Waters Corp (WAT) 2013 Q3 法說會逐字稿

Good morning and welcome to Waters Corporation third-quarter 2013 financial results conference call. All participants will be able to listen only until the question-and-answer session of the conference. This conference is being recorded. If anyone has any objections, please disconnect at this time.

I would now 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. Well, good morning and welcome to the Waters Corporation third-quarter financial results conference call. (Technical difficulty) Art Caputo, the President of the Waters Division, and Gene Cassis, Vice President of Investor Relations.

As is our normal practice, I will start with an overview of the quarter's highlights; then John will follow with details of our financial results and provide you with our outlook for the fourth quarter.

But before we get going, I would like John to cover the cautionary language.

During the course of this conference call, we will 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 Q4 2013.

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, 2012, in part one, under the caption Business Risk Factors, and the cautionary language included in this morning's press release and 8-K.

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 call and webcast is currently planned for January 2014.

During this call, we will be referring to certain non-GAAP financial measures. A reconciliation of the non-GAAP financial measure to the most directly comparable GAAP measure 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 exclude the impact of items such as those outlined in our schedule entitled Quarterly Reconciliation of GAAP to Adjusted Non-GAAP Financials included in this morning's press release.

Well, thank you John. Well, our constant currency sales growth rate in the third quarter was 4%, which was a slight improvement over the second quarter's performance, but clearly moderately below our expectations.

Earnings per diluted share were up 1%, again an improvement from our earnings picture in the second quarter, but still significantly lower than what we have typically delivered. That was due primarily to currency headwinds and somewhat slower organic growth.

In comparison to our business in the second quarter, we saw a slowing of demand from our global pharmaceutical end markets in combination with a strengthening in chemical analysis segments. The stronger demand for industrial chemical applications was most apparent in the very strong sales growth that our TA instruments division achieved in the quarter.

In total, instrument system sales were up 2% and our recurring revenues were up 6%.

Turning now to analysis of our third-quarter sales, constant currency sales growth for the waters division was 2%. In comparison to the third quarter of 2012, instrument sales were flat and recurring revenues were up mid-single digits. Flat growth in pharmaceutical sales significantly offset a strong quarterly performance from chemical analysis and nonprofit end markets.

Geographically and for the waters division, sales growth in the US was 3%, which included a double-digit decline in government and academic spending. Pharma sales were up low single digits, a slight improvement over our second-quarter results, but not as strong as we had hoped for.

Industrial chemicals spending was healthy in the quarter and up high single digits, due to the continuation of the strength that we saw earlier in the year and indicative of continued but shallow economic recovery.

Sales growth in Europe for the waters division moderated in the quarter in comparison to the first half of 2013 and was up low single digits.

As we saw earlier in the year for Europe, government and academic spending was fairly robust and grew at a high-single-digit rate in the quarter, while our pharmaceutical end-market business decelerated from the first-half pace and finished slightly down. Pharmaceutical weakness in Europe is significantly related to budgetary delays associated with restructuring activities at certain key accounts.

Waters division constant currency sales in Japan were up nicely in the quarter as the pickup in government and academic spending that began to materialize late in the second quarter continued through the third. Governmental supplemental stimulus programs are having a positive impact on our Japanese business. Sectors in Japan which are not associated with governmental funding activities remain under pressure, including industrial chemical and pharmaceutical end markets.

Our quarterly sales growth in China was at mid-single-digit rates and lagged our orders growth rate there. Through the first three quarters of 2013, orders growth in China has been at a mid-teens rate. I think the underlying demand for research-focused systems, especially mass-spectrometry-based, is strong and should be reflected in accelerating shipment volume as we close out 2013.

Sales in India were up modestly in the quarter and demand in that country seems to have stabilized as the large generic drug user base appears to be returning to a more normal buying pattern despite significant local currency unfavorable dynamics.

Our sales in Asian markets outside of Japan, China and India were generally in line with our expectations and grew at a mid-single-digit rate, an improvement from what we saw in the second quarter, but still slower than the typical double-digit growth that we have historically enjoyed in periods of stronger global economic conditions.

Our TA instruments division had a very strong quarter, with double-digit sales growth, primarily based upon strong demand for core thermal and rheology products. Strong sales in the US were indicative of a continuation of economic recovery and of TA's strong market position.

During the quarter, TA continued to augment its technological capabilities in materials characterization with the acquisition of a small, privately-held German innovator in elastomer analysis. Through the first three quarters of 2013, TA's constant currency growth rate is in the high single digits, and the third quarter's strong momentum suggests that a similar growth rate may be achievable in the fourth quarter.

Now I would like to talk about the product line dynamics that we saw for the waters division in the quarter. Our recurring revenues, the combination of service and chromatography consumables, grew as expected in the third quarter, delivering mid-single-digit sales growth before currency effects.

Column sales to pharmaceutical accounts were strong in the quarter, with ACQUITY columns, including our new line of CORTEC columns, growing at a double-digit rate within most regions.

Looking at our waters division mass spec instrument system sales, we continued to see strong demand in the quarter for high-performance Q-Toftechnology systems, including Xevo and SYNAPT platform instruments. New SYNAPT G-2 SI features, which we introduced at ASMS earlier this year, have been well-received for large biomolecules applications, including proteomics and lipidomic workflows.

Our tandem quadrupole system sales for clinical and applied market applications grew nicely in the quarter, while demand for high-end tandems, used in more classical small-molecule drug development, slowed in the quarter due to generally weaker pharma spending and to delays associated with evaluation of new competitive products.

Through three quarters of this year, our MS-based system business is tracking at a high-single-digit growth rate, and our prospects look encouraging as we close out the year.

On the chromatography instrumentation front, instrument system sales growth improved from what we saw in the second quarter, but remain below our expectations. Capital spending delays, primarily from larger pharmaceutical customers, continued to adversely impact new system growth in classical small-molecule research applications.

Looking toward the future, (inaudible) will shortly be talking to you about a very recent product launch that we feel will begin to stimulate chromatography system demand in the fourth quarter and serve as a meaningful growth platform in 2014.

So in summarizing our third-quarter results, overall instrument system demand improved slightly from what we saw in the second quarter. However, a combination of factors, including weak public sector demand in the US, restructuring activities at some of our large accounts and shipment delays that we saw in China, all contributed to a less-than-hoped-for quarterly performance.

Through the first three quarters of 2013, we feel that our recurring revenues, our mass spectrometry growth and TA instrument performance were mostly in line with our expectations. And it has been our chromatography instrument systems, primarily for pharma research applications, which have been weaker than expected.

On the topic of pharma research, earlier this month, we introduced a quadrupole-based detection technology that is specifically tailored to provide more qualitative information to chromatographers seeking higher levels of confidence in compound identification. This new detector is called the waters QDa, and it is no coincidence that the name sounds pretty similar to PDA, our photodiode array, the detection technology that is dominant today among chromatographers, especially those in drug research, requiring more qualitative information as part of the chromatography experiment.

The key features of this new product include a small footprint, ease of use and a price that truly supports its positioning as an LC detector. Scientists using Waters LC, our UPLC instrumentation, can easily upgrade their existing systems by adding a QDa detector.

In addition, customers in the market for a versatile and high-performance new complete ACQUITY system can now purchase a superior instrument which includes both PDA and QDa detection.

You know, the promise of LC-MS for a number of years has been based on the notion that all chromatographers would one day be able to simply incorporate mass measurement into their existing workflows. However, even with all the improvements in sensitivity, versatility and reliability that we have witnessed over the past two decades, the perception persists among chromatographers that mass spectrometry is too complex, big and expensive to be considered a practical LC detector module.

We believe that the QDa goes a long way in changing that perception and will define a new high-end segment for ACQUITY UPLC.

So at this point, we have already booked orders for the QDa and have begun customer shipments. I look forward to updating you with more information on this exciting product launch on the January call

Now before turning it over to John, I would like to say a few words about our nonoperational plans. On the M&A front, we will continue to seek smaller complementary technology opportunities that fit our profitability and growth characteristics. As I mentioned earlier, our TA instruments division completed a small acquisition. In addition, we also purchased a technology leader in software development for interpretation of ion mobility MS separations in the third quarter. Both acquisitions augment our technology portfolio and will accelerate new system introductions in coming years.

Our strategy on the M&A front remains focused on seeking assets that enhance our technology and market-leading positions within the broadly defined liquid chromatography, mass spectrometry and thermal analysis markets.

As you heard me say before, we remain focused on strong free cash flow generation. In the third quarter, we grew free cash flow at a rate higher than sales and operating income, and are on track to generate more than $400 million for the full year.

The key deployment of our cash flow has been toward our share repurchase program and this will likely continue into the future.

In closing, I will reiterate that 2013 has been a challenging year for us. We believe that the slower growth in our business that we have seen in recent quarters can be largely attributed to factors that are external to the Company and not related to the core business strategy that has driven our growth for nearly two decades.

However, we also recognize the need to adapt to changes in market conditions by continuously refreshing our product offerings, by targeting market segments that offer superior growth characteristics and by judiciously managing our expenses to create business leverage. All of these key factors will be considered as we develop our operating plan for 2014.

Now, here is John for a review of our financials and an update on our outlook.

Thank you, Doug, and good morning. Third-quarter sales grew by 4% before currency translation. Currency translation reduced sales growth by 2%, resulting in 2% overall sales growth.

Non-GAAP earnings per fully-diluted share were up 1% to $1.19 this quarter compared to earnings of $1.18 last year. On a GAAP basis, our earnings were $1.14 this quarter versus $1.12 last year, and a reconciliation of our GAAP to non-GAAP earnings is attached to our press release issued this morning.

As I just mentioned, before foreign currency translation, sales were up 4%. And looking at this sales growth geographically, and again before foreign-exchange effects, sales within the US were up 6%, Europe was down 1%, Japan was up 5%, and sales in Asia outside of Japan were up 6%.

On the product front and in constant currency, within the waters division, instrument system sales decreased by 1% and recurring revenues grew by 5% this quarter.

Within our TA instruments division, total sales increased by 15% versus prior year.

Now I would like to comment on our Q3 non-GAAP financial performance versus prior year. Like last quarter, gross margins continue to be negatively impacted by foreign currency translation, capitalized software amortization and a product shift in this quarter towards more Q-Tof instruments versus tandem quadrupole systems.

Operating expenses were up 3% this quarter. On the tax front, a modest shift in production levels and profits favored our tax-advantaged geographies. We brought our effective operating rate for the year to about 14%. Within the quarter, the effect of applying this rate to our year-to-date income added $0.03 to earnings.

In the quarter, net interest expense was $6.4 million and share count came in at 86.4 million shares, 2.1 million shares lower than Q3 last year as a result of our continued share repurchase programs.

On the balance sheet, cash and investments totaled $1.699 billion and debt totaled $1.294 billion, bringing us to a net cash position of about $405 million.

As for Q3 share repurchases, we bought 541,000 shares of our common stock for $55 million. This leaves $423 million remaining on our authorized share repurchase program.

We define free cash flow as cash from operations less capital expenditures plus any non-cash tax benefit from stock-based compensation accounting and excluding unusual nonrecurring items. For Q3, free cash flow came in at $88 million, after funding $17 million of CapEx. Excluded from this CapEx amount is $14 million of spend associated with our new Manchester, UK mass spectrometry facility, which is expected to be ready for occupancy in 2014.

Accounts receivable days sales outstanding stood at 74 days this quarter, up one day from Q3 last year. And in the quarter and as is typical at this time in the year, inventories increased by $14 million.

Now, thinking about the remainder of 2013, we expect conditions will remain constrained for our LC systems business within the pharmaceutical accounts in the fourth quarter. We believe our recurring revenues will provide a foundation of stable mid- to high-single-digit growth in the fourth quarter, resulting in an overall growth rate of around 4%. Foreign currency translation at today's rates is expected to continue to depress sales by about 2% in the fourth quarter.

Moving down to P&L, gross margins in the fourth quarter are expected to be about 59.5%; operating expenses are expected to be up between 2% and 3%; net interest expense is expected to be approximately $6.5 million; and we expect our operating tax rate to be about 14%.

Our average diluted share count is likely to be just under 86 million shares in the quarter. And rolling all of this together, are non-GAAP earnings per fully-diluted share are expected to be in the range of $1.58 to $1.63.

For the full year then, our non-GAAP earnings per fully-diluted share are expected to be in the range of $4.92 to $4.97. Doug?

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

(Operator Instructions). Ross Muken, ISI Group.

I guess as you sort of try to tease out the pharma weakness in terms of some of the different buckets, whether it is generic CROs, emerging pharmas, traditional pharma, where are you sort of most surprised about the trend that you are seeing? And is it a product cycle issue, is it a budgeting issue, is it a timing issue? We are just trying to get a sense for where you feel like that incremental delta versus your expected sort of come from.

Ross, I would say the disappointment that we see in generics has been there for a while, largely driven off India and the struggle of the Indian generic accounts.

Outside of India and maybe the issues with the large Israel generic manufacturer, which has also been slow, the rest of the generic world has been okay.

In the ethical pharmaceutical world, I would say the large dynamic -- most significant dynamic that we are seeing can broadly be characterized as restructuring. And the layoffs that are going on, many of which are focused in R&D, that is certainly where we are seeing kind of the most delays and issues in programs that we had identified through our marketing and sales efforts earlier in the year. They are not lost; they keep just being pushed back.

We don't see big programs there going to competitors, so we don't think it is a market share issue. We think it is just one of continued delays as they struggle with kind of dealing with their own economic issues. I would say that is the main things we see going on in pharma.

And maybe on China, it is interesting commentary. I mean, you are sort of suggesting order rates there continue to be strong, but you are not seeing the pull-through. Is that a distributor issue? Is it a channel issue? Is it a timing issue? Again, I am just trying to get a sense for magnitude. I mean, we saw this with another one of your players -- another one of your peers earlier in the year. And obviously, there has been a lot of noise in that channel overall.

Just trying to get a sense for, particularly on the pharma side, what sort of you think the culprit is in terms of the slow conversions.

Yes, I think the China issue, we really do believe it is more of a short-term issue than a long-term issue. We have seen symptoms like this on the fringe before, but this quarter, it was a more significant issue, really with delays in importation and tax paperwork.

You know, these orders can come through in significant amounts, and so they indicate the real demand and the customer has settled on you and has tendered the order. But in most cases, you can't ship it until there is a valid tax certificate so that the government lab doesn't have to pay a tax or an import tax on that.

For the first time, we saw a number of those kinds of issues push out from the third quarter. To the best we can determine, it was somewhat serendipitous. It wasn't indicative of a government edict coming down. And in fact, we have seen some of those ship early in the fourth quarter.

So we don't believe -- we are watching it very closely. We still have reasonably high expectations for the China business. We don't think there is anything fundamental on the demand side of the equation. But it was a pretty significant surprise to us that those multimillion dollars of shipments that we thought we were going to come that pushed from the third quarter into the fourth.

Great. Thanks, Doug.

Dan Leonard, Leerink Swann.

Great, thank you. On the weakness you are seeing in pharma, how much of it do think represents a secular shift in where pharma is spending money, perhaps a shift from small molecule research to large molecule? How much is that perhaps accelerating versus just something temporary or restructuring?

That is clearly happening, Dan, that they are changing many of their programs from small to large. So we do think we are in somewhat of a shift -- a technological shift.

Long-term, that should help us, because those large molecules are more intensely invested in our type of technologies, particularly high-end mass spectrometry. But it is still at the early phase. They are still, I believe, longing out the replacement cycle in a lot of the small molecule areas. We clearly see somewhat of an aging of workhorse systems in the mainstream QC areas.

And so whether they are ramping up significantly in the bio area, we are seeing a lot of programs, a lot of interest in early-stage programs, but I can't say that we have seen the release of orders that offsets the dynamics that we are seeing in small molecules.

Okay. And then my follow-up, have you seen any opportunities pop up as a result of the healthy capital raising environment in biotech? And if not, why not?

I think we have seen some of that, and that has helped offset some weak conditions in big pharma. But I think a lot of that in those small bio is still early-phase, and they are still not fully investing at the pace of big pharmaceutical companies.

We have seen good results from that segment of the market in our high-end mass spectrometry, SYNAPT and Q-Tof, and we had a good quarter in the high end in that segment of the marketplace. But you don't see quite the same large volume of QC systems that flow into that segment of the pharma market.

Okay, thank you.

Daniel Brennan, Morgan Stanley.

Hi, thanks for taking the questions. Maybe just one quick one on kind of acquisitions and backlog in the quarter. I think you entered the quarter with double the rate of backlog you typically have. Can you just give us an update on did backlog contribute this quarter and was there any acquisition impact in the quarter on the top line?

Yes, there wasn't anything meaningful in the acquisition impact that rounded us one way or the other. And from a backlog perspective, we were able to take down some of the backlog that we had planned in the Waters side of the business.

On the TA side, though, we ended up not quite getting as far as we thought we would. But as you saw in the strength that we had in that business, we ended up with a very good result anyway, and we think there is probably a little bit more opportunity in the TA side in Q4, perhaps not so much with the Waters division, as a result of pulling some of that down in Q3.

But overall, it wasn't quite as meaningful as we had originally thought as a result of some technical issues that were resolved very late on the TA side.

I would say the only dynamic there, Dan, might be as it relates to China. And we were a bit surprised at some of the lags there in getting those certificates that Doug mentioned. And we are hopeful in the fourth quarter that that growth can accelerate, and we don't see it -- we might not get back everything that we put into backlog in the quarter, but I don't think we are going to add to it in the fourth.

Okay. Thanks, John. And then maybe just one on LC. So Doug, can you just comment on kind of the penetration of UPLC today? I think you mentioned in the last questions -- you answered the last question regarding some delays at pharma right now for maybe upgrading for all new equipment.

But just give us an update on kind of where you are with the penetration of UPLC. Is that one of the key issues here that's been a drag on your LC growth, such that you are just not seeing the uptake of UPLC penetration right now, as pharma struggles with some tighter budgets?

Dan, I think it's a very insightful question. The ACQUITY penetration in early-stage R&D and even middle-stage R&D in pharma continues to be very strong. We see no -- very clear that -- our belief that UPLC takes over that market long-term as continues to be strongly indicative by the facts.

The pickup of UPLC in downstream applications continues to be disappointing, I would say. And I think that is also a function of this reluctance to move processes in times of change and restructuring in that industry. Things tend to -- the decision-making tends to slow down. And it is very clear that we have had trouble penetrating into downstream applications with ACQUITY. So I think that has been a factor in this.

I think it has been as much, though, a factor in the whole issue of how pharma views their investments in the various segments of their market, particularly in a period when most of the major pharmas are going through some period of restructuring.

So I think we clearly continued to see very strong results coming out of our consumables business, no sign that that is slacking off. So overall, we are still very happy with UPLC, but we are still struggling with trying to get the downstream penetration.

Great. Thanks, Doug.

Paul Knight, Janney Capital Markets.

Good morning, Doug.

Good morning, Paul.

When do you think that the diagnostics market and the funding occurring there and the technology breakthroughs in that area will start to increase the growth rate of your business?

Well, clearly, the clinical applications, if you look over a five-year period, have been amongst the strongest growth applications for us. Unfortunately, it is still a relatively small piece of our overall revenue base, something a little less than 10% of our revenue base.

I think the encouraging thing is that there are many applications that are being worked on in the field, as well as with us, that offer a great deal of optimism long-term. But they are not ready to break as we speak.

We clearly see much penetration in neonatal screening, in anti-rejection, immunosuppressant drugs. We continue to see a lot of interest and activity in pain monitoring and in drugs-of-abuse testing. Probably even more so, probably see in drug testing more opportunity to move GC applications into broader-based LC-MS applications.

So, I mean, the level of activity grows significantly quarter by quarter, but I can't point to you one specific application that I think is going to dramatically multiply the business in the short-term. There are some promising things, but I think right now, I would be happy with saying we continue to see good double-digit type of annual growth opportunities, but it will still take a while for that to make a dent into our traditional analytical laboratory business.

Thank you.

Doug Schenkel, Cowen and Company.

Good morning. So my first question is over the years, you have developed a well-earned reputation as strong operators. That said, operating income has declined now, I believe, in five of the seven last quarters as organic revenue lags peers. And it does seem like you may be starting to find ways to cut operating spend below levels you have already cut.

Your R&D spend as a percentage of sales is below the typical levels of your peer group. Is there any reason we shouldn't be concerned that a focus on cutting operating spend has maybe started to catch up with you in the form of share loss and potentially inability to maintain price?

I think that the market facts don't -- take the LC marketplace. I don't -- we track in certainly annual context -- which I think is probably the only relevant one, because quarterly dynamics swing around quite a bit -- there is no indication of lost market share. I would say there is more evidence of gradual accretion in market share in our LC business.

So it certainly is a notion that all of us who service the pharmaceutical industry and have suffered through swings in the industrial market have faced the same dynamics, and I don't think we are doing worse. I think the evidence suggests we are doing better. Now, it's doing better in a tough market, I agree.

Certainly in the thermal analysis marketplace, I think the evidence is strong that we continue to gain share.

So that brings us to the mass spectrometry piece of the market, and I think that clearly is a tougher call and that is subject to quarterly swings that can move one way one quarter and another way another quarter. We clearly, with our QDa, think that we are moving things on the analytical benchtop level of the marketplace. We think we have a good, strong offering on the high end.

The area that is challenged right now is that pharmacokinetics, drug metabolism segment of the pharma market that competitors have launched some new products. I think that has introduced some level of reevaluation in that customer segment.

Now, to be fair, we haven't been the strongest players in that segment of the market. Our triple quads have been more targeted at the applied marketplace and the food and beverage segment of the market, where we continue to do well.

So I think -- on balance, I think that is a pretty good picture. I think that the marketplace has suffered and we continue to look to try to manage our resources and our expenses as prudently as we can. Absolutely, when your growth rates are in the low single digits, that is tougher to do than when they are approaching double digits. But we feel that we have an obligation to manage the business as well as we can.

We don't think that we are cutting into the muscle and sinew of our R&D operations. We have always had a very productive R&D organization. And if you go back 20 years, you will see that we have spent less as a percentage of sales on R&D than almost everybody in our industry. And we are not spending markedly less as a percentage of sales today than we were then.

So we think we are right-sized, but we continue to look at all of our projects and we will not be constrained to spend on a major project that we think pays off long-term.

Okay, well, that is really helpful and it is a good segue to my second question. Over the years, you guys have always talked about Waters being a mid-single-digit to high-single-digit revenue growth company. And you are going through a second tough year of coming up a little bit light of that.

With that said, as we look ahead to 2014, the comparisons will be again favorable. You will have a new product that could accelerate demand in LC. So recognizing some positive dynamics but also the recent trends, how should we be thinking about 2014, at least at this point? Is it fair to think of it as a mid-single-digit growth top-line year with the same type of one or two points of operating leverage at the operating line, and with typical buybacks below the line that give you a few more points? Is that reasonable, given recent (multiple speakers) --?

That is certainly our thinking at this point in the process, Doug. I think you summarize it pretty well. We do firmly believe that there is pent-up replacement demand in our biggest customer segments.

Now, our thought would begin to see some of that work its way through. We think 2014 sets up well with that. We have a great new product that I have talked about here. That is not the only set of new products that we will be talking about as we move into 2014. And you are right -- you hate to say a low base prepares you well for the future, but that is the fact. So I think cautious optimism about next year is a fair picture.

Okay, that's great. Thank you, guys.

Tony Butler, Barclays Capital.

Thanks very much. Doug, on QDa, does that actually substitute potentially for a higher-cost instrument? In other words on an instrument to instrument basis, are you actually achieving less profit?

And the second question may be more for John, who I think answered this, but I didn't hear. In Q2, there was a roughly $20 million backlog. Did that all get converted in this quarter, is there still some left or will it not convert? Thanks very much.

Do you want to answer part two?

Yes, on the backlog side, Tony, we did convert the piece that we thought we would in the Waters side of the business. We didn't on the TA side as a result of a late fix to some of the acquired technologies that were in the works. There is a piece remaining that will come out in the fourth quarter per plan.

So in sum total, there wasn't a big difference in expectation versus where we landed, though on the TA side, like I said, there will be a little bit more coming in Q4 than we originally thought.

Thank you.

And in terms of the benchtop quadrupole market, Tony, we and others have sold a single quadrupole mass spectrometer for a number of years.

If you go back and look at when we acquired Micromass in 1997 -- and there are still a few of us left here who were part of that deal -- certainly Art and I would have said that a major part of the strategic benefit to that would be driving mass spectrometry into the benchtop chromatographer marketplace. And early on, we had some success in that, possibly because of its novelty.

But that quickly wore off and really carved out a niche in the purification segment of the marketplace, but never really established a position in the workhorse, day-to-day chromatography marketplace.

So if you look at our single quadrupole sales over the last several years, they have been de minimis -- they have been not a significant part of our market. And they are sold into a specialty segment of the analytical marketplace.

So as we launch this QDa and it is launched that a price point lower than the traditional single quadrupoles, so it is attractive to that analytical marketplace, we expect to get a little cannibalization, if you will, of the existing single quad, but not a lot. It largely is aimed at a new marketplace. We might see a little bit of cannibalization of the high-end traditional optical detector marketplace. But we think for the most part, this is an incremental revenue source with margins that are right in line with our traditional margins. And with a price point that is higher than the high-end optical system sale, but lower than any comparable benchtop mass spectrometer sale.

Does that cover all the bases? Tony? Operator, are you still there?

Tony, your line is open.

Thank you, Doug, very much. It certainly did. I appreciate that color.

Isaac Ro, Goldman Sachs.

Hi, guys. Thanks for taking the questions. I wanted to touch on the pharma dynamic you mentioned specifically with regards to QA/QC portion of the business. Can you put some color there regarding how much of the slowdown there was a function of capital equipment spending and budget delays versus just overall volumes on the consumables front? And the reason I ask is as we look towards next year, I would assume there should be some positive correlation on QA/QC work as it relates to total volumes, assuming healthcare reform actually takes hold. So I am just wondering what happened this quarter and where expectations are going to look like over the next 12, 18 months as volumes potentially pick up. Thanks.

Sure, Isaac. Actually, the QA/QC segment of the business was okay. It was much more of the research side of the marketplace that was slow. And that was certainly true in the consumables side of the business, where samples overall. Maybe a little bit less in India because of the issues facing the generics, but overall, the chemistry business continued to crank along.

So I would say while we are seeing -- we are not seeing the kind of pickup in QA/QC moving UPLC in there, the more traditional hardware is doing fine.

And then can you maybe comment on the forward view for the next -- I don't know -- whether it is the next 12 months or 24, but just thematically, what kind of a view you have regarding the potential benefit to QA/QC volumes as healthcare reform goes through the system, at least in the US?

Well, I think a segment of the QA/QC market that is likely to pick up is India, where most of that business is QA/QC; it is not research-oriented. And we know that there is pent-up replacement demand in India. So they still have to work their way through the rupee, they still have to make their way through some regulatory issues, but we are finally beginning to see some of the near-term interest pick up in India that says, you have got to get back to investing for that marketplace.

I think -- in the US, I don't think that the dynamics are as noticeable as we look at it today. I say what we are expecting is kind of more of the same as we move through the next two or three quarters.

Okay, fair enough. And if I can sneak in just one more, any update on the CEO transition process there? Thank you.

On update on the CEO transition process. I think you have read the announcement. The Board has a very active committee that is meeting very regularly. But we are at the front end of the process, with the senior management kind of committed to seeing this process through to a very favorable conclusion.

I suspect that we won't have a whole lot to talk about maybe for the next six months anyway, Isaac. So absent any unusual events, that is what I would lead you to think about.

Got you. Thanks very much.

Peter Lawson, Mizuho Securities.

Doug, just on the pent-up demand in the pharma replacement, how long can accounts delay purchase and then -- or is that just a structural change that just doesn't return?

It is not a finite answer, Peter. You know, I have seen big pharma over my lifetime here at Waters go from a very formal eight, nine, 10-year replacement, stated replacement cycle on HPLC, to six-year replacement cycles that was either driven by a perception that technology changed or service costs crossed the productivity timeline. It took you too much to keep an existing system operating versus replacing it.

I think what we are seeing now is kind of situational as various companies struggle with kind of what they want to be when they grow up, and you see some companies announcing thousands of people being laid off. In times like that, I think decision-making changes and common processes begin to be torqued one way or another.

I would say we clearly have aging systems in the pharma marketplace that are aged greater than they were three or four years ago. And I just think physics demands that those things build up to a point and then have to be replaced, because the technology other than moving towards UPLC, you are not going to change the process of chromatography as your continued workhorse technology here.

So I am betting and certainly our plans call for that to kick in, and it is a matter of how much and when. But we are pretty certain that it is a dynamic that is going to kick in.

Do you think biotech is just naturally less capital-intensive versus pharma, or essentially are they more efficient; so as pharma consolidates biotech, does that lead to a stepdown in investment?

I don't think so. I think to some extent at different phases of their development, biotech invests in different technologies. That is clearly true on the process side where fermentation technologies prevail versus typical small molecule synthesis technologies.

I think the downstream applications, as particularly when you move into things like biosimilars, really works in the favor of our type of instrumentation where you have to do much greater characterization of molecules as they come off QC to prove that you have got the right molecule synthesized.

So I don't think long-term that we see the investment being significantly lower. We do clearly see it as being more mass spec-centric in the biotech world. But then again, all mass specs require a very strong HPLC or UPLC on the front end.

So I think it is a very beneficial segment of the marketplace, but probably takes a little bit longer to develop from the beginning stages through the full production stages.

Great. Thanks much for your insight.

Amit Bhalla, Citigroup.

Thanks. John, you mentioned in your comments about potential trialing of competitor products in the high-end tandem quad market. I was wondering if maybe you and Doug could elaborate on that, why you don't think that that is a competitive share loss and just competitive trialing?

Yes, I think that was me who commented on it. We clearly have seen competitive introductions of new tandem quadrupole instruments in the past several months. And we have seen competitors report that they had a pretty good quarter in that segment of the market that they traditionally have the highest market share. So we are not -- I don't think we are terribly surprised by that.

As it relates to market shares though, that has been a marketplace that we haven't penetrated to a large extent. That has kind of been the province of one of our competitors. So when they are coming off several years of slower growth and they introduce a new instrument, I am not terribly surprised that they do a pretty good quarter of penetrating in the first quarters of their introduction.

I think over the next several quarters, you will see that modulate. It's very unusual to see fundamental market shares change on the basis of one quarter's dynamic. You have got to look at market shares over a longer-term period. And in the face of a brand-new introduction by somebody who has a strong presence in that segment of the market, that is not surprising. Come back and talk to me in a year and a half and see if they have continued to grow at a double-digit rate in those applications, and I think you will be on firmer ground saying that fundamental market shares have changed. But I don't think that is likely to happen.

Okay. I will definitely try to track you down in a year and a half, if you are still around there.

As I have disclosed, I think I will still be here.

Second question is for John, and it is around the gross margin. Last quarter, the gross margin was weak and you talked about a shift from LC to MS. And now you are talking about a shift within MS, and the gross margin missed our estimate there again. Can you get into a little more detail, maybe peel apart the margin to help us with the underlying dynamics? Thanks.

Sure. Within the quarter, FX is still the biggest play on the margin front. The impact of the yen that we have been talking about throughout the year remains in place.

The euro got a little stronger in the quarter. But still at the end of the day, when you add up the currency effects versus prior year in the quarter, there is still about 70 bps of margin deterioration versus prior year, which wasn't much different than what we had anticipated.

The software amortization costs that are in this quarter on a relatively low sales basis, we ramped that product introduction up, cost somewhere around 30 bps in the quarter overall.

And then we had a shift of product shipments in Q3 towards Tof, away from triples. There is a meaningful margin differential between the two, and that added about another 30 bps, which was beyond what we had anticipated at the start of the quarter. So that explains the 130-ish bps in margin deterioration. And again, that is probably the only difference versus guide or expectation within that Tof versus triples piece.

That product shipment dynamic into the fourth quarter, is that not being taken into account? Like how does the fourth (multiple speakers)?

No, that is being taken into account. So as I look at the fourth quarter now, I am assuming that we are going to have a stronger Tof business and a somewhat weaker triples business. As Doug had said, during a quarter of introduction of new products like we saw in Q3, with a couple of introductions on that front, there was no doubt that people are doing demos, people who are perhaps still likely to buy our tandem quadrupole are at least going to look to see what else is out there. So I am accounting for the fact that even in the fourth quarter, we will continue to see some of that dynamic, and we are likely to see better growth in Tofs than triples.

Thanks a lot.

Dan Arias, UBS.

Hi. Good morning, guys. Thanks. I just wanted to ask one as a follow-up on the molecule mix question from earlier. Doug, when you look back at the expectations for sort of the mix of large molecules and drug classes that you thought would drive the business, is that generally in line with what you are seeing now? Or has the protein drug world sort of evolved in a way that has been different from what you envisioned earlier?

I would say in its broadest terms it is moving in the direction that we anticipated. All big pharma accounts have talked about moving their development towards large molecules and away from small molecules, and have been for many years now. So we clearly have had fair warning about the direction of their development. Certainly the small pharma startups have been almost all into the field of biotech.

I would say the movement of those into therapies has been maybe slower than they and we believed. And I think the movement into actual production has somewhat slowed the uptake of downstream technologies. So we think they have stayed in development longer than people believed.

And the movement to biosimilars, which I think also is something that is fundamentally attractive to us, has been a little slower -- a lot slower in the US -- but slower overall than the industry anticipated. But around the corners and the fringes of the strategy, we have seen some changes. But in general, this movement to large molecules I think is pretty clearly as described.

Okay, thanks. That's helpful. And then just maybe on the strategy side, specifically within the clinical markets, how important is partnering there for you guys, when you think about how you can be most effective?

I think it depends. In terms of the way we approach the clinical market on kind of an application-by-application basis, we have been pretty successful in developing the applications in things like vitamin D, in things like pain monitoring, where we have largely done those kinds of things on our own. Now, we partner in the neonatal business, largely because of the proprietary chemistry capabilities that we didn't have, and we saw it as appropriate to access that marketplace.

There are some interesting things that could emerge on the clinical market that I'm kind of not ready to talk specifically about that might well offer big mainstream applications, that if we develop it to a point, we might well think of a broader partnering with somebody who is more intense in the clinical or medical device marketplace. I think that is a topic probably for sometime next year.

But in the applications that we think we will build into our 2014 kind of budget, those are things that we think we can largely develop on our own.

Okay, thanks very much for the comments.

Tycho Peterson, JPMC.

Hey, thanks for taking the question. I want to go back to actually one of the earlier questions Doug Schenkel kind of asked about, the competitive dynamics. And Doug, you made the comment that you are taking share. But I think as Doug Schenkel highlighted, you are growing below some of the peers.

So can you maybe just talk specifically about where you are taking share? And also maybe overlay that with some comments on your pricing strategy. In other words, in a world with more budget constraints, do you have to get a little bit more aggressive on price going forward?

Sure, Tycho. I think -- although I think I laid it out pretty explicitly, I think the growing more slowly than some of our peers -- you know, I would have to see chapter and verse. I am aware of one mass spec vendor who, after three years of below-average growth, has talked about one quarter of good mass spec growth. So if you consider that a massive share change, then I guess I have got to give you that.

In the LC area, we track -- we have information from the industry, that industry, from almost everybody in the world who imports LCs, and we have very clear indication that not only are we not losing share in the LC marketplace -- again, over a multiyear period, we are -- in a difficult market, grant you -- we are probably gaining share.

And I think our TA instruments, although a smaller part of our business, has very clear indications of the same.

Now, having a good share position in a very tough marketplace can be -- it's not the strongest place we'd want to be. But I think those are the facts. Almost everybody else in our world is doing significant acquisitions of some kind muddy the field of what organic growth is versus acquired growth.

So obviously, I can't necessarily see my way through all of those dynamics, but I try to look at the core data that I can get through other sources. And I am frankly just not convinced that any of these share moves are fundamental. So if you have got better data than that, I would be delighted to look at it, but I have trouble getting my hands on it, Tycho.

And then just how about thoughts on the pricing strategy then. Do you need to be a little bit more flexible on price in a budget-constrained environment?

The question about -- I guess should we lower price is the question. I think that is a terrible idea. I think between Art and I, over 30 years in this industry, with regularity, both internally and externally, people have suggested that we should cut our prices to gain market share. We have successfully fought off that strategic initiative for 30 years.

And I think the long-term evolution of this marketplace has been, I think, the same as it was 10, 15 years ago. The customers want performance, they want productivity, they want service, they want reliability. And they continue to tell us that price is very low on their list, assuming that they can get everything else. I think we will stick with the strategy that we have employed. I don't see anything out there to suggest this time is different.

Okay, and then for John, just two very quick ones. As we think about 2014, I know you kind of gave some preliminary color on the top line. Any thoughts on the cost side? I mean, given your experience in 2013, should we think about a consistent approach to cost management or will you bake in a little extra cushion?

And then longer-term, one of the uncertainties is tax rate. How do you think about your tax rate in Singapore over time? Any preliminary discussions on where that could go?

Yes, I think from an operating leverage perspective, Tycho, we would be continuing to look to provide some level of operating leverage, even if we continue to live in a mid-single-digit type world.

Yes, it is tough to do that, but as Doug said, it is our obligation to find ways to do that, so we will be able to create operating leverage at that top-line rate. We will be able to continue with the share repurchase program as being the fundamental use of cash.

And on the tax rate side, I mean, outside of the R&D tax credit that kind of doubled up this year, I don't see any reason that our tax rate is going to go up or down for mix reasons as I think about 2014.

As we think about beyond 2015, we do have to consider that we do have a treaty with Singapore that expires that we will be looking to see how we manage that. That will be an activity that will take place probably mid-next year to get ready for that in early 2016. So it is a little early to say how much success we will have on that front. But to the extent that we don't, there is probably a point or two of overall impact that could be negative as we think about the rate all the way out to 2016. Certainly for 2014, I would say, outside of not doubling up on the US tax credit piece, there shouldn't be a meaningful change in the tax side.

Okay, thank you very much.

Operator, we've hung on here for a while past our normal closing date. We are trying to be sensitive to people's morning schedules. Maybe we could take one more question and then call it a morning.

Brandon Couillard, Jefferies.

Great, thanks for squeezing me in here. Doug or John, if you could just elaborate on the dynamics you saw within the industrial end market between both the applied categories and the more cyclical chemical industrial accounts. How was the pacing through the third quarter especially within that segment?

I would say that we saw stronger performance in the applied segment of the marketplace. We are seeing a great deal of interest in some of our new technologies, including our new RI system, from the mainline chemical industrial players. But it is early on as they think about switching segments of their marketplace.

John, on TA --?

TA had a good quarter actually right across the three months, and they had a somewhat strong product line. They had, across the quarter, as we said, a backlog that helped a little bit, not to the extent that we thought. But I would say right across their end markets, they saw reasonably good demand.

They didn't have as much of government impact in the US as we might have thought. So I would say that as we look at TA's business right across their various segments, there isn't one that stood out as being meaningfully weak. It was across the board.

Thanks. And then, John, on the buyback front, it looks like a little bit slower activity here over the past two quarters than is traditional. Would you still expect to do 100% of free cash flow in the share repurchase this year?

There is no doubt that we did have a situation with the window being closed bit longer in the third quarter, so the buying opportunity was a bit limited. So we will pick that pace up in the fourth quarter to get back closer to the targeted level of about $300 million or so in repurchases.

So I would say nothing has changed in our strategy. We just -- with the announcement that went out in late August, we kept the window closed just to be safe.

Great, thank you.

Okay, operator, I think we will close it off at that point. I want to thank everybody for their attendance and we'll look forward to talking to you again in January. Thank you.

This concludes today's conference. Thank you for participating. You may disconnect at this time.