Waters Corp (WAT) 2022 Q3 法說會逐字稿

Good morning, and welcome to the Waters Corporation Third Quarter 2022 Financial Results Conference Call. (Operator Instructions) The conference is being recorded. If you have any objections, please disconnect at this time.

It is now my pleasure to turn the call over to Caspar Tudor, Head of Investor Relations. Please go ahead, sir.

Thank you, operator. Good morning, everyone, and welcome to the Waters Corporation third quarter earnings call. Today, I'm joined by Dr. Udit Batra, Waters' President and Chief Executive Officer; and Amol Chaubal, Waters' Senior Vice President and Chief Financial Officer.

Before we begin, I will cover the cautionary language. In 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 results and commentary on potential market and business conditions that may impact Waters Corporation over the fourth quarter of 2022, all year 2022 and 2023.

These statements are only our present expectations and actual events or results may differ materially. For more details, please see the risk factors included in our most recent annual report on Form 10-K, our Form 10-Qs and the cautionary language included in this morning's press release.

During today's call, we will refer to certain non-GAAP financial measures, including in our discussions of the results of operations. Reconciliations of the non-GAAP financial measures to the most directly comparable GAAP measures are attached to our earnings release issued this morning, and in the appendix of our presentation, which are available on the company's website. Unless stated otherwise, references to quarterly results increasing or decreasing are in comparison to the third quarter of fiscal year 2021.

In addition, unless stated otherwise, all year-over-year revenue growth rates and ranges given on today's call, are given on a comparable constant currency basis. Finally, we do not intend to update our predictions or projections, except as part of a regularly scheduled quarterly earnings release or as otherwise required by law.

Now I'd like to turn the call over to Udit to deliver our key messages for the quarter, then Amol will provide a more detailed look of our financial results. After we will open the phone lines up to take questions. Udit?

Thank you, Caspar, and good morning, everyone. We continue to deliver excellent results in the third quarter with very strong growth across our product portfolio, our end markets and geographies. This was led by instrument growth of more than 20%. Similar to previous quarters, orders again outpaced sales.

A result like this takes an exceptional effort and dedication from all our colleagues, we are very proud of what our teams continue to consistently deliver. Today, we have 3 key messages to share, which reflect the ongoing strength and exciting drivers of our business.

First, we are consistently delivering strong commercial execution. Our transformation has become embedded in how we operate with a relentless focus on commercial excellence. You can see this in our results.

Second, innovation at Waters is back. It's delivering across our portfolio and contributing meaningfully to our growth. Our refreshed product portfolio is answering our customers' unmet needs across a variety of applications. Adoption rates for new instruments have been impressive and are driving market share gains.

Thirdly, our growth initiatives are gaining traction. We continue to make measurable progress on our high-growth adjacencies and have proof points that are giving us confidence.

Turning now to our third quarter results. Our revenue grew 7% as reported, and 15% on a constant currency basis. We saw broad strength across our end markets and geographies with robust demand from our customers.

Growth in the quarter was led by industrial and academic and government, which both grew over 20% and pharma, which grew 9%. Each of our regions grew double digits. China grew over 20%. India grew 20%. Europe grew mid-teens, and the U.S. grew 11%.

Instruments grew over 20% with our LC, mass spec and TA portfolios each growing double digits. Mass spec growth was very strong at almost 40%. Recurring revenues grew 10%, supported by our growth initiatives in e-commerce and service attachment.

Our Q3 non-GAAP adjusted earnings per share was $2.64. This is roughly flat year-over-year despite FX headwinds of 13%.

Now looking at our year-to-date performance, we're executing well throughout the organization despite a tough macroeconomic environment. Our strength has been broad-based across our geographies and end markets. Each of which are up double digits this year.

Pharma is up 12%. Industrial is up 15%, and academic and government is up 16%. The instrument growth has been very strong throughout the year, growing 19% year-to-date, led by the U.S. at almost 30%. We expect this to take future growth in our recurring revenues.

Our transformation has allowed us to consistently deliver excellent results. Our 3-year CAGR underscores the momentum we've built across our business. Year-to-date, we've delivered 9%, 3-year stacked growth overall on a constant currency basis.

Moving on to our second key message, innovation. Waters has long been known as an innovation leader. Our investments in innovation are again driving results and contributing meaningfully to our growth. Sales of Arc HPLC, ACQUITY Premier and Max Premier Columns again doubled in the quarter versus the previous year.

Our new products are solving problems that matter to our customers, supported by our technical strength and strong commercial execution. Arc HPLC is driving customers to upgrade their LC fleet used for routine small molecule analysis. This is advancing customer lab capabilities and productivity while accelerating the cadence of instrument replacement.

Our MaxPeak Premier technology separates complex molecules like biologics. By eliminating the need for passivation, MaxPeak Columns can get scientists answers up to 20x faster than their non-Premier equivalent. They also gave sharper peaks with 12x the sensitivity when separating oligonucleotides as an example.

The customer benefits around Premier are very compelling. This has resulted in significant large molecule growth in recent quarters, which now accounts for over 30% of our pharma revenues versus 20% just a few years ago. Today, biologics represents 20% of the pharmaceutical market, but account for 40% of the R&D pipeline, positioning us very well for future growth.

With our cyclic ion mobility separation, high-resolution mass spec, Cyclic IMS for short, scientists can separate molecules by shape as well as mass due to the combination of ion mobility with time-of-flight. This is providing customers with amplified resolution and clarity. Demand has ramped up for Cyclic within OMEX research for lipids, proteins and metabolites, all exciting areas within early disease detection and discovery.

As an example, the largest privately funded mass [spectrometry] facility in Canada has been using Cyclic for antibody sequencing and discovery. They're impressed with the quality of data that Cyclic has provided supporting their lab at the forefront of scientific discovery.

Also within mass spec, we're seeing great traction for our recently launched Xevo TQ Absolute. It has seen strong demand in food and environmental applications, led by Per and perfluorinated compound testing. The PFAS testing market has seen rapid growth in recent months, driven by increased surveillance testing and newly added compounds of interest. We see this as a multiyear growth opportunity.

In June of this year, the U.S. EPA announced new drinking water health advisories for the 4 most notorious PFAS compounds setting measurement levels finer than part-per-billion. TQ Absolute is so sensitive, it can detect PFAS at 1 part-per-quadrillion. This is less than a grain of sand in an Olympic-sized Summing pool.

TQ Absolute's ability to quantitate low abundance molecules is beyond anything on the market and gives us the right to win in this space. Since launching TQ Absolute, we won competitive placements for PFAS testing across every region. In one example, a large global testing organization is using its infant food and water testing in Southeast Asia. This customer is developing a new set of methods that are -- that can be used for routine testing across workflows in their organization.

Within informatics, waters_connect is enabling exciting new analytical areas in large molecule analysis. On instruments like the G3 QTof and BioAccord. This includes cell culture media analysis, peptide mapping and oligonucleotide characterization. There is a lot of long-term potential in this area, given demand for stability, quality and impurity analysis.

The characterization of biologics and novel modalities allows these molecules to move downstream into routine QA/QC workflows. Additionally, at TA, we have added new powder rheology capabilities to our portfolio. This is to support the strong growth we are seeing in battery-related applications.

Orders are critical to anode and cathode manufacturing, allowing battery producers to better screen electrode coatings and solvent-free dry coatings helps ensures optimal performance, prevent defects and reduce cell failure rates.

According to industry sources, in the next 10 years, production of lithium-ion batteries is expected to grow tenfold. Demand is expected to exceed 4,000 gigawatt hours per year by 2022, driven by electric vehicles and energy storage. As battery volume scale, our TA instrument portfolio is well positioned to support an expanding set of testing demands within the battery development and safety analysis space.

One of our European customers, the fast-growing Scandinavian battery producer, uses our rheometers to test incoming materials for critical electrode components. This company has tripled its purchases of TA instruments this year, reflecting not only its own growth, but the confidence they have in our technology and support as they scale their operations.

I would now like to share some of the recent progress we've made in our -- towards the high-growth adjacencies as our third key message. Since time is limited, I will only focus on Bioprocess Characterization.

BioAccord offers a compelling value proposition to bioprocess engineers. It provides a paradigm shift in analytical capabilities for biologics manufacturing, which while being quick and easy to use. Through our collaboration with Sartorius, we've expanded the capabilities of BioAccord in this area. We can dramatically shorten clone selection times.

We are also enabling improvements in tighter and yields, which can reduce COGS. Our value proposition is resonating amongst industry leaders. At the recent Bioprocess International Conference in Boston, which I attended per study, AstraZeneca publicly highlighted the benefits of implementing online process analytical technology using the BioAccord monitoring to monitor drug substance and cell culture media.

Meanwhile, Janssen and other pharmaceutical companies are already using it to monitor vital components during cell culture production and for analysis of raw materials used in bioprocessing. By finger printing components in cell culture media using BioAccord, they are generating insights that can help streamline the manufacturing process. These are just a few of the early proof points we can share with you today for BioAccord. We're encouraged by the long-term opportunity we have to solve unmet needs in Bioprocess Characterization.

Now I will pass the call over to Amol to continue covering our third quarter financial performance and provide our guidance for the remainder of 2022. Amol?

Thank you, Udit, and good morning, everyone. We delivered another excellent quarter in Q3 with 15% constant currency growth. Waters Division grew 14% and TA grew 18%. By end market, pharma grew 9%, industrial grew 22% and academic and government grew 29%.

In pharma, we saw growth in both large and small molecule with strength across segments, applications and regions. In industrial, each of our major regions grew mid-teens or above, with China up almost 30%, Europe up over 20% and U.S. growing 16%. Growth was led by LC-MS instrument sales, which grew 50% with our chemical analysis, food and environmental businesses, all delivering strong growth. In academic and government, growth was also strong across all regions.

Now by geography, sales in Asia grew 18%. The Americas grew 11% and Europe grew 14%. In Asia, growth was led by China, where sales grew 23% as we executed well across all trade classes despite the challenges posed by new lockdowns.

In the Americas, the U.S. grew 11% with growth across applications and end markets. Europe grew 14% in the quarter, led by industrial, which grew over 20% and pharma, which grew low double digits. By products and services, instruments grew 21% with our LC-MS and TA portfolios each growing double digits. Recurring revenues grew 10% with chemistry up 10% and service up 9%. There was no change in the number of days versus the prior year's quarter.

Finally, TA had another great quarter with sales up 18%, led by strong growth in thermal analysis and rheology. Demand for TA products remained strong across all regions with sales in electronics and batteries continuing to ramp. Gross margin for the quarter was 56.7% compared to 58.9% in the third quarter of 2021.

We had incredible growth in instrument sales this quarter with mass spec growing nearly 40%. While this resulted in approximately 40 basis points of adverse mix impact for the quarter, it is expected to drive future margin accretive recurring revenue growth. The strong U.S. dollar resulted in 120 basis points of FX headwind on gross margin in the quarter.

We have continued to offset the impact of inflation with pricing increases. Working with our customers, our teams delivered over 350 basis points of net pricing gains in the quarter. While inflation had no net impact on our gross profit dollars, it does affect margin calculation as the revenue base is also higher. These dynamics drove the remaining difference in the year-over-year gross margin for the quarter. But again, there was no net impact of inflation on gross profit dollars or earnings per share as the incremental inflationary costs were offset by pricing increases.

Operating margin for the quarter was approximately 27.8% compared to 29.7% in the third quarter of 2021, driven primarily by foreign exchange headwinds and the gross margin dynamics. Year-to-date, operating margins have expanded 70 basis points before 110 basis points of foreign exchange headwind.

The expansion of 70 basis points includes the investments we have been making to nurture our higher growth adjacencies and includes the impact of higher instrument mix and the inflation dynamics I just discussed. Our effective operating tax rate for the quarter was 15.1%. Average share count came in at 60.1 million shares, which is about 1.8 million less than the third quarter of last year.

Our non-GAAP earnings per fully diluted share for the third quarter was $2.64 in comparison to $2.66 last year. The foreign exchange headwind lowered our non-GAAP EPS growth by 13%. On a GAAP basis, our earnings per fully diluted share was $2.60. A reconciliation of our GAAP to non-GAAP earnings is attached to the press release issued this morning and in the appendix of our earnings call presentation.

Turning to free cash flow, capital deployment and our balance sheet. We define free cash flow as cash from operations, less capital expenditures and excludes special items. In the third quarter of 2022, free cash flow was $126 million after funding $32 million of capital expenditures.

Since last quarter, accounts receivables have moved back in line with historical pattern relative to our sales volume. However, we continue to build inventory as a proactive measure to secure supply and build safety stock, given strong instrument demand.

In the third quarter, our inventory balance increased by $32 million. We maintain a strong balance sheet, access to liquidity and a well-structured debt maturity profile. This strength allows us the ability to prioritize investing in growth, including M&A and returning capital to shareholders.

We continue to evaluate M&A opportunities that will meaningfully accelerate value creation in well-thought-out attractive, high-growth adjacent markets. In Q3, we repurchased approximately 483,000 shares of our common stock for $155 million. At the end of the quarter, our net debt position was approximately $1.1 billion with a net debt-to-EBITDA ratio of about 1.1.

Now as we look ahead to the remainder of the year, I would like to provide some updated context on our thoughts for 2022. We have seen continued strong performance this year, driven by robust end market demand, excellent commercial execution across all our geographies and new product introductions, which are driving growth.

As we close the year, we expect our sales momentum to remain solid and that our refreshed portfolio and growth initiatives will continue to enhance our performance. We also expect to successfully navigate supply chain constraints and inflationary pressures assuming these challenges do not worsen.

In light of this continued strong performance, we are raising our full year 2022 guidance to 11.5% to 12% constant currency sales growth, up from our prior guide of 9.5% to 10.5%. At current rates, a negative currency translation is expected to subtract approximately 6 percentage points resulting in a full year reported sales growth guidance of 5.5% to 6%.

Gross margin for the full year is expected to be nearly 58%, and includes 100 basis points of FX headwinds versus prior year. Operating margin is expected to be 30.2%, which includes 120 basis points of underlying margin expansion, offset by 120 basis points of FX headwind.

We expect our full year net interest expense to be approximately $38 million and full year tax rate to be approximately 15.5%. Average diluted 2022 share count is expected to be approximately 60.3 million. Our share repurchase program will continue as we progress through the rest of the year, and we'll provide updates as appropriate.

Rolling all this together and on a non-GAAP basis, full year 2022 earnings per fully diluted share are now projected in the range of $11.85 to $11.95, which is 6% to 7% growth versus last year despite a negative currency impact of approximately 11 percentage points. Versus the previous guide, our updated guidance includes improved underlying business performance of $0.14, offset by $0.24 of higher FX headwind.

At current FX rates, we estimate the full year FX impact on 2023 to be a year-over-year headwind of 2% to 3% on sales, and 4% to 5% on adjusted EPS. FX impact is expected to be largely concentrated in the first half of 2023 at current rates.

Looking to the fourth quarter of 2022, we expect constant currency sales growth to be 6% to 8%. At today's rates, currency translation is expected to subtract approximately 8 percentage points, resulting in a fourth quarter reported sales growth guidance of minus 2% to 0%.

Fourth quarter non-GAAP earnings per fully diluted share are estimated to be in the range of $3.66 to $3.76, which is flat to 3% higher than prior year's quarter despite negative currency impact of approximately 15 percentage points.

Now I would like to turn it to Udit for summary comments. Udit?

Thank you, Amol. In summary, we are very pleased with our performance. Demand has continued to be robust across our resilient end markets and geographies. This, together with our strong commercial execution and refreshed portfolio is allowing us to consistently deliver excellent results. Once again, we are raising our full year sales guidance from a prior range of 9.5% to 10.5%, now to 11.5% to 12%.

In closing, I would like to point out that our 2022 ESG report will be released next week. At Waters, we're proud to have been widely recognized as an ESG leader. We believe that we all have a part to play in leaving the world better than we found it from decreasing our environmental footprint to becoming more representative of the society we live in.

This year, we made further progress towards our goals, delivering approximately 60% of our electricity from renewable or low-carbon sources. We launched the Water Student Academy and our partnering with 3 historically black colleges and universities to provide STEM education and career opportunities. We also conducted broad stakeholder engagement in our comprehensive materiality assessment.

We are proud that our new state-of-the-art chemical manufacturing facility in Taunton, Massachusetts was recognized by the U.S. Green Building Council as the only LEED-certified facility of its kind in the state and among the small number in the United States. While there is always more work to be done in ESG, I'm proud of the progress we've made.

And with that, I'll turn the call back over to Caspar.

Thanks, Udit. That concludes our formal comments, and we are now ready to open the phone lines for questions.

(Operator Instructions) And the first question is coming from Vijay Kumar of Evercore ISI.

Congrats on the very strong prints here. Udit, maybe my first one for you on, on this revenue outperformance in the Q. In a big picture, when you look at the state of end markets, whether it's a pharma CapEx environment replacement cycle or industrial perhaps macro situation, talk about the big drivers here on what's happening and whether any of these drivers should change for '23?

Sure. So Vijay, firstly, thank you. Look, from a demand perspective, I mean we are operating in very resilient end markets, right? I mean, starting with pharma, which is 60% of our business. And I'll remind you that we are more levered to late-stage development and QA/QC, pharma continue to grow. And even if there is a downturn, people don't stop consuming medicines, right? So I think that we believe, is a very strong place to be.

Second is our industrial business, which over the years has transformed and is heavily focused on our food and environmental and increasingly in the TA business on battery testing and the need for, say, food, clean water, especially with PFAS testing as well as battery testing is our salient driver. So roughly 80% of our business is levered towards, I would say, resilient end markets.

Now in those rather resilient growing end markets, I think there are Waters' specific drivers that I'd like to point out that gave us confidence in continued outperformance, right? So if you just simply start with our commercial initiatives, right? I mean, we see those continuing to add value over the next couple of years. Be it instrument replacement, be it e-commerce, which is well over 30% now from a 20% starting point for our consumable's revenue, but we think we're going to end up north of 55% over the next few years.

Our CDMO footprint has increased quite nicely over the -- on a stacked basis over the last 2 to 3 years, that portion of the business has grown double the rate of the overall business, almost 20%. So we think our commercial initiatives have runway, #1 in these strong markets.

Second, as I pointed out in my prepared remarks, innovation is really contributing well to our growth. And that is a driver that will continue to contribute, right? I mean starting with pharma, we, of course, talked about Arc HPLC. But then what gives me even more confidence is our increased focus on biologics, right? And that is one of the more salient drivers of growth for pharma. Over 30% of our pharma business now is levered towards large molecules with now the launch of MaxPeak Premier Columns, now increasingly focused on the mass spec business.

I remember when I joined folks told me what is Waters' going to do about the mass spec business. And 2 years later, I mean you see strong, strong outperformance in our mass spec business. I mean instruments grew this quarter, 21%. Mass spec almost touched 40%, and the Xevo TQ Absolute really solving problems for our customers in detecting increasingly low quantities of PFAS.

So the mass spec portfolio is contributing very nicely to the growth of the business. I can go on, on the innovation side, but I feel very good about where we stand from an innovation standpoint. And then finally, the third specific driver for Waters is our adjacencies. I pointed out the increased traction we have for BioAccord, not just in QA/QC, but upstream in clone selection in selection of -- and detection of raw materials for bioprocessing. And there's a lot of traction for simplified LC-MS in the -- from our customers.

And finally, despite the sort of turbulent environment, be it rolling shutdowns due to COVID in China or the geopolitical challenges in Europe, we've been able to navigate through these extremely well. So that gives me confidence that from a macro perspective in these resilient end markets, I mean, Waters is commercial execution, really now supported by strong innovation and increased traction in our adjacencies gives me a lot of confidence that in the future, we'll see even more robust performance.

And really, I mean, I'll end here. Look, a faster instrument growth and don't ask me when this slows down. It looks really good. Orders were again higher than sales. This looks really good, but it bodes well for what we see in the future for our consumables business, especially service, which we've been focusing on a lot. So I hope that gives you clarity on why we have so much confidence and we've raised the full year guidance as well on constant currency growth.

That's helpful, Udit. And maybe, Amol, one quick one for you. When you look at the margin performance, inflation, FX and mix were around the main 3 components. When you look at '22, should we expect any -- perhaps some margin expansion? I know FX is a headwind, not sure how to think about the impact of inflation on margins in mix?

Yes. So Vijay, look, I mean, on the gross margin line, there are sort of 4 vectors that are playing out, right? There is FX. There is a higher instrument mix. There is new product launches, and then there is the pricing inflation dynamics that I just discussed. And each of these vectors are going to be accretive in driving gross margin expansion in the times to come.

I mean on the FX side, we really feel excited about the fact that despite this headwind, the business has rallied to find ways to offset the impact of exchange rate. And when the exchange rates normalize, you will see a much more pronounced impact on the margin because of the resilience that has already played out in our 2022 numbers.

On the instrument mix, I mean, it's a great problem to have. While this instrument growth is creating somewhat of a headwind on the margin today, it is going to drive accretive recurring gross margin growth from chemistry and service in the future. We've seen also great growth from our new products, and it sort of underscores that innovation matters in this space.

But as you can understand, anytime when you launch new products, they haven't gone through the typical value engineering cycle that they go at Waters like we've gone through with Alliance. And we will see that play out on the gross margin of these newer products in the coming years.

And then the last piece is the pricing inflation dynamics, right? And there the pricing gains are systemic. We build muscle in terms of systems and processes to drive pricing gains more than what we have historically driven, which was 50 to 75 basis points.

And on the other hand, a lot of inflation is spot buys. And as the electronic component market sort of normalizes, some of the spot buy pressure will go away again providing tailwind to the gross margin.

So overall, I mean, we are still on track where we say, look, I mean, we will have about 100 basis points of margin expansion in the underlying business between volume leverage, mix and productivity gains. And we will reinvest 70 to 80 basis points of those gains in nurturing our higher growth adjacencies in the near-term.

The next question is coming from Dan Brennan of Cowen.

Maybe just as a jumping off point as we kind of look ahead, you just kind of address a little bit of the margin drivers. I know at the Investor Day, you talked about '23, still feel good about mid-single digit plus. I'm just wondering, it doesn't sound like anything has really changed. But just wondering, is that still the right Zip code as we sit here today, which would imply a 3-year stack acceleration from what you're doing?

And then kind of related to the prior question, given the FX headwind that you're talking about for next year, 3 to 4 points, it would imply kind of modest top line growth. So in a modest top line growth environment, kind of what's the ability to expand margins in '23, if that's fair?

So Dan, firstly, thank you for your question. Look, I'll start, and then I'll pass over to Amol. The 5% to 7%, we talked about was in a different context, right? I mean, from a constant currency -- on a constant currency basis. I mean, we've been clocking well ahead of that, as you know, right? So year-to-date, when you see it close to 14% growth, on a 3-year stack basis, it's almost a double-digit growth, slightly shy of a double-digit growth. So we really -- really had well ahead of that.

And that's not just strong end markets, but also really strong execution of our commercial initiatives, we still have some legs over the next couple of years. We're seeing innovation really starting to contribute meaningfully to this growth, of course, helping with the instrument replacement, but also improving our biologics footprint.

And then finally, our adjacencies are also starting to contribute, especially the bioanalytical characterization and the battery testing initiatives. So we feel very good about where we sit today.

In terms of what we expect for 2023, there will be ample time to discuss that in our Q4 earnings, and there's still a bit more data to be collected before the year-end, as you can imagine, in such a turbulent environment, we want to take our time to think through what that will look like.

But sitting here today, we feel very good about what we've told you in the past in terms of drivers, wherever the market is, you can assume that our commercial execution will add on top of it. Second, our innovation is really meeting the unmet needs in the market. And third, our adjacencies are starting to contribute, especially the biologics and the batteries' part. So feel very good about where we sit, more to come in Q4. Amol?

Yes. And then covering on the margin, right? So I think at this stage, we feel really good about where each of our initiatives are. I mean, our volume leverage is working with a strong instrument growth this year, we think that will have an accretive mix impact on the recurring revenue, bringing better gross margin profile next year.

We do see sort of the level of spot buy slowing down, and we have gained a lot of confidence and comfort in the systems and processes that we've implemented for pricing. So all of that will enable us to stay on the track that we outlined at our Investor Day, which is still roughly 100 basis points of underlying margin expansion with a 70 to 80 basis points of reinvestment in higher growth adjacencies.

Great. And then maybe just a follow-up on instruments. Obviously, you spent a fair amount of time already. But we love just to expand a bit. I mean the 40% mass spec growth is just very notable, and the 21% and the 10% 3-year stack is really strong. So maybe could you just step back and as you look at all the adjacency opportunity, new innovation opportunity. Like, what's the right way as we look ahead on the durability of kind of instrument growth for Waters?

It's a fantastic question. Near and dear to my heart. Look, I have made it a point to go to many of the conferences that many of the technical conferences, like the AAPS, this is the American Association of Pharmaceutical Scientists, right, where I went recently the Bioprocess International the AACR, just to talk to customers directly and not just drink our own cooled.

And I can tell you, our mass spec portfolio is solving fairly significant unmet needs across the portfolio. Now we've talked about LC in the past, Arc HPLC and the ACQUITY Premier, what they do for especially ACQUITY Premier and MaxPeak Premier Columns, what they do for biologics testing.

On the mass spec side, you can go across the portfolio. High-risk portfolios, our Cyclic IMS is the only instrument that is able to analyze molecules by shape and size, which is quite an important attribute to have as you're looking at larger molecules, and that's direct feedback from our -- from some of our top customers. And Cyclic has been doing very well recently.

The MRT, which we launched recently, the Multi Reflecting ToF, in its early innings. We've also got the license for charge detection mass spec. And we feel very good about our IRS portfolio as a consequence. Second, the application of tandem quads. This is sort of the workhorse instruments in the industry, right?

I mean, I already talked about the Xevo TQ Absolute, and the waters_connect software that we developed for our Xevo TQ-XS, which is the food, which is levered towards the food testing environment. This is a very deliberate effort, Dan, right?

I mean, the challenges in environmental testing with increasingly sensitive -- increasing amount of sensitivity required for PFAS testing is something that's known to all of us. And it's an unmet need across all geographies, and we are just seeing the start of that demand buildup. So we expect that to grow very nicely over the next couple of years.

Second, on the food testing side, our customers came to us and said, look, we want to be able to do our testing faster and quantitate faster and the waters_connect platform, especially with mass Quan application, speeds up the process by 50%. Again, a very deliberate focus unmet needs for our customers.

And then finally, we've talked about BioAccord, which was initially launched in the QA/QC environment. Of course, it has traction. As I mentioned in my prepared remarks, with several large pharmaceutical companies. But not just in QA/QC, now for clone selection with our collaboration with Sartorius. We've already placed several instruments, and there is a very large number of seeds out there, and we think the seed conversion is going to be pretty high in this case for clone selection.

And we have seen increasingly customers use it to test raw materials, again, something I pointed out in my prepared remarks. And again, the pipeline of pharmaceuticals is roughly 40% towards large molecules, and the use of a simplified LC-MS method, which create great workflows is something that we expect to contribute to -- for many months to come.

So across the portfolio, and I've really focused on elaborating on mass spec now. We've talked about LC in the past. We feel extremely, extremely good about what it's doing in the pharma space or towards biologics, but also how it's helping us revive the growth in food and environmental and the academic segment.

Thank you for the question. I could go on forever. I mean, being an engineer, I can get into a lot more details, but I think this is -- I'll stop here, and I hope that gives you some flavor of why we're so confident about what we're doing.

The next question is coming from Matt Sykes, Goldman Sachs.

Congrats on the quarter. Udit, maybe the first question just on China. It seems that for you and others, the China lockdowns have been less impactful this time around than previously. Could you maybe talk about what has changed there? Is it just where the lockdowns are occurring? Or have you changed the way that you're managing that business over there to adjust to that type of environment? So we should expect maybe less volatility in China going forward?

Matt, it's an excellent question, something that we think about and talk about a lot in our team.

Look, make no mistake, there are rolling lockdowns across China going on even now. That said, we have, as I mentioned previously, we had a -- we have a very strong leadership in China that we brought in over the last couple of years. And we've managed to navigate these lockdowns really well. And I hope, and I think that's not going to change over the next few quarters as this continues.

Now just looking at the facts, I mean, year-to-date, China is growing roughly 16%. I mean, this quarter was roughly 23%. And the growth, and again, I focus more on our Waters specific factors. I mean the growth is driven by our strong commercial execution; the instrument replacement driven by Arc HPLC. And now mass spec has contributed to the revival of the academic segment, where the business has almost doubled and the industrial segment as well, right?

So we feel very good about what we're doing across end markets, not just in pharma. Our contract manufacturing initiative has done extremely well, and we started in China with strong, strong growth with a biologics manufacturer, biologics contract manufacturer there. The commercial execution has been going extremely well in China.

Innovation is contributing like everywhere else geographically. The mass spec tandem portfolio has again helped us grow the food and environmental and the electronics testing market. And then finally, as we look ahead, we feel that the fact that we've been able to navigate through these ups and downs gives us a lot of confidence as things ease up, that we will continue to accelerate in China.

So China remains a strong growth market for us. We feel very good with the leadership we've had and the execution we've had that we can manage the volatility that we've seen so far.

And just to add to that, Matt, right? For Q3, China benefited with a lower base line because of the $12 million shipment delay last year. So that's about 10 percentage points of growth. But at the same time, they did have a headwind from some of the newer lockdowns.

So one has to keep that in mind. And as Udit outlined, for us, the team is executing really well and working towards a mid-teens' growth profile for the year.

Great. And then just one quick one for you, Amol. Just on inventories, obviously, a lot of focus on the customer side inventories. But as you think about your own inventory, and you think about the potential visibility of demand as we go into '23, and it still could be somewhat uncertain. How are you thinking about building your own inventories to solve for constraints that still exist, but also for maybe a more uncertain demand environment in '23?

Yes. So I mean what we've done is we've looked at sort of our product profile, and we've gone through bill of materials for pretty much every product. We've gone through secondary and tertiary supply chains and identified hotspots where a certain component that travels to the supply chain is sort of in shortage. And there, we've gone deep to build relationships with the primary supplier and have secured quantities that will last us for longer than usual times, right?

And where possible, we have built alternative supplies, especially for electronic components. And where possible, we will also build a geographical diversification, so you sort of not struck in a lockdown in China or in a place where you have a sole source. Now that has put some pressure on inventory because we've sort of accumulated this inventory in preparation for the demand that we are seeing on the instrument side and in preparation for potential supply disruptions that may be caused by COVID or other sort of macroeconomic events.

But at this point, we feel really good where supply chain stands, right? Progressively, a lot of the yellows have been resolved and things are sort of between green and yellow on most of the items.

The next question is coming from Luke Sergott of Barclays.

Can you dig in here what you're seeing on the CDMO side? There's been a lot of mixed signals coming from peers and also CDMOs themselves. Can you just give us a sense of how you guys are seeing that market shake out, and what your -- how you're factoring that in as you start planning for next year?

So Luke, thanks for the question. Look, I mean, let me just start with some context and then I'll answer your question, right?

I mean, when we started our transformation process, CDMOs where I would say, less than 20% of our pharma business. And we worked -- and this is, as you know, one of the most dynamic segments for the pharma business.

Over the last couple of years, we worked extremely hard to build tools, systems, processes and go after that customer segment. And the growth in that segment over the last 2 years has been double the dynamic growth that you see, right?

So if you see our 3-year stacked growth number, it's almost double digits, about 9%. The CDMO growth has been close to 20%, right? So the overall demand for us and our value proposition in that market has been recognized very widely.

And the value proposition, I'll remind you, is not just one of pricing and giving better lease terms. It's actually a technical value proposition, meaning, as more complex molecules are transferred from pharma and others into CDMO, our scientists are working hand-in-hand with our CDMO customers to help them transfer those processes from the Pfizer and the Merck and the AstraZeneca's of the world.

So the value proposition is recognized. We've done extremely so far. And yes, we are following the volatility in the CDMO market. Now I'll give you an example, right? So global CDMOs like any other -- like any other multinational have global footprints now, right? And if there is a geopolitically driven volatility, for instance, either in China or in the United States, what we are seeing is if any of our customers, CDMO customers is starting to look at diversifying their footprint, they're coming to us and saying, "Hey, I'm no longer going to expand my facility" as an example, in China or no longer going to do it in the U.S. I'm going to actually diversify to Ireland or diversify to Singapore.

They come to us first. And so for us, the overall demand, given our deep relationships with our top customers in the CDMO space has not fluctuated, right? So we find that to be a very strong growth segment for us. It might just shift geographically given all the geopolitical challenges that are occurring and with a lot of repatriation, our CDMO customers are diversifying.

So I hope that clarifies why we still remain confident that while individual geographies might suffer a little bit. We pick up the volume in other geographies. And by and large, none of our customers have come back so far and said, "Hey, we want to slow down."

Okay. Great. And then you talked about service a little bit. And as you guys continue to drive a lot of strong instrument growth, can you update us on how much you've expanded your installed base? And then talk about the service attach rates, and what's driving part of your strong service growth? Is it more about just placing new boxes? Or is it also driving that incremental service revenue per instrument?

Yes. So let me start, and then I'll hand over to -- hand it over to Amol.

So we had started with the aspiration, Luke, of increasing our service attachment rates by and its already industry leading. We wanted to expand it by about 1,000 basis points, meaning 10% -- 10 percentage points. We've already done 200 basis points so far in the last 1.5 years or so.

We still see a long runway of increasing our attach rates. And this is through many different tactics, right? So quoting at the point of sale, having automated renewal and several other tactics that I won't discuss openly due to competitive reasons. We feel extremely good about the increasing attach rates for any installed base that we have.

Now with such terrific instrument growth with LC, with mass spec double digit over -- on a stacked basis, I mean 21% year-to-date -- sorry, 19% year-to-date, 21% for the quarter. We feel very good that we should see that flow through in the service business over the next few years. I know, Amol super enthusiastic about this, and he gets very analytical with our teams and says, you've grown your instrument base as much. Your service should go up this month. So I'll let him comment a little bit.

Yes. Luke, it's a great question. And the way we look at it is, let's say, when you grow instruments by 21%, your installed base doesn't grow by 21%, right? Because the installed base on an average is, let's say, 7 years. And so you get a 3% bump if all these instruments were new placements. But close to 70% or 80% of them are replacements, so they are sort of not adding to the installed base. The new ones are, but also on the ones that you replace, you expect higher utilization at least on chemistry.

So all of these become available to what you can drive your recurring revenue on. And as Udit pointed out on service, we've been very successful 200 basis points. Last year and this year, we said we would do 100, we already did 100 in the first half of the year. And again, there, one has to think not all of it is incremental revenue because these customers are already buying spare parts from us outside of the plants.

So the incremental revenue is sort of a fraction of what the attachment rate would bring. But overall, with this great instrument growth, we feel really excited how much recurring revenue we can drive both on chemistry as well as on service in the years to come.

And just to sort of summarize, Luke, the simplest way to think about it is, if we replace 100 instruments, 20 to 30, closer to 30 these days, our new customers and new users, right? And they then convert into service revenue, de novo service revenue, add on top, better service performance with increased attachment rates gives us confidence that the increased installed base, especially the newer ones are going to add incrementally to service growth over the coming years. And of course, consumables attachment is an added benefit.

The next question is coming from Rachel Vatnsdal of JPMorgan.

Okay. So first off here, we've had a few of your peers just talk about changing and ordering patterns from customers throughout various end markets. Just as supply chain constraints have slowed down, so you're seeing customers returning back to normalized ordering patterns. So just wondering, if you've seen anything in line with that across any of your end markets, or any shift in ordering patterns from your customers so far?

Rachel, on the orders to sales ratio, right? So our orders are again grown more than the sales this particular quarter. So orders were higher than sales. Again, we have not seen, I would say, any sort of significant change in order patterns so far this year. I mean it's a very robust pipeline.

We're very -- and again, I'll remind you, I mean we're not dealing with volatile end markets, close to 80% of our end markets are highly, highly resilient. Second, our products are very innovative, right? I mean, we are now meeting unmet needs for our customers, right? So we don't expect customers to stop ordering in Xevo TQ Absolute because they need it, and it's the most sensitive instrument in the space for testing PFAS.

We don't expect customers to stop ordering Xevo TQ with waters_connect because it's 50% faster than any competitive instrument in terms of analysis. We don't expect them to stop ordering ACQUITY Premier or Arc HPLC, given the benefits that they get. So innovative products in resilient demand segments don't seem to be impacted by what you are pointing out.

So we're not seeing any of that. And I think it could be a Waters-specific thing. I mean, as I mentioned earlier, the demand overall is good, but we also think we are doing some specific things, which are deliberately improving our traction with our customers, especially from an innovation standpoint.

Great. and then just a follow-up here on M&A. Can you just talk about how the pipeline is looking? And then anecdotally, we've heard that those private valuations in the private type of things have still remained high. So what have you seen from that? And kind of what's the latest time line for when you think that you could maybe get a deal done here?

And then finally, what type of leverage range would you be willing to reach for the right size deal in any of those high-growth adjacent markets that you flagged?

Sure, Rachel. I mean M&A is something we're thinking about quite regularly, right? I mean -- but I can just remind you sort of our overall capital allocation priorities, right? I mean growth is the imperative. We're seeing tremendous organic growth, and that remains the #1 priority. I mean we'll invest in CapEx and OpEx, as Amol mentioned earlier, about 80 basis points even in this environment to support our growth ambitions. We feel extremely good about that.

Second, to support the growth, we're looking at M&A opportunities, and the pipeline is very robust, not just in the adjacencies, but also in the core. In some areas, richer than others. Of course, you can imagine, I can't comment more specifically on it.

And if we don't find something that is financially reasonable and sensible, we'll of course, continue to do buybacks as we've done in the past, but growth remains the priority. As far as timing is concerned, that's always better to comment in the rearview mirror.

Amol, do you want to talk about the leverage ratios?

Yes. I mean, in general, our thinking is, first of all, we want to be absolutely financially disciplined and make sure that on a risk-adjusted basis, any transaction creates value for our shareholders. And then in terms of financing, we want to stay investment grade as much as possible or even lower. So that -- the interest rates have gone up and that can create a dilutive impact on EPS accretion. But as long as we are sort of within investment grade, we should be able to thread the needle.

The next question is coming from Derik De Bruin, Bank of America.

Great. This is Mike Ryskin on for Derik. I want to ask this one for you. Udit, I think you specifically said one asked me when this is going to slow down, but I still kind of have to go there first. Can you maybe try to parse out some of the components of the growth? I mean we hear you on the innovation, we hear you on sort of the robust markets, but still, these are really impressive results quarter-after-quarter.

So any additional clarity you could get maybe kind of rank ordering, share gains versus replacement cycle versus how much is new lab construction or new end markets? You spend a lot of time talking about PFAS and how that's becoming more and more prominent.

So just maybe going through and saying, where -- what are you seeing as the biggest contributors to the step-up in growth? And that will hopefully give us a little more clarity and how durable this will be going forward?

So Michael, I can give you the algorithm, and I'm going to disappoint you that I'm not going to give you very, very deep specifics on each of these.

So just to review the drivers, right? First, I mean, the end markets that we serve are resilient and robust, as you know, right? So 80%, as I've talked repeatedly are pretty robust, and we feel good about the resiliency of these end markets.

Now whatever that number is historically been x, and now it's definitely, x percentile, some of it driven by volume and some of it also driven by increased pricing, right? So take that as a starting point.

Then from a Waters-specific standpoint, there are 3 different contributors. We had said at our Analyst Day about 100 basis points, you can expect, probably a bit higher this particular year from our commercial initiatives, instrument replacement, CDMO service as well as e-commerce. All of those are contributing quite handsomely.

And so definitely north of 100 basis points this year. What we're seeing very nicely now dovetail into that is the second independent driver, which is innovation, right? And I took some time today and we had a big debate internally how much we should elaborate, but I felt it was necessary given the questions that I think you guys have asked on the durability of growth.

Innovation is really, really contributing already significantly, right? MaxPeak Premier fastest launch in Waters' history in terms of columns. And we've been launching a column since 1970 and some of them are still in the market, and this one has done better than anything we've launched. Second, the mass spec portfolio is totally revived, and we're definitely in the early innings of extraction.

PFAS testing is a significant need for water testing, and we have the best instrument in class. So really feel good about that. And we didn't talk much about TA today, right? But TA has also revitalized innovation with our powder rheology instrument that as powders that go into coating anodes and cathodes oratory testing.

So I feel extremely good about it. I won't give you a number. I mean, likely in Q4, we can comment looking backwards on what the contribution has been from innovation. But innovation is contributing handsomely. The adjacencies now, again, a question that I think several of you have asked how good is attraction. I took some time today to talk about BioAccord.

I mean the same thing we see with batteries. We're starting to see with LC-MS. I was at the AACR. This is the American Association of Clinical Research in Chicago with the team and there's a strong demand for mass spec for early disease detection in the clinical space.

So again, the different adjacencies are starting to contribute. And remember, we said that they will more meaningfully contribute beyond 2024, but we're already starting to see them contribute. And that, I think, overall, explains the beyond market performance. And I think, again, we took some time to give you the 3-year stack growth rate because, I mean, short-term changes quarter-on-quarter can sort of dilute the performance, but if you look at it on a stack basis, on a 2- to 3-year basis, we're outperforming quite significantly the peer group.

So I hope that gives you clarity and helps you think through how the demand is going to shape up for the coming years.

This will conclude our question-and-answer session for today's call.

Thank you.

And this will conclude our conference for today. All parties may disconnect at this time.