Waters Corp (WAT) 2006 Q3 法說會逐字稿

Good morning and welcome to Waters Corporation third quarter financial results conference call. [OPERATOR INSTRUCTIONS] This conference is being recorded. 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 third quarter financial results conference call. With me on today's call is John Ornell, Waters' Chief Financial Officer, and Gene Cassis, the Vice President of Investor Relations. As is our normal practice, I will provide an overview of the third quarter results, then John will take you through the financial details and lay out our fourth quarter estimates and the full-year 2006 outlook, and finally we'll open it up for Q&A. But before we begin I'd like John to cover the cautionary language.

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 Q4 2006. 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, 2005 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 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 January 2007. During this call we will be referring to certain non-GAAP financial measures, a reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures attached to the Company's earnings release issued this morning. In our discussion of the results of operations we may refer to pro forma results which exclude the impact of restructuring or other one-time charges.

Thank you, John. Well, I'd like to start by noting that our performance in the third quarter was in many ways a continuation of what we saw during the first half of the year. You will recall that through the first half of 2006, our sales growth before currency impact was 9%, and our adjusted earnings per share were up 21%. Our third quarter was incrementally stronger with sales up 10% and our adjusted earnings per share up 26%. Even more significant than these good results are the encouraging underlying dynamics that supported our growth.

First, and I think by far the greatest significance, was the improvement that we saw in our Waters division business in the United States. You may also recall that for several quarters weakness in our large pharmaceutical accounts has restrained sales growth in the United States, and as a result and despite strengths in other market segments outside of big pharma, the overall U.S. business has hovered around a flat growth rate. Well, that changed in the third quarter as we saw the improvement we had hoped for but were somewhat hesitant to forecast. Our larger pharmaceutical accounts began to release capital budgets and started to buy instrumentation at a faster pace in the United States. As a result, our U.S. Waters division sales grew at a low double-digit rate in the third quarter, a significant improvement and an encouraging sign that we may finally be seeing the bounce in our big pharma business from the weak conditions we have experienced for the past year or more.

Outside of the U.S., the Waters division continued its positive momentum. Asia, particularly India and China, recorded strong double digit growth, and we don't see any signs of a let up in these regions. Europe had another quarter of solid growth with notably strong results from eastern Europe, where investments in pharma-related businesses, as well as food and environmental testing, are key business drivers. Of particular note in the third quarter is the success of our systems-based selling strategy. Employing both our proprietary Acquity UPLC technology and our workhorse Alliance HPLC platform we have been successful in configuring comprehensive systems solutions to meet the needs of our customers. Our

Acquity technology has been especially valuable to researchers and Acquity-based systems continue to drive our overall LC and LC/MS system growth. More recently we are seeing greater uptake of Acquity technology by customers in productivity-focused labs such as those working in CROs and generic drug manufacturing. In the third quarter our Alliance system sales growth was also strong and concentrated among customers in pharmaceutical QA/QC labs where established and regulated methods dominate the instrumentation usage. In the fourth quarter, and moving into 2007, our higher end systems offering will be significantly enhanced as we begin to ship our new tandem quadrupole and Synapt HDMS mass spectrometry system.

Our Synapt HDMS technology continues to attract customer interest with its unique ability to characterize molecules based on a combination of accurate mass measurements and molecular shape. Our chromatography consumables and service businesses are very attractive and profitable, recurring revenue business segments for us. In the third quarter these businesses in total delivered double-digit sales growth. This growth resulted from increasing penetration of proprietary Acquity columns and exceptionally strong demand for our oasis brand sample preparation cartridges that are used for clinical drug development analysis.

Now I would like to say a few words about our TA Instruments division. During the quarter, TA laid significant groundwork for future business expansion. In August, we announced our entry into the field of microcalorimetry with the acquisition of Thermal Metrics AB, a Swedish company with advanced technology useful in drug discovery applications. And during the quarter TA also introduced three new differential scanning calorimeters, further raising the performance bar to broaden its market leadership in this important instrument category.

However, during the quarter sales growth for the TA division was flat, as shipments did not keep pace with orders and some softness was encountered in developed markets. We are confident that the third quarter sales growth is not indicative of any significant shift in the market, and our indications suggest that we will see a return to the higher growth rate that we saw earlier this year. Our precurrency performance for our nine months year to date has leveraged a 9% top-line growth to achieve over 20% growth in adjusted earnings per share. An important factor in achieving this leverage has been our focus on productivity programs, our global manufacturing strategy, and our careful control of operating expenses. We will continue our efforts to leverage our worldwide infrastructure by planning to grow our expenses at a slower pace than our expected sales growth. On the investment front, we remain committed to deploying our cash on both targeted M&A opportunities and share repurchase programs.

So in summary, we're pleased with our third quarter results, nearly all aspects of our business are moving in a positive direction. On the market side the positive trends that we encountered in the first half of the year continued into the third quarter, and, in fact, were accompanied with improving pharmaceutical customer demand. In addition, our new initiatives especially Acquity UPLC continue to do well and we feel we are poised to build on this success in the fourth quarter of this year and into next year as we broaden our systems offerings with new mass spectrometry instrumentation. All together, we're excited about the opportunities in front of us, and we believe we're poised to continue to deliver strong financial performance as we look toward 2007. And now here's John with a review of the financial details.

Thank you, Doug, and good morning. We are pleased to report third quarter results of 10% growth in sales and 26% growth in non-GAAP earnings per diluted share at $0.54 this quarter compared to earnings of $0.43 last year. On a GAAP basis our earnings included a small restructuring charge related to the tail end of charges from our February restructuring initiative and FAS 123R stock option expense, including these expenses earnings per share were $0.49 for the quarter.

Looking at sales growth before currency effects, our sales grew 10% versus last year, and while currency had a small positive impact, it contributed less than a full point to overall sales growth. Looking at corporate sales growth regionally, our sales results were positive in our major geographies with strong sales in Asia where we saw 16% growth in the quarter. Sales within Europe were up 8%, and in the U.S. sales rebounded this quarter and grew by 9%. Sales to large pharmaceutical accounts improved and global sales to smaller pharma and industrial-based customers continued their positive strong momentum.

Looking at quarterly product line revenues, sales of LC products led by the continued adoption of our Acquity UPLC technology grew by 13% versus prior year, and mass spectrometry product shipments were up 3%. Our mass spec growth is expected to accelerate in the fourth quarter as we ramp up shipments of our new single quad products and begin shipments of our new high-end instruments. Our thermal analysis business had an unexpected slowdown in Q3 and sales were flat versus prior year. However, orders were up and business prospects looked good so we expect to return to positive sales growth in Q4.

Now I would like to comment on non-GAAP margins and expenses which exclude FAS 123R and restructuring charges. Gross margins came in a little better than expected and were up 40 basis points from Q3 last year. This favorable result is largely due to productivity improvements from our global manufacturing programs. SG&A expenses were up 8% this quarter compared to prior year as we continued to make investments of additional personnel to support our businesses in faster growing regions of the world. R&D spending growth this quarter slowed from the first half of the year as the significant costs of introducing multiple mass spec instruments were largely behind us. All in, operating income for the quarter showed strong growth with operating margin of 24.2%, up 130 basis points from Q3 last year continuing the favorable trend we saw in the first half of the year. Our effective tax rate dropped this quarter and is now expected to be 17% for the year before FAS 123 expenses. The rate drop is the result of additional manufacturing volume at our offshore production facilities. On a GAAP basis, our full-year effective tax rate is expected to be 15.8%.

During the second quarter, we purchased 1.4 million shares of our common stock for $58 million against our authorized share repurchase program leaving a remaining balance of $56 million to complete the program. Over the last four years we have deployed over $1.5 billion in buyback programs and repurchased over 42 million shares. Cash and short-term investments totaled $512 million, bringing us to a net debt position of $374 million, with our strong balance sheet and liquidity we believe we have adequate flexibility to fund future working capital needs and acquisition opportunities. Cash from operations after funding $14 million of capital spending this quarter was $48 million. Accounts receivable day sales outstanding stood at 68 days this quarter, down 6 days versus Q3 last year.

While strong collections performance aided cash flow this quarter, inventories grew beyond typical seasonal levels as a result of a number of factors, most significantly by the ramp-up of production of new mass spec products for both customer shipments in the fourth quarter as well as for demonstration purposes. Additionally, we built inventory in LC instruments associated with the transition to Acquity systems from Alliance systems and the move of Alliance production to Singapore. Foreign currency translation contributed to the inventory increase as well. We expect our inventory to decline in the fourth quarter but to remain above historical levels through the end of the first quarter of next year when many of these transition activities should be behind us.

Now I'd like to turn to our outlook for the remainder of 2006. First, I'll talk about the year without FAS 123R expense, then I will layer on the anticipated FAS 123R impact. On balance we believe the underlying growth of the business this year is about 8% with currency expected to be about neutral to full-year sales growth. In the fourth quarter, we expect sales to grow 8%, including about 1 point of favorable currency impact. Gross margins in the fourth quarter are likely to be about equal to last year. SG&A and R&D spending should grow similarly in Q4 as in Q3. At the operating margin line we expect to see an improvement in Q4 of about 50 basis points versus Q4 last year. And we presently expect our effective tax rate to be approximately 17% for 2006 before FAS 123R effects. Net interest expense is expected to be just under $7 million in Q4. The net impact of our share repurchase programs will likely reduce outstanding share count to around 102 million fully diluted average shares for Q4.

Rolling all of this together we currently expect earnings of $0.83 in Q4 and full year 2006 earnings of $2.40 per fully diluted share with the normal tolerance of $0.01 to $0.02 for the quarter and before unusual charges and FAS 123R expense. And on a GAAP basis we expect FAS 123R to be about $0.05 in the fourth quarter bringing GAAP earnings to $0.78. For the full year we expect FAS 123R expense of $0.20 per fully diluted share, resulting in earnings of $2.20 before restructuring charges. Restructuring charges recorded earlier this year are $0.06, bringing expected full-year GAAP earnings to $2.14 per fully diluted share. Doug.

Thanks, John. Operator, I think at this time we can now open it up for Q&A.

[OPERATOR INSTRUCTIONS] Our first question comes from Tycho Peterson, JP Morgan. You may ask your question.

Good morning and congratulations on the quarter. Wondering if you can give us an idea how much of demand you're seeing particularly in the mass spec side, and I guess for Acquity as well as coming from new lab build out versus a replacement cycle in the existing lab base?

Well, it's hard to get definitive about that, Tycho. I'd say maybe qualitatively we're seeing a lot of new customers and I think what you're seeing with this large pharma dynamic, we're clearly seeing large pharma outsource more of their research in later stage development activity to other organizations. And so we're seeing a lot of that new activity take place. Some of those are relatively new institutions and organizations, and I think that -- so to us those are new. They're not into the same kind of pharmaceutical lab that the big five or ten that we have been used to putting them into. On the same -- not in the same context, but in large pharma we saw this quarter in the -- particularly in the United States, a tick up in what we saw in demand in those more traditional pharma accounts, particularly in R&D. As you know, for most of the last year we've seen demand problems in those accounts. This is the quarter where we have thought, as we moved into the latter half of this year, demand would pick up. It might not make it a totally successful year, but second half versus first half was likely to be better. That's certainly what we saw in the third quarter.

Okay. That's helpful. Then with regards to UPLC there's obviously been a lot of noise in the market between Agilent and then Thermal introducing a product, is it fair that you're not seeing the competitive pressure that you may have anticipated or how do we look at that dynamic?

Well, it's certainly fair to say that others have come into the market following the UPLC success. And -- I guess I can only say that I don't think that the competitive introductions have had a material impact on the performance -- the sales performance of our UPLC. We have just come through a series of technology seminars. As a matter of fact, they're still going on. But we've had hundreds of customers come through here, just in the last month and a half or two months, and unsolicited we continue to get from those customers that nothing touches the UPLC pro forma. So I think we're still in very good shape. No question that others are out there touting their own instrument's benefits, but we don't think when they're run side by side and when customers really are determining what they're going to bank on that anything matches UPLC at this point.

Okay. Thank you very much.

Derik De Bruin, UBS.

What was the contribution from the acquisitions during the quarter? Just trying to get to the overall organic growth rate.

It was less than 1%. It was about 0.7 of a percent, thereabouts, on the top line, and marginal on the bottom line. It was positive, which is a little bit better than we forecast, but it was immaterial.

Okay. And I guess, as you start looking into 2007 and trying to look at the pharma spending, certainly Pfizer was talking about particularly reducing -- controlling costs. I guess -- just remind us in terms of how the budget cycle goes when people start looking at the capital expenditures. Is that in negotiation now and then they release the budget in the March/April time frame? Just refresh us on that process.

For almost all of big pharma, almost all of them have calendar year ends. So their budgets, essentially get set in the fourth quarter of this year for next year, and that's been true for as long as I have been in the business. The issue as it -- and that tends to be a very solid process as it relates to operating expense budget and revenue plans.

What we have seen in recent years is that the -- in the capital budget, it gets set at the same time as part of the same process. But what we really have seen is that those capital budgets are really much more tightly controlled as they relate to spending releases. And so while they may represent the true wants and prayers and hopes of that organization, they are much more careful about actually approving the capital spending early on in the year. So while they may say they have a capital budget of $800 million for one of those large pharmas, they really operate quarter to quarter with their releases, and they monitor their behavior and tend to push off spending into the latter parts of the year. Now, obviously they don't push all of their spending off, but they've been much more cautious about seeing what their business is producing and evaluating other risks before they put major capital spending initiatives into place.

Would you think that this year could be a little bit trickier just because of all the questions about the upcoming election?

2007, you mean?

Yes.

I wouldn't say it's impossible, but we've had pretty weak capital spending out of these accounts for the last year. I believe we're pretty close to reaching a kind of replacement threshold in many of these accounts. So I won't say it's impossible to be a little tougher, but we don't anticipate that it's going to get materially worse.

Great. I'll get back in the queue. Thank you.

Quintin Lai, Robert W. Baird, you may ask your question.

With respect to Acquity with the customers that are using it now are you seeing any type of productivity increases on their side -- as it relates to you maybe more usage of columns for installed base?

We're certainly seeing customers report productivity improvement. In most cases, dramatic productivity improvement. I would say that the issue -- and we're seeing Acquity columns ramp up significantly. So on both fronts, we're very pleased. I would say that the application today, the preponderance of Acquity applications are generally not in high volume QA/QC applications. They're still more centered on R&D, high sensitivity type of applications. So we're on the front end of penetrating the high volume applications that use a lot more columns. So we're seeing some of that, but I'd say we're on the front end of that wave, and likely to ll more of that over the next year or two.

Okay. Thank you. Then with respect to acquisition front, the Thermal Metric deal for microcalorimetry looks very interesting, looks like there's nice growth dynamics off of a small base. Are there a lot of deals like in that your space, and do you anticipate continuing to do these type of niche deals?

I would say we are very interested in these kinds of deals. I mean, if you look at what I have said for several years now, what I call the industrial instrument space, kind of away from the life science, pharmaceutical basin of traditional stronghold in LC and mass spec, we look at these industrial technologies that would fit nicely, particularly within the TA Instruments sphere, and serve as either bolt-on product lines, which we have done, or little increments to our technology, thermometric certainly is different from the core calorimetry product but obviously very related. So a lot of our expertise carries over into that sphere. I'd say that area, we're always interested in the consumable space, particularly the proprietary consumable space, and services and support activities, and we're, I'd say, actively looking at opportunities in all of those areas. Just to differentiate, we tend not to be interested in significant horizontal expansion of our technology.

Thank you very much. Congratulations on a nice quarter.

Thank you.

John Sullivan from Leerink Swann, you may ask your question.

Hey, guys. Good morning. Couple of quick ones. First of all, John, can you just go over again, what was the LC transition that was part of the inventory build in the third quarter?

Yes, we have a situation obviously where we've got customers moving from Alliance-based systems to Acquity-based systems, nano Acquity, so on the demand planning side it gets a little trickier in the quarter as we manage that, but more significantly than that is the fact that we have got Alliance production being transferred to Singapore. So as we do that we obviously need to build up safety stocks of the Alliance product here and then burn them off as we go through the next couple of quarters as Singapore ramps up. So it's that entire process that I'm describing.

When would you expect Singapore to be fully up and running and have this inventory issue behind you?

I'd say we expect it to be fully producing the Alliance this quarter. There will be some safety stock that we'll keep just to ensure that there isn't an interruption of some sort, and by the end of the first quarter that will go away.

Thanks very much. Then one more question. Can you estimate the percentage of your Alliance installed base in pharma QA QC where you are selling consumables for use with the product?

I'm sorry, I didn't get that.

Could you repeat that, John, please.

Can you estimate the percentage of your Alliance installed base in pharma QA QC where you are selling consumables for use with the product?

Probably 50% would be our best estimate. It's a tough one to call, but somewhere in that range. Let me just clarify the inventory situation as well, that will decrease in the fourth quarter, then the remainder of the issue will be eliminated by the end of the first quarter.

Thank you.

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

Good morning. Just first questions, could you talk about the growth in the mass spec business in the quarter? Was that primarily the roll out of the single quad or something else?

Our single quad was available for sale and did perform in the quarter. Our new triple quad and the Synapt did not ship in the third quarter. Won't ship until the fourth quarter. So if you look at our business in the third quarter for mass spec the only thing new in that quarter was the single quad.

Okay. And then are you expecting growth in the mass spec business to accelerate in the fourth quarter and into 2007?

Yes, we are. With the new triple quad and the new Synapt, we are expecting our mass spec business to accelerate. I think it's fair to say that all in, when we make our financial forecast for the fourth quarter, while we're still being a little bit cautious, as we look at the fourth quarter, in terms of how much we take to the bank, but I think it's fair to say that we clearly expect our mass spec business to perform better in the fourth quarter.

Okay. And then without pinning you down, I guess, in terms of next year, what do you think will be a greater contributor to growth for the Company, the mass spec business or the LC business?

Well, I think a couple of points. Number one, it's getting harder and harder to differentiate an LC business and a mass spec business. We're clearly involved in selling systems, and while not all of our HPLC systems go with a mass spec, almost all of our mass specs go with an LC, particularly more and more an Acquity HPLC. So it's getting harder and harder to just split these babies down the middle and talk specifically about one product line or another product line. And I think you'll see us more talk about applications. Certainly something like the Synapt is going to be individually significant enough that we'll take you through that. But more and more we're going to be talking about biomarker discovery that's going to be a systems approach, as opposed to whether it's a mass spec or an HPLC.

If you look at the dynamics driving our business, and why we're optimistic about next year, fundamentally, we've got two technologies that are significantly improving the position, vis-a-vis the marketplace. The continuing strength of Acquity, both in its normal configuration, as well as nanoAcquity for bio applications, and the full year effects of a brand-new triple quad, a new single quad, and the high end Synapt HDMS. So if you look at total revenues it's still likely that when you peel back that onion you would say total revenues will be leveraged more on the LC side of that equation rather than on the MS equation. If you look at growth rate I think if you peeled it back that way you would say the mass spec element there is likely to contribute. But both of them are going to be, I think, significantly stronger on average in '07 than they have been in '06.

Excellent. And then just one quick question for John. The stock options expense for next year, should that be going up or down? I know you did some accelerated investing.

I'd say on that front to the extent that we continue our granting practice, which we expect to, consistent with this year, we would expect over the next few years that that expense would come down slightly, probably $0.01 or so a year for the next few years as we get the benefit of the new granting program versus the old. So it directionally is going to come down a bit.

Congratulations, guys. Great quarter.

Thank you.

Derik De Bruin from UBS, you may ask your question.

Just a quick follow-up. John, could you just run through the EPS guidance again for the rest of the year?

Yes. We're saying for the fourth quarter that we're looking for earnings of $0.83 before accounting for $0.05 of FAS 123. So $0.78 on a GAAP basis. And for the full year then would get you to $2.40 on a pro forma basis $2.20 with 123, an I said there's about $0.06 of charges associated for the restructuring that will bring the full GAAP number down to $2.14 from $2.20.

Great. Thanks.

Sure.

John Sullivan from Leerink Swann, you may ask your question.

Hey, guys, quick follow-up. Some of your competitors talk about the growth and the strategic benefit from lab instrument services as a business going in to do labwide maintenance and calibration, and validation, things like that. Are you considering expanding your service offerings in this way?

Generally no, John. One of our strengths is that we stick reasonably close to our knitting. We -- we understand our HPLC business and our mass spec business. We have focused on that, our customer surveys continue to rank us extraordinarily high in terms of our knowledge, service, and support in basically keeping them running. So -- and as a result, frankly, our service and support revenues grow at or above our corporate average. So we're very happy with our approach here. We think it differentiates us. We're clearly the only people who can service and support our new products, like Acquity, like Synapt, so we're pleased to stick with that strategy and think that it's paid off for us very well in growing our market share.

Great. Then John, can you just repeat the cash flow number in the quarter and the CapEx number in the quarter?

Yes. We had cash from operations, 48 million, which included 14 million of CapEx. So 62 before CapEx.

Thanks very much.

Yes.

At this time there are no further questions.

Okay. Well, thank you all for being with us this morning, and we'll look forward to talking to you in January. Bye-bye.

This concludes today's conference. Thank you for attending.