Waters Corp (WAT) 2005 Q2 法說會逐字稿

Welcome to the Waters Corporation second quarter financial results conference call. [OPERATOR INSTRUCTIONS] This conference is being recorded. If anyone has any objections, please disconnect at this time. I would like to introduce your host for today's call Mr. Douglas Berthiaume, Chairman, President, and Chief Executive Officer of Waters Corporation. Sir, you may begin.

Thank you. Good morning. And welcome to the Waters Corporation second quarter financial results conference call. Presenting with me on today's call is John Ornell, the Waters Chief Financial Officer and as our normal practice I will also provide an overview of the second quarter, then John will take you through the financial details and lay out our third quarter and full-year 2005 outlook for you. Finally, we will open it up for Q&A. Before I begin, I would like John to cover the cautionary language. John?

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, this time for Q3, and full-year 2005. We caution you that all 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 31, 2004, in part one 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 future income statement results except during our regularly scheduled quarterly earnings release conference calls and Webcasts.

The next earnings release call and Webcast is currently planned for October of 2005. During this call, we will be referring to certain non-GAAP financial measures, a reconciliation for the non-GAAp financial measures to the most directly comparable GAAP measures is attached to the Company's earnings release issued this morning. In our discussions of the results of operations, we may refer to pro forma results which include -- exclude the impact of restructuring, one-time, and facilities-related charges.

Thank you, John. Well, I'm pleased to tell that you that our second quarter results indicate both an improvement in business conditions as well as continued positive customer response to our key new product initiatives. During the quarter, sales grew by 9%, while orders grew at a marginally faster rate. A number of large mass spec orders arrived pretty late in the quarter and we were unable to ship them before the end of the quarter.

As you may recall, the weakness that we encountered in the first quarter was principally attributed to delays in orders by large pharmaceutical customers in Europe, along with some accompanying softness in the U.S. pharmaceutical market. During our first quarter conference call, in April, I indicated that it appeared that the situation in Europe was improving, and that in fact some of the orders anticipated in March were received in April. Today, with our second quarter sales results for Europe in hand, I can confirm that we were in fact dealing with delays rather than cancellations or loss of share, and can further say that our current outlook for second half 2005 sales in Europe suggest that we will finish the year with positive European sales growth despite our slow start in the first quarter.

Outside of Europe, our business was largely in line with our expectations, with sales growth particularly strong in India and North America. Looking at end markets, pharmaceutical spending accelerated in the second quarter led by an improvement in Europe, however, we saw many of our major ethical pharmaceutical accounts, especially in the U.S. remaining cautious in the first half of 2005. And we believe that we are -- we believe that they are delaying the release of capital budgets until the second half of the year. This indicates somewhat of a replay of spending behavior that we experienced last year. In spite of this trend, overall pharmaceutical sales, when you include the smaller houses, biotech accounts, and generics, grew nicely in the second quarter.

Sales to our industrial customers in the second quarter settled into the more typical mid single digit growth rates that we have seen in the past. Our TA Instruments division, a business with exceptionally strong first quarter 2005 results and a heavy industrial focus delivered sales growth of 5% for the quarter. With half-year results above 10%. We anticipate a general continuation of this industrial spending trend in the second half, with some potential upside from a strengthening business that we're seeing in China.

Turning to our product lines, liquid chromatography sales grew at a double digit rate in the quarter. This growth was due to a record level of ACQUITY UPLC shipments and return to strong service and chromatography consumables growth. In mass spectrometry, our year-over-year sales growth was in the mid single digit range, however it is important to note that our orders growth was strong, as we built considerable backlog for recently launched products including the Quattro Premiere XE, a tandem quadrupole that we just begin shipping in June.

ACQUITY UPLC system sales represent the most important story in our quarterly performance. The quarter's revenue for ACQUITY-based system sales was at an all-time high. The potential ACQUITY customers for the first time had the opportunity to hear about the advantages of UPLC technology directly from independent researchers delivering presentations at this year's AMS conference in June. Both orders and shipments for ACQUITY UPLC were significantly stronger in the second quarter than for any prior quarter. A strong indication that this technology is gaining momentum. However, I still must tell you that I feel the best is yet to come with ACQUITY.

A closer examination of our ACQUITY business to date shows that orders are typically for one or two systems at a time, and that these orders are largely coming from first-time ACQUITY users. We feel that the business dynamics will change in the second half, as we expect to see broader adoption of UPLC by accounts who have thoroughly evaluated the technology for multiple quarters now. This new wave of business could coincide with the expected release of delayed capital budgets by our large pharmaceutical accounts, in the third and fourth quarters of this year.

In mass spectrometry, we generated substantial interest with new products introduced at ASMS in San Antonio. Most notably we exhibited a new tandem quadrupole, the Quattro Premiere XE, targeted for a broad array of applications, this new instrument is the highest performance tandem quadrupole system we have designed and has features specially suited to optimize speed and sensitivity when it is combined with ACQUITY UPLC. I'm pleased to tell you that we have begun shipment of this system, and orders for our tandem quad line were up double digits in the second quarter. Proteomics and research metabolite applications are driving demand for our Q-Tof products. In the second quarter we began shipment of our novel protein expression system, a unique tool that combines Q-Tof ACQUITY and bio informatics technologies to deliver unmatched identification and quantification information. Orders for Q-Tof based systems were up dramatically over the prior year's results.

Offsetting strength that we saw in quadrupole and Q-Tof-based instruments, sales of magnetic sector and multitop devices were soft and declined in the quarter. Sales for laboratory informatics currently accounting for between 1 and 2% of our revenue were again down compared to last year's results. The rate of uptick for this technology continues to be below our expectations, and we are clearly facing challenges in placing these new scientific data management systems at large pharmaceutical accounts in this cautious spending environment.

On the business development front, in June, we announced the signing of an agreement with PerkinElmer to collaborate on the sales support and development of future products for our clinical diagnostics testing. As part of this agreement, PerkinElmer will become the exclusive distributor for Waters tandem quadrupole instruments for certain clinical applications including neonatal screening. We are pleased that PerkinElmer chose to couple our mass spectrometry technology with their FDA-approved reagent kits and specialized software features to offer a true integrated and turnkey solution to mass spectrometry based testing for these targeted applications.

Looking ahead we plan to continue to evaluate the acquisitions of business, product lines, and technologies to augment our Waters and TA Instruments divisions. In the meantime, we currently expect to continue to apply our strong cash generation to buying back shares of our stock through the $500 million program authorized by our Board in October of 2004. With the net $68 million in free cash flow generated in the second quarter, and about $136 million of free cash flow for the first half of 2005, we are well ahead of last year's pace of cash generation, and in fact, an agressive 2005 plan.

Now, if I could take just a minute to express a CEO's pride, I am pleased to announce that Waters has recently been chosen as a recipient of an R&D 100 award for our ACQUITY-based instrument technology. I'm very pleased to report that fact for our organization.

Finally, and in summary, the second quarter's results provide us with a higher degree of confidence in achieving our growth targets in 2005. The weakness that we encountered in Europe during the first quarter now appears to have been an issue with the timing of orders rather than the start of a significant trend. The energetic marketing of our new products and programs appears to be bearing fruit, as ACQUITY and mass spectrometry system orders are accelerating. Looking to the second half of 2005, we feel pharmaceutical spending will likely increase as budgets are released, and with our strong product lines and trained technical field organization, we feel uniquely well positioned to benefit from this anticipated improved market environment. Now I would like to turn it over to John with a more detailed view of the financials.

Thank you, Doug. And good morning. Earnings per diluted share were $0.46 this quarter, compared to adjusted earnings of $0.40 last year before unusual charges an increase of 15%. Earnings per share this quarter includes a $0.01 benefit related to a decrease in our full-year 2005 effective tax rate. On a GAAP basis, which includes a credit for litigation proceeds in Q2 of 2004, earnings per diluted share were $0.46 this quarter versus $0.49 last year. Sales grew 9% for the quarter versus last year, on a reported basis, and included a 1% benefit from foreign currency translation. Our sales results were positively impacted by stronger sales in Europe and Latin America, and improved conditions in India and China. Pharmaceutical spending improved this quarter through -- though many large pharmaceutical companies continued to delay capital spending. Industrial demand grew moderately this quarter across LC and thermo analysis markets.

Looking at product sales in cost and currency terms, sales of LC products grew by 10% versus prior year. Informatics revenue declined about $1 million this quarter from Q2 last year. Our mass spectrometry product shipments grew by 5% this period, positively impacted by sales of our new Q-Tof Premiere and Quattro Premiere XE. And our thermo analysis business continued its positive performance with revenue growth of 5%.

Gross margins were down about 30 basis points and came in at 58.9%. This decline is largely the result of a planned reduction in inventory levels, temporarily impacting margins this quarter. Accordingly, we anticipate a return to higher gross margins in the second half of the year. SG&A expenses increased 9% over Q2 last year. Currency impacted SG&A growth by about 2% this quarter. We continued to review our resource needs and support of the business and we will act conservatively by holding back on incremental head count while we wait for large pharma customers to return to more normal ordering patterns. R&D expenses were up 5% this quarter. And operating margin was 23.5% for the quarter.

Our effective tax rate for 2005, before any impact from potential repatriation activities was reduced to 19.3% this quarter based on our latest assessment of anticipated profits among our business units. We have reviewed the benefits afforded by the American Jobs Creation Act of 2004. And have decided to repatriate approximately $500 million in 2005 at a reduced tax rate. This is expected to result in an additional tax charge of approximately 22 to $28 million in the third quarter or $0.19 to $0.24 per diluted share. We plan to utilize this cash to fund current and future operating expenses within the parameters of the IRS guidelines.

During the second quarter, we purchased 2.5 million shares of our common stock for $100 million against our approved $500 million program. This brings our total purchases to $305 million for the program to date, with 195 million of authorized purchases remaining. We plan to continue to buyback -- our buyback activities in the second half of 2005, assuming we encounter no significant acquisition opportunities in the analytical instruments and chemistry space. At quarter's end, outstanding debt totaled $657 million, primarily related to borrowings in the U.S. Cash and short-term investments totaled $615 million. With our strong balance sheet and liquidity, we believe we have adequate flexibility to fund future share repurchases and potential acquisitions.

Cash flow continues to be very strong, with cash from operations of $82 million this quarter. Capital expenditures were $14 million, yielding net cash from operations of $68 million for Q2. Accounts receivable day sales outstanding stood at 73 days this quarter, down 5 days from Q2 last year. And inventories were down $8 million over Q1 balances.

Turning to our outlook for the remainder of 2005, and before any impact from taxes on repatriated cash, we expect overall pharmaceutical spending to continue to improve as the year progresses. In China, we believe we will see an improving economic environment that should provide for a return to even higher growth. The industrial markets continue to look positive, and we believe we will meet our original expectations for growth in this market. As the year progress, we are confident our ACQUITY UPLC, our Q-Tof Premiere, and protein expression systems will help fuel sales growth. In all, we believe these factors will allow us to grow organic sales by about 7% in 2005.

Currency at today's levels should be neutral to full-year growth rates but will have a negative impact on sales in the fourth quarter. Gross margins are expected to improve by about 20 basis points for the full year versus 2004. We continue to examine SG&A spending. And plan to postpone any new spending that is not revenue generating. At this time, I would estimate SG&A will grow at a slightly faster rate than sales growth for the full year. R&D is likely to grow at a slightly slower rate than sales. And all of this should leave operating margin as a percent of sales about equal to 2004 before unusual charges.

Continuation of the buyback program should fully impact the fully diluted average share count in 2005 providing EPS leverage. Putting all of this together we continue to expect earnings per diluted share of $2.02 for 2005 with the normal $0.02 to $0.04 tolerance and before unusually charges. For Q3 we expect sales growth of 8%, where foreign exchange at today's rates would have little impact on sales growth. At the sales level we expect earnings per fully diluted share of $0.47, with the normal tolerance of $0.01 to $0.02 for the quarter before any tax charges related to cash repatriated under the American Jobs Creation Act. Doug?

Thank you, John, Operator I think at this point we can open it up for Q&A.

[OPERATOR INSTRUCTIONS] Steven Weiss of Mindflow Capital Investment. You may ask your question.

Great. Thank you very much, Doug, congratulations on another solid quarter. You guys always seem to amaze. A couple of questions. Over the past year a lot of your competitors have been recently implementing some new strategic initiatives, reduced their raw material costs by establishing a better line of communication with their supplier base. Interested if you could provide some color today on the call as to what you guys are planning on doing to reduce your raw material commodity cost by establishing a better line of communication, opening up more collaborative opportunities with your supplier base?

Well, sure. In broad terms, we have been probably in strategic terms evaluating our supplier base for the past three years, I would say. And have entered into some broad strategic alliances with a stronger subcontracting base. We've made I would say increasing use of the Far East electronics capabilities, particularly when you look at the electronic components of our instruments, the ability to have broad access to electronic components, and broad purchasing capabilities we have made extensive use of that, and you have seen that in our ability to hold and improve gross margins. We expect that we will continue to develop that line of supplier capability as we go forward although I'm not prepared to talk in any more detail about that now.

I do think that one of the keys that we've been finding as we go down this road is that we invested in SAP MIS technology, long ago, and I believe we have a very strong MIS and systems capability. We're finding that SAP capability really helps us quickly establish direct links with the supplier base, and serves as a competitive advantage for us. So we're rapidly able to turn around, draw rings, and capabilities in this worldwide supplier world. So we feel good about that. And we feel that is a long-term part of our ability to continue to leverage our margins.

One thing I noticed over the last couple of years by following your company is Waters Corporation is very -- it's built on quality. And what are you guys doing to make sure your suppliers are meeting up to your standards in terms of providing quality components at the right time, are you meeting with them quarterly, are you scorecarding them on a regular basis? What are you guys doing to make sure they're meeting your objectives?

We absolutely, we have embarked, as I said over the last, particularly -- I wouldn't say that it was instituted in the last three years, but it has definitely become part of our normal operating procedures to scorecard our suppliers. We have been dropping suppliers who can't meet our rigorous requirements. And I think, as I say, that's -- it is just part of our day to day operating procedures and I think you can see that in how our ACQUITY has come to market and the kind of quality and lack of warranty requirements, lack of returns, it's been a substantial piece of that, the success of that launch.

A significant piece of our ISO 9000 reporting system springs back quality issues all the way from customer back to raw materials. So that's been a process that's been in place for multiple years. And I would say we have a very quick turn-around in being able to analyze what is going on at customer sites and bring it all the way back down to a vendor level.

Great. Sounds like you have great initiatives. How do you see them reducing these initiatives--?

I'm sorry, I think we better -- you can get back in the queue, Steve, but I think we need to take a question from someone else.

Okay. Thank you.

Aaron Geist of Robert W. Baird. You may ask your question.

Good morning a couple quick questions if I could. Could you provide the local currency growth for Europe, Asia, and the U.S.? And then your assumptions for growth for those geographies for the back half of the year?

Yes. If we look at the quarter, the U.S. grew at about 8%. Europe grew at about 10. And Asia was about 5. And I would say, as we look forward from here, I think -- as we look at the U.S. at 8, that is probably a relatively fair comparison, as to what we will see in the second half. Europe on the other hand at 10, I wouldn't expect to continue at quite that rate, there is a little bit of a rebound, if you will in the second quarter from the first there, but as Doug had said, I think Europe is likely to end up the year in low to mid single digit growth, given the relatively slow start that we've had, so I think looking at Europe in low to mid single digits for the second half is a fair place to be. And Asia, at 5, is a little low. I think the fundamental demand that we saw coming out of India and China was actually more encouraging than that result, so I would say Asia is probably as we go forward looking more like a double digit grower.

I recall on your last conference call you talked about measures that the Chinese government had taken to slow economic growth there. Is this a fundamental change that you're seeing, that the business is now expanding once again and the measures to cool the economy have sort of run their course? Or this is something else happening in China that you can speak to?

We were a little bit surprised by the weakness that we saw in orders in China in the first quarter. And we -- unfortunately, you pick up bits and scraps of information and you try to weave a consistent story across that. I think in a similar way, we saw China orders bounce back in the second quarter, and frankly, we're seeing a great deal of optimism out of our China organization and out of the Chinese customers that we're talking to. So there is no question that at the individual demand level, there is a great deal of desire and want. And there is always some question as to how fast that underlying demand gets reflected in the purchase orders, and the approval of capital to actually spend. But I would say we were encouraged by what we saw in the second quarter, and we are thinking that China is going to be more likely to be a double digit growth position for us in the second half.

Would you say it is fair to say at this point in time that the slowness that you saw in China was much more similar to the slowness you saw in Europe which was more of a lengthening of a sales cycle and a delay rather than a cancellation of budgets and going forward, Asia, China will return to the growth that you had anticipated up to that point in time?

I think there is nothing fundamental to take us off a strong double digit growth curve in Asia. Europe I think deals fundamentally -- we've always thought that Europe was going to be a more difficult environment for us. The first quarter was substantially worse than we had thought, even though we thought it would be difficult. The second quarter was better. I think if you average those two quarters, we're probably long-term, and economic conditions in Europe, just still aren't that great. And so you have to cope with that, and that's why John and I are a little bit more cautious about the second half in Europe. But we see nothing fundamental in the major growth drivers in Asia that don't make us believe that we're in a strong position of the next several years.

Can I ask one more question?

Sure.

Can you provide a little bit more color on the informatics business and the initiatives that you're putting in place to try to jump start that business? It seems like it habitually takes a little bit longer than you think. Can you talk a little bit more about your expectations?

Sure. There is no question that we're disappointed by the level of business we've been able to generate in that area. What we believe is that we're dealing with a strategic change in the way that a number of these customers approach their archiving and management of data. And while we believe that many of these customers believe that the future depends on them making investments in this area, it's still something where a number of people in these companies have to get involved, including senior management, and senior IT people's involvement. So it takes longer. It takes longer than we had anticipated, and then you will layer in a dollop of capital spending controls, in these major pharmaceutical accounts, and I think that all pushes us further behind the growth curve. And we've had some internal issues with delays in iterations of our product line, but we don't think that is the principal culprit at this point in time.

We think it is largely a market-based phenomenon. We still feel that over the long term, this product line is going to be important. We need to continue to invest here. But we have to be more realistic about the revenue growth that we're going to see in the short term. So in this forecast, you do see that, and we're disappointed in it, but we still feel that the future is -- that it is a strong area for us in the future. So we're going to continue to hold the course.

Thank you very much.

Daryl Pardi of Merrill Lynch. You may ask your question.

Hi, good morning, guys.

Good morning, Daryl.

Doug, what gives you the confidence to get on the call today and to say that you expect that broader adoption of ACQUITY could happen in the second half of the year? I know we've been -- it is something, a trend you've been talking about for six to eight months that ACQUITY sales have been primarily to individual users in core chromatography labs and there has certainly been a lot of excitement about it in the market but it seems that you have a bit more confidence in when those larger orders and broader adoptions could be coming.

Yes, Daryl, I think it is -- first, I mean let me be clear that we're very happy about the sales and orders growth in ACQUITY. It's just been very strong. To some extent, it's surprising that it has been so strong without giant orders coming from our traditional good -- large pharma accounts. The reason why you hear us talk constantly that this is going to happen is because it is what our customers are telling us. Boy, I can't tell you how many groups of scientists from each one of these accounts has been into our offices and bringing delegations in to look at our plans, look at where we are, and to share with us what their plans are. And I don't think they're lying to us when they talk about the fact that they're almost prepared to move whole areas of their laboratories to ACQUITY technology. It is just that it is because it is such a major investment for them, and because it cuts across groups of laboratories and locations, that it has taken longer for them, particularly when they're faced with major capital control issues at their home offices.

So I think that there is that -- I don't think we can be misreading those signals from our large accounts. I frankly had expected that we would have seen a bit more of it by this point, but the number of those kinds of interactions with these large accounts is only growing. So that's why we're -- we feel pretty confident that it is coming. We think it is coming soon. And we think it is going to be a major impact on our ACQUITY business.

John, the lower tax rate in the quarter, is that primarily the result of higher production to Ireland?

Yes, I mean within Ireland, I mean we have the Quattro Premiere XE production lifting up, but we also have Europe coming back, being a bit more -- a higher contributor to volume sales than we would have thought, U.S. a little bit less, so it is really just tweaking, I will say, our expectations as to where profits are generated and in the new world order here, of Sarbanes 404, and just keeping on top of forecasts and understanding the tax ramifications quarter by quarter, these are fine tunings that might have been done at year end where as you're really required to look at this in a lot more detail in a quarter by quarter. So I feel the 19.3 is a sustainable rate. And again, really just based on fine tuning production and profit levels around the globe.

Okay. But 19.3 is for the full year of '05, correct?

Right. So each quarter, we have to do a projection of what the profitability will be for the year. And then in the quarter where you make that assessment, you have to catch up in that particular quarter, so the benefit of that 19.3% full-year tax rate is -- you're afforded two quarters of that, if you will, of adjustment in the second quarter, thus the penny, and probably about another penny of benefit in the second half.

Okay. That's what I was going to get at. Okay. So -- because that does imply a tax rate slightly below 20% for the second half of the year?

That's right. That implies a 19.3% rate for Q3 and Q4, again before any impact from the American Jobs Creation Act.

Okay. And actually that leads into my next question. What will the repatriation of funds do and any subsequent debt reduction due to your net interest expense in future periods? It looks like you're no longer earning more on your overseas cash than you're paying on the domestic debt.

Yes, I would say as we look at the second half, it is probably fair to think that we're going to be in a position where we will have a net interest cost each quarter, somewhere between maybe 1 and $2 million a quarter would be my best estimate at this stage, and we have that factored into our guidance.

And interest cost of 1 to 2 million per quarter?

Right, for Q3 and Q4. So about 1.5 million a quarter, roughly. So 3 million net interest costs in the second half.

Okay. Great. Thanks. I will get back in the queue.

Okay. Thanks.

Steve Salamon of Infinium Capital. You may ask your question.

Yes, thank you. If I could just follow on Daryl's line of questioning a little bit, with respect to ACQUITY, if you could give us maybe a little bit more color in terms of how the ramp is progressing, presumably you've talked about an evaluation process, presumably that leads to requests, is there anything that has come out of those requests that is really going to -- that you need to deliver before things get going? And can you give us a sense by end market who is buying and who is evaluating and maybe down to the granularity of the different parts of pharma in terms of who has actually gone to the point of buying versus who is evaluating, and--?

Sure, I mean I think the overall impression you should get is that people are buying ACQUITY across the board in kind of all trade classes, and almost all applications. The level of -- the level of optimism that you hear in our voices concerning the future is largely driven off ethical pharmaceutical accounts. And they are the companies that gear up to do side by side evaluations, they look at how many HPLC's they have in QC, they look at the kind of productivity that they can get coming out of an investment in ACQUITY. That's where we see the real long-term strategic interest in major adoption of ACQUITY technology. If you look tangentially to that, we're seeing that over 30% of our mass specs are going with ACQUITY technology now.

So the combination in this promise that we've had for years about our ability to link novel HPLC or UPLC technology with our mass spectrometry technology I think is bearing out. So you see a lot of ACQUITYs going down in various applications, in industrial applications, food safety applications, and in pharma discovery and QC applications, with this combination of ACQUITY UPLC and mass spectrometry. So if you look at our building momentum in mass spec, a piece of that is clearly due to good mass spec technology, but a piece of it is good that that system combined with UPLC is clearly superior in the circumstances. So that's kind of the broad look at it.

Okay. If I could just ask one other quick question. Could you give the break down of HPLC growth by instrument, consumable service, if you haven't done that already?

Yes, we can do that.

Yes, for the quarter, we had -- let's see. HPLC breaks down into instrument growth of about 10%, chemistry growth of about 11, and service at about 11% as well.

So pretty even. Thank you very much.

Pretty even.

Derik deBruin of of UBS, you may ask your question.

Hi, thank you. Could you give us a specific number for the ACQUITY sales? You said it was about $15 million in the first quarter.

Yes, we can. Although you know, this is going to get blurrier as we go forward. In terms of system sales, and what have you. But we -- our sales of ACQUITY systems were about $23 million for the quarter.

Okay. I noticed that -- you seem to be talking a little bit more about acquisitions recently. Could you just give us a flavor for what type of analytical instruments you would be looking for? For example would you be looking to expand your mass spec line perhaps from FTMS products or just an idea of how you're thinking of what does Waters need?

Yes, we largely continue to say this because it is a potential use of cash, Derrick. We -- as you know we haven't been inclined to make large acquisitions. Principally because we don't think we need to take undue risks to sustain long-term double digit growth in our business. And to make a large acquisition that dilutes our growth rate to me doesn't make a lot of sense. So we're more focused on smaller, either add-on acquisitions, or product lines or technologies that augment our existing businesses. There is no question that there is some related mass spec technologies that are not under our umbrella currently, that we would certainly be interested in adding, but most of those are part of broader organizations that either are not currently available to us. So we look at ways to try to get into those technologies on a independent development basis, or through licensing and other methods. I wouldn't have you believe that we're typically looking at large scale acquisitions, we're more comfortable dealing with things that are easily digestible within our organization, and that's likely to be what we're going to continue to do.

Okay. Looking at the spending environment in pharma, and just the discussion about the capital budgets being released, now, are you hearing any noise whatsoever about people being worried about their budgets being cut or they're not getting -- they're worried about getting their money?

No, we're not. But frankly, when you are talking at the researcher level, nobody ever really believes they're not going to get their money. So I'm not sure how relevant that is. I think maybe what is more relevant is what we've seen in past cycles like this. Where -- does a poor capital release in a first quarter come back and show itself in higher releases later on in the year. That's clearly what we saw last year. We saw top conditions early on in the year, and then we saw a much more conducive environment late in the year.

I can tell you that as we've gone and looked at previous cycles, we have seen that kind of behavior. I mean what's interesting, I think, to an investor, is even though our large pharmaceutical customers have been operating in at best a flat environment for us, we're producing on a broad scale double digit growth in broadly-described pharma, biotech, generic, et cetera. So I think if we do see what we think is possible, of a pickup in these budgets later on in the year, we are optimistic that we can leverage that in good performance.

Great. Thank you very much.

Tycho Peterson of JP Morgan. You may ask your question.

Thank you for taking my call. I think the last quarter you had talked about columns being a little bit weak in Asia. Has that washed through at this point?

Last quarter we were talking about column performance that was slow generally. In Asia -- Asia sometimes you see this lumpy column business, because you have accounts that buy a year's supply of columns together with an instrument order. But I would say in general, our consumables performance has been -- has returned to very good performance across the world. We're very encouraged by this next generation X bridge launch that we just brought to the market. Early indications from customers are ecstatic about the performance of this technology, and I think we're really pleased with the ability of our chemistry business, or particularly the marketing and development arms to really now compress the amount of time between generations of chemistry products.

This -- we're bringing a new generation of chemistry products to the market much faster today than even five years ago, and that really puts us in a strong competitive position in this marketplace. And when you couple it with ACQUITY and new mass spec technology, it really makes the price of poker high to compete in this world. So I think that's a very -- you've heard me talk over the years about how well positioned we are with this instrument software chemistry capability that is second to none in the industry, and I think our new product launches really punctuate that promise very strongly.

Okay. And then I guess with regards to the instruments, are you still seeing about a third of the ACQUITY systems have mass spec pull-through? And is that a reasonable run rate?

That's a reasonable, yes, position.

And then finally, just a broader question on some of the industrial testing opportunities and the outlook for that business, it seems like there is a lot that you are tapping into and potentially could be tapping into going forward in the food and beverage analysis, et cetera. How should we think about the kind of growth in that business over the next two to three years say?

Well, I would say we still think that there is a lot of legs left in the food safety applications. In the United States, and around the world. There is no question that the regulators are, if anything, more aggressive on food analysis, pesticide residues, drinking water analysis. We interestingly didn't have that great a quarter in that area. We had a particularly strong quarter in the second quarter of last year. And so we're up against a tough comparison. But if you look at the lead generation work, and you look at the seminar activity go on in food safety, it is still driven by Asia, driven by China, Japan, and the people who are exporting particularly into the EU, there is a great deal of long-term opportunity there, and I think that is going to drive that application for the foreseeable future.

Okay. Thank you.

Steve Unger of Bear Stearns, you may ask your question.

Question, what have been the total ACQUITY shipments to date? I think you have given us that number in the past. And then could you comment on the success you're having in the core QA/QC area with ACQUITY?

Sure. In terms of the QA/QC area, I would say that's where probably the most -- when we talk about pharmaceutical customers, we're looking at the long-term implications for their business, and looking at wholesale changes to ACQUITY technology. That's where a great deal of this very large opportunity exists. And interestingly enough, it is where we think, regardless of what these large pharma might be doing to their R&D budgets, or their R&D capital, that we can drive ACQUITY into these applications because it is all productivity-related in these accounts. And there is no question that they are all addressing productivity and through-put advantages in their QA/QC operations. And John, you want to handle the ACQUITY?

Yes, on the ACQUITY system, the system orders that we've -- shipments, I'm sorry that we've had to date we had last year about $32 million in the second half of the year and through the mid year this year we've talked about $38 million worth of shipments.

What about just the absolute number of installs?

We have not communicated that for competitive reasons.

Okay. And then the split, could you give us the revenue split between product sales and service sales that you provide in the 10-Q?

Service sales -- I don't have that right in front of me, but it is not dissimilar from what it was for 2004. So service sales will be roughly 20, 25% of our business.

Okay. And then you mentioned that there was some solid orders for the protein expression system. Could you comment as to where you're selling that system to right now, and where you're targeting?

Well, sure. I mean we're selling it into proteomics broadly described applications. And I'm not sure, I guess we are selling them into large pharma, some of the largest pharma have invested in it, as well as what you would call more biotech kind of startup kind of applications. I think they -- I think some of -- maybe the anecdotes are that some of these customers that have invested in competitive technologies are describing situations where the -- it is hard to keep those systems running, there is a lot of start-up problems or issues, or -- and so they're coming back to Q-Tof related technology in some instances, and their ability with protein expression to get both qualitative and quantitative information in the same run at a higher level, is I think probably what has got them strongly interested in buying these systems.

Okay. So that's more of a commercial customer at this point than an academic customer? Is that fair to say?

Yes, I would say that's the trend that we're seeing.

Okay. Great. Thanks.

John Sullivan of Leerink Swann. You may ask your question.

Thanks for taking the question. Just a quick one. First of all, share buyback in the quarter exceeded free cash flow. Is free cash flow a relevant metric for investors to watch when thinking about your share buyback activities in upcoming quarters?

Sure, it is a relevant metric, John, but I wouldn't say that we necessarily are limited to free cash flow. I think clearly our ability to generate at least the term that I use is free cash flow, which is operating cash less capital expenditures, we generate more cash flow pound for pound than anybody in the industry, and we're growing it faster. And so that gives us a natural ability to use more cash for things like cash buybacks than maybe others. We have tended to make our annual cash buyback to be somewhere around our annual free cash flow generation. Although I wouldn't say that we are necessarily limited to that. And the Board of Directors is constantly evaluating what we can do with our cash, and I would say we generally have looked very favorably upon using it to reacquire shares, and our general tendency is then to do that in an accelerating rate rather than a decelerating rate. So that is kind of the lay of the land as we look at it now.

Thanks. Thanks very much. Separately, can you talk about what you think it will take for large drug companies to release their 2005 capital budgets, those that have been perhaps slow to do so so far? Is it primarily their confidence in their own business? Or is it another primary consideration in your eyes?

I think it is largely internally driven. And interestingly enough, this is not a homogeneous dynamic across our business. I mean we have some large pharma accounts that are growing very nicely this year. And others that are down significantly. So it is not a peanut butter, but in general, all of that the layers itself out in a flat performance and it's part of our largest pharmaceutical accounts. So if you look at the ones that are down, I would say our take of that is that they're looking at their internal performance, their internal results, many of them have projects going on that are -- that they need to apply resources to. And it is hard to break orders out of that if they're under strong corporate constraints.

Now, we -- that is not to say we don't get large orders out of those accounts, none of these accounts have gone anything near zero, but they've gone to more of a replacement cycle I would say in their instrument procurement. And frankly, I just don't think that can hold up for too long. We've never seen that maintain itself for years at a time. And that's part of why we believe that we're somewhere towards the end of this cycle. But it is hard to call it quarter to quarter.

Thanks very much. My last question refers to something you mentioned in your opening remarks, you said orders for mass spec at the end of Q2, were strong. And I'm wondering if that is an annual effect to any extent? There are a couple of important trade shows in the first part of the year. End of second quarter -- is end of second quarter a traditional point in the year where you see backlog building?

Traditionally not. I mean certainly ASMS happens either in very late May or early June every year and so you definitely do see some customers perhaps waiting for anything new that comes out of ASMS, but frankly, we haven't seen that to be a really strong influencing factor in prior years. I will say that I think ACQUITY and their desire to see what ACQUITY means with these new products was some element of this evaluation, I think, as some of them wanted to see our new products accompanied by ACQUITY. And I do think we saw some just natural building of momentum in a number of these applications as we went through the quarter. We did see a rush of orders late in the quarter. And that happened around the world. It wasn't just a particular geography. So it is kind of hard to take that and extrapolate it totally through the rest of the year, but generally, what we're seeing is some strong signals in these mass spec applications.

Thanks very much for taking my questions.

Tony Butler of Lehman Brothers. You may ask your question.

Thank you. John, could you comment about the service sales revenue growth for the quarter and that comparison also to Q1? And secondly, Doug, could you comment as to how pricing and/or perhaps -- and the increasing need for discounts has affected this quarter and what those trends are going forward? Thank you very much.

I think the service revenue at 11% really just puts us back on what we've always thought of our service business as being a double digit top-line revenue grower. I think the first quarter was a little bit of a point off of a line, with sub double digit performance, and I think what we're seeing with the second quarter is just a continuation of the trend in that service growth that we anticipate will continue as we move through the year. That service revenue growth is really pretty much all unit growth, if you will. There isn't -- it wasn't caused by a price increase. We do try to eke out some amount of price increases year-over-year on these products but it is generally fairly small versus volume impacts and I think as you look at the gross margins, you can see overall that outside of a small impact this quarter from reducing inventory, even in a more difficult economic environment with large pharma, we're still able to hold pricing on products, and I think,as you look at some of our newer products that are out there, at either premiums or high margins I think the trend on margins generally speaking would suggest that we will see a bit of improvement as we go through the year, and I don't foresee there being pricing discount problems that we will be facing.

Thank you.

Sure.

There are no further questions at this time.

Okay. Well, thank you all. I appreciate you taking the time. And we'll look forward to seeing you on our next conference call. Thank you, operator.