Waters Corp (WAT) 2018 Q2 法說會逐字稿

Good morning. Welcome to the Waters Corporation Second Quarter 2018 Financial Results Conference Call. (Operator Instructions) This conference call is being recorded. If you have any objections, please disconnect at this time. It is now my pleasure to turn the call over to Mr. Bryan Brokmeier, Head of Investor Relations. Please go ahead, sir.

Thank you, operator. Good morning, everyone, and welcome to the Waters Corporation Second Quarter Earnings Conference Call. Before we begin, I will 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 for the third quarter and full year 2018. 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 annual report on Form 10-K for the fiscal year ended December 31, 2017, in Part 1 under the caption 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 release call and webcast is currently planned for October 23, 2018. During today's call, we will be referring to certain non-GAAP financial measures. Reconciliations of the non-GAAP financial measures to the most directly comparable GAAP measures are 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 titled Reconciliation of GAAP to Adjusted Non-GAAP Financials included in this morning's press release.

Unless we say otherwise, references to quarterly results increasing or decreasing are in comparison to the second quarter of fiscal year 2017. In addition, unless we say otherwise, all year-over-year revenue growth rates, including revenue growth ranges given on today's call, are given on a comparable constant-currency basis.

Now, I'd like to turn the call over to Waters' Chairman and Chief Executive Officer, Chris O'Connell. Chris?

Thanks, Bryan, and good morning, everyone. Thank you for joining us today. Along with Bryan Brokmeier, joining me on this morning's call is Sherry Buck, Waters' Chief Financial Officer. During today's call, I will provide an overview of our second quarter operating results as well as some broader commentary on our business. Sherry will then review our financial results in detail and provide comments on our third quarter and full year 2018 financial outlook. We will then open up the phone lines to take your questions.

Briefly reviewing our financial highlights for the second quarter, revenues grew 5% and adjusted earnings per share grew 11%. Overall, I am pleased with the progress we made in the quarter, demonstrating clear sequential improvement versus the first quarter and reinforcing the confidence we have in the ongoing growth trajectory of our business. Highlights in the quarter included mid-teens growth in China, double-digit growth from our TA product line and high single-digit growth of recurring revenues.

Looking briefly at the P&L, we are pleased with the operating leverage we generated and the solid earnings results we realized in the quarter. While investing in growth through organic innovation, we demonstrated disciplined operating expense management that drove margin expansion, which enabled us to deliver double-digit earnings per share growth in the quarter.

Before I review our end market, geographic and product line performance, I'd like to provide an update on 2 factors we cited in last quarter's call that adversely impacted our first quarter: mass spectrometry and India. First, in mass spectrometry, we saw sequential improvement in the second quarter driven by solid growth from our core tandem quad portfolio. Our tandem quads, which represent the majority of our mass spec sales, have continued to sell strongly over the past year, offset by softer growth from our high-resolution mass spec product line.

For further context, mass spec technologies are a key part of our LC-MS and direct mass spec system offerings, yet represent a smaller part of our overall business. And within mass spec, high-resolution mass spec represents only about 1/4 of the total mass spec revenue. Our sales force realignment, which had a minor impact in our U.S. mass spec business during the first quarter, is now complete and remains a key element of our ongoing market development strategy.

With respect to India, growth was flat in the second quarter, with a return to growth in pharma, partially offset by some weakness in industrial and governmental and academic. We remain confident in the improvement of our Indian business in the second half of the year as customers continue to regain purchasing momentum.

Now taking a closer look at the business, starting with a review of our market categories at the corporate level. Sales to our broadly-defined pharmaceutical category grew 4% in the quarter. Growth was driven by double-digit growth in China, partially offset by a slight decline in developed markets due to slower-than-expected budget releases by our largest pharma customers. Importantly, we saw strong year-over-year growth in our large molecule business as we continue to leverage our refreshed Xevo tandem quad portfolio in this high-growth market. We feel good about our pharma market position and, in particular, our ability to meet the needs of our biomolecule customers as their investment environment continues to be positive.

Sales to our worldwide industrial category, which includes the materials characterization, food, environmental and fine chemical markets, were up 3% in the quarter. Sales within our TA brand continued the strong trend we have seen, giving us confidence in a positive outlook for our industrial category, as volume in our thermal and rheology product lines has been our best proxy for industrial end market demand.

We saw softer demand from food and environmental customers in the quarter, partially offset by strength in the chemical materials market. Despite these near-term puts and takes, we continue to be excited about our product positions and pipeline as well as the breadth of opportunity across materials characterization, food safety and environmental applications.

Looking at our governmental and academic category, sales grew by 13% in the second quarter, with broad-based growth across all major geographies. Weakness in biomedical research was more than offset by improvement in other research applications, including pharmaceutical, materials and clinical diagnostics.

Next, I will review our sales performance by geography at the corporate level. Asia, our largest region in terms of revenue, was up 8% in the second quarter as strong mid-teens growth in China offset flat performance in India. Demand in China continues to be robust, with strong growth in pharma, food and materials.

Turning to the Americas. Overall, sales grew 1% in the quarter with sales in the U.S. declining 2%. Although, growth in Canada and Latin America was strong, including Brazil, Mexico and Puerto Rico, it was offset by some softness in the U.S., particularly in biomedical research markets as well as slower-than-expected pharma growth.

In Europe, sales were up 5% in the quarter. Industrial as well as government and academic were particularly strong in the region, while European pharmaceutical growth was a bit softer, driven mostly by tough comps in big pharma.

Finally, I will review product line dynamics within our Waters and TA brands. Waters-branded instrument sales were flat in the second quarter, driven by the previously mentioned mass spec system softness. On the other hand, we were pleased with our sales of stand-alone chromatography instruments. Within LC, the ACQUITY Arc continues to see significant broad-based demand and the newly launched ACQUITY PLUS is receiving strong market acceptance. Our core tandem quad mass spec portfolio has sold really well over the last year, highlighted by the Xevo TQ-S micro and the Xevo TQ-XS. In high-resolution mass spec, growth was challenged within the biomedical research market. We recognize we are currently in the latter phases of product cycle in high-resolution mass spec and, therefore, face more competitive pressure than the rest of our portfolio. That said, we continue to see significant growth opportunity in the space, are investing assertively and are confident in the strength of our technology pipeline that we expect will begin to show in the coming year. Waters-branded recurring revenues, which reflect the combination of service and precision chemistries and represent approximately 50% of the total business, grew 8% in the quarter. Recurring revenues were driven by global strength in our service, sample prep, application kits and UPLC columns.

Turning to our TA product line. Sales increased 12% in the quarter. Instrument sales for TA increased 12% and service sales increased 11%. There was broad-based growth across our key thermal analysis, microcalorimetry and ElectroForce product lines. In particular, growth within our discovery line of thermal analyzers continues to be very strong. We have now introduced 9 new instruments over the past 2 years within the Discovery series, including the DMA 850, which was introduced earlier this year. Our balanced growth of new customers and existing customer upgrades gives us confidence that the Discovery series continues to have a long runway ahead of it.

In summary, we are pleased that we saw a sequential improvement in our second quarter results, highlighted by strong growth in China, our TA product line and our recurring revenues. In addition, we delivered meaningful operating leverage, which enabled us to deliver double-digit earnings per share growth.

As always, we remain steadfastly focused on executing to our 5-point value creation model. As we have previously communicated, we aim to create shareholder value by: first, holding a focused and highly differentiated leadership position in structurally attractive markets; second, executing a clear growth strategy driven by organic innovation; third, seeking opportunity for continuous operational improvement; fourth, being a disciplined capital allocator; and fifth, operating with a performance-oriented culture and management team.

I would now like to add a few comments highlighting our strong focus on innovation at Waters. We are pleased with the progress of our product portfolio, including our recent introductions of the ACQUITY Arc bio system, the ACQUITY UPLC PLUS series and the Xevo TQ-GC as well as numerous new products from our TA instruments business, such as the recently launched DMA 850. We continue to prioritize and invest proactively in organic innovation, with second quarter R&D investment growing 9% year-over-year. I am personally excited about the rich pipeline we are building across instruments, informatics and precision chemistries. To augment these internal innovations, we are increasingly evaluating select external technologies to strengthen our overall product portfolio and enhance organically developed products. As an example, yesterday, we announced the acquisition of Prosolia's desorption electrospray ionization, or DESI, technology for mass spec imaging.

The acquisition of DESI technology bolsters Waters' market-leading portfolio of direct ionization mass spec, which also includes MALDI, REIMS and the DART QDa with LiveID. These technologies allow for simplified direct sample analysis under ambient conditions without any required sample preparation. We are excited about our unique ability to provide advanced digital molecular imaging solutions and related analytical tools to researchers who strive to answer complex biological questions. In fact, my recent visit to ASMS reinforced to me the excitement of the research community for mass spec imaging technologies, which saw 18 oral presentations and 105 poster presentations. When coupled with our Xevo G2-XS QTof and SYNAPT G2-Si mass spectrometers, DESI provides maximum flexibility by leveraging the power of time-of-flight mass spectrometry analysis and for more demanding applications, additional orthogonal resolution using ion mobility mass spectrometry. Importantly, DESI is highly complementary to other imaging modalities, such as MALDI, making it a strategic addition to our evolving imaging portfolio and positioning Waters as the market leader in direct ionization mass spec techniques.

With that, I'd like to pass the call over to Sherry Buck for a deeper review of the second quarter financials. Sherry?

Thank you, Chris. And good morning, everyone. In the second quarter, we recorded net sales of $596 million, an increase of approximately 5% in constant currency. Currency translation increased sales growth by approximately 2%, resulting in 7% sales growth as reported. In the quarter, sales into our pharmaceutical markets grew 4%, sales into our industrial markets increased 3%, and sales into our governmental and academic markets grew 13%. Looking at product line growth. Our recurring revenue, which represents the combination of precision chemistry products and service revenue, grew 8% in the quarter, and instrument sales grew 2%. As we noted last quarter, there is no year-over-year difference in the number of calendar days during the second or third quarters, but there is 1 additional calendar day in the fourth quarter of 2018 compared to 2017.

Breaking product sales down further. Sales related to Waters-branded products and services grew 4%, while sales of TA-branded products grew 12%. Combined LC and LC-MS instrument platform sales were flat, and TA's instrumentation system sales grew 12%. Our total recurring revenues associated with both Waters and TA products grew by 8%. As Chris already shared, we're encouraged by the strong momentum that we've seen from TA in the first half of the year, which gives us confidence in the positive outlook for our industrial category.

Looking at our growth rates in the second quarter geographically and on a constant-currency basis, sales in the Americas were up 1%, with sales in the U.S. down 2%. European sales were up 5%. And sales in Asia were up 8%, led by 14% growth in China.

Now I'd like to comment on our second quarter non-GAAP financial performance versus the prior year. Gross margin for the quarter was 59.2% versus 58.9% in the second quarter of 2017, positively impacted by mix and FX.

Moving down the second quarter P&L. Operating expenses were up approximately 3% on a constant-currency basis, and foreign currency translation increased operating expense growth by approximately 3% on a reported basis. In the quarter, our effective operating tax rate was 14.7%, up 280 basis points year-over-year, which was in line with our expectation and reflects the net impact of U.S. tax reform that we discussed in our Q4 2017 earnings call.

Net interest expense was $3 million, down $3 million from the prior year, benefiting from the reduced debt levels as part of our capital allocation framework as well as higher rates of return on investments versus the prior year.

Our average share count came in at 78.4 million shares or approximately 2.3 million shares lower than in the second quarter of last year. This was a net effect of our ongoing share repurchase program. Our non-GAAP earnings per diluted share for the second quarter were up 11% to $1.95 in comparison to earnings of $1.76 last year. On a GAAP basis, our earnings per share were $1.98 versus $1.63 last year. A reconciliation of our GAAP to non-GAAP earnings is attached to the press release issued this morning.

Turning to free cash flow, capital allocation and our balance sheet. I'd like to summarize our second quarter results and activities. We define free cash flow as cash from operations, less capital expenditures and excluding special items. In the second quarter of 2018, free cash flow came in at $144 million after funding $21 million of capital expenditures. Excluded from free cash flow were $47 million for U.S. tax reform payments, a $15 million payment for a litigation settlement and $2 million related to the investment in our Taunton precision chemistry operation. Just as a reminder on U.S. tax reform, we incurred a $550 million GAAP tax expense charge in Q4 of 2017, primarily associated with the transition tax on earnings and profits outside the U.S. This tax liability is expected to be paid over 8 years, with the first payment of $47 million remitted in this quarter.

The lower free cash flow generation in the second quarter as compared to the prior year is impacted by a change in the timing of our current year U.S. estimated tax payment. We anticipate our free cash flow will normalize by the end of the year. Year-to-date 2018, we have converted $0.27 of each dollar of sales into free cash flow. In terms of returns to shareholders in the quarter, we repurchased 1.4 million shares of our common stock for $271 million. These capital allocation activities, along with our free cash flow, resulted in cash and short-term investments of $2.2 billion and debt of $1.1 billion on our balance sheet at the end of the quarter, resulting in a net cash position of $1.1 billion.

Accounts receivable days sales outstanding stood at 75 days this quarter, which is the same as in the second quarter of last year. In the quarter, inventories increased by approximately $13 million in comparison to the prior year quarter, which is in line with typical seasonal patterns.

As we look forward to the balance of the year, I'd like to comment on our full year 2018 guidance. Our outlook assumes continued global growth in demand from our pharmaceutical end markets, year-over-year growth in our industrial markets and consistent growth in our recurring revenue. These dynamics, along with the sequential improvement that we saw in our second quarter performance, support full year 2018 guidance for constant currency sales growth of 4% to 6%.

At current rates, currency translation is assumed to increase 2018 sales growth by less than 1%, which is a change from our prior 2018 guidance that assumed a benefit of 2% to 3%. Gross margin guidance for the year is unchanged at 58.5% to 59%. Our plan for the full year is to continue managing operating expense growth at a rate that is below our sales growth rate.

Moving below the operating income line. Net interest expense is expected to be approximately $14 million. This assumes that the debt repaid in the first half of 2018 is not reborrowed during the course of the year. Our full year tax rate guidance is unchanged at an effective tax rate of 13% to 15%.

Regarding capital allocation, our guidance assumes a continuance of our share repurchase program at a level that would result in an average diluted share count of about 78.5 million shares outstanding. Rolling all this together and on a non-GAAP basis, full year 2018 earnings per fully diluted share are projected in the range of $8.05 to $8.20, which is a revision from our previous range of $8.10 to $8.30. At current rates, the foreign currency impact on the full year earnings per share growth is expected to be neutral, which is a change from our prior 2018 guidance that assumed a benefit of about 1%.

Looking at the third quarter of 2018, we expect 4% to 6% constant currency sales growth. At today's rates, currency translation is expected to decrease third quarter sales growth by about 1% to 2%.

Combining these top line factors with the moderate increase in expenses, we estimate third quarter non-GAAP earnings per diluted share in the range of $1.85 to $1.95, which assumes an approximate 3% negative impact from currency translation at current rates.

Now, I'd like to turn the call back to Chris. Chris?

Great. Thank you, Sherry. To recap, after a slower-than-expected start to 2018, we were resolved to deliver a solid second quarter, and I am pleased that we delivered 5% revenue growth and 11% earnings per share growth. We made good progress in the parts of the business that held us back in the first quarter, and we benefited from a number of key areas of strength that we will continue to leverage in the back half of the year. As such, we expect our constant currency revenue growth for the back half of 2018 to be stronger than the first half of the year.

With that said, we will now begin the question-and-answer session. As we are not always able to get to everyone's questions, please limit yourself to 1 question and 1 follow-up. And if you have additional questions, please contact the Waters' Investor Relations team after the call. Operator?

(Operator Instructions) Our first question today will be from Steve Beuchaw of Morgan Stanley.

I wonder if you could maybe go into even a little bit more detail on just a couple of the components there. Number one is India, can you talk to us in a little bit more granularity on what you're seeing that gives you comfort from the ground level there about what the drivers are for the improved confidence and spending patterns for your customer base there in India? And the second piece of the back half outlook that I'd love to hear just a little bit more on is the sales force. You mentioned that the sales force, the key positions are now filled, people are in their seats. How recently did that happen and how much of an impact did that have on 2Q?

Sure. Thanks, Steve, for the questions. First of all, on India, I guess, the way I would characterize it is that the caution that we saw in our first quarter, which -- as we talked last quarter, was the final quarter of the year for Indian pharmaceutical companies. The caution that they expressed there has eased gradually over our second quarter, which is their first quarter, and that caution is really around the overall financial year they had, had before plus what is continuing to be a robust regulatory environment, FDA compliance, et cetera. And we've seen this caution warm up gradually over the last quarter, and we expect it to continue to warm up. In particular, the pharma sector is firming up. Pharma was really what held us back in India in Q1. And as I noted in my prepared comments, pharma turned positive in our second quarter. And so we do see some pent-up demand building, and really are just continuing to press forward and stay very focused on what we do to serve our customers. And we do expect that as we get into the back half of the year that, that improvement will become more pronounced. As it relates to the sales force, like I said, the expansion and re-territory activity in some parts of the sales force were -- left some open positions during the course of Q1. Those were predominantly filled by the end of Q1. And as those positions have onboarded and gained traction in terms of building their territories, they are becoming more productive. And we expect that to really pay off in the second half of the year. So like I said before, I've had the opportunity to be part of a lot of sales force changes over the course of my career and investments, and this one, in the broad scheme of the world, was very modest in terms of the overall scope. And I think, the team executed well through it. And I'm excited about what this team is going to contribute as we move forward.

Really appreciate that. And then just one quick follow-up. Given some of the commentary in your prepared remarks about, maybe, a somewhat elevated focus on capital deployment to M&A, can you remind us of what your parameters are, what your commitments are? How you think about required returns, accretion and then the most appropriate sizes of deals? I recall you saying in past years, past quarters, that you think about M&A as a tactic and not a strategy. Can you just remind us where your thinking lies there?

Sure. Thanks, Steve. Happy to comment on that. And first of all, I would completely reinforce my view on M&A, which is that M&A is a tactic, it's not an overall strategy for the company for capital deployment. We will be opportunistic in acquiring everything from intellectual property, to technologies, to tuck-in type opportunities if they meet a high strategic bar and a high financial bar. And nothing has really changed in that regard. So in terms of any additional guidance on financial hurdles, that's probably not needed because we retain all of the parameters that we've operated with. That being said, one thing I've had the opportunity to do over the past couple years is to build a Corporate Development department here at Waters. And it's a lean group, but one that is trying to enhance our focus outside of the company to make sure that we remain oriented to thinking about growth and innovation from a 360-degree view. And I think, the team has been very productive. We've had the opportunity to make a few very high-impact minority investments in very promising new technologies that fit right squarely in the center of our strategy. And then the acquisition -- the full acquisition of the DESI technology from Prosolia where we had a partially exclusive position before, now we really have locked up that technology, which we think is one of the most interesting things going on in mass spec imaging. I think those are just examples of our -- the way we're thinking about it, and just trying to make sure that as we strive to deliver on our growth and innovation strategy that we're certainly prioritizing organic innovation but also taking advantage of some really interesting technologies that are out in the marketplace.

Our next question is from Dan Arias of Citigroup.

Chris, can you just help us with the overall mass spec gross number for the quarter? And then, I guess, should we expect some meaningful product news later this year at the high end of the market? I know you don't like to preempt your announcements, but you kind of hinted at some things last quarter in terms of new high-res systems. Was that a reference to the GC/MS announcement at ASMS? Or should we sort of think about some things in the second half of the year that we can look for and that would be meaningful when you think about the portfolio going forward?

Sure, sure, Dan. I'd rather not break out specific growth numbers other than to reinforce what I said that we had quite a slow start to the year in mass spec. Things definitely picked up in the second quarter, not where we wanted to be yet but moving in the right direction. And really excited, frankly, about what we're doing in terms of R&D investment. Mass spec is a huge priority for the company, particularly as it relates to a true system orientation around LC mass spec as well as what I talked a little bit more about this morning, which is this sort of wide-open field of direct mass spec. I think as we move into the future, there's going to be more interest in some of these direct ionization techniques, and there is a lot of kind of white space out there for growth. And so we've been assertively investing. We have increased the system orientation of our core mass spec portfolio, which I think is a competitive advantage for Waters, and we've also created greater focus around our high-resolution mass spec. In terms of the product that's new and coming, yes, the GC mass spec is interesting and new and current, but clearly there is a lot more beyond that. I've talked in the past about our BioTOF system, which is working its way through development very, very well. And then we have a few, what we believe to be, groundbreaking technologies in high-resolution mass spectrometry that will certainly give more visibility, too, as we roll into 2019, so stay tuned for that. And -- but the bottom line is that we remain very focused on pushing forward technology, pushing forward system orientation and doing things that we can do uniquely well.

Okay. And then maybe just on industrial. Can you add a clarification there. I believe you said that food and industrial were soft, but that chemicals was strong. And I usually lump chemical into industrial. So I guess, how are you thinking -- how are you parsing things out there? And then what is the growth expectation for the year for industrial in the way that you stated in the press release?

Sure. So industrial was -- had a lot of puts and takes, of course, led by TA, which gives me the most comfort in the overall tone of the market. Obviously, we're benefiting in TA from a really strong product -- a new product launch cadence right now, but we're also benefiting from what we believe are stable end market factors. Overall in industrial, we did see a sequential improvement from Q1 to Q2. And while there were puts and takes, like the ones you mentioned there, we do feel that the overall portfolio of industrial on the Waters side is normalizing. There were some tough comps, for example, in China and India, in particular, and Q2 of last year was very, very strong in industrial. There was also a dynamic within the environmental business where the EPA had some pretty big purchasing activity last year, where -- that has not yet recurred in this year. And so, like I said, there's a lot of puts and takes, but overall, we feel good about the category and expect some of the puts and takes we've seen in the first part of the year to normalize in the back half of the year with continued strong TA performance.

Our next question will be from Jack Meehan of Barclays.

Chris, I was hoping you could start -- just elaborate on the trends you are seeing here in the United States? And what was weaker versus what was better across the different end markets?

Sure. Happy to, Jack. The U.S., as I mentioned before, was a bit slower in the first half and a little bit of a mixed bag, and I think that really reflects some of the unique customer mix that we have. I mentioned our biomedical research sector has been slow out of the gates but is very much a lumpy business, so hard to quantify exactly what direction that goes. But pharma, particularly large pharma, was a little softer coming out of the chute and certainly offset to a certain degree by biotechnology and generics. But we really remain confident in the overall end market around pharma and ongoing investments they're making, and we're encouraged by quoting activity that we're seeing. And so the tone of a lot of our customers in the U.S. and particularly in pharma gives us some confidence in the stability of the market. And we think it's a very reasonable expectation for a stronger second half, assuming that we get the typical year-end purchasing activity. And at this point, we have no evidence to suggest that won't be the case. So again, another point there that I think is important is the strong service in chemistry. Performance indicates to us some building in terms of some pent-up demand for instruments in terms of our unique customer mix. But overall, like I said, we are expecting a solid second half of the year.

Great, thanks for all that. And then just a follow-up on the government and academic performance. I know this can be lumpy on a quarterly basis but obviously 2Q looked pretty good. Were there any revenue that was in or out of the quarter from a timing perspective? And just what's the outlook for the rest of the year there?

Yes. Good point, Jack. And yes, it's governmental and academic is the smaller sector of our 3, and it is lumpy, and it was even mixed a little bit within that. I mentioned biomedical research was soft, but yet other research applications were strong. Research, particularly on the part of academics, in areas like pharmaceutical discovery, in areas like material sciences, in areas like clinical diagnostics that are more research-oriented, so there was a good quarter there. The patterns in that business tend to be a little more cyclical. And so we're just trying to focus on the things that are going well and try to make sure they are more enduring.

Our next question will be from Tycho Peterson of JP Morgan.

Chris, I want to follow up on your comment a minute ago about the U.S. And you mentioned slower-than-expected budget release from pharma. Can you maybe just elaborate? Has some of that subsequently come through post the quarter? And I guess, what gives you confidence it's a budget release issue and not something else?

It's a good question. I would just sort of reiterate what I said, Tycho. We watch this very, very carefully. And in many ways, it feels like last year, where we saw this same pattern, where we had a slower budget release from our largest pharma customers in the first half of the year and that firmed up in the second half of the year. And at this point, like I said, we don't have any evidence that that's sort of not headed in that direction again. And the things that we focus on when understanding the tone of our largest pharma customers is certainly the service and chemistry and the utilization of the technology, which is solid, the quoting activity, which we're encouraged by. And so the tone that we're hearing, we're obviously very close to these customers, gives us, like I said, a reasonable expectation for a more solid second half. And that's what I can see from where I sit right now.

Okay. And then you guys are obviously putting up good numbers in China and that's kind of consistent with what we've heard from peers about the demand environment. Can you talk to how you think about the back half of the year, the sustainability? You didn't proactively make any comments on tariffs, so presumably there is nothing we really need to be worried about there either.

Yes. From a China standpoint, tariffs is really not a factor right now. And that's obviously an evolving picture. But at the end of the day, we don't export out of China. We import very little directly into China from the U.S. The vast majority of our business into China comes from our global manufacturing and supply chain network. And so we don't necessarily foresee a large impact on that part of it. But just in general, China is performing well. It appears, from everything we can see, solid. And even in our forecast, we're not necessarily assuming everything goes perfectly right. And my impression, just from spending a lot of time in China and around Asia, generally, is just, while it's not always in a straight line, the long-term outlook is promising. And we have a very diverse business in China. It's actually the most diverse portfolio we have of any major geographical end market. There is less pharma weight there, more food and materials weight, and there appears to be a really decent amount of balance in the business right now. So our expectations of our China team continue to be high, and we're investing to sustain that type of growth and investing to win.

Right. And then just last one. I'm curious about the decision to enter the GC market. Obviously, you partnered up with Agilent to OEMs, the GC piece of it. But what do think your advantage is in that market or is it just opportunistically pushing into the new (inaudible).

It's interesting because the GC/MS market is an important market where we think there is unmet measurement need, if you will, unmet technology need on the mass spec side. And historically -- and I don't have the full history because I've only been here a few years, but historically we did have quite a bit of presence in that GC/MS field and I think our position faded over time. And the team has been really excited about reasserting that, particularly in applied workflows, in food and material science. Large food labs in China and Europe are demanding this technology. And we thought it was a very focused way to play it to really be able to hook on to some of the more broadly accepted core GC technology to provide a superior mass spec interface, which we think the market needs. And so we definitely see an opportunity there. It's not the -- it won't be the largest product offering in our mass spec portfolio for sure, but we think it's a nice niche. And frankly, it will help us drive our overall portfolio, particularly on the food side.

Our next question will be from Puneet Souda of Leerink Partners.

I have 2 broader questions, maybe 1 around -- first, let me say around Empower. How would you characterize the Empower strength today and the position that it holds in the market versus a year or 2 back? Is it as strong and sticky as in the accounts? And I am asking that in context of the U.S. decline here and somewhat of pharma that looks back half loaded. Could you maybe characterize what -- the strength you see in Empower, how is it versus before?

Sure. Yes, happy to talk about Empower. Empower is a really major competitive advantage for the company, particularly in pharma, in the most rigorous regulatory compliance environments. And the one trend that's unmistakable, for sure, is the rising regulatory requirements on our customers and the increased priority our customers have on rigorous data management and compliance. And in that environment, the Empower position is only strengthened, particularly for global companies who are working on kind of the Empower enterprise-type network system. And if anything, we've seen major customers work to adopt this across their LC platforms and earn, what I'd call, incremental strategic wins. Now the reason I say incremental is because we already have a really strong and leading market share. We're really in all of the top 20 or 25 major pharma accounts in one way shape or form, and those typically trend towards more enterprise-type deployments. Furthermore, we continue to push the technology down that curve where we started with workstations. We've been very oriented around enterprise solutions. And now we're increasingly migrating towards the cloud. And so really, we're continuing to invest in our next-generation chromatography data systems. I've personally had a chance to review a lot of that work. I'm excited about taking the strength further. And we obviously want to see many more companies besides the enterprise customers continue to behave in that way. And we think for that reason there is runway.

Okay. Thanks for that. And the second one I have is around the recent retirement and management changes. I wanted to get a higher view from you, your vision, your longer-term strategy. So we have seen 15 to 30 years tenures at senior leadership at Waters. But recently, I mean, Rohit Khanna, SVP Applied Technologies, he was there for 30 years. He, I believe, retired. Dave Terricciano, who was the Head of Global Operations, I believe, he has also taken retirement. And Ian King is approaching close to 35 years. He's been excellent at technology and new product introductions. So my question here is, how are you thinking about the next round of leadership? Should we expect them to rise from within the company, as traditionally been the case, or should we expect maybe potentially outside of the LC-MS business? Just wanted to you get your views there.

Sure. Well, thank you for the question, because certainly investing in our organization in a very broad, deep and diverse management team is a very top priority of mine. I spend an awful lot of my time on this. And you've mentioned some outstanding people. Our current executive team is a very strong balance between deep, credible, proven industry experience with a sprinkling in of some fresh perspectives, which is exactly the way you want a management team to look. Some of the retirements you mentioned, were sort of long-planned retirements both on those individuals parts as well as our part. We had robust succession plans for all of them. You mentioned Ian. He's the Head of our Product Development organization and doing a fantastic job. And we continue to leverage that expertise. But one thing that's been a real joy for me coming into the company is getting to know management at the next level and employees throughout. I've brought in really a transformational talent to review, organizational development process that has substantially increased the rigor and development and investment in our top talent. I've even personally designed and teach a 3-day leadership course to our top up-and-coming people. And all of our management is involved in that process and in, furthermore, leading and developing and teaching others. I couldn't be more excited about the talent pool at Waters, and you do see the tenure and the depth and the expertise at many levels. And we're increasingly tapping into that as a leadership community. So I could go on and on, other than to say I just want to express confidence in what we're doing. And I do expect that as any organization evolves over time that we have a very strong and increasingly strong bench that we're developing from within and then opportunistically supplementing that with new skill sets and new perspectives from the outside where warranted. So it's a great equation.

Our next question will be from Brandon Couillard of Jefferies.

Sherry, a couple housekeeping items for you. First, could you walk through the impact of currency in the second quarter on the gross operating margin lines as well as EPS? And then, when you alluded to free cash flow normalizing by the end of the year, what exactly does that mean? Does that mean a return to growth? Or are you referring to more like a free cash flow conversion metric?

Sure, yes. So your first part of the question about the FX dynamics in this quarter. Maybe just recapping for the top line, the euro and the yen is really what drove kind of the FX of 2% on the top line. And we saw that favorability flow through to gross margin. We had probably a slight positive impact on the gross margin. But the dynamic that happened in the second quarter was because of our euro and pound, and particularly our cost base that we have in the pound. It impacted our operating expense. So that kind of flowed through on operating expenses as a headwind on our operating expense line. So we had guided on the EPS. We thought it would be 1% to 2% -- $0.01 positive, and we ended up a little bit more positive than that. As far as the cash flow normalizing. I would say, it would be more of a return to growth. We like to look at our cash flow conversion. We're at $0.27 for the half. We also probably see that improving, but really returning to growth. And the second quarter was really a dynamic of timing of some of our estimated tax payments as a result of the U.S. tax reform. Our balance sheet and working capital were -- are in good position.

What exactly did the $15 million litigation settlement payment relate to?

We have some ongoing litigation, and we had disclosed in our Q that, that had gotten settled. So we got that settled and paid in the quarter.

Our next question will be from Doug Schenkel with Cowen.

I just want to start with 2 follow ups on some earlier questions, and then I'll come back with a buyback question. So on the follow ups, first, in the fourth -- first quarter, you noted that India represented a, what you called, about a 3% year-over-year headwind to total pharmaceutical growth, which, I believe, implies that this was about an $8 million to $9 million revenue headwind. With that in mind, how much of the Q2 strength that you saw in India, specific to pharma, was a function of improvement in demand versus just a recapture of revenue you didn't get in Q1? And the second follow up is, recognizing U.S. revenue declined 2% year-over-year and that this was against a down 2% to 2.5% comparison from last year, do you expect U.S. to grow in the second half, given you're going to face tougher comparisons than you did in the first half where you actually maybe struggled relative to expectations?

Yes. So thanks, Doug. I think, for the most part, I would just say, in India, just to follow-up on those questions, the Q2 kind of incremental strength we saw in pharma was probably some combination of a little bit of pent-up demand plus just a warmed up purchasing tone of the customers, as I mentioned. And pharma was positive in Q2. It's certainly not where we want it to be in India or where we expect it to be in the back half of the year. And I guess, looking at the big picture, it doesn't necessarily surprise us that, as we sort of anticipated when we were on the call last quarter, that it would sort of build over the course of the rest of the year. So that's moving along as we expected it to. Relative to the U.S., I think it's a fairly simple answer to your question, which is, yes, we do expect the U.S. to grow in the back half of the year, and that is just based on, as I mentioned earlier, a reasonable expectation for typical year-end purchasing activity in somewhat of the pattern that we saw last year. So we're just focused on the basics there and making sure that we understand the tone of our customers that were -- the quoting activity and how we translate that into their deployment of their budgets, which have been conservative in the first part of this year as I mentioned.

Okay, thank you for that. And then on buybacks. Last quarter, you noted your share count guidance for the year assumes $800 million in buybacks. You're on pace for $1.1 billion in total buybacks, just annualizing what you've done thus far. Given the significant authorization last quarter, is there any reason you don't continue to buy back shares at the current pace of around $270 million to $280 million per quarter?

Yes, Doug. So far, through the first half, your numbers there, we've had about $550 million. And I'd say, we could maintain that through the second half. And we'll evaluate that over the course of the coming months.

Our next question will be from Catherine Schulte of Baird.

Chris, when you look at Waters-branded instruments, what do you think the most important factors will be in order to get that piece of the business back to mid-single digit growth and how long do you think that takes?

Yes. I know that's a fair question. And certainly, it is a portfolio effect. Obviously, we need to continue to step forward in our progress we're making in mass spec and continue to leverage the strength of our tandem quad portfolio in that regard, while also competing well on the high-resolution side as we continue to invest for the future. And on the LC side, there are ebbs and flows in the LC business. We have a fantastic portfolio and feel better about our portfolio now, probably, than any time over the past few years, given some of the refresh we've done there. I mentioned the ACQUITY Arc has done well, but now we have the ACQUITY Arc Bio, the ACQUITY PLUS which brings in a whole new set of capabilities to our core UPLC platform. And really if you look at broader trends and just the stand-alone LC business, the first half as a whole, U.S. LC was more like a mid-single-digit grower with worldwide being in that same range. And so it's really a matter of making that whole portfolio work and leveraging the benefit of some of the newer technology we have and continue to meet the needs of our customers. But we certainly have an expectation as well as goals to make sure that, that overall portfolio of Waters-branded instruments performs at the levels we expect.

Great, thank you. And then, Sherry, can you just give us a bridge for the EPS guidance change? Sounds like $0.07 or $0.08 of less favorable FX, but any other changed assumptions there?

Yes. Catherine, so you hit that one on the head. So our guidance change, we lowered the midpoint about $0.07, and it's really because of the change in our FX guidance for the second half of the year. And really, our overall assumptions for the guide kind of remain unchanged.

Our next question is from Derik De Bruin, Bank of America Merrill Lynch.

A couple of questions. So first one is, the DESI technology has been around for a while. And obviously, it's been partnered with some other mass spec companies. I'm just curious as to why you're doing that acquisition now? And then just in terms of -- can you give us some metrics in terms of what M&A is going to contribute to your constant currency growth in 2018?

Sure. Yes, just a couple additional comments on DESI. This technology has been around, for sure. It's been in a semi or a co-exclusive type of an arrangement with other partners. And frankly, we see a huge opportunity to, personally within Waters, develop the technology to make it even more robust, usable and widespread for mass spec imaging. And frankly, we see a significant pull from our customers. It's one of the key sources of differentiation in some of our high-end systems. And I think, we were held back probably from doing all we can with the technology in that type of model. There's obviously a transition period in there relative to other technologies. We want to support our customers as they evolve to the next generation of sort of Waters-driven DESI technology and having full control over the technology was a really critical step in doing that. I think it's also reflective of our belief in the direct mass spec technology category, mass spec imaging as part of that, and the really interesting technology portfolio we have. We just see more and more direct sample mass spec applications coming for all the reasons I mentioned, and want to control our destiny even more significantly. As it relates to M&A metrics and inorganic growth, there is very little of that in the business and even on the DESI side. It's completely immaterial at this point. So really the growth we're getting this year is truly organically driven.

Great. And then just one follow-up. So obviously, the dollar has been moving quite a bit and getting stronger. And I know previously there has been some issues with particularly your Indian customers losing some purchasing power and obviously things moving around and currencies in China. I'm just curious have you seen any sort of hesitation on people to buy because of their budgets? And then also, is there any sort of indication that the trade issues that are going on are bleeding over into maybe some of the OUS competitors like Shimadzu maybe getting a little bit more business?

Yes, thanks. I don't know. I think that's a really interesting question, Derik, and one we just really don't know. I personally don't see any evidence that trade or tariff or currency -- associated currency issues that we all watch very carefully have changed purchasing behavior. Certainly in India, the dynamics we've seen have been much more related to the specific kind of customer and country issues in India around some of the broader economy reforms. China, we really haven't seen any effect there. Obviously, there's a lot of unknowns out there relative to trade more broadly. I guess, personally, the way I look at that is I just try to understand it and if there are any threats but very much remain kind of a free trader in terms of my mentality and offering my voice to that where I can. And hopefully, a lot of the rhetoric that's going on right now is really a negotiation that ultimately restores and affirms the sort of inexorable globalization of our economies and enables free and fair trade. So again, no direct evidence that there's issues that get in the way of our normal commercial activities. But we'll obviously stay focused on that question. I think in the interests of time here, we have 1 more -- time for 1 more question.

Our final question will be from Patrick Donnelly of Goldman Sachs.

Just on the sales force realignment, I know you mentioned the positions were mostly filled by the end of 1Q. Can you just kind of talk through what historically has been the timing kind of ramp up to productivity there? And have you seen the territories bounce back once the positions have been filled over the last 3 or 4 months?

Yes. I appreciate the question. And we've -- like I said last quarter, we've tried to just be extremely transparent about what's going on here. But I'd continue to reinforce that this is a very small impact in terms of the overall results. It's a relatively minor set of changes. And obviously, there's a difference when you hire new people, when you're hiring kind of fresh, inexperienced reps in the company that have a big upside, but have a longer curve versus competitive and experienced reps, and we do have a mix there. So I don't want to put too fine a point on that other than to say that this is normal course of business, and we feel good about the modifications we've made over time, and it's all about investing in our team to win in a changing environment. So I'll just leave it at that.

That's helpful. And then maybe just a quick one on the P&L. Margins came in a little ahead of our expectations. Could you just talk through any key initiatives driving expansion there, I mean, even in a lower growth environment relative to where you guys have been historically driving some nice expansion? So I'm just kind of curious what the key lever is there, and how you're feeling going forward?

Just a quick comment and I'll let Sherry comment as well. But one of our key parts of our value-creation framework is continuous operational improvement. And since Sherry has come in, we have put together a comprehensive program to scale the company and drive efficiencies in all parts of the P&L, everything from how we design products and manage our cost to goods and non-product costs all the way through G&A and selling and marketing-type expenses. And really a lot of that's being done to preserve and enhance our overall commitment to our growth investments in R&D and sales force expansion. So I don't want to put too much detail on it right now. We look forward to sharing more over time. But we are really developing a comprehensive program in that regard, and are excited about what it will do to help us continue to grow scale and invest in the company.

And the only thing I'd just add, for the quarter, we did see some favorable mix in the quarter that impacted that and a little bit of FX as well.

Good, thanks, Sherry. I think we'll turn to the wrap-up here. And I want to just say thank you all for your great questions as always. In conclusion, here at Waters, we remain focused on delivering our growth plans for 2018, headlined by an acceleration in the back half of the year within our pharmaceutical market, continued growth in TA and broad-based growth in China. We believe that market conditions and our strong competitive position support continuing success. So on behalf of our entire management team, I'd like to thank you for your continued support and interest in Waters. We look forward to updating you on our progress during our Q3 2018 call, which we currently anticipate holding on October 23, 2018. Thank you, and have a great day.

We thank you, all, on your participation in today's conference. That will conclude the call. You may now disconnect. Thank you.