as amended by the Amendment, is September 9, 2021. This Amendment became effective on September 17, 2019, the first date any Notes were issued. The Company accounted for the modification of the Credit Facility by writing off approximately $33 thousand of remaining unamortized debt issuance costs related to the Credit Agreement.

The foregoing discussion of the Credit Facility is a summary only and is qualified in its entirety by reference to the full text of the Credit Agreement, a copy of which has been filed as an exhibit to the Company's Current Report on Form 8-K filed with the SEC on August 2, 2017, incorporated herein by reference. Additionally, the following amendments are included in summary only and are qualified in their entirety by reference to the full text of the First Facility Amendment, a copy of which has been filed as an exhibit to the Company's Quarterly Report on Form 10-Q filed with the SEC on August 8, 2018, the Second Facility Amendment, a copy of which has been filed as an exhibit to the Company's Annual Report on Form 10-K filed with the SEC on March 7, 2019 and the Third Facility Amendment, a copy of which has been filed as an exhibit to the Company's Quarterly Report on Form 10-Q filed with the SEC on August 7, 2019, and the Fourth Facility Amendment, a copy of which has been filed as an exhibit to this Quarterly Report on Form 10-Q filed with the SEC on November 6, 2019, each of which are incorporated herein by reference.

As of September 30, 2019, we had fully collateralized the $2.0 million letter of credit facility. There were no letters of credit outstanding under the facility at September 30, 2019. The $2.0 million of collateral has been recorded as restricted cash on the Company's Consolidated Balance Sheets at September 30, 2019. In connection with the Credit Agreement, the Company incurred debt issuance costs of $38 thousand. These costs are included in other non-current assets on the Company's Consolidated Balance Sheets, and will be amortized to interest expense ratably over the term of the agreement.

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

17.    SEGMENT REPORTING

The Company is composed of two reportable segments: CCA and OVP. The CCA segment includes Point of Care diagnostic laboratory instruments and consumables, and Point of Care digital imaging diagnostic instruments and software services as well as single use diagnostic and other tests, pharmaceuticals and vaccines, primarily for canine and feline use. These products are sold directly by the Company as well as through independent third-party distributors and through other distribution relationships. CCA segment products manufactured at the Des Moines, Iowa production facility included in the OVP segment's assets are transferred at cost and are not recorded as revenue for the OVP segment. The OVP segment includes private label vaccine and pharmaceutical production, primarily for cattle, but also for other animals including small mammals. All OVP products are sold by third parties under third-party labels.

Summarized financial information concerning the Company's reportable segments is shown in the following tables (in thousands):

Three Months Ended September 30, 2019		Core Companion Animal				Other Vaccines and Pharmaceuticals				Total
Total revenue		$	26,339			$	4,898			$	31,237
Operating income (loss)		560				(367		)		193
Loss before income taxes		(367		)		(367		)		(734		)
Capital expenditures		27				66				93
Depreciation and amortization		908				329				1,237

Three Months Ended September 30, 2018		Core Companion Animal				Other Vaccines and Pharmaceuticals				Total
Total revenue		$	27,190			$	3,765			$	30,955
Operating (loss) income		(4,402		)		807				(3,595		)
(Loss) income before income taxes		(4,352		)		807				(3,545		)
Capital expenditures		20				229				249
Depreciation and amortization		823				317				1,140

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HESKA CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued)

Nine Months Ended September 30, 2019		Core Companion Animal				Other Vaccines and Pharmaceuticals				Total
Total revenue		$	75,771			$	13,123			$	88,894
Operating income (loss)		255				(703		)		(448		)
Loss before income taxes		(677		)		(703		)		(1,380		)
Capital expenditures		103				619				722
Depreciation and amortization		2,789				970				3,759

Nine Months Ended September 30, 2018		Core Companion Animal				Other Vaccines and Pharmaceuticals				Total
Total revenue		$	80,652			$	12,729			$	93,381
Operating income		384				95				479
Income before income taxes		347				95				442
Capital expenditures		117				944				1,061
Depreciation and amortization		2,568				905				3,473

Asset information by reportable segment as of September 30, 2019 is as follows (in thousands):

As of September 30, 2019		Core Companion Animal				Other Vaccines and Pharmaceuticals				Total
Investments in unconsolidated affiliates		$	7,563			$	—			$	7,563
Total assets		202,306				21,705				224,011
Net assets		135,190				18,493				153,683

Asset information by reportable segment as of December 31, 2018 is as follows (in thousands):

As of December 31, 2018		Core Companion Animal				Other Vaccines and Pharmaceuticals				Total
Investments in unconsolidated affiliates		$	8,018			$	—			$	8,018
Total assets		133,586				22,866				156,452
Net assets		96,129				26,280				122,409

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the unaudited Condensed Consolidated Financial Statements and related Notes included in Part I Item 1 of this Form 10-Q.

This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, that involve risks and uncertainties, and can generally be identified by our use of the words "scheduled,"  "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," and variations of such words and similar expressions. Such statements, which include statements concerning future revenue sources and concentration, international market expansion, gross profit margins, selling and marketing expenses, remaining minimum performance obligations, research and development expenses, general and administrative expenses, capital resources, financings or borrowings and additional losses, are subject to risks and uncertainties, including, but not limited to, those discussed under the caption "Risk Factors" contained in Part II, Item 1A, below of this Quarterly Report on Form 10-Q that could cause actual results to differ materially from those projected. The Risk Factors and others described in the Company’s periodic and current reports filed with the SEC from time to time are not necessarily all of the important factors that could cause the Company’s actual results to differ materially from those projected. Other unknown or unpredictable factors could also harm the Company’s results. The forward-looking statements set forth in this Form 10-Q are as of the close of business on November 5, 2019 and we undertake no duty and do not intend to update this information, except as required by applicable laws. If we updated one or more forward looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth above.

Overview

We sell advanced veterinary diagnostic and specialty products. Our offerings include Point of Care laboratory instruments and consumables, Point of Care digital imaging diagnostic products; vaccines; local and cloud-based data services; allergy testing and immunotherapy; and single-use offerings such as in-clinic diagnostic tests and heartworm preventive products. Our core focus is on supporting veterinarians in the canine and feline healthcare space.

Our business is composed of two reportable segments, Core companion animal ("CCA") and Other vaccines and pharmaceuticals ("OVP"). The CCA segment includes, primarily for canine and feline use, Point of Care laboratory instruments and consumables; digital imaging diagnostic instruments, software and services; local and cloud-based data services; allergy testing and immunotherapy; and single use offerings such as in-clinic diagnostic tests and heartworm preventive products. The OVP segment includes private label vaccine and pharmaceutical production, primarily for cattle but also for other species including equine, porcine, avian, feline and canine. OVP products are sold by third parties under third party labels.

The CCA segment represented approximately 84.3% and 85.2% of our revenue for the three and nine months ended September 30, 2019, respectively, and the OVP segment represented approximately 15.7% and 14.8% of our revenue for the three and nine months ended September 30, 2019, respectively.

CCA Segment

Revenue from Point of Care laboratory represented 66.5% and 65.5% of CCA revenue for the three and nine months ended September 30, 2019, respectively. Revenue from this area primarily involves placing an instrument under contract in the field and generating future revenue from testing consumables, such as

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cartridges and reagents, as that instrument is used. The majority of revenue from Point of Care laboratory results from the revenue of such testing consumables to an installed base of instruments, which are generally under minimum take or pay contracts, followed by instrument sales and other revenue sources such as service and repairs. Instruments placed under subscription agreements are considered operating or sales-type leases, depending on the duration and other factors of the underlying agreement. A loss of, or disruption in, the procurement of consumables we are selling to an installed base of instruments could substantially harm our business. All of our Point of Care laboratory and other non-imaging instruments and consumables are supplied by third parties, who typically own the product rights and supply the product to us under marketing and/or distribution agreements. In many cases, we have collaborated with a third party to adapt a human instrument for veterinary use. Major products in this area include our instruments for chemistry, hematology, blood gas, coagulation and immunodiagnostic testing and their affiliated operating consumables.

Point of Care imaging hardware, software and services represented 20.3% and 21.1% of CCA revenue for the three and nine months ended September 30, 2019, respectively. Digital radiography is the largest product offering in this area, which also includes ultrasound and endoscopy instruments. Digital radiography solutions typically consist of a combination of hardware and software placed with a customer, often combined with an ongoing service and support contract. We sell our imaging solutions both in the U.S. and internationally. Our experience has been that most of the revenue is generated at the time of sale in this area, in contrast to the Point of Care diagnostic laboratory placements discussed above where ongoing consumable revenue is often a larger component of economic value as a given instrument is used.

Other CCA revenue, including single use diagnostic and other tests, pharmaceuticals and biologicals as well as research and development, licensing and royalty revenue, represented 13.2% and 13.4% of CCA revenue for the three and nine months ended September 30, 2019, respectively. Since items in this area are often single use by their nature, our typical aim is to build customer satisfaction and loyalty for each product, generate repeat annual sales from existing customers and expand our customer base in the future. Products in this area are both supplied by third parties and provided by us. Major products and services in this area include heartworm diagnostic tests and preventives, and allergy test kits, allergy immunotherapy and testing.

We consider the CCA segment to be our core business and devote most of our management time and other resources to improving the prospects for this segment. Maintaining a continuing, reliable and economic supply of products we currently obtain from third parties is critical to our success in this area. Virtually all of our sales and marketing expenses occur in the CCA segment. The majority of our research and development spending is dedicated to this segment as well.

Our CCA products are ultimately sold primarily to or through veterinarians. In many cases, veterinarians will mark up their costs to their customer. The acceptance of our products by veterinarians is critical to our success. CCA products are sold directly to end users by us as well as through distribution relationships, such as the sale of kits to conduct blood testing to third-party veterinary diagnostic laboratories and sales to independent third-party distributors. Revenue from direct sales and distribution relationships represented approximately 71.4% and 28.6%, respectively, of CCA revenue for the three months ended September 30, 2019, and approximately 72.2% and 27.8%, respectively, of CCA revenue for the nine months ended September 30, 2019.

OVP Segment

The OVP segment includes our approximately 160,000 square foot USDA, FDA and EPA licensed production facility in Des Moines, Iowa. We view this facility as an asset which could allow us to control our cost of goods on any pharmaceuticals and vaccines that we may commercialize in the future. We have increased integration of this facility with our operations elsewhere. For example, virtually all of our U.S. inventory, excluding our imaging products, is now stored at this facility and related fulfillment logistics are managed

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there. CCA segment products manufactured at this facility are transferred at cost and are not recorded as revenue for our OVP segment. We view OVP reported revenue as revenue primarily to cover the overhead costs of the facility and to generate incremental cash flow to fund our CCA segment.

Historically, a significant portion of our OVP segment's revenue has been generated from the sale of certain bovine vaccines, which have been sold primarily under the Titanium® and MasterGuard® brands. We have an agreement with Eli Lilly and Company and its affiliates operating through Elanco for the production of these vaccines (the "Elanco Agreement"). Our OVP segment also produces vaccines and pharmaceuticals for other third parties.

Results of Operations

Our analysis presented below is organized to provide the information we believe will facilitate an understanding of our historical performance and relevant trends going forward.

The following tables set forth, for the periods indicated, certain data derived from our unaudited Condensed Consolidated Statements of Income (in thousands):

	Three Months Ended September 30,								Nine Months Ended September 30,
	2019				2018				2019				2018
Revenue	$	31,237			$	30,955			$	88,894			$	93,381
Gross profit	13,664				14,794				38,619				41,166
Operating expenses	13,471				18,389				39,067				40,687
Operating income (loss)	193				(3,595		)		(448		)		479
Interest and other expense (income), net	927				(50		)		932				37
(Loss) income before income taxes and equity in losses of unconsolidated affiliates	(734		)		(3,545		)		(1,380		)		442
Income tax (benefit)	(530		)		(1,875		)		(1,966		)		(1,941		)
Net (loss) income before equity in losses of unconsolidated affiliates	(204		)		(1,670		)		586				2,383
Equity in losses of unconsolidated affiliates	(147		)		—				(455		)		—
Net (loss) income after equity in losses of unconsolidated affiliates	(351		)		(1,670		)		131				2,383
Net loss attributable to redeemable non-controlling interest	(41		)		—				(132		)		—
Net (loss) income attributable to Heska Corporation	$	(310	)		$	(1,670	)		$	263			$	2,383

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CCA Segment

	Three Months Ended September 30,								Change							Nine Months Ended September 30,								Change
	2019				2018				Dollar Change				% Change			2019				2018				Dollar Change				% Change
Point of Care laboratory:	$	17,524			$	14,584			$	2,940			20.2	%		$	49,605			$	43,277			$	6,328			14.6	%
Consumables	14,021				11,598				2,423				20.9	%		39,545				33,942				5,603				16.5	%
Instruments	3,134				2,610				524				20.1	%		8,943				8,087				856				10.6	%
Other	369				376				(7		)		(1.9	)%		1,117				1,248				(131		)		(10.5	)%
Point of Care imaging	5,337				5,326				11				0.2	%		15,976				15,759				217				1.4	%
Other CCA revenue	3,478				7,280				(3,802		)		(52.2	)%		10,190				21,616				(11,426		)		(52.9	)%
Total CCA revenue	$	26,339			$	27,190			$	(851	)		(3.1	)%		$	75,771			$	80,652			$	(4,881	)		(6.1	)%
Percent of total revenue	84.3		%		87.8		%									85.2		%		86.4		%
Cost of revenue	12,735				13,759				(1,024		)		(7.4	)%		37,818				41,294				(3,476		)		(8.4	)%
Gross profit	13,604				13,431				173				1.3	%		37,953				39,358				(1,405		)		(3.6	)%
Operating income (loss)	$	560			$	(4,402	)		$	4,962			(112.7	)%		$	255			$	384			$	(129	)		(33.6	)%

OVP Segment

	Three Months Ended September 30,								Change							Nine Months Ended September 30,								Change
	2019				2018				Dollar  Change				%  Change			2019				2018				Dollar  Change				%  Change
Revenue	$	4,898			$	3,765			$	1,133			30.1	%		$	13,123			$	12,729			$	394			3.1	%
Percent of total revenue	15.7		%		12.2		%									14.8		%		13.6		%
Cost of revenue	4,838				2,402				2,436				101.4	%		12,457				10,921				1,536				14.1	%
Gross profit	60				1,363				(1,303		)		(95.6	)%		666				1,808				(1,142		)		(63.2	)%
Operating (loss) income	$	(367	)		$	807			$	(1,174	)		(145.5	)%		$	(703	)		$	95			$	(798	)		(840.0	)%

Revenue

Total revenue increased 0.9% to $31.2 million in the three months ended September 30, 2019, compared to $31.0 million in the three months ended September 30, 2018. Total revenue decreased 4.8% to $88.9 million in the nine months ended September 30, 2019, compared to $93.4 million in the nine months ended September 30, 2018.

CCA segment revenue decreased 3.1% to $26.3 million in the three months ended September 30, 2019, compared to $27.2 million in the three months ended September 30, 2018. The $0.9 million decrease was primarily driven by a $4.0 million decrease in revenue from contract manufactured heartworm preventative, Tri-Heart, as a result of reduced customer demand. This was partially offset by a $2.4 million increase in Point of Care laboratory consumables revenue. CCA segment revenue decreased 6.1% to $75.8 million in the nine months ended September 30, 2019, compared to $80.7 million in the nine months ended September 30, 2018. The $4.9 million decrease was primarily driven by an $11.3 million decrease in Tri-Heart revenue, partially offset by a $5.6 million increase in Point of Care laboratory consumables revenue.

OVP segment revenue increased 30.1% to $4.9 million in the three months ended September 30, 2019, compared to $3.8 million in the three months ended September 30, 2018. OVP segment revenue increased

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3.1% to $13.1 million in the nine months ended September 30, 2019, compared to $12.7 million in the nine months ended September 30, 2018. The increase in both periods is due to timing of shipments related to customer demands.

Gross Profit

Gross profit decreased 7.6% to $13.7 million in the three months ended September 30, 2019, compared to $14.8 million in the three months ended September 30, 2018. Gross margin decreased to 43.7% in the three months ended September 30, 2019 compared to 47.8% in the three months ended September 30, 2018. Gross profit decreased 6.2% to $38.6 million in the nine months ended September 30, 2019, compared to $41.2 million in the nine months ended September 30, 2018. Gross margin decreased to 43.4% in the nine months ended September 30, 2019 compared to 44.1% in the nine months ended September 30, 2018. The decrease in gross profit and gross margin for both periods was mainly driven by lower Tri-Heart revenue and the timing of contractual take or pay arrangements and product mix within our OVP segment, partially offset by favorable margins in Point of Care laboratory and imaging products.

Operating Expenses

Selling and marketing expenses increased 7.9% to $6.7 million in the three months ended September 30, 2019, compared to $6.2 million in the three months ended September 30, 2018. Selling and marketing expenses increased 11.8% to $20.5 million in the nine months ended September 30, 2019, compared to $18.3 million in the nine months ended September 30, 2018. The increase in both periods was primarily driven by an increase in compensation, including stock-based compensation, benefits, and commissions expense, which is mostly related to our commercial team expansion both domestically and internationally. The increase is in line with management expectations as we continue to invest in future growth and expanding the footprint of the Company.

Research and development expenses increased 170.8% to $2.5 million in the three months ended September 30, 2019, compared to $0.9 million in the three months ended September 30, 2018. Research and development expenses increased 183.5% to $6.1 million in the nine months ended September 30, 2019, compared to $2.2 million in the nine months ended September 30, 2018. The increase in both periods was primarily driven by spending on product development for urine and fecal diagnostics and enhanced immunodiagnostic offerings. As we invest in future growth of the Company, the increased research and development expenses are consistent with the spending initiatives of management.

General and administrative expenses decreased 62.4% to $4.2 million in the three months ended September 30, 2019, compared to $11.2 million in the three months ended September 30, 2018. The decrease was driven primarily by a $6.8 million settlement accrual in the prior year. General and administrative expenses decreased 38.3% to $12.5 million in the nine months ended September 30, 2019, compared to $20.2 million in the nine months ended September 30, 2018. The decrease was driven primarily by a $6.8 million settlement accrual in the prior year, as well as a decrease in consulting fees and severance expense. This was partially offset by increased administrative costs related to international expansion.

Interest and Other Expense (Income), net

Interest and other expense (income), net, was $927 thousand in the three months ended September 30, 2019, compared to $(50) thousand in the three months ended September 30, 2018. Interest and other expense (income), net, was $932 thousand in the nine months ended September 30, 2019, compared to $37 thousand in the nine months ended September 30, 2018. The increase in other expense for both periods was driven primarily by a $0.6 million loss as a result of a cyber theft event, for which we have insurance coverage that

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may mitigate this loss in a future period, and an increase in interest expense as a result of the convertible note offering.

Income Tax (Benefit) Expense

In the three months ended September 30, 2019, we had a total income tax benefit of $0.5 million, including $0.6 million of domestic deferred income tax benefit and $40 thousand current income tax expense. In the three months ended September 30, 2018, we had a total income tax expense of $1.9 million, including $1.9 million of domestic deferred income tax benefit and $27 thousand of current income tax expense. In the nine months ended September 30, 2019, we had a total income tax benefit of $2.0 million, including $2.1 million of domestic deferred income tax benefit and $112 thousand current income tax expense. In the nine months ended September 30, 2018, we had a total income tax benefit of $1.9 million, including $2.0 million of domestic deferred income tax benefit and $56 thousand of current income tax expense. The decrease in tax benefits is due to the lower financial loss. The Company recognized $0.1 million in excess tax benefits related to employee share-based compensation for the three months ended September 30, 2019 compared to $0.8 million recognized for the three months ended September 30, 2018. The Company recognized $1.5 million in excess tax benefits related to employee share-based compensation for the nine months ended September 30, 2019 compared to $2.1 million recognized for the nine months ended September 30, 2018.

Net (Loss) Income Attributable to Heska Corporation

Net loss attributable to Heska was $0.3 million for the three months ended September 30, 2019, compared to net loss attributable to Heska of $1.7 million in the prior year period. Net income attributable to Heska was $0.3 million for the nine months ended September 30, 2019, compared to net income attributable to Heska of $2.4 million in the prior year period. The difference between this line item and "Net income after equity in losses of unconsolidated affiliates" is the net income or loss attributable to our minority interest in our French subsidiary, which we purchased in February 2019. Net income is lower in the three months ended September 30, 2019 as compared to the three months ended September 30, 2018 due to decreased margins and a $0.6 million other loss as a result of cyber theft, which is discussed above. Net income is lower in the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018 due to lower revenue and increased operating expenses as a result of our future growth initiatives.

Impact of Inflation

In recent years, inflation has not had a significant impact on our operations.

Liquidity, Capital Resources and Financial Condition

We believe that adequate liquidity and cash generation is important to the execution of our strategic initiatives. Our ability to fund our operations, acquisitions, capital expenditures, and product development efforts may depend on our ability to generate cash from operating activities, which is subject to future operating performance, as well as general economic, financial, competitive, legislative, regulatory, and other conditions, some of which may be beyond our control. Our primary sources of liquidity are our available cash, including $70.9 million remaining from the issuance and sale of the Notes, after deducting the initial purchasers’ discounts, debt issuance costs paid or payable by us, and the repayment in full of our Credit Facility, as described in Note 16 to our unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q, cash generated from current operations, and availability under our Credit Facility, as amended by the Amendment, also described in Note 16 to our unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.

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For the nine months ended September 30, 2019, we had net income attributable to Heska Corporation of $0.3 million and net cash used by operations of $3.3 million. At September 30, 2019, we had $80.5 million of cash and cash equivalents and working capital of $114.5 million.

A summary of our cash from operating, investing and financing activities is as follows (in thousands):

	Nine Months Ended September 30,								Change
	2019				2018				Dollar Change				% Change
Net cash (used in) provided by operating activities	$	(3,276	)		$	6,458			$	(9,734	)		(150.7	)%
Net cash (used in) investing activities	(1,344		)		(9,126		)		7,782				(85.3	)%
Net cash provided by financing activities	73,767				2,255				71,512				3,171.3	%
Foreign exchange effect on cash, cash equivalents and restricted cash	(31		)		(10		)		(21		)		210.0	%
Increase (decrease) in cash, cash equivalents and restricted cash	69,116				(423		)		69,539				(16,439.5	)%
Cash, cash equivalents and restricted cash, beginning of the period	13,389				9,659				3,730				38.6	%
Cash, cash equivalents and restricted cash, end of the period	$	82,505			$	9,236			$	73,269			793.3	%

Net cash used in operating activities was $3.3 million in the nine months ended September 30, 2019, compared to net cash provided by operating activities of $6.5 million in the nine months ended September 30, 2018, a decrease of approximately $9.7 million. Net cash from operating activities decreased due to significant working capital fluctuations such as a $12.6 million increase in cash used by accrued liabilities, driven by a $6.8 million settlement payment (see Note 14 of this Form 10-Q), and a $4.4 million decrease in cash provided by inventories due to timing of purchases and lower sales in the current year. Additionally, net cash from operating activities was $2.3 million less in the nine months ended September 30, 2019 due to the decrease in net income compared to the nine months ended September 30, 2018. These factors were partially offset by a $7.2 million increase in the cash provided by the aggregate of accounts payable, accounts receivable, related party balances, deferred revenue and other non-current assets, due to the timing of collections and payments in the ordinary course of business, as well as a $0.5 million increase in lease receivables. Non-cash transactions impacting cash used by operating activities included a $1.1 million increase in the non-cash lease impact from adopting ASC 842, Leases, a $0.5 million increase in equity in losses of unconsolidated affiliates, and a $0.3 million increase in debt issuance cost amortization.

Net cash used in investing activities was $1.3 million in the nine months ended September 30, 2019, compared to net cash used in investing activities of $9.1 million in the nine months ended September 30, 2018, a decrease of approximately $7.8 million. The decrease in cash used for investing activities was mainly driven by the 2018 investments in unconsolidated affiliates for $8.1 million as compared to the 2019 acquisition of Optomed for $0.6 million. Additionally, there was a $0.3 million decrease in purchases of property and equipment.

Net cash provided by financing activities was $73.8 million in the nine months ended September 30, 2019, compared to net cash provided by financing activities of $2.3 million in the nine months ended September 30, 2018, an increase of approximately $71.5 million. The increase in cash provided by financing activities was driven primarily by convertible debt proceeds of $86.3 million (see Note 16 of this Form 10-Q). This was partially offset by an increase of $6.0 million in repayments on the line of credit, net of borrowings, a $3.1 million increase in debt issuance costs related to the convertible debt, a $2.4 million decrease in proceeds from the issuance of common stock, a $2.2 million increase in repurchases of common stock, and a $1.2 million increase in payments on other debts related to our subsidiary in France.

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We believe that our cash, cash equivalents and marketable securities balances, as well as the cash flows generated by our operations and borrowings expected to be available under our Credit Facility, will be sufficient to satisfy our anticipated cash needs for working capital and capital expenditures, including selling and marketing team expansion and product development initiatives, for at least the next 12 months. Our belief may prove to be incorrect, however, and we could utilize our available financial resources sooner the we currently expect. For example, we are actively seeking acquisitions that are consistent with our strategic direction, which may require additional capital. Our future capital requirements and the adequacy of available funds will depend on many factors, including those set forth in Part II, Item 1A, "Risk Factors", of this Form 10-Q. We may be required to seek additional equity or debt financing in order to meet these future capital requirements, even in the absence of any acquisitions. In the event that additional financing is required from outside sources, we may not be able to raise it on terms acceptable to us, or at all. If we are unable to raise additional capital when desired, our business, results of operations and financial condition would be adversely affected.

Effect of currency translation on cash

Net effect of foreign currency translations on cash changed $21 thousand to a $31 thousand negative impact in the nine months ended September 30, 2019, compared to a $10 thousand negative impact in the nine months ended September 30, 2018. These effects are related to changes in exchange rates of our foreign subsidiaries functional currencies and the U.S. dollar, the functional and reporting currency of Heska Corporation. Our foreign subsidiaries primary currencies are the Swiss Franc, Euro, Canadian dollar and Australian dollar.

Off-Balance Sheet Arrangements and Contractual Obligations

The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provided financing, liquidity, market risk or credit risk support to the Company, or engages in leasing, hedging or research and development services with the Company.

Purchase Obligations

Purchase obligations represent contractual agreements to purchase goods or services that are legally binding; specify a fixed, minimum or range of quantities; specify a fixed, minimum, variable, or indexed price provision; and specify approximate timing of the transaction. As of September 30, 2019, the Company had purchase obligations for inventory of $17.0 million and an approximate commitment of $1.0 million to purchase real estate from Optomed's minority interest holder within a reasonable amount of time from acquisition date of the French company. Approximately half of the $1.0 million commitment was prepaid in the quarter ended September 30, 2019 and the remainder was paid on November 4, 2019.

Critical Accounting Policies and Estimates

Our accounting policies are described in our audited Consolidated Financial Statements and Notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2018 and other than the recently adopted accounting pronouncements described in Note 1 - Operations and Summary of Significant Accounting Policies in our Condensed Consolidated Financial Statements included in Item 1 of this Form 10-Q, have not changed significantly since such filing.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

In September 2019, we issued $86.25 million aggregate principal amount of Notes. The fair market value of the Notes is affected by our common stock price. The fair value of the Notes will generally increase as our common stock price increases and will generally decrease as our common stock price declines in value. In addition, the fair market value of the Notes are exposed to interest rate risk. Generally, the fair market value of our fixed interest rate Notes will increase as interest rates fall and decrease as interest rates rise. Additionally, on our balance sheet we carry the Notes at face value less unamortized discount and debt issuance cost and we present the fair value for required disclosure purposes only.

For quantitative and qualitative disclosures about other market risk affecting us, see the section under the heading “Part II, Item 7A. Quantitative and Qualitative Disclosures About Market Risk” of our Annual Report on Form 10-K for the year ended December 31, 2018, which is incorporated by reference herein. As of the date of this Quarterly Report on Form 10-Q, except as described above, there have been no material changes to the market risks described in our Annual Report on Form 10-K for the year ended December 31, 2018.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our principal executive officer and our principal financial officer, evaluated the effectiveness of our disclosure controls and procedures, as defined by Rule 13a-15(e) of the Exchange Act, as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures were effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting that occurred since our last fiscal year-end that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.    Legal Proceedings

The information required by this item is incorporated by reference to Note 14 (Commitments and Contingencies) to the unaudited Condensed Consolidated Financial Statements included in Part 1, Item 1 of this Form 10-Q.

Item 1A.Risk Factors

Our future operating results may vary substantially from period to period due to a number of factors, many of which are beyond our control. The following discussion highlights some of these factors and the possible impact of these factors on future results of operations. The risks and uncertainties described below are not the only ones we face. Additional risks or uncertainties not presently known to us or that we deem to be currently immaterial also may impair our business operations. If any of the following factors actually occur, our

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business, financial condition or results of operations could be harmed. In that case, the price of our Public Common Stock could decline and investors in our Public Common Stock could experience losses on their investment.

Risks related to our business and our industry

If the third parties that have substantial marketing rights for certain of our historical products, existing products or future products under development are not successful in marketing those products, then our sales and financial position may suffer.

We are party to an agreement with Merck Animal Health, which grants Merck Animal Health exclusive distribution and marketing rights for our canine heartworm preventive product, TRI-HEART Plus Chewable Tablets, ultimately sold to or through veterinarians in the United States and Canada. Historically, a significant portion of our OVP segment’s revenue has been generated from the sale of certain bovine vaccines, which have been sold primarily under the Titanium and MasterGuard brands. We have a supply agreement with Eli Lilly and its affiliates operating through Elanco for the production of these vaccines. Either of these marketing partners may not devote sufficient resources to marketing our products and our sales and financial position could suffer significantly as a result. Revenue from Merck & Co., Inc. (“Merck”) entities, including Merck Animal Health, for example, represented approximately 12% of our 2018 revenue, but is expected to represent approximately 1% of our 2019 revenue. Revenue from Eli Lilly entities, including Elanco, represents approximately 10% of our revenue for the nine months ended September 30, 2019, and represented approximately 9% of our 2018 revenue. If Elanco were to fail to market, sell and support the bovine vaccines we produce and sell to Elanco sufficiently, similar to Merck Animal Health's failure to market, sell and support our heartworm preventive product in 2019, our sales could decline. Furthermore, there may be nothing to prevent these partners from pursuing alternative technologies, products or supply arrangements, including as part of mergers, acquisitions or divestitures. Third party marketing assistance may not be available in the future on reasonable terms, if at all. If the third parties with marketing rights for our products were to merge or go out of business, the sale and promotion of our products could be diminished.

Our Chief Executive Officer has acknowledged outside business interests which may occupy a portion of his time.

On November 26, 2018, Heska Imaging, LLC entered into a Purchase Agreement for Certain Assets with Cuattro, LLC, pursuant to which Heska Imaging, LLC purchased certain software and related assets and terminated its existing Amended and Restated Master License Agreement and Supply Agreement with Cuattro, LLC. Heska Imaging, LLC is required to make a good faith effort to transition to a new cloud provider in a timely way; however Cuattro, LLC is required to provide services until that transition happens. As discussed below, Mr. Wilson has an interest in these agreements and any time and resources devoted to monitoring and overseeing this relationship may prevent us from deploying such time and resources on more productive matters.

Mr. Wilson’s employment agreement with us acknowledges that Mr. Wilson has business interests in Cuattro, LLC, Cuattro Software, LLC and Cuattro Medical, LLC which may require a portion of his time, resources and attention during his working hours. If Mr. Wilson is distracted by these or other business interests, he may not contribute as much as he otherwise would have to enhancing our business, to the detriment of our shareholder value. Mr. Wilson is the spouse of Shawna M. Wilson (“Mrs. Wilson”). Mr. Wilson, Mrs. Wilson and trusts for their children and family own a majority interest in Cuattro Medical, LLC. In addition, including equity held by Mrs. Wilson and by trusts for the benefit of Mr. and Mrs. Wilson’s children and family, Mr. Wilson also owns a 100% interest in Cuattro, LLC, the largest supplier to Heska Imaging, LLC, our wholly-owned subsidiary. Cuattro, LLC owns a 100% interest in Cuattro Software, LLC.

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Cuattro, LLC charged Heska Imaging, LLC $6.0 thousand during the nine months ended September 30, 2019, and $4.6 million, $17.7 million, and $14.5 million in the years ended December 31, 2018, 2017, and 2016, respectively, primarily related to digital imaging products, for which there was an underlying supply contract with minimum purchase obligations, software and services as well as other operating expenses. Heska Corporation charged Cuattro, LLC $0.0 during the nine months ended September 30, 2019, and $3 thousand, $0.1 million, and $0.2 million in the years ended December 31, 2018, 2017, and 2016, respectively, primarily related to facility usage and other services.

We rely substantially on third party suppliers. The loss of products or delays in product availability from one or more third party suppliers could substantially harm our business.

To be successful, we must contract for the supply of, or manufacture ourselves, current and future products of appropriate quantity, quality and cost. Such products must be available on a timely basis and be in compliance with any regulatory requirements. Similarly, we must provide ourselves, or contract for the supply of, certain services. Such services must be provided in a timely and appropriate manner. Failure to do any of the above could substantially harm our business.

We rely on third party suppliers to manufacture those products we do not manufacture ourselves and to provide services we do not provide ourselves. Proprietary products provided by these suppliers represent a majority of our revenue. We currently rely on these suppliers for our point of care laboratory instruments and consumable supplies for these instruments, for our imaging products and related software and services, for key components of our point-of-care diagnostic tests as well as for the manufacture of other products.

The loss of access to products from one or more suppliers could have a significant, negative impact on our business. Major suppliers that sell us proprietary products are FUJIFILM Corporation and Shenzen Mindray Bio-Medical Electronics Co., Ltd. We often purchase products from our suppliers under agreements that are of limited duration or potentially can be terminated on an annual basis. In the case of our point of care laboratory instruments and our digital radiography solutions, post-termination, we are typically entitled to non-exclusive access to consumable supplies, or ongoing non-exclusive access to products and services to meet the needs of an existing customer base, respectively, for a defined period upon expiration of exclusive rights, which could subject us to competitive pressures in the period of non-exclusive access. There can be no assurance that our suppliers will meet their obligations under any agreements we may have in place with them or that we will be able to compel them to do so. Risks of relying on suppliers include:

•

Inability to meet minimum obligations. Current agreements, or agreements we may negotiate in the future, may commit us to certain minimum purchase or other spending obligations. It is possible we will not be able to create the market demand to meet such obligations, which could create a drain on our financial resources and liquidity. Some agreements may require minimum purchases and/or sales to maintain product rights and we may be significantly harmed if we are unable to meet such requirements and lose product rights.

•

Loss of exclusivity. In the case of our point of care laboratory instruments, if we are entitled to non-exclusive access to consumable supplies for a defined period upon expiration of exclusive rights, we may face increased competition from a third party with similar non-exclusive access or our former supplier, which could cause us to lose customers and/or significantly decrease our margins and could significantly affect our financial results. In addition, current agreements, or agreements we may negotiate in the future, with suppliers may require us to meet minimum annual sales levels to maintain our position as the exclusive distributor of these products. We may not meet these minimum sales levels and maintain exclusivity over the distribution and sale of these products. If we are not the exclusive distributor of these products, competition may increase significantly, reducing our revenues and/or decreasing our margins.

•	Changes in economics. An underlying change in the economics with a supplier, such as a large price increase or new requirement of large minimum purchase amounts, could have a significant, adverse effect

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on our business, particularly if we are unable to identify and implement an alternative source of supply in a timely manner.

•

The loss of product rights upon expiration or termination of an existing agreement. Unless we are able to find an alternate supply of a similar product, we would not be able to continue to offer our customers the same breadth of products and our sales and operating results would likely suffer. In the case of an instrument supplier, we could also potentially suffer the loss of sales of consumable supplies, which would be significant in cases where we have built a significant installed base, further harming our sales prospects and opportunities. Even if we were able to find an alternate supply for a product to which we lost rights, we would likely face increased competition from the product whose rights we lost being marketed by a third party or the former supplier and it may take us additional time and expense to gain the necessary approvals and launch an alternative product.

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High switching costs. In our point of care laboratory instrument products, we could face significant competition and lose all or some of the consumable revenues from the installed base of those instruments if we were to switch to a competitive instrument. If we need to change to other commercial manufacturing contractors for certain of our regulated products, additional regulatory licenses or approvals generally must be obtained for these contractors prior to our use. This would require new testing and compliance inspections prior to sale, thus resulting in potential delays. Any new manufacturer would have to be educated in, or develop, substantially equivalent processes necessary for the production of our products. We likely would have to train our sales force, distribution network employees and customer support organization on the new product and spend significant funds marketing the new product to our customer base.

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The involuntary or voluntary discontinuation of a product line. Unless we are able to find an alternate supply of a similar product in this or similar circumstances with any product, we would not be able to continue to offer our customers the same breadth of products and our sales would likely suffer. Even if we are able to identify an alternate supply, it may take us additional time and expense to gain the necessary approvals and launch an alternative product, especially if the product is discontinued unexpectedly.

•	Inconsistent or inadequate quality control. We may not be able to control or adequately monitor the quality of products we receive from our suppliers. Poor quality items could damage our reputation with our customers.

•

Limited capacity or ability to scale capacity. If market demand for our products increases suddenly, our current suppliers might not be able to fulfill our commercial needs, which would require us to seek new manufacturing arrangements and may result in substantial delays in meeting market demand. If we consistently generate more demand for a product than a given supplier is capable of handling, it could lead to large backorders and potentially lost sales to competitive products that are readily available. This could require us to seek or fund new sources of supply, which may be difficult to find or may require terms that are less advantageous if available at all.

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Regulatory risk. Our manufacturing facility and those of some of our third party suppliers are subject to ongoing periodic unannounced inspection by regulatory authorities, including the FDA, USDA and other federal, state and foreign agencies for compliance with strictly enforced Good Manufacturing Practices, regulations and similar foreign standards. We do not have control over our suppliers’ compliance with these regulations and standards. Regulatory violations could potentially lead to interruptions in supply that could cause us to lose sales to readily available competitive products. If one of our suppliers is unable to provide a raw material or finished product due to regulatory issues, it could have a material adverse financial impact on our business and could expose us to legal action if we are unable to perform on contracts to our customers involving related products.

•	Developmental delays. We may experience delays in the scale-up quantities needed for product development that could delay regulatory submissions and commercialization of our products in development, causing us to miss key opportunities.

•	Limited geographic rights. We typically do not have global geographic rights to products supplied by third parties. If we were to determine a market opportunity in a geography where we did not have distribution

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rights and were unable to obtain such rights from the supplier, it might hamper our ability to succeed in such geography and our sales and profits would be lower than they otherwise would have been.

•	Limited intellectual property rights. We typically do not have intellectual property rights, or may have to share intellectual property rights, to the products supplied by third parties and any improvements to the manufacturing processes or new manufacturing processes for these products.

•

Changes to United States tariff and import/export regulations. Changes to United States trade policies, treaties and tariffs could have a material adverse effect on global trade. These changes could result in increased costs of goods imported into the United States for the Company and our third party suppliers. Our third party suppliers may limit their trade with companies in the United States, including us.

Potential problems with suppliers such as those discussed above could substantially decrease sales, lead to higher costs and/or damage our reputation with our customers due to factors such as poor quality goods or delays in order fulfillment, resulting in our being unable to sell our products effectively and substantially harming our business.

We depend on key personnel for our future success. If we lose our key personnel or are unable to attract and retain additional personnel, we may be unable to achieve our goals.

Our future success is substantially dependent on the efforts of our senior management and other key personnel, including our Chief Executive Officer (“CEO”) and President, Kevin Wilson. The loss of the services of members of our senior management or other key personnel may significantly delay or prevent the achievement of our business objectives. Although we have employment agreements with many of these individuals, all are at-will employees, which means that either the employee or Heska may terminate employment at any time without prior notice. If we lose the services of, or fail to recruit, key personnel, the growth of our business could be substantially impaired. We do not maintain key person life insurance for any of our senior management or key personnel.

The loss of significant customers which, for example, are historically large purchasers or which are considered leaders in their fields could damage our business and financial results.

In our CCA segment, revenue from Covetrus, Inc., formerly known as Henry Schein Animal Health ("Covetrus"), represented approximately 14% of our consolidated revenue for the nine months ended September 30, 2019, and represented approximately 15%, 13% and 13% of our consolidated revenue for the years ended December 31, 2018, 2017 and 2016, respectively. Revenue from Merck entities, including Merck Animal Health, represented approximately 0% of our consolidated revenue for the nine months ended September 30, 2019, but represented approximately 12%, 12% and 11% of our consolidated revenue for the years ended December 31, 2018, 2017 and 2016, respectively. Revenue from De Lage Landen Financial Services, Inc. (“DLL”) represented approximately 6% of our consolidated revenue for the nine months ended September 30, 2019, and represented approximately 6%, 7% and 11% of our consolidated revenue for the years ended December 31, 2018, 2017 and 2016, respectively. DLL is a third party financing company that provides financing and leasing for, primarily, our imaging product customers. In our OVP segment, revenue from Eli Lilly entities, including Elanco, represented approximately 10% of our consolidated revenue for the nine months ended September 30, 2019, and represented approximately 9%, 11% and 12% of our consolidated revenue for the years ended December 31, 2018, 2017 and 2016, respectively. No other customer accounted for more than 10% of our consolidated revenue for the nine months ended September 30, 2019, or accounted for more than 10% of our consolidated revenue for the years ended December 31, 2018, 2017 or 2016.

Covetrus represented approximately 18% of our consolidated accounts receivable at September 30, 2019, and represented 12% and 17% of our consolidated accounts receivable at December 31, 2018 and 2017, respectively. Merck entities, including Merck Animal Health, represented approximately 0% of our

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consolidated accounts receivable for the nine months ended September 30, 2019, and represented approximately 10% and 15% of our consolidated accounts receivable at December 31, 2018 and 2017, respectively. DLL represented approximately 10% of our consolidated accounts receivable for the nine months ended September 30, 2019, and represented 8% and 11% of our consolidated accounts receivable at December 31, 2018 and 2017, respectively. Eli Lilly entities, including Elanco, represented approximately 20% of our consolidated accounts receivable for the nine months ended September 30, 2019, and represented approximately 32% and 4% of our consolidated accounts receivable at December 31, 2018 and 2017, respectively. No other customer accounted for more than 10% of our consolidated accounts receivable at September 30, 2019, or accounted for more than 10% of our consolidated accounts receivable at December 31, 2018 or 2017.

The loss of these or other significant customers could damage our business, reputation, and financial results.

We operate in a highly competitive industry, which could render our products obsolete or substantially limit the volume of products that we sell. This would limit our ability to compete and maintain sustained profitability.

The market in which we compete is intensely competitive. Our competitors include independent animal health companies and major pharmaceutical companies that have animal health divisions. We also compete with independent, third party distributors, including distributors that sell products under their own private labels. In the point-of-care diagnostic testing market, our major competitors include IDEXX Laboratories, Inc. (‘‘IDEXX”) and Zoetis Inc. (‘‘Zoetis’). The products manufactured by our OVP segment for sale by third parties compete with similar products offered by a number of other companies, some of which have substantially greater financial, technical, research and other resources than us and may have more established marketing, sales, distribution and service organizations than those of our OVP segment customers. Competitors may have facilities with similar capabilities to our OVP segment, which they may operate and sell at a lower unit price to customers than our OVP segment does, which could cause us to lose customers. Companies with a significant presence in the companion animal health market, such as Bayer AG, CEVA Sante´ Animale, Eli Lilly, Merck, Sanofi, Vétoquinol S.A. and Virbac S.A. may be marketing or developing products that compete with our products or would compete with them if developed. These and other competitors and potential competitors may have substantially greater financial, technical, research and other resources and larger, more established marketing, sales and service organizations than we do. For example, if Zoetis devotes its significant commercial and financial resources to growing its market share in the veterinary allergy market, our allergy-related sales could suffer significantly. Our competitors may offer broader product lines and have greater name recognition than we do. Our competitors may also develop or market technologies or products that are more effective or commercially attractive than our current or future products or that would render our technologies and products obsolete. Further, additional competition could come from new entrants to the animal health care market. Moreover, we may not have the financial resources, technical expertise or marketing, sales or support capabilities to compete successfully. Zoetis has recently launched allergy products which may diminish the competitiveness and sales prospects for our own allergy immunotherapy products. IDEXX has recently launched an SDMA test in its point of care laboratory chemistry line, which may cause veterinary customers to prefer IDEXX products to ours.

If we fail to compete successfully, our ability to achieve sustained profitability will be limited and sustained profitability, or profitability at all, may not be possible.

We benefit from relationships or collaboration with third parties, including but not limited to, companies, buying groups, veterinary hospital groups and reference laboratory entities that operate in our markets. Beneficial third party, semi-competitive, directly competitive and cooperative relationships that affect how we go to market, develop products, generate leads and other commercial efforts of Heska may be negatively

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affected as a result of consolidation, acquisition, merger, exclusive arrangement or other agreements or activities between and amongst those third parties and others.

We often depend on third parties for products we intend to introduce in the future. If our current relationships and collaborations are not successful, we may not be able to introduce the products we intend to introduce in the future.

We are often dependent on third parties and collaborative partners to successfully and timely perform research and development activities to successfully develop new products. We routinely discuss Heska marketing in the veterinary market instruments being developed by third parties for use in the human health care market. In the future, one or more of these third parties or collaborative partners may not complete research and development activities in a timely fashion, or at all. Even if these third parties are successful in their research and development activities, we may not be able to come to an economic agreement with them. If these third parties or collaborative partners fail to complete research and development activities or fail to complete them in a timely fashion, or if we are unable to negotiate economic agreements with such third parties or collaborative partners, our ability to introduce new products will be impacted negatively and our revenues may decline.

We may be unable to market and sell our products successfully.

We may not develop and maintain marketing and/or sales capabilities successfully, and we may not be able to make arrangements with third parties to perform these activities on satisfactory terms, or at all. If our marketing and sales strategy is unsuccessful, our ability to sell our products will be negatively impacted and our revenues will decrease. This could result in the loss of distribution rights for products or failure to gain access to new products and could cause damage to our reputation and adversely affect our business and future prospects. The market for companion animal healthcare products is highly fragmented. Because our CCA proprietary products are generally available only to veterinarians or by prescription and our medical instruments require technical training to operate, we ultimately sell all our CCA products primarily to or through veterinarians. The acceptance of our products by veterinarians is critical to our success. Changes in our ability to obtain or maintain such acceptance or changes in veterinary medical practice could significantly decrease our anticipated sales. As the vast majority of cash flow to veterinarians ultimately is funded by pet owners without private insurance or government support, our business may be more susceptible to severe economic downturns than other health care businesses that rely less on individual consumers.

For our point of care laboratory blood diagnostics products, we primarily rely on contracts with our veterinary customers for their use of our owned equipment and our consumable supplies over a multiple year period. If veterinarians under these contracts experience a significant downturn in their business, they may not fulfill their use and financial obligations under these contracts. If veterinarians breach our contracts, and we are unable to collect on default payment provisions or otherwise enforce the terms of our contracts, our business will be adversely affected. If we have to litigate against customer(s) to enforce our contracts, our expenses may increase, our sales may decrease to those customers, and our reputation may suffer. If significant numbers of our customers under contracts for use of our equipment and consumable supplies do not renew their contracts, our business will be adversely affected.

We have entered into agreements with independent third party distributors, including Covetrus, who we anticipate will market and sell our products to a greater degree than in the recent past. Independent third party distributors may be effective in increasing sales of our products to veterinarians, although we would expect a corresponding lower gross margin as such distributors typically buy products from us at a discount to end user prices. It is possible new or existing independent third party distributors could cannibalize our direct sales efforts and lower our total gross margin. For us to be effective when working with an independent third party distributor, the distributor must agree to market and/or sell our products and we

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must provide proper economic incentives to the distributor as well as contend effectively for the time, energy and focus of the employees of such distributor given other products the distributor may be carrying, potentially including those of our competitors. If we fail to be effective with new or existing independent third party distributors, our financial performance may suffer.

A core component of our future growth strategy is international expansion. As we continue to expand our international footprint, we will be increasingly susceptible to the risks associated with international operations including, but not limited to, the following:

•	uncertain political and economic climates, fluctuations in exchange rates that may increase the volatility of foreign-based revenue and expenses.

•	burdens of complying with and unexpected changes in foreign laws, accounting and legal standards, regulatory requirements, taxes, tariffs and other barriers or trade restrictions.

•	lack of experience in connection with the customs, cultures, languages and sales cycle.

•	reduced or altered protection for intellectual property rights in foreign countries data privacy laws which require that data storage and processing be subject to laws different than the United States.

As a result of these and other factors, international expansion may be more difficult and not generate the results we anticipate, which could negatively impact our business.

We may face costly legal disputes, including disputes related to our intellectual property or technology or that of our suppliers or collaborators.

We may face legal disputes related to our business. Even if meritless, these disputes may require significant expenditures on our part and could entail a significant distraction to members of our management team or other key employees. For example, it took us until October 10, 2018, to reach an agreement in principle to settle the complaint that was filed against the Company by Shaun Fauley on March 12, 2015 in the United States District Court for the Northern District of Illinois alleging our transmittal of unauthorized faxes in violation of the federal Telephone Consumer Protection Act of 1991, as amended by the Junk Fax Prevention Act of 2005, as a class action (the “Fauley class action”). The settlement, which was approved by the court on February 28, 2019, required us, among other things, to pay $6.75 million to class members, as well as to pay attorneys’ fees and expenses to legal counsel to the class, which we paid in full on April 3, 2019. Insurance coverage may not cover any costs required to litigate a legal dispute or an unfavorable ruling or settlement. We did not have insurance coverage for the settlement arrangement regarding the Fauley class action and had to borrow under our Credit Facility to fund the settlement. A legal dispute leading to an unfavorable ruling or settlement, whether or not insurance coverage may be available for any portion thereof, could have material adverse consequences on our business. Moreover, we may have to use legal means and incur affiliated costs to secure the benefits to which we are entitled under third party agreements, such as to collect payment for goods shipped to third parties, which would reduce our income as compared to what it otherwise would have been.

We may become subject to patent infringement claims and litigation in the United States or other countries or interference proceedings conducted in the United States Patent and Trademark Office, or USPTO, to determine the priority of inventions. The defense and prosecution of intellectual property suits, USPTO interference proceedings and related legal and administrative proceedings are likely to be costly, time-consuming and distracting. As is typical in our industry, from time to time we and our collaborators and suppliers have received, and may in the future receive, notices from third parties claiming infringement and invitations to take licenses under third-party patents. Any legal action against us or our collaborators or suppliers may require us or our collaborators or suppliers to obtain one or more licenses in order to market or manufacture affected products or services. We or our collaborators or suppliers may not, however, be able to obtain licenses for technology patented by others on commercially reasonable terms, or at all, or to develop

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alternative approaches to access or replace such technology if we or they are unable to obtain such licenses or if current and future licenses prove inadequate, any of which could substantially harm our business.

We may also need to pursue litigation to enforce any patents issued to us or our collaborative partners, to protect trade secrets or know-how owned by us or our collaborative partners, or to determine the enforceability, scope and validity of the proprietary rights of others. Any litigation or interference proceedings will likely result in substantial expense to us and significant diversion of the efforts of our technical and management personnel. Any adverse determination in litigation or interference proceedings could subject us to significant liabilities to third parties. Further, as a result of litigation or other proceedings, we may be required to seek licenses from third parties which may not be available on commercially reasonable terms, or at all.

Interpretation of existing legislation, regulations and rules, including financial accounting standards, or implementation of future legislation, regulations and rules could cause our costs to increase or could harm us in other ways.

We prepare our financial statements in conformance with GAAP. These accounting principles are established by and are subject to interpretation by the SEC, the FASB and others which interpret and create accounting policies. A change in those policies or how those policies are interpreted can have a significant effect on our reported results and may affect our reporting of transactions completed before a change is made effective. Such changes may adversely affect our reported financial results and the way we conduct our business, or have a negative impact on us if we fail to track such changes.

If our regulators and/or auditors adopt or interpret more stringent standards than we anticipate, we could experience unanticipated changes in our reported financial statements, including but not limited to restatements, which could adversely affect our business due to litigation and investor confidence in our financial statements. In addition, changes in the underlying circumstances to which we apply given accounting standards and principles may affect our results of operations and have a negative impact on us. For example, we review goodwill recognized on our consolidated balance sheets at least annually and if we were to conclude there was an impairment of goodwill, we would reduce the corresponding goodwill to its estimated fair value and recognize a corresponding expense in our statement of operations. This impairment and corresponding expense could be as large as the total amount of goodwill recognized on our consolidated balance sheets, which was $27.2 million at September 30, 2019, and $26.7 million at December 31, 2018. There can be no assurance that future goodwill impairments will not occur if projected financial results are not met, or otherwise.

The Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) has increased our required administrative actions and expenses as a public company since its enactment. The general and administrative costs of complying with Sarbanes-Oxley will depend on how it is interpreted over time. Of particular concern are the level of standards for internal control evaluation and reporting adopted under Section 404 of Sarbanes-Oxley. If our regulators and/or auditors adopt or interpret more stringent standards than we anticipate, we and/or our auditors may be unable to conclude that our internal controls over financial reporting are designed and operating effectively, which could adversely affect investor confidence in our financial statements and cause our stock price to decline. Even if we and our auditors are able to conclude that our internal control over financial reporting is designed and operating effectively in such a circumstance, our general and administrative costs are likely to increase. For example, in both 2018 and 2017, we were required to have our independent registered public accountant conduct an audit of our internal control over financial reporting because as of June 30 of both years our stock market value was above a certain level prescribed by regulation. This increased our general and administrative costs from what they otherwise would have been.

Similarly, we are required to comply with the SEC’s mandate to provide interactive data using the eXtensible Business Reporting Language as an exhibit to certain SEC filings. Compliance with this mandate has

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required a significant time investment, which has and may in the future preclude some of our employees from spending time on more productive matters. In addition, future legislative, regulatory or rule-making action or more stringent interpretations of existing legislation, regulations and rules may increase our general and administrative costs or have other adverse effects on us.

We are currently evaluating, and we intend to pursue, acquisitions and other strategic development opportunities, which may not have desired results and could be detrimental to our financial position.

We are currently evaluating, and we intend to pursue, acquisitions and other strategic development opportunities, including minority investments where strategic. The ultimate business and financial performance of these opportunities may not create, and may end up adversely affecting materially, the value we hope to enhance by pursuing them. Any acquisition may significantly underperform relative to our financial expectations and may serve to diminish rather than enhance shareholder value. We may also diminish our cash resources or dilute stockholders in order to finance any such acquisition or other strategic transaction.

The success of any acquisition will depend on, among other things, our ability to integrate assets and personnel acquired in these transactions and to apply our internal controls process to these acquired businesses. The integration of acquisitions may require significant attention from our management, and the diversion of management’s attention and resources could have a material adverse effect on our ability to manage our business. Furthermore, we may not realize the degree or timing of benefits we anticipated when we first entered into the acquisition transaction. If actual integration costs are higher than amounts originally anticipated, if we are unable to integrate the assets and personnel acquired in an acquisition as anticipated, or if we are unable to fully benefit from anticipated synergies, our business, financial condition, results of operations and cash flows could be materially adversely affected. Furthermore, it is possible we will use management time and resources to pursue opportunities we ultimately are unable or decide not to consummate, in which case, we may not be able to utilize such management time and resources on what may have proved to be more productive matters in other areas of our business.

Obtaining and maintaining regulatory approvals in order to market our products may be costly and could delay the marketing and sales of our products. Failure to meet all regulatory requirements could cause significant losses from affected inventory and the loss of market share.

Many of the products we develop, market or manufacture may subject us to extensive regulation by one or more of the USDA, the FDA, the EPA and foreign and other regulatory authorities. These regulations govern, among other things, the development, testing, manufacturing, labeling, storage, pre-market approval, advertising, promotion and sale of some of our products. Satisfaction of these requirements can take several years and time needed to satisfy them may vary substantially, based on the type, complexity and novelty of the product. The decision by a regulatory authority to regulate a currently non-regulated product or product area could significantly impact our revenue and have a corresponding adverse impact on our financial performance and position while we attempt to comply with the new regulation, if such compliance is possible at all.

The effect of government regulation may be to delay or to prevent marketing of our products for a considerable period of time and to impose costly procedures upon our activities. We may not be able to estimate the time to obtain required regulatory approvals accurately and such approvals may require significantly more time than we anticipate. We have experienced in the past, and may experience in the future, difficulties that could delay or prevent us from obtaining the regulatory approval or license necessary to introduce or market our products. Such delays in approval may cause us to forego a significant portion of a new product’s sales in its first year due to seasonality and advanced booking periods associated with certain

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products. Regulatory approval of our products may also impose limitations on the indicated or intended uses for which our products may be marketed.

Difficulties in making established products to all regulatory specifications may lead to significant losses related to affected inventory as well as market share. Among the conditions for certain regulatory approvals is the requirement that our facilities and/or the facilities of our third party manufacturers conform to current Good Manufacturing Practices and other analogous or additional requirements. If any regulatory authority determines that our manufacturing facilities or those of our third party manufacturers do not conform to appropriate manufacturing requirements, we or the manufacturers of our products may be subject to sanctions, including, but not limited to, warning letters, manufacturing suspensions, product recalls or seizures, injunctions, refusal to permit products to be imported into or exported out of the United States, refusals of regulatory authorities to grant approval or to allow us to enter into government supply contracts, withdrawals of previously approved marketing applications, civil fines and criminal prosecutions. Furthermore, third parties may perceive procedures required to obtain regulatory approval objectionable and may attempt to disrupt or otherwise damage our business as a result. In addition, certain of our agreements may require us to pay penalties if we are unable to supply products, including for failure to maintain regulatory approvals.

Any of these events, alone or in combination with others, could significantly damage our business or results of operations.

Our future revenues depend on successful product development, commercialization and/or market acceptance, any of which can be slower than we expect or may not occur.

The product development and regulatory approval process for many of our potential products is extensive and may take substantially longer than we anticipate. Research projects may fail. New products that we may be developing for the veterinary marketplace may not perform consistently within our expectations. Because we have limited resources to devote to product development and commercialization, any delay in the development of one product or reallocation of resources to product development efforts that prove unsuccessful may delay or jeopardize the development of other product candidates. If we fail to successfully develop new products and bring them to market in a timely manner, our ability to generate additional revenue will decrease.

Even if we are successful in the development of a product or obtain rights to a product from a third party supplier, we may experience delays or shortfalls in commercialization and/or market acceptance of the product. For example, veterinarians may be slow to adopt a product, a product may not achieve the anticipated technical performance in field use or there may be delays in producing large volumes of a product. The former is particularly likely where there is no comparable product available or historical precedent for such a product. The ultimate adoption of a new product by veterinarians, the rate of such adoption and the extent veterinarians choose to integrate such a product into their practice are all important factors in the economic success of any new products and are factors that we do not control to a large extent. If our products do not achieve a significant level of market acceptance, demand for our products will not develop as expected and our revenues will be lower than we anticipate.

Many of our expenses are fixed and if factors beyond our control cause our revenue to fluctuate, this fluctuation could cause greater than expected losses, cash flow and liquidity shortfalls.

We believe that our future operating results will fluctuate on a quarterly basis due to a variety of factors which are generally beyond our control, including:

•	supply of products, including minimum purchase agreements, from third party suppliers or termination, cancellation or expiration of such relationships;

•	competition and pricing pressures from competitive products;

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•	the introduction of new products or services by our competitors or by us;

•	large customers failing to purchase at historical levels;

•	fundamental shifts in market demand;

•	manufacturing delays;

•	shipment problems;

•	information technology problems, which may prevent us from conducting our business effectively, or at all, and may also raise our costs;

•	regulatory and other delays in product development;

•	product recalls or other issues which may raise our costs;

•	changes in our reputation and/or market acceptance of our current or new products; and

•	changes in the mix of products sold.

We have high operating expenses, including those related to personnel. Many of these expenses are fixed in the short term and may increase over time. If any of the factors listed above cause our revenues to decline, our operating results could be substantially harmed.

Cyberattack related breaches of our information technology systems could have an adverse effect on our business.

Cyberattacks are increasing in their frequency, sophistication and intensity, and have become increasingly difficult to detect and defend against, notwithstanding our ongoing evaluation of and improvements to the preventive measures we take on to reduce the risks associated with these threats based on our own experience and those observed in the broader market. Cyberattacks, ranging from the use of malware, computer viruses, dedicated denial of services attacks, credential harvesting, social engineering and other means for obtaining unauthorized access to our Company's confidential information or assets or disrupting our Company’s ability to operate normally, could have a material adverse effect on our business.

Cyberattacks may cause equipment failures, loss of information or assets, including sensitive personal information of third party vendors, customers or employees, or valuable technical and marketing information, as well as disruptions to our or our vendor or customers’ operations. These attacks may be committed by company employees or external actors operating in any geography, including jurisdictions where law enforcement measures to address such attacks are unavailable or ineffective. Cyberattacks may occur alone or in conjunction with physical attacks, especially where disruption of service is an objective of the attacker. The preventive actions we take on an ongoing basis to reduce the risks and mitigate the potential damages associated with cyberattacks, including protection of our systems, networks and assets and the retention of cybersecurity insurance policies, may be insufficient to repel or mitigate entirely the effects of a cyberattack.

We devote significant resources to network security, data encryption and other security measures to protect our systems and data, but these security measures cannot provide absolute security. To the extent we were to experience a breach of our systems and were unable to protect sensitive data in the wake of the breach, such a breach could materially damage business partner and customer relationships, and reduce or otherwise negatively impact access to online services. Moreover, if a computer security breach affects our systems or results in the unauthorized release of Personally Identifiable Information (“PII”), our reputation and brand could be materially damaged; use of our products and services could decrease, we could suffer from reputational harm impacting sales revenue, and we could be faced with unforeseen regulatory investigation, remediation and litigation costs. Our cybersecurity insurance policies may not cover the full extent, or any, of the potential financial harm that could be caused by a breach of our systems, including in respect of theft or possible damages claims that may be brought against us by our business partners and customers in respect of any such breach.

The frequently changing attack techniques, along with the increased volume and sophistication of the attacks, create additional potential for us to be adversely impacted by this activity. This impact could result in

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reputational, competitive, operational or other business harm as well as management distraction, financial losses and costs, and regulatory action.

We may be unable to protect our stakeholders’ privacy or we may fail to comply with privacy laws.

The protection of customer, employee, supplier and company data is critical and the regulatory environment surrounding information security, storage, use, processing, disclosure and privacy is demanding, with the frequent imposition of new and changing requirements. In addition, our customers, employees and suppliers expect that we will protect their personal information. Any actual or perceived significant breakdown, intrusion, interruption, cyberattack or corruption of customer, employee or supplier data or our failure to comply with federal, state, local and foreign privacy laws, including the European Union’s General Data Protection Regulation (“GDPR”) and the Health Insurance Portability and Accountability Act, could result in lost sales, remediation costs, and legal liability including severe penalties, regulatory action and reputational harm. GDPR became effective in 2018, for example, and requires companies to meet new and enhanced requirements regarding the handling of personal data, including its use, protection and the rights of data subjects to request correction or deletion of their personal data. Failure to meet GDPR requirements could result in penalties of up to 4% of worldwide revenue. Despite our efforts and investments in technology to secure our computer network, security could be compromised, confidential information could be misappropriated or system disruptions could occur. Failure to comply with the security requirements or rectify a security issue may result in fines and the imposition of restrictions on our ability to accept payment by credit or debit cards. In addition, the payment card industry (“PCI”) is controlled by a limited number of vendors that have the ability to impose changes in PCI’s fee structure and operational requirements on us without negotiation. Such changes in fees and operational requirements may result in our failure to comply with PCI security standards, as well as significant unanticipated expenses. Such failures could materially adversely affect our operating results and financial condition. Furthermore, we maintain cybersecurity insurance coverage at levels that we believe are appropriate for our business. The costs related to significant security breaches or disruptions, however, could be material and exceed the limits of the cybersecurity insurance we maintain against such risks. If the amounts of our insurance coverage are inadequate to satisfy any damages and losses in the event of a cybersecurity incident, we may have to expend significant resources to mitigate the impact of such an incident, and to develop and implement protections to prevent future incidents of this nature from occurring. Such financial exposure could have a material adverse effect on our business.

We may not be able to continue to achieve sustained profitability or increase profitability on a quarterly or annual basis.

Prior to 2005, we incurred net losses on an annual basis since our inception in 1988 and, as of September 30, 2019 and December 31, 2018, we had an accumulated deficit of $134.7 million and $135.0 million, respectively. Relatively small differences in our performance metrics may cause us to generate an operating or net loss in future periods. Our ability to continue to be profitable in future periods will depend, in part, on our ability to increase sales in our CCA segment, including maintaining and growing our installed base of instruments and related consumables, to maintain or increase gross margins and to limit the increase in our operating expenses to a reasonable level as well as avoid or effectively manage any unanticipated issues. We may not be able to generate, sustain or increase profitability on a quarterly or annual basis. If we cannot achieve or sustain profitability for an extended period, we may not be able to fund our expected cash needs, including the repayment of debt as it comes due, or continue our operations.

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We may face product returns and product liability litigation in excess of, or not covered by, our insurance coverage or indemnities and/or warranties from our suppliers. If we become subject to product liability claims resulting from defects in our products, we may fail to achieve market acceptance of our products and our sales could substantially decline.

The testing, manufacturing and marketing of our current products as well as those currently under development entail an inherent risk of product liability claims and associated adverse publicity. Following the introduction of a product, adverse side effects may be discovered. Adverse publicity regarding such effects could affect sales of our other products for an indeterminate time period. To date, we have not experienced any material product liability claims, but any claim arising in the future could substantially harm our business. Potential product liability claims may exceed the amount of our insurance coverage or may be excluded from coverage under the terms of the policy. We may not be able to continue to obtain adequate insurance at a reasonable cost, if at all. In the event that we are held liable for a claim against which we are not indemnified or for damages exceeding the $10 million limit of our insurance coverage or which results in significant adverse publicity against us, we may lose revenue, be required to make substantial payments which could exceed our financial capacity and/or lose or fail to achieve market acceptance.

We may be held liable for the release of hazardous materials, which could result in extensive remediation costs or otherwise harm our business.

Certain of our products and development programs produced at our Des Moines, Iowa facility involve the controlled use of hazardous and bio hazardous materials, including chemicals and infectious disease agents. We cannot eliminate the risk of accidental contamination or injury from these materials. In the event of such an accident, we could be held liable for any fines, penalties, remediation costs or other damages that result. Our liability for the release of hazardous materials could exceed our resources, which could lead to a shutdown of our operations, significant remediation costs and potential legal liability. In addition, we may incur substantial costs to comply with environmental regulations if we choose to expand our manufacturing capacity.

Risks related to our common stock

Our stock price has historically experienced high volatility, and could do so in the future, including experiencing a material price decline resulting from a large sale in a short period of time. This volatility could affect the value of our common stock.

Should a relatively large stockholder decide to sell a large number of shares in a short period of time, it could lead to an excess supply of our shares available for sale and correspondingly result in a significant decline in our stock price.

The securities markets have experienced significant price and volume fluctuations and the market prices of securities of many small cap companies have in the past been, and can in the future be expected to be, especially volatile. During the twelve months ended September 30, 2019, the closing stock price of our common stock has ranged from a low of $64.17 to a high of $110.34, and the closing sale price of our common stock on November 5, 2019 was $94.30 per share. Fluctuations in the trading price or liquidity of our common stock may adversely affect our ability to raise capital through future equity financings. Factors that may have a significant impact on the market price and marketability of our common stock include:

•	stock sales by large stockholders or by insiders;

•	changes in the outlook for our business;

•	our quarterly operating results, including as compared to expected revenue or earnings and in comparison to historical results;

•	termination, cancellation or expiration of our third-party supplier relationships;

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•	announcements of technological innovations or new products by our competitors or by us;

•	litigation;

•	regulatory developments, including delays in product introductions;

•	developments or disputes concerning patents or proprietary rights;

•	availability of our revolving line of credit and compliance with debt covenants;

•	releases of reports by securities analysts;

•	economic and other external factors;

•	issuances of equity or equity-linked securities by us; and

•	general market conditions

In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted. If a securities class action suit is filed against us, it is likely we would incur substantial legal fees and our management’s attention and resources would be diverted from operating our business in order to respond to the litigation.

On May 4, 2010, our stockholders approved an amendment (the “NOL Protective Amendment”) to our Certificate of Incorporation. The NOL Protective Amendment places restrictions on the transfer of our common stock that could adversely affect our ability to use our domestic Federal Net Operating Loss carryforward (“NOL”). In particular, the NOL Protective Amendment prevents the transfer of shares without the approval of our board of directors if, as a consequence, an individual, entity or groups of individuals or entities would become a 5-percent holder under Section 382 of the Internal Revenue Code of 1986, as amended, and the related Treasury regulations, and also prevents any existing 5-percent holder from increasing his or her ownership position in the Company without the approval of our board of directors. Any transfer of shares in violation of the NOL Protective Amendment (a “Transfer Violation”) shall be void ab initio under the our Certificate of Incorporation and our board of directors has procedures under our Certificate of Incorporation to remedy a Transfer Violation including requiring the shares causing such Transfer Violation to be sold and any profit resulting from such sale to be transferred to a charitable entity chosen by the Company’s board of directors in specified circumstances. The NOL Protective Amendment could have an adverse impact on the value and trading liquidity of our stock if certain buyers who would otherwise have bid on or purchased our stock, including buyers who may not be comfortable owning stock with transfer restrictions, do not bid on or purchase our stock as a result of the NOL Protective Amendment. In addition, because some corporate takeovers occur through the acquirer’s purchase, in the public market or otherwise, of sufficient shares to give it control of a company, any provision that restricts the transfer of shares can have the effect of preventing a takeover. The NOL Protective Amendment could discourage or otherwise prevent accumulations of substantial blocks of shares in which our stockholders might receive a substantial premium above market value and might tend to insulate management and the board of directors against the possibility of removal to a greater degree than had the NOL Protective Amendment not passed.

In February 2018, our board of directors granted a waiver to a non-affiliated stockholder to allow the purchase, subject to certain limitations, of up to 730,000 shares of our common stock without causing a Transfer Violation. This waiver can be withdrawn by our board of directors at any time, in which case the non-affiliated stockholder is to only sell our stock until the non-affiliated stockholder ceases to be a Five Percent Shareholder (as defined in our Certificate of Incorporation). On August 7, 2019, our board of directors determined to waive the application of any NOL transfer restrictions contained in our Certificate of Incorporation with respect to the issuance and transfer of the Notes, any issuance of shares of the Company’s common stock upon conversion of any of the Notes, and any subsequent and further transfer of any such common stock, to the extent such restrictions would otherwise have been applicable thereto. These waivers, and any similar waivers that our board of directors may grant in the future, may make it more likely that we have a “change of ownership” as defined under the provisions of Section 382 of the Internal Revenue Code of 1986, as amended, which could place a significant restriction on our ability to utilize our domestic Federal NOL in the future and materially adversely affect our results of operations. State net operating loss

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carryforwards may be similarly or more stringently limited. Any limitations on our ability to use our pre-change of ownership net operating losses to offset taxable income could potentially result in increased future tax liability to us.

If securities analysts do not publish research or reports about our business, or if they downgrade our stock, the price of our stock could decline.

The trading market for our common stock will likely be influenced by research and reports that securities or industry analysts publish about us or our business. In the event securities or industry analysts cover our company and one or more of these analysts downgrades our stock, lowers their price target, or publishes unfavorable or inaccurate research about our business, our stock price would likely decline. If one or more of these analysts ceases coverage of our company or fails to publish reports on us regularly, demand for our stock could decrease, which could cause our stock price and trading volume to decline.

We have not declared or paid any dividends on our common stock since 2012 and we do not anticipate paying any cash dividends in the foreseeable future.

We have not declared or paid any dividends on our common stock since October 2012. We intend to retain any earnings to finance the operation and expansion of our business, and we do not anticipate paying any cash dividends in the future. As a result, investors in our common stock may only receive a return on their investment in our common stock if the market price of our common stock increases.

We have fewer than 300 holders of record, which could allow us to terminate voluntarily the registration of our common stock with the SEC and after which we would no longer be eligible to maintain the listing of our common stock on The Nasdaq Capital Market. We may also be unable to otherwise maintain our listing on The Nasdaq Capital Market.

We have fewer than 300 holders of record as of our latest information, a fact which could make us eligible to terminate voluntarily the registration of our common stock with the SEC and therefore suspend our reporting obligations with the SEC under the Exchange Act and become a non-reporting company. If we were to cease reporting with the SEC, we would no longer be eligible to maintain the listing of our common stock on The Nasdaq Capital Market, which we would expect to materially adversely affect the liquidity and market price for our common stock. The Nasdaq Capital Market has several additional quantitative and qualitative requirements companies must comply with to maintain this listing. While we believe we are currently in compliance with all Nasdaq requirements, there can be no assurance we will continue to meet Nasdaq listing requirements, that Nasdaq will interpret these requirements in the same manner we do if we believe we meet the requirements, or that Nasdaq will not change such requirements or add new requirements to include requirements we do not meet in the future.

If we were delisted from The Nasdaq Capital Market, our common stock may be considered a penny stock under the regulations of the SEC and would therefore be subject to rules that impose additional sales practice requirements on broker-dealers who sell our securities. The additional burdens imposed upon broker-dealers may discourage broker-dealers from effecting transactions in our common stock, which could severely limit market liquidity of the common stock and any stockholder’s ability to sell our securities in the secondary market. This lack of liquidity would also likely make it more difficult for us to raise capital in the future.

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Provisions in our Certificate of Incorporation and bylaws and under Delaware law might discourage, delay or prevent a change of control of our company or changes in our management and, therefore, depress the trading price of our common stock.

Our Certificate of Incorporation and bylaws contain provisions that could depress the trading price of our common stock by acting to discourage, delay or prevent a change of control of our company or changes in our management that the stockholders of our company may deem advantageous. These provisions:

•	place restrictions on the transfer of our common stock that could adversely affect our ability to use our domestic NOL, which can have an effect of preventing a takeover;

•	establish a classified board of directors through our 2020 annual meeting of stockholders so that not all members of our board of directors are elected at one time;

•	provide that our board of directors may, without stockholder approval, issue shares of preferred stock with special voting or economic rights;

•	prohibit stockholders from calling a special meeting of our stockholders;

•	set forth supermajority requirements for amending certain provisions of our Certificate of Incorporation or our bylaws;

•	provide that the board of directors is expressly authorized to make, alter or repeal our bylaws; and

•	establish advance notice requirements for nominations for elections to our board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings.

Additionally, we are subject to Section 203 of the Delaware General Corporation Law, which generally prohibits a Delaware corporation from engaging in any of a broad range of business combinations with any “interested” stockholder for a period of three years following the date on which the stockholder became an “interested’ stockholder and which may discourage, delay, or prevent a change of control of our company.

Any provision of our Certificate of Incorporation, bylaws or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for our stockholders to receive a premium for their shares of our common stock, and could also negatively affect the price that some investors are willing to pay for our common stock.

Risks related to the outstanding Notes

Servicing our debt will require a significant amount of cash, and we may not have sufficient cash flow from our business to pay our substantial debt.

Our ability to make scheduled payments of the principal of, to pay interest on or to refinance our indebtedness, including the amounts payable under the Notes and any future borrowings under our $2.0 million, cash collateralized, letter of credit facility, depends on our future performance, which is subject to economic, financial, competitive and other factors beyond our control. Our business may not continue to generate cash flow from operations in the future sufficient to service our debt and make necessary capital expenditures. If we are unable to generate such cash flow, we may be required to adopt one or more alternatives, such as selling assets, restructuring debt or obtaining additional equity capital on terms that may be onerous or highly dilutive. Our ability to refinance our indebtedness will depend on the capital markets and our financial condition at such time. We may not be able to engage in any of these activities or engage in these activities on desirable terms, which could result in a default on our debt obligations.

We may not have the ability to raise the funds necessary to settle conversions of the Notes in cash or to repurchase the notes upon a fundamental change, and our future debt may contain, limitations on our ability to pay cash upon conversion or repurchase of the notes.

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Holders of the Notes will have the right to require us to repurchase their notes upon the occurrence of a fundamental change at a fundamental change repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus accrued and unpaid interest, if any. In addition, upon conversion of the Notes, unless we elect to deliver solely shares of our common stock to settle such conversion (other than paying cash in lieu of delivering any fractional share), we will be required to make cash payments in respect of the Notes being converted. However, we may not have enough available cash or be able to obtain financing at the time we are required to make repurchases of Notes surrendered therefor or Notes being converted. In addition, our ability to repurchase the Notes or to pay cash upon conversions of the Notes may be limited by law, by regulatory authority or by agreements governing our existing and future indebtedness. Our failure to repurchase Notes at a time when the repurchase is required by the indenture or to pay any cash payable on future conversions of the Notes as required by the indenture would constitute a default under the indenture. If a fundamental change occurs, or if the Notes are accelerated due to an event of default under the indenture, such events may lead to a default under agreements governing our future indebtedness. Any future indebtedness of ours may contain restrictions on our ability to pay cash upon conversion or repurchase of the Notes. If the repayment of the related indebtedness were to be accelerated after any applicable notice or grace periods, we may not have sufficient funds to repay the indebtedness and repurchase the Notes or make cash payments upon conversions thereof.

The conditional conversion feature of the Notes, if triggered, may adversely affect our financial condition and operating results.

In the event the conditional conversion feature of the Notes is triggered, holders of Notes will be entitled to convert the Notes at any time during specified periods at their option. If one or more holders elect to convert their Notes, unless we elect to satisfy our conversion obligation by delivering solely shares of our common stock (other than paying cash in lieu of delivering any fractional share) or by electing an exchange process for the Notes and a designated financial institution delivers the applicable conversion consideration, we would be required to settle a portion or all of our conversion obligation through the payment of cash, which could adversely affect our liquidity. In addition, even if holders of Notes do not elect to convert their Notes, we could be required under applicable accounting rules to reclassify all or a portion of the outstanding principal of the Notes as a current rather than long-term liability, which would result in a material reduction of our net working capital.

The accounting method for convertible debt securities that may be settled in cash, such as the Notes, could have a material effect on our reported financial results.

Under Accounting Standards Codification 470-20, Debt with Conversion and Other Options (“ASC 470-20”), an entity must separately account for the liability and equity components of the convertible debt instruments (such as the Notes) that may be settled entirely or partially in cash upon conversion in a manner that reflects the issuer’s economic interest cost. The effect of ASC 470-20 on the accounting for the Notes is that the equity component is required to be included in the additional paid-in capital section of stockholders’ equity on our consolidated balance sheet at the issuance date and the value of the equity component would be treated as debt discount for purposes of accounting for the debt component of the Notes. As a result, we will be required to record a greater amount of non-cash interest expense as a result of the amortization of the discounted carrying value of the Notes to their face amount over the term of the Notes. We will report lower net income (or larger net losses) in our financial results because ASC 470-20 will require interest to include both the amortization of the debt discount and the instrument’s non-convertible coupon interest rate, which could adversely affect our reported or future financial results and the trading price of our common stock and the trading price of the notes.

In addition, under certain circumstances, convertible debt instruments (such as the Notes) that may be settled entirely or partly in cash may be accounted for utilizing the treasury stock method, the effect of which is that

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the shares issuable upon conversion of such Notes are not included in the calculation of diluted earnings per share except to the extent that the conversion value of such Notes exceeds their principal amount. Under the treasury stock method, for diluted earnings per share purposes, the transaction is accounted for as if the number of shares of common stock that would be necessary to settle such excess, if we elected to settle such excess in shares, are issued. We cannot be sure that the accounting standards in the future will continue to permit the use of the treasury stock method. If we are unable or otherwise elect not to use the treasury stock method in accounting for the shares issuable upon conversion of the Notes, then our diluted earnings per share could be adversely affected.

Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds

In September 2019, the Company issued and sold $86.25 million in aggregate principal amount of Notes (which included the exercise in full by the Initial Purchasers of their option to purchase an additional $11.25 million in aggregate principal amount of the Notes) in a private offering to the Initial Purchasers in reliance on the exemption from registration provided by Section 4(a)(2) of the Securities Act of 1933, as amended (the “Securities Act”), and for resale by the Initial Purchasers to qualified institutional buyers pursuant to the exemption from registration provided by Rule 144A under the Securities Act. Additional disclosure concerning this issuance can be found in our Current Report on Form 8-K filed with the SEC on September 11, 2019 and in our Current Report on Form 8-K filed with the SEC on September 17, 2019. The shares of the common stock issuable upon conversion of the Notes, if any, have not been registered under the Securities Act and may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements.

Item 6.        Exhibits

	Exhibit Number		Notes		Description of Document
	4.1		(1)		Indenture, dated as of September 17, 2019, by and between the Heska Corporation and U.S. Bank National Association, as Trustee (including the form of the Notes)
	4.2		(1)		Form of 3.750% Convertible Senior Notes due 2026 (included with Exhibit 4.1)
	10.1		(2)		Amendment to Credit Facility
	31.1				Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.
	31.2				Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.
	32.1		*		Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
	101.INS				XBRL Instance Document.
	101.SCH				XBRL Taxonomy Extension Schema Document.
	101.CAL				XBRL Taxonomy Extension Calculation Linkbase Document.
	101.DEF				XBRL Taxonomy Extension Definition Linkbase Document.
	101.PRE				XBRL Taxonomy Extension Presentation Linkbase Document.
	101.LAB				XBRL Taxonomy Extension Label Linkbase Document.

Notes
*	Furnished and not filed herewith.
(1)	Filed with the Registrant's Form 8-K on September 17, 2019.
(2)	Filed with the Registrant's Form 8-K on September 11, 2019.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized on November 6, 2019.

 

	HESKA CORPORATION
	By:  /s/ KEVIN S. WILSON   Kevin S. Wilson Chief Executive Officer and President (Principal Executive Officer)
	By:  /s/ CATHERINE GRASSMAN                               Catherine Grassman Executive Vice President, Chief Financial Officer (Principal Financial and Accounting Officer)

 

 

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