Waters Corp (WAT) 2002 Q2 法說會逐字稿

Welcome to the second-quarter 2002 earnings conference call. All participants will be able to listen only throughout the conference until the question and answer session of the call. Today's conference call is being recorded. If anyone has any objections, please disconnect at this time.

I'll now turn the conference call over to Douglas Berthiaume, chairman and CEO. You may begin when ready.

Thank you. And good morning, and welcome to the Waters Corporation second-quarter 2002 conference call. With me on the call this morning is John Nelson, the company's president and chief operating officer, John Ornell, the company's chief financial officer, and Gene Cassis, the director of investor relations. As is our normal practice, I'll cover the second-quarter results. Then John Ornell will take you through the financial details and our forecast, and then we'll open it up for Q and A.

Before I begin, I'd like to ask John to cover the safe harbor language, please. John?

Yes. During the course of this conference call, we may make various forward-looking statements regarding future events or future financial performance of the company. In particular, we will provide guidance regarding possible future income statement results of the company at this time for 2002 third quarter and full year. We caution you that such statements are only predictions and that actual events or results may differ materially. For a detailed discussion of some of the risks and contingencies that could cause our actual performance to differ significantly from our present expectations, see our 10-K annual report for the fiscal year ended December 31st, 2001, in part 1, under the caption "business risk factors." We further caution you that the company does not obligate or commit itself by providing this guidance to update predictions.

We do not plan to update predictions regarding possible [inaudible] except during our regularly-scheduled quarterly earnings release conference call and webcast. The next earnings release call and webcast is currently planned for October 2002.

Doug?

Thank you, John. Well, the second quarter contains a real mixture of dynamics. Some unfavorable, but quite a bit that's positive. And before I get into the business dynamics, I'd like to touch on the accounting change that we made in the quarter.

Up until this year, we had always capitalized our patent litigation costs in accordance with GAAP, and these costs that resulted from specific litigation to support your patent portfolio, during the last several years, were running, oh, about two-and-a-half million dollars a year there being deferred and then amortized to operations over the remaining life of the patent.

This year, because of the significant case that was adjudicated in the first quarter, as well as a generally more active patent litigation environment, we thought we should re-evaluate our procedures for deferring these costs and decided, with our outside auditors, that a more preferable policy would be to expense all these costs as incurred, rather than to defer them and then amortize them over the life of the patent.

As a result, we adopted this new policy during this quarter, and you see the effects of writing off that beginning balance of these costs as a line item in this second-quarter report.

John can cover that in any more detail that you'd like to go into.

Turning now to our business results, as you've now seen, revenues were up 3% organically, 5% after currency, in the second quarter.

While earnings were 28 cents per share versus 29 cents last year.

Generally, these results were close to our expectations, although foreign exchange helped us a little bit more on the top line than original expectations, and unit shipments were a bit lower than forecast.

I think, however, underlying these top-level dynamics is a business that's a little stronger than it looks. First, we built some backlog during the quarter. That gives us a little better visibility on third-quarter sales. And our incoming order rate was up in the high single digits, so we believe overall customer demand continues to be reasonably strong. Additionally, cash flow continues to be robust, just about equal in the first quarter rate, and about $80 million for the half, making us very confident on our 150-plus million dollars target for the full year.

If I now turn to our various product segments, clearly the overall star of the quarter was our HPLC business. Top-line organic growth came in at the high single digits, while orders were up double digits. All of this is the HPLC segment. Instruments, chemicals, services and supports showed underlying strength. However, the chemical segment saw sales revenue that was lower, due to a large shipment of bulk purification chemistry in the 2001 quarter. That marked the point where we discontinued that bulk business, so that dynamic, you won't see in any future quarters.

Service and support, once again, was quite strong, with orders and sales up in the solid double-digit area. With chemistry and service, we continue to have about 40% of our HPLC sales in predictable, repeatable, high-profit, strong-cash-flow segments.

Of note in the instrument segment is the continued strength of our LC/MS MassLynx kind of auto-purification products that as a segment are growing very nicely in the double digits. Our core alliance [inaudible] has continued to do well, and our strategic data products, particularly our network data products grew in the strong double digits, as our new Empower software has built good momentum.

Something I'm sure you're interested in is that the lie science segment, big pharma company, biotech and life science labs, had strong incoming orders, up in the double-digit range.

Geographically, Europe has been our strongest territory for HPLC, with almost every country showing good double-digit growth. Asia and other rest of the world territories also were good and strong, but only North America coming in softer than average, with sales up in the low single digits in North America.

With our mass spec products, it's a more complicated story. As most all of you know, the jury verdict we lost in March forced us to withdraw products from the U.S. and re-engineer several for eventual reintroduction. We have relaunched our [Q Toss] electro-spray and [Q Toss] [maldie] and now looks like a [Q Toss] global will be a 2003 relaunch.

The results of all this product change in the North American market was clearly slowing momentum. Overall, mass spec revenues in North America were down about 13% as a result.

We do think that this is now a trough, and that North America should get better over the remainder of the year. Outside of North America, however, where the patent ruling didn't reach, is a much different story. Incoming orders were very strong here, well into the double-digit growth area. Sales revenue outside the U.S. didn't match our order strength, as the product changes that we've been forced to make still presented a challenge to move through the manufacturing process, ultimately to shipment.

We think that manufacturing challenge is largely behind us, and will get easier as we move into the second half.

In terms of mass spec product dynamics, U top in the international markets are still doing extremely well, again driven by [proteomics] applications. With [triple QWAS] internationally, we're doing well with our Quattro micro product while the higher-end [triple QWAS] market remains very competitive. We're also seeing renewed interest in the international market for magnetic sector instruments, to serve environmental applications.

So for mass spectrometry, the story is dramatically different between the North American market and the international business. We anticipate that in general, this performance differential will continue throughout 2002 and it's factored into our forecast.

One other factor will come into play as we go forward. As we described in a press release earlier this month, we are in the process of reorganizing our HPLC and mass spec field organizations. In essence, we're merging the field management and administrative functions and rationalizing territory and product assignments. As most of you know, since the merger with Micromass in 1997, we've been operating with separate autonomous field groups for HPLC and mass spec, and this structure served us well for several years. However, as the product lines have evolved in the last couple years in particular, with the bench-top products becoming more powerful and easier to use, and the high-end products and technologies becoming lower cost and easier to use, and importantly, the combination of LC and mass spec in all of its attributes, both at the instrument level and in the software, becoming more important in almost all of these applications, the clear differentiation, particularly in the customers' minds, of these technologies has blurred. And so we find in more and more cases, customers want to deal with one sales and service organization, a common pricing schedule, common administration, et cetera.

And frankly, we've seen this coming for a while now and have been discussing it internally at high levels within the company for well over a year. So it's not the current state of the North American business that drove us to change. It's really something we've done because we thought that it would be best to present one face to our customers.

I will admit that a by-product of the change will be to allow us to focus very clearly on the correct sizing of our resources by geography, market, and product, and we think that as the second half progresses, you will see favorable dynamics in the SG and A growth rate as the field synergies take shape.

We are particularly enthused about the opportunity to address mass spectrometry service and support with the Waters industry-leading connection service and support infrastructure. We think there are major opportunities to both enhance revenues and contain costs by taking advantage of a Waters program that has been consistently able to produce fast growth and very high profits.

Finally, in our TA instruments business, sales were flat for the quarter, as we forecast, but there does seem to be a little optimism, perhaps, growing in the industrial market applications. We also saw stronger activity in HPLC in the industrial markets, and so after several years of weakness, we may be seeing some improvement in these markets. We believe long-term that these markets can still provide the company with good profitable growth.

At this point, I'd like to turn the mic over to John Ornell for the financial details. John?

Thank you, Doug.

Good morning. The results for the second quarter generally met our latest sales expectations, with sales growth of 3% before currency impacts, and 5% after. Favorable sales impact from currency accelerated during June as the dollar weakened and provided Waters with the first favorable currency impact in recent memory. Earnings per diluted share were 28 cents for the quarter, which was one cent below our estimate and prior year.

We also revised our year-to-date earnings for a change in accounting principles which is retroactive to the start of the year, and reduces our reported earnings by 3 cents after tax. This change in accounting principle is related to our accounting for patent litigation costs. Historically, we had capitalized and amortized patent litigation costs in accordance with GAAP. However, in reviewing this policy in light of recent events, and recognizing that our world has become more litigious, we believe a more preferable accounting treatment of immediately expensing patent related litigation costs is prudent. Therefore, going forward, we will expense patent related litigation costs as incurred.

For the second quarter of 2002, we have expensed patent litigation costs of $1.5 million, which represents a heavy quarter, and expect that this new practice will result in a less significant impact in future quarters and will be incorporated in our future guidance.

Looking at sales growth by product line before currency impacts, we saw the HPLC product line perform as expected, with sales growth in the high single digits. Geographies outside the United States grew in the low double digits, and business within the United States grew in the mid-single digits.

Turning to our mass spec business, the loss of the [inaudible] order and the litigation related sales deficit in the United States caused this business to decline as expected, and was down in the mid-single digits. While we saw some strength outside the United States, the deficit from lost [Q Toss] and Quattro Ultima sales in the U.S. resulted in an overall sales decline.

Q2 was also a difficult comparison for the mass spec business, with large Canadian shipments in the base period. Thus, North America's sales declined in the low double digits.

Sales of thermal analysis products were flat for the quarter, with modest growth in orders this quarter may be signaling a turning point in that business.

Earnings per share declined slightly for the quarter, principally as a result of higher SG and A expenses. The quarter saw significant legal expenses resulting from our new policy to immediately expense these costs of $1.5 million, along with an estimate for damages in an ongoing case of $1.5 million.

Secondly, foreign exchange translations added $1.5 million of expense to the quarter.

Next, we added $1.1 million of expenses associated with the purchase of our Korean and Ireland businesses, and a corresponding offset in improved gross margin.

Remaining SG and A increase is the result of additions principally made to the mass spectrometry business in anticipation of higher sales. These expenses will be rationalized in the ongoing process of declining our HPLC and mass spec product lines. 2002 results continue to benefit from discontinuance of goodwill amortization and a reduced tax rate versus prior year.

Included in this quarter's results in other income is a termination fee of $7.6 million relating to settlement of a contract with Gene pros. This income was awful set by evaluation adjustment of investments of $7.5 million relating principally to our [gene prod] investment.

Our balance sheet continues to be strong at the end of the second quarter, with the benefit of free cash flow of $40 million for the quarter and $79 million year-to-date.

Inventories increased somewhat for the quarter, largely the result of the [gene prod] order cancellation, and currency translation. We plan to work off this inventory product build during the second half.

Receivables days sales outstanding was 75 days, up slightly from Q2 last year. We anticipate seasonal improvements to bring DSO lower at year end. One other note on the accounting front I'd like to discuss before looking at guidance for the remainder of the year is our ongoing review of service and labor costs and how they are classified on the income statement.

Presently, we include service labor and related costs in SG and A. With the combination of Micromass and Waters HPLC businesses, we will be collecting labor costs with more granularity and will be able to identify costs associated with revenue generating activities for reclassification into cost of sales from SG and A. We plan to have this new service cost reclassification implemented by year end. This change will have no net impact on earnings.

In reviewing our business prospects for the remainder of 2002, we see little net change from our earnings estimates for the full year of $1.32 to $1.37 per diluted share before onetime charges, and remain confident with this range.

Currency should provide up side to our prior estimates, and could offset possible short-term growth disruptions caused by the HPLC and mass spec business combinations. We don't expect any significant impact here, we want to remain cautious in our estimates. We expect sales growth for Q3 to be around 5% before currency impacts. Currency at today's rates would add about 3% to sales growth for the quarter.

Our estimate for EPS for Q3 is 30 cents per diluted share, with the normal 1 to 2 cents tolerance for the quarter.

Back to you, Doug.

Thank you, John. Before I open it up for Q and A, I'd like to cover one thing more.

As you know, we generally don't publicly look out to 2003 until later in the year, and you should know that our internal processes that roll up to formal budgets culminate late in the year. But because of the unusual dynamics that we've been facing in our business and questions about markets and products, I thought I would provide you with top-level sizing of what we currently see for a 2003 outlook.

First, you should know that at current rates, foreign exchange will be significantly favorable for us in 2003. Since 1995, currency has consistently hurt our results, and at least so far, in 2002, it's pushing strongly in the other direction.

This is a significant factor in HPLC profitability because we're basically a U.S. manufacturer in HPLC. Less important to our mass spectrometry business because of substantial European mass spec manufacturing. But in sum, it helps a fair amount, both at the top and bottom line.

From a business point of view, we continue to see good growth coming from HPLC. Our product positions are very good, and even in this time of difficult conditions for the healthcare industry, we are grinding out good growth.

We expect the industrial applications, conditions there, to continue to gradually improve, and overall, I think we have a fairly optimistic outlook for HPLC.

In mass spectrometry, we expect to have our product portfolios back into balance by the first part of 2003, primarily with the introduction of a new [triple QWAS] on the horizon for 2003. The expected [proteomics] applications continue to be strong and we think the knew field organization gives us substantially better coverage everywhere in the world and will help stimulate growth.

As we look at the world, that would produce organic growth in the high single digits, and currency would add 2 to 3 points on top. That would produce a full-year 2003 sales revenue a smidge over a billion dollars.

Now, while there's still a lot of I's to be dotted and T's to be crossed, that would result in an earnings per share of about $1.50 a share. So that's an admittedly early look at next year, and we'll, of course, update you as we go through the rest of the year, but I thought with all of the uncertainty facing everybody, it would be helpful if we shared with you what our look for 2003 is at this point.

00:22:10 Now I'd like to open it up for Q and A.

At this time, if anyone would like to ask a question, please press star 1 and I will announce you prior to asking your question. To withdraw your question, it's star 2. Once again, if anyone would like to ask a question at this time, please press star 1 now.

I have a question from Sherry Walker of Deutsche Banc.

Good morning. Just quickly, what was the capex?

Capex was about $9 million for the quarter.

Great. And looking at SG and A, there seems to be quite a shift due to a lot of different issues. What can we look for going forward in the third quarter, and then maybe even looking outward?

Yeah. I mean, that's certainly an area that, as both Doug and I had mentioned, we're looking at pretty carefully as we speak. But from a guidance perspective, we have not yet rolled in, in a significant way, any impacts from the review that's currently taking place. So the growth rates going forward will certainly be much less than the 19, but I'd suggest they're going to be probably low double-digit until we, again, have the opportunity to readdress some of the costs associated with - or some of the benefits to the costs associated with the reorganization activity that's taking place.

Okay. And in terms of what should we look at for patent litigation going forward in this line?

Yeah. I think, you know, as we look at patent litigation, we're currently projecting another perhaps million-and-a-half dollars for the patent expenses for the second half of the year but that's offset by about $800,000 during that same period in amortization that will now not take place.

Okay.

So the net amount would be closer to three-quarters of a million dollars, or somewhat de-minimus. Kind of a one-cent full-year impact, perhaps, as we look forward on this line, but we all know the world of litigation is a difficult one to predict.

Sure. Great. Thank you.

Sure.

The next question comes from Donna Dicata of Merrill Lynch.

Thank you. Good morning, everybody. Doug, I think you mentioned in your initial comments that you - it now looked like [Q Toss] global would be out in 2003 rather than the end of this year. Any - could you talk about what the reasons for that are, and any estimate of when during the year it might be out?

Well, I think - you know, I can ask John to chime in here, too, Donna, but we've - the whole notion of the global is - and determining its dynamics is a little bit complicated because in reality, most of the global sales that we made were electro-spray sales and the quick switch-over to [maldie] was kind of a nice to have if it were available. We always believed that if we were only offering the electro-spray, most of those companies would still, you know, go with our electro-spray. But it was a nice low-cost kind of accessory to have.

What - in prioritizing what we have to do to get solidly back into the U.S. market with our [Q Toss], work those changes through our manufacturing cycle, the design cycle, and manufacturing, we clearly needed to focus on the electro-spray and we needed a stand-alone [maldie] application, so that's where we focused most of our attention. But global requires additional engineering activity, and frankly, it just seemed to us too aggressive to continue with what might be a late fourth quarter capability there, and we're more comfortable with 2003. It wasn't anything we had really factored significantly into any revenue projections, but that's where it came out. John, do you want to add anything to that?

Yeah. I'd just add, Donna, as you know, we started shipping the [maldie] configuration, and we have a different front end for the configuration that's just [maldie], and making that decision and actually being able to do that sort of took the pressure off on the global side, as Doug said, so we were thinking about an interim position for global and we decided that we wouldn't do the interim position.

As - in terms of the other part of your question, we're - you know, we're sitting here in July, we're probably saying first half of '03, first half could be anywhere between Pitcon or AMSM, but that's what we call it and we basically made the decision to kind of wait for the final implementation of this change.

Well, in that case, given the product life cycles -

Yeah.

- in the mass spec area, is it even worth pursuing that?

What do you mean, Donna?

The global. Is it even worth trying to bring that back into the states.

There is some - there is some desire for it, as Doug mentioned. It's a nice to have sort of feature, so we've been looking at it and saying, you know, people do say, "Gee, if I could have that, I'd like to," and we don't - we don't see us paying a penalty for putting it back in, particularly with the newer front end. So I'd say yeah, we're going to - we're going to continue with it, and there's no reason not to, and as I say, we just decided not to do something interim in the short term, given the situation.

Okay. A lot of your pharmaceutical customers have been in the news lately over manufacturing problems or struggling to comply with EPA regulations, I guess. How does that affect you? I mean, is it a benefit to you? Is it sort of a shorter, intermediate term risk to your HPLC sales? How should we think about what's going on?

Well, I mean, frankly, it's - it's never in our interest to have our customers have problems. I mean, in the long term. In the short term sense, yeah, with some of the companies that have been in the news that had problems in a specific manufacturing area, we have seen a blip up in business, you know, as they try to perhaps beef up QA/QC procedures in a particular plant.

But it's not a huge dynamic in terms of a level of business that's designed to focus on a particular problem. I couldn't say that - we don't think any major part of our current strength in HPLC is related to companies addressing and significantly upgrading QA/QC procedures.

I think, you know, the broader context is, you know, it's an industry that has been under some pressures, it has been under some FDA scrutiny, and I think overall, if that makes them look more carefully at release criteria, at the need to beef up their release, it may very well make them look up - look at their data and software and how that works and how that gets reported. I think we're well positioned within our industry to take advantage of those dynamics, because I think that's where a lot of this will go to. It's procedures, it's recordkeeping. Most of these FDA kind of issues aren't with companies releasing poor product. It's poor recordkeeping, in most of them. So I think in that, our market-leading position in that area holds us in good position.

Those issues, though, Doug, tend to relate to the old way of doing it, not the new - the look electronic records and signatures, right?

No, that's right, but the answer to it oftentimes is upgrading your procedures.

Right. Okay. I'll get back in the queue. Thanks.

The next question comes from Carissa Marino of Goldman Sachs.

Thanks so much. First of all, have you started buying back shares, and if so, how many have you bought back to date and what - at what average price?

Yeah. Hi, Carissa. On the buyback program, we're following the same blackout window periods that insiders have at the corporation, so we're giving the time frame on the release here, we're not able to begin that program until Thursday. So our intent is to begin that process later this week.

Okay. And then could you provide any color on mass spec demand outside of the U.S. by market segment, pharma, biotech, et cetera?

The strength internationally, I'd say, is largely pharma, biotech related. We saw a good bit of strength coming out of the large UK pharmaceutical market for our mass spec products, and good strength in Asia coming out of those type of customers. So we certainly didn't see pharma weakness outside the United States. The dynamics are going on in North America are really so kind of product related, it's harder to tell about market dynamics.

Okay. And then just finally, can you provide any color on whether there's any difference in HPLC demand for research applications versus for manufacturing applications?

I'd say that maybe we're seeing a little bit of an uptick in the development QA/QC side versus pure research, but, John, you want to chime in on that?

Yeah. There's - that's a tougher one to dissect. I mean, I think if you take a look at the strength in the - you know, the underlying chemistry business and service business, I mean, certainly a lot of that is manufacturing related and, you know, we're not seeing any slowdown in the QA side. Certainly earlier in the year, we had talked about a slowdown that was perhaps more related to the research end of the business and, you know, we've seen an improvement in the second quarter there, which I think is the development side coming back. But to have really specific, you know, figures on that, it's difficult.

Great. Okay. Thank you very much.

Sure.

The next question comes from Thomas Blanton of RBC Capital Markets.

Thanks. Just a couple of housekeeping questions to follow up. John Ornell, I was wondering if you could run through some of the items that increased SG and A for this quarter. There was a number of things you ran through. I didn't catch all those.

Yeah. Sure. For the quarter, you're right, we ended up with a fair number of onetimers or increases related to policy change, but what I had gone through was about a million five in legal expenses incurred in the quarter that would have been capitalized but, instead, with the change in the policy, were expensed, and those costs are related to ongoing litigation that is in a number of different cases, many of which are disclosed in the K and the Q.

There's also another million five beyond that of damages that we've estimated for a particular case that we're looking at coming close to settlement on that we've accrued for the - for the quarter.

Additionally, there's about $1.1 million of expenses associated with bringing on board our Korean and Ireland businesses that had been distributor businesses, such that we end up with a - another million one in SG and A expense, but an offsetting benefit in the gross margin line.

And there was a foreign exchange in the quarter of a million five as well. So those were the - were the pieces, I'll say, that were easily identifiable. Beyond that, I mean obviously we had made investments historically that are coming to bear in 2002, principally on the Micromass side of the business, mostly in the service area in building up that business as kind of a stand-alone service business that, as we had said, we're now rationalizing with the combination that's taking place with HPLC sales and service.

So based on an earlier question, in terms of growth rates for SG and A, is it fair to strip out somewhere between 5 and 6 million and use that as a base for SG and A going forward?

I'd say right now, just given the fact that we are, you know, still looking at what the results of this combination will ultimately be, I'd rather model in the short term - I mean, it's not going to be 19% growth in the - for the remainder of the year, but, you know, for the third quarter, my model is closer to, you know, a low teens, high single digit type growth model, which I'll admit going forward has some up side, but that - that, even in the fourth, is what's in my current guidance and until we get through this process over the next couple of months, perhaps with the October call, we'll be able to go through some specifics as to what the situation looks like going forward.

And then I guess just to continue with you one more question, on the gross margin line, 65%, that - some of that, obviously, came from the Korea/Ireland integrations. Is that a sustainable number or do you see that dropping down a little bit?

Yeah, I think that's a sustainable number. I mean, the other - you got that aspect of impact, but the other thing you have is we talked about pricing that went into place at the start of the year, didn't see as much of the benefit, obviously, the first quarter as we pulled through backlog at lower gross margins. The second quarter saw kind of the full impact or a fuller impact of pricing, principally in Europe. We were able to raise pricing fairly early in the year with the European version. So I think the 65 looks pretty firm as we move forward.

And then one final, if I could. On looking at your 2003 EPS , I guess, guidance, I believe it's very preliminary but if you look at some of the new changes to accounting principles and then offsetting against that, obviously, the integration of the sales force, what kind of leverage do you think you can get on the SG and A line in terms of percentage point drop in sales. Or are you willing to speculate on that.

Yeah. You know what, it's so early on, with '03. As Doug had said, we wanted to do kind of a thumbnail on that, but, you know, to be able to go through and, you know, really give you something meaningful on gross margins and SG and A and the like, I think it would be a little presumptuous on our part this early on.

Yeah. Tom, let me jump in, just from my perspective.

I think clearly we're happy with our ability to continue to generate good strong gross margins. I mean, even, you know, ultimately we're going to reclassify some service costs up there and, you know, that will be comparable in gross margins in all likelihood will, you know, come down from this lofty level. The improvement year to year is still, I think, reasonably impressive in the face of the kind of disruption that's going on in all the markets around us.

John talks about pricing. You shouldn't get the wrong impression. Massive price increases are not underlying anything that we do. We always have price increases that go into effect kind of at the end of the year or a little into the new year, so there's - there's a little bit of effect of pricing. It - you know, it's maybe a half a point one year versus, you know, nothing in the base period. We just happen to get it a little bit earlier, a little bit faster.

Again, all these things kind of add and describe a business that I think, even in tough times, as you have to admit these are, I think the business has been very successful in churning out very good gross margins. We admittedly have a structural issue and we're kind of trying to rationalize this SG and A growth that's combined with a business disruption. We're trying not to eviscerate resources that we think we're going to need in the very near future, but at the same time, we know we can't go on with, you know, major differences in growth rates and SG and A versus sales lines for the long term.

So we know that's going to come into line. We're looking at how best to do that. You know, it's probably going to be really into the fourth quarter and to the first quarter before you see significantly those dynamics change. We think that only adds to our overall outlook for the future.

Great. Thank you.

The next question comes from Larry Niber of Robert W. Baird.

Thank you. Could you give - please give us a breakdown of your sales composition by mass spec, HPLC, and thermal analysis?

Portions of the business?

Right. What percentage of sales were each in the quarter.

Yeah. We can tell you in broad strokes, Larry.

Yeah. I mean we - I mean basically HPLC is somewhere around 60%, maybe slightly higher than that, of the business. Mass spec is right around 30%. And TA is just slightly less than 10% of the business. That hasn't changed dramatically over the last few periods.

Okay. You mentioned that your international mass spec order book grew significantly in the quarter. I was wondering if you could say what the situation was in North America.

Yeah. I mean, North American orders were down a little bit. Not as dramatically as sales. Down in the single digits. That's a better picture than we saw in the first quarter, still not great, but a little bit better picture.

Okay. And then finally, I want to make sure that I heard you correctly earlier. I think you said that your preliminary EPS guidance for '03 was $1.50?

Yes.

Okay. Great. Thank you.

The next question comes from Scott Jones of A.G. Edwards.

Good morning. I just wanted to follow up on your comment about the industrial demand and how you are seeing some early signs of pickup. Is that both inside and outside the U.S.? And just could you just comment on that?

Yes. Generally, Scott, it is - it is inside and outside. You know, I'm a little bit reluctant on the TA side, because, you know, that's - we've seen, you know, one quarter be up, one quarter be down, so, you know, we've looked behind that. I think the most clear place we're seeing that in TA is probably Europe. But, you know, there - or maybe I should say internationally, I think seeing a little bit better than the U.S.

There are indications in the U.S., but, you know, I'm reluctant to hang my hat on that.

On the HPLC front, which is kind of a broader class of industrial customers, food and beverage is more important in the HPLC front, as well as classical, you know, polymer analysis and other industrial applications.

I think there are clear signs that we're seeing some - some good opportunities.

How much of it is opportunities for us versus a broad-based industrial resurgence, I think it's a fair question. We have - we have spent time developing those applications. While we have always talked about the importance of pharmaceutical and life science, we don't ignore the industrial applications, and we continue to believe that we can invest time, effort, and resources and get good growth. It may not be as - as high long-term as the life science applications, but it's good solid opportunity.

And my second question is just on your - your backlog. Could you remind me, again, what your typical backlog is in weeks?

Yeah. We generally have four to six weeks of backlog, so it's not - you know, it's not like we're sitting here looking at the quarter, obviously. But that doesn't change dramatically over time, you know. A few million to perhaps a bit more than that quarter to quarter is kind of the dynamic that we're looking at, but as Doug said, we did grow it in this particular quarter.

Great. Thank you.

You're welcome:

The next question comes from Derek Debruen of UBS Warburg.

Oh, hi. This is Mare [inaudible] as well as Derek. We have a little bit of housekeeping questions. The 3-cent charge that you mentioned, were any of that included in the second quarter or we have to look at the first quarter which means that instead of booking 27 cents for the first quarter, it was actually 24, and is that included in the guidance for the year?

Yeah. I understand. Basically, the three-cent charge brings you back to the - to the start of the year. There was a small amount of legal expense in the first quarter, I think 400,000 or thereabouts, that would have come out, but it wasn't enough to change the EPS. So what you're looking at is the start of the year impact of that accumulated amount.

So - so the first quarter should have been 24 cents or that - or this quarter should have been 31 cents?

No. The first quarter remains unchanged. The 3-cent charge relates to periods prior to 2002, okay? So it's the cumulative effect of that change for the years going back in time.

Okay. So -

And then the current quarter's - current year is stated as if the policy were in place at the start of the year.

Okay. The other question that we have, considering that you're going to be buying $200 million worth of share, which is about - around 8% of the total outstanding, is your $1.50 number guidance for next year, does this include that buyback?

You're asking for a granular determination of something that's, you know, meant to be interpreted at the 30,000-foot level, mare, so I think the pure answer is no. I - you know, we haven't worked through a detailed financial model. What we have done is, I think, give you a feeling of our level of confidence of being able to produce meaningful growth in top and bottom line in what's a reasonably difficult economic climate, and we want to make sure that that general assessment gets across.

But, you know, I haven't factored in a 8% reduction in outstanding shares. I haven't factored in what our salary increase assumptions are going to be starting January 1st and worked it through inventory turns or anything like that.

So, you know, it's just, you know, from a global picture, I think in that $1.50 range, if you got me down to it, could it be $1.53 or could it be $1.49, yes, the answer is.

Okay. Well, thank you very much.

The next question comes from Scott Wilkins of S. G. Cowan.

Thank you. Just was hoping to maybe get an update on where you stand with the [triple QWAS] and your re-engineering effort there. If you would please give us that.

Okay. John Nelson, you want to cover that?

Sure. As we said kind of coming out of the second quarter, we were looking at several different approaches and one of the things on our mind was the final kind of what the courts said coming out of the closure of the case, in terms of, you know, the final rulings.

I think it's important to state that the court's ruling at the end of that case was very specific to the Quattro product line period, and to specific technologies. That's actually a very clean ruling for us.

I think we're in the period right now of evaluating more than one attractive approach, but I think we sort of see enough to feel pretty comfortable with where we're going here, and I think the time line we've laid out is something into the first half of next year. We feel pretty good about that. So I think we see a general direction, we actually see perhaps more than one, and, you know, I think it's now a question of making sure of the engineering aspect of it and kind of just doing the work. But we feel pretty good about it.

Great. John, just a follow-up. Do you feel that you will have a product that will be, in fact, more sensitive than the competitive landscape, given that that is such an important criteria to customers?

That is certainly our objective. As you know, sensitivity depends on many, many variables in these things. You know, and it is not one number. So you can have sensitivity for small molecules versus big molecules and so forth, but we do not intend to, you know, give up the position of being the leading supplier and the - you know, of this technology and clearly, you know, part of our objective is to have a best in class product.

That's helpful and if I could just have one additional follow-up for Doug or John. Just on the guidance for '03, I know you don't want to get too much more granular but I'll go ahead and try. Just could you maybe give a little color on the segments? You know, what kind of growth rate you expect out of HPLC and mass spec, if you wouldn't mind.

I - I think, again, with the caveat that it's from 30,000 feet, we expect, you know, the HPLC business to continue to be high single digits, could get a little bit better but right now, you know, that's - that's what we're comfortable with, in terms of top-line growth. We expect the mass spec business to be double-digit growth. You know, probably, you know, lower double-digit growth. Of course that's off depressed levels of this year.

Yeah.

So you can look at that as half full, half empty, optimistic, pessimistic. We think it's probably midline, but we think that overall mass spec business can grow in the double digits next year.

We've got TA more in the single-digit - mid-single-digit range, and currency that adds 2 to 3 points on top of that.

Okay. So that gets us into the double-digit range top line?

That gets you to the high single-digit side I'd say is probably what I'd be comfortable with.

Okay. That's real helpful. Thanks a lot.

The next question comes from Dennis Goldman of Lehman Brothers.

Good morning. Thank you. Could you just say a few words about the most recent litigation that you've brought against ABI and their mass spec?

Yeah. I'll handle that. That refers to some intellectual property developed actually here at Waters during the earlier development of the Waters single Quattro pole. This was work that we were working on around the time that we were working on Micromass. It came to our attention in the recent past that we felt that there was an infringement situation with that IP, and basically that's what we filed.

And how does that affect - I mean, which product line does that affect and how do you see that sort of ending up, either in a licensing agreement or trying to obtain some kind of injunction against the sale of whatever product they're using that IP with?

Well, in terms of obviously our preference would be, you know, hopefully not to litigate anything, but I think, you know, it's very early in the day to see how that ends up. It's a - it's against a specific product line, as we described, I think, in the - that press release, the Mariner, but I think it's early on in terms of where we stand with that, so we do think it's a clear situation. We've, in fact, made measurements and so forth. But it's very early on that.

Thank you.

Our next question comes from Ron Renault of Bear Stearns.

Good morning. A question for John Ornell. I know you guys don't want to go into details on 2003 but let's try 2002.

Closing out the year, given that your plan is for a 200 million - $200 million share repurchase, I guess I'm just trying to understand where do you think you'll at least come out by the end of this year? Where do you exit this year in terms of - in terms of shares outstanding? Because if I look at even last night's closing price, I have to believe you'd probably want to be more aggressive at, you know, these historically low levels and maybe front-end weight this, which would give you - which would give you a little bit of a - probably a better benefit this year, as opposed to first half of next year. Any insight?

Yeah. I mean certainly the plan that was announced was 200 million with a one-year life, and that was what was approved by the - by the board.

Certainly as - you know, as the price is more attractive out there in the market space, we're going to be more inclined, obviously, as you point out, to be a bit more aggressive early on. That's true. We have not, though, modeled or, you know, made commitments, if you will, as to how aggressive that might be. You know, our original thinking was to - was to do it somewhat ratably over the period, but certainly given the current situation, you're rate, we will be expediting that process and they'll be more than perhaps half that benefit moving into the last half of this year.

I think it's fair to say, Ron, that if you - if you look at the second quarter, certainly in a cash flow dynamic, it would reinforce the strength of our ongoing cash flow. If the stock buyback made sense at 23, $24 a share, clearly at $18 a share it makes more sense, so we're not going to slide back on what we think we can buy back at these prices.

Okay. Agreed. So the $1.32 to $1.37 range, then, for 2002 assumes you exit the year at how many shares outstanding?

That range, quite honestly, was not contemplating a huge pickup from the buyback program, so that - before the buyback, that would be somewhere in the one - you know, 137, 130 - high 137's, and then, you know, we can all make our own estimates, perhaps, as to how much that might be impacted. But I don't want to - I don't think - speculate on that, as we sit today.

Great. Thank you very much.

Sure.

The next question comes from Daniel Chase of Neuberger Berman.

Thanks. Doug, you may have gone over this before. I may have missed it. But could you go over the rise in inventories in the quarter again for me?

Sure, John. You want to do that?

Yeah. Inventories in the quarter went up principally at the Micromass facility. We had the [gene prod] order cancellation that unfortunately had fair amounts of inventory already in the works. Some much further along, obviously, than others. But that ended up with, you know, a few million dollars, perhaps, of pain that we're going to need to burn off over the next couple of quarters.

Beyond that, the foreign exchange dynamic cost us a few million dollars in the quarter as well, as we translate ending inventories to U.S. dollars, and there was a small - another few million dollars of increase in HPLC inventory that's somewhat seasonal, I'll say, with the holiday season upon us in early summer that will be burnt off by the end of the year as well.

Okay. Great. Thanks.

The next question comes from John Sullivan of Stephens, Inc.

Hi, guys. Just a couple of quick ones regarding revenues for - in the most recent quarter.

The Korea and Ireland business association changes that you're making, does that work through the top line in the second quarter at all? And to what extent?

I - structurally, John, the Irish business has typically been done through a distributor, so we ship the product to Ireland but we got a manufacturer profit and they incurred the SG and A and they got a delta over that manufacturer's profit to fund their SG and A and their profits.

We have - you know, we have a - a handful of these territories around the world. Ireland being really the biggest one, that we have longtime distributors and have good relationships and we've just been waiting really for the owners to kind of retire, and this was one where he finally retired and we very amicably, you know, took over the business directly.

So that winds up with us taking on the SG and A and us getting the top-line profit. You know, that resulted - that was basically about a million dollars incremental in revenue and about a million dollars incremental in spending for this quarter, so it kind of washes out.

Okay. Terrific. And then second question, also - also regarding revenues or cash flow into the company, the [gene prod] termination fee, that came into the company in the second quarter, is that right?

The -

The cash itself.

Cash itself, John, it's a little more complicated be that.

Yeah. I mean the cash that came into the company in the quarter was about - closer to two-and-a-half million. There was a prepayment that was made earlier that was already on hand that was converted into the - into the fee. So the quarter has a two-and-a-half million dollars pickup based on that agreement.

And is that in the top line for the quarter?

No, no, no.

No, no. Okay. That's just in cash flow for the quarter?

That's in cash flow and the - and it's in the other income expense line, netted, is where you're seeing it.

Just to make clear, the prepayment that we had received earlier in the year wasn't ever recorded in revenue. It was a balance sheet deferral.

It was a prepayment.

That's not uncommon for big contracts that we get prepayments prior to the total fulfillment of the contract. Just in this case, the contract was cancelled so we didn't return that prepayment, and in addition, we got a two-and-a-half million dollars in incremental cash.

Understood. Okay. Thank you.

The next question comes from Donna Dicata of Merrill Lynch.

Hello?

Yes. Donna. Donna?

We'll move on to the next question from Thomas Blanton of RBC Capital Markets.

Hi. Thanks. A quick follow-up, if I could. John Ornell, at the end of the first quarter call, you had stipulated that your organic growth for the year would be somewhere between 7 and 8% with a 2% hit from foreign exchange. Now that the foreign exchange is reversed, do you care to comment on what your organic growth expectations are for the year?

Yeah. We are still looking at somewhere near the - kind of a five or so percent organic growth rate in the both third and fourth quarters. We're looking at currency in the third and fourth quarters perhaps adding three points. it could be even stronger to that, so we're looking at moving to about 8% in Q3, perhaps in 4 as we look at FX wind at our back to get to 8.

So which part of the business is causing you to effectively take down by, you know, 2 to 3 percentages points your organic growth rate?

We're at - I mean, we were at 6 to 7. We're basically, at this stage, hedging I'll say a little bit on the Micromass front. As I said before, we certainly have, you know, a little bit of risk as we look at the combination that is taking place in the third quarter. There's a little bit of hesitancy with the global not being in there and moving people to [Q Toss], so, you know, we're going to be a little - hopefully safe on this one, and, you know, expect a bit more risk on that front.

But Tom, I think your - it's a very fair question. I mean, it's - in reality, our second quarter came in pretty much where we expected it to. A little bit more strength, maybe, on the HPLC front. Mass spec came in pretty much right where we anticipated it.

The major probably element that provides a little bit more uncertainty is the fact that international is so much more strong than the North American business, and so, you know, with the FX dynamic, we've chosen not to uptake our guidance. We thought that that was probably a wiser path, but it's fair to say that nothing has happened in the second quarter that has really knocked down our expectations for organic growth.

The other thing, Tom, is that the last time we spoke, that was before we removed the [gene prod] business as well, so, you know, the [gene prod] full year was - you know, was 8-and-a-half Q2 and 8-and-a-half million basically Q3, that, you know, we're not seeing being replaced at this stage.

Perfect. Thank you.

Okay.

Are you showing any other questions? Hello?

Yes. I have a question from eastern Shay of state street research.

Hi. Thank you for taking my question. Could you please comment on the potential impact on your business from, you know, pharmaceutical M and A activity?

Sure. Historically, you know, a large pharmaceutical merger does cause some short-term disruption. We have - we have seen it in other times, and there is a period when those companies sort through who the new bosses are and whose standards are going to prevail. So we have seen some short-term disruption. In almost every case, the combined entity long-term goes back to a growth slope that's consistent with our overall, you know, growth in the separate businesses.

So I can't say that you - we wouldn't see a dynamic going on in the short-term, but we think long-term, it's - it's just kind of works itself through.

And have you factored that potential impact into, you know, your guidance with this year and next?

We've factored it in in the sense that in all of the - if you go back over the last three years, we've had merger activity in our run rates. You know, this quarter, we probably haven't had a significant impact of pharmaceutical merger activity. But we don't think that at the level that we're talking about, it's any more material than a number of other uncertainties that kind of come together, some being pluses, some being minuses, so I'd say it's intuitively factored into our overall outlook in terms of what we think the underlying growth rate can be sustained at, but no more than that.

And with the current tough financing environment for the biotech companies, could you please comment on what you are seeing with your biotech customers?

Yeah. I'd say it's, in general terms, it's - first of all, for the large biotech companies, you can think of them as being large pharmaceutical companies, and the business there can - tends to be, you know, just as predictable as the pharma companies.

The medium and smaller biotech companies for us tend to be a changing mix, you know, quarter in and quarter out. You just don't see the same biotech companies buying in the first quarter, second quarter, third quarter.

The financing climate for biotech has been soft for a while now, and we have continued to see that general class of customer in the United States be pretty consistent. That class of customer hasn't been generally as active internationally, and so when we look at our strength internationally, it's not predicated nearly as much on those kinds of customers.

I'd say what we're seeing in the U.S. and have been for the last couple of quarters is kind of consistent with a generally soft financing market for biotech.

Okay. Thank you very much.

The next question comes from Donna Dicata of Merrill Lynch.

Hi, guys. Sorry about that before. That's why I'm not a tech analyst. I managed to disconnect myself just as I went to pick up the phone.

A couple of things, but first let's follow up on the previous question.

Could you just go over, again, kind of the size of your largest customers? As I recall, it's a pretty diverse customer base. And also, how much of your life sciences sales are coming from, let's say, big pharma, big biotech, versus the small and medium size customers that you were just talking about, Doug?

Sure. John, you want to -

Yeah.

- start on that?

Yeah. As we looked at, you know, our customer base, we don't have any one customer that's greater than 3% or even, a few tenths less than that, quite honestly, of sales. So any one large pharma account, while important, isn't - isn't more than 3%. I think that's the dynamic there.

And that's, of course, including every segment of that company.

Worldwide.

In every application. So it's not -

Yeah.

- one application or one department.

All right. And in terms of that, when you're - when you go through one of these segments or a merger among a couple of your large customers, I'm assuming they don't stop spending altogether. There's some level of service, consumables, stuff like that that they're still buying, right?

Oh, absolutely.

Right.

Absolutely. And we've seen cases where we've grown our business right through mergers, you know, when you look at the combined business. But typically you do see a quarter or two where -

A period of confusion.

- you know, where they slow things down.

Right.

They just -

Basically down to the aftermarket consumables and stuff like that?

Well, they don't slow them - they don't stop making instrument purchases. It's just they may not make them combined at the same rate that we think they would have made them individually.

Ah. Okay.

So - but I caution, you know, we've seen this - it's in our run rate, you know. The -

Oh, yeah. This has been going on for -

- merger, the Upjohn/Pharmacia merger, you know, it's something that happens, you know. The Pfizer/Pharmacia planned merger, you know, is no bigger than the Glaxo/SmithKline merger. You know, it's - so it's not - I wouldn't hold it out as being generally a good thing that we look forward to, but it's been something that's been a constant in our infield.

Right. Well, this has been affecting you for the better part of the last decade.

Yeah.

Yeah. Okay. How about the portion of small and medium size biotech versus the larger companies?

I don't have that right at my fingertips now, Donna. Maybe John could get back to you with -

Yeah. I mean certainly the preponderance of the shipments, obviously, is to the - you know, the large pharma, large bio, generics make up the very big pieces. You know, our business to the small players, the emerging players, is rather small, but I don't - I don't have that at my fingertips either.

Okay. Can we go back to the - the change in the field service organization, the consolidation of the field, as well as the change on the P and L?

What are we talking about in terms of numbers of offices, numbers of people? And might there be any charges in the third quarter for either severance or changes in leases?

HIAUME:

That's - let me start out here, Donna, and John can jump in. As I said, you know, we have been thinking about what the long-term structure of our field organization should be for a while now, and, you know, several of us in Milford have have realized that what we were doing for the last - [The audio portion of the call was lost at this 01:13:13 point.]