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Waters (NYSE:WAT)

Q4 2012 Earnings Call

January 22, 2013 8:30 am ET

Executives

Douglas A. Berthiaume - Chairman, Chief Executive Officer and President

John A. Ornell - Chief Financial Officer and Vice President of Finance & Administration

Analysts

Daniel Brennan - Morgan Stanley, Research Division

Amit Bhalla - Citigroup Inc, Research Division

Isaac Ro - Goldman Sachs Group Inc., Research Division

Timothy C. Evans - Wells Fargo Securities, LLC, Research Division

Daniel L. Leonard - Leerink Swann LLC, Research Division

Doug Schenkel - Cowen and Company, LLC, Research Division

Paul R. Knight - Credit Agricole Securities (NYSE:USA) Inc., Research Division

Ross Muken - ISI Group Inc., Research Division

Derik De Bruin - BofA Merrill Lynch, Research Division

Peter Lawson - Mizuho Securities USA Inc., Research Division

Daniel Arias - UBS Investment Bank, Research Division

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

Jonathan P. Groberg - Macquarie Research

Sung Ji Nam - Cantor Fitzgerald & Co., Research Division

Operator

Good morning. Welcome to the Waters Corporation Fourth Quarter 2012 Financial Results Conference Call. [Operator Instructions] This conference is being recorded. If anyone has any objections, you may disconnect at this time. I would like to introduce your host for today's call, Mr. Douglas Berthiaume, Chairman, President and Chief Executive Officer of Waters Corporation. Sir, you may begin.

Douglas A. Berthiaume

Thank you. Good morning, and welcome to this Waters Corporation Fourth Quarter 2012 Financial Results Conference Call. With me on today's call is John Ornell, Waters' Chief Financial Officer; Art Caputo, the President of the Waters division; and Gene Cassis, the Vice President of Investor Relations. As is our normal practice, I will start with an overview of the quarter's highlights, and John will follow with details of our financial results and provide you with our outlook for the first quarter of 2013 and for the full year of 2013. But before we get going, I'd like John to cover the cautionary language.

John A. Ornell

During the course of this conference call, we will be making various forward-looking statements regarding future events or future financial performance of the company. In particular, we will provide guidance regarding possible future income statement results of the company this time for Q1 and full year 2013. We caution you that all such statements are only predictions and that actual events or results may differ materially. For a detailed discussion of some of the risks and contingencies that could cause our actual performance to differ significantly from our present expectations, see our 10-K annual report for the fiscal year ended December 31, 2011, in Part 1 under the caption Business Risk Factors, and the cautionary language included in this morning's press release and 8-K.

We further caution you that the company does not obligate or commit itself by providing this guidance to update predictions. We do not plan to update predictions regarding possible future income statement results except during our regularly scheduled quarterly earnings release conference calls and webcasts. The next earnings release call and webcast is currently planned for April 2013.

During this call, we will be referring to certain non-GAAP financial measures. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is attached to the company's earnings release issued this morning. In our discussions of the results of operations, we may refer to pro forma results, which exclude the impact of items such as those outlined in our schedule entitled, Reconciliation of Net Income per Diluted Share included in this morning's press release.

Douglas A. Berthiaume

Okay. Thank you, John. Well, 2012 was certainly a challenging year for Waters, especially in comparison to the stronger growth rates we enjoyed in 2010 and 2011. After a slower-than-expected start to the year, we recalibrated our expectations and continued to track at a pretty consistent organic growth rate through the following quarters. However, and as we have seen in previous periods of sluggish demand, pricing held up across our product line and we were able to control our expense growth. These factors were important in delivering stable levels of profitability.

If you look at 2012 growth rates across our major product lines, we continued to benefit from newer core offerings in chromatography, mass spectrometry and thermal technologies. Our recurring revenues, the combination of chromatography consumables and total instrument service sales, generated consistent growth in 2012 and contributed to our overall profitability.

Pharmaceutical end markets were mostly stable across the year while many industrial chemical customers, given the weaker general economic conditions, held back on capital spending. Governmental and academic spending during the year, as might have been expected, was pretty soft.

Geographically, we were pleased by the relative strength of our business in Europe. At the onset of the year, the concerns that instability in smaller European Union countries would spread across the continent appeared to have been somewhat overstated. And in fact, European pharmaceutical demand remains sufficiently strong to offset the somewhat slower sales to governmental and chemical consumers.

Our business in developing regions was mixed during the year. Most importantly, growth in China remained robust off a strong 2011 performance. On the other hand, a convergence of issues hampered our performance in India. Our developing market businesses in Eastern Europe, South America and Eastern Asia delivered uneven results and cumulatively performed at levels weaker than we had hoped.

There are some speculation that the potentially recessionary economic conditions in the larger consuming economies, principally Western Europe and the United States, limited scientific investment growth in the more fragile export-oriented countries. We are hopeful that an outlook for moderate but stable global economic growth in 2013 will result in a recovery of spending for analytical tools in many of these developing countries.

On the competitive front, we feel the landscape remain relatively unchanged in 2012. At this point, nearly all companies offering liquid chromatography systems have acknowledged the momentum toward UPLC-type separations, and we feel confident that our leadership position will allow us to continue to direct future market developments and maintain a premier market share position. Our ACQUITY H-Class instrument system continued to bridge UPLC capability to classical HPLC applications.

Also on the separations technology front, we launched our UPC2 system in 2012. An industry first of its kind, UPC2 has begun to establish a new performance category in analytical instrumentation that meaningfully improves workflows across many applications. In mass spectrometry, I believe we have established a performance leading position in tandem quadrupole technology, and sales growth for our Xevo TQ-S in 2012 suggests a strengthening market position. In applications ranging from clinical drug development to food safety testing, Xevo TQ-S offers a new level of sensitivity combined with high reliability and usability.

In 2012, sales of our top base instruments declined in comparison to somewhat stronger 2011 results. However, recent business activity for instruments, such as our SYNAPT HDMS and Xevo QTof systems, has improved, and we are anticipating a return to growth in 2013.

Our TA Instruments division performed well in 2012. For the full year, TA's constant currency revenues were up about 8%. Following a double-digit growth performance in 2011 and in light of global economic weakness, these results are pretty impressive. High points for TA in 2012 include the continued successful integration of purchased businesses into the TA portfolio and the buildout of a discovery line of thermal analyzers and rheometers. In 2012, TA also successfully acquired new product lines and technologies to expand their business into high temperature material characterization markets.

Looking at the fourth quarter, our constant currency sales grew about 1.5%, and our adjusted earnings at a moderately higher level. These results were in line with our expectations and include both the adverse impact to margins from a recently significantly weaker Japanese yen and the positive effect of a lower-than-anticipated tax rate. For the Waters division, we saw growth in our pharmaceutical end markets, significantly driven by strong demand in Europe and China, a continuation of a dynamic that we saw in the third quarter.

The global combination of government and university shipments declined at a mid-single digit rate in the quarter, with weakness in academic demand most pronounced in Europe, Japan and in a few smaller countries. U.S. government and academic sales held up well with recent ordering trends suggesting stronger, high-end mass spec demand.

Looking at our applied markets and focusing on food and environmental applications, we have a history of healthy but lumpy growth performance. In the fourth quarter, our global food and environmental growth was down in comparison to last year. However, the decline came as a result of strong growth in the U.S. market, offset by a more significant decline in Europe. We are encouraged to see more food testing uptake in the U.S. as we feel that this market represents a large future growth opportunity. In fact, within the last month, the U.S. Congress passed legislation sending a clear message detailing the importance of scientific training on advanced methods of analysis. This is certainly encouraging for Waters as we have actively assisted in developing such methods and training protocols in cooperation with global regulatory agencies.

Our TA division finished 2012 with a strong fourth quarter performance, completing a year of profitable growth. In the quarter, constant currency sales were up 7%. TA's organic growth was primarily driven by continued global adoption of discovery thermal and rheology systems and generally strong international sales. High-temperature instrument sales also contributed nicely to the division's overall performance in the quarter, a trend that's promising for 2013.

Looking at the Waters division fourth quarter sales geographically, constant currency sales growth in Europe was in line with the company's overall growth rate. European strength in biopharmaceutical markets was offset by weak academic and chemical analysis sales, including a decline in applied market instrument system sales against the tough prior year comparison. European pharmaceutical results included healthy spending from large global firms in the region.

In China, our sales growth was strong and broad based in the quarter, with most major product and market segments growing at double-digit rates. The fourth quarter results in China complete a year of strong growth in a very important market for Waters. Our competitive position in China is strong, and our access to the most attractive analytical market segments within China is reflected in the sales growth and profitability we have delivered in the fourth quarter and for the full year.

On the other hand, our sales in India were lighter than we had hoped as local currency weakness, recent drug manufacturing and CRO issues, combined with government inertia, have contributed to slower business momentum. We continue to believe that underlying demand for new instruments, primarily for generic drug manufacturers in India, remains strong, and we anticipate seeing improved ordering trends in upcoming quarters. We remain confident in being able to maintain a leading share position and know that in the long run, India is an important and attractive market for us.

Waters division constant currency sales in Japan were moderately down in the fourth quarter as weaker industrial chemical results offset strong growth in our pharmaceutical business. We're cautiously optimistic that a recent weaker yen may stimulate more business in 2013 from our industrial chemical export-oriented customers in Japan.

In the U.S., and staying on the Waters division performance, we saw the strongest growth in instrumentation for our applied markets, including food and environmental testing. A modest decline in shipments to pharmaceutical segments is largely accounted for by weaker sales to large accounts, interestingly, the same set of customers that grew nicely in Europe. Combination of government and academic business grew at a solid mid-single rate in the quarter, with increased business activity in the high-end mass spectrometry system.

Now, I'll discuss some product line dynamics that we saw in the quarter. Our recurring revenues, the combination of service and chromatography consumables, grew at a high single-digit rate in the quarter. The growth in chromatography consumables was strongest in China and more moderate in most other regions. Sales growth of ACQUITY UPLC columns suggests a continuation of high attachment rates and of a gradual increase in UPLC technology and regulated methods. Our service business growth was more geographically balanced and close to a double-digit rate in most regions.

Looking at our Waters division instrument system sales, performance was comparable for LC/MS instruments and LC instruments in the quarter, with moderate declines in sales in comparison to last year's results. For LC/MS, our strongest performing instrument systems embodied Xevo TQ-S mass spec technology combined with ACQUITY UPLC. This configuration is a workhorse tool for quantitative bioanalysis applications and drug development. And as I mentioned earlier, there are signs based on our recent ordering trends in the fourth quarter of 2012 and as we start 2013 that we are seeing improvements in our high-end top base demand.

On the chromatography front, ACQUITY UPLC continued to edge into more QC applications. We believe that opportunity to see higher utilization of UPLC technology and QC application lies ahead of us. Up to this point, expansion into this segment has been limited by a combination of the 10-year length of the drug development cycle and by the somewhat restricted spending environment at most large pharmaceutical accounts. When drugs that are currently under development in labs that are using UPLC technology eventually make their way at volume production, we are confident that the preferred QC methodologies will transition to UPLC technology.

Continuing on the chromatography front, 2012 marked the start of Waters' entry into a new separations technology that leverages the high resolving power of supercritical carbon dioxide in a high performance analytical format. We introduced our ACQUITY UPC2 platform at Pittcon 2012, and after receiving the Editors' Gold Award recognizing this system as the most innovative showcase at the conference, shipment volumes have nicely ramped through the remainder of the year. In 2013, we expect to see a positive impact of this system on our overall results, especially as UPC2 has the potential to improve analytical workflows at our customer labs while driving sales growth at Waters for not only new instruments but also associated growth in specialized ACQUITY columns and customer service plans.

Well, so where do we go from here? In 2013, look for us to continue to introduce new application-tailored systems that offer more complete workflow benefits to customers. As you've seen for the past couple of years, you should expect that these systems will combine advanced mass spectrometry, ACQUITY UPLC and UPC2, our new unified operating system platform, application-specific separation chemistries and software applications. In addition, I expect that 2013 will be an exciting year for new instrument platform introductions. We have maintained a rich R&D product pipeline, and we look forward to significant launches at conferences this spring, which will showcase innovations in LC/MS and thermal analysis.

In 2012, our sales and earnings growth rates were well below historical averages and our long-standing internal benchmarks. Though we are confident that generally weaker market conditions were responsible for our 2012 performance, we feel that these market conditions are temporary, and accordingly, we will maintain the same long-term internal growth targets for sales and earnings growth and manage our business to best achieve these long-term goals. We continue to believe that our technologically-focused business strategy and conservative asset allocation plan will continue to benefit our customers, employees and shareholders.

Before turning it over to John, let me say that I am cautiously optimistic that 2013 will be a better year for Waters than 2012. Looking at the macro environment, the global economy appears more stable, and our outlook for business growth in nearly all geographic locations is positive. I'm also confident that our competitive position remains strong and that planned new product introductions will further enhance our competitive leadership position.

Now I'd like to turn it over to John for a review of our financials and an update on the future outlook.

John A. Ornell

Thank you, Doug, and good morning. Fourth quarter sales were about the same as last year's, and non-GAAP earnings per diluted share were up 2% at $1.59 this quarter compared to earnings of $1.56 last year. However, on a GAAP basis, our earnings were $2 this quarter versus $1.51 last year, and a reconciliation of our GAAP to non-GAAP earnings is attached to our press release issued this morning. Our GAAP results this quarter contain a large tax benefit associated with recent tax planning activities that will allow us to access previously trapped net operating losses and apply them to future taxable income streams within our legal entity structure. This will result in reduced cash payments for taxes over the next several years than would otherwise have been the case. This benefit is calculated to be about $36 million and results in $0.41 of EPS benefit in our GAAP results. These benefits do not affect our non-GAAP earnings.

Reviewing Q4 sales results in comparison with Q4 last year before foreign currency translation, sales were up about 1.5% and currency translation reduced sales by just over 1%. Looking at our sales growth geographically and before foreign exchange effects, sales within the U.S. were down 3%, Europe sales were up 2%, Japan was up 1% and sales in Asia outside of Japan were up 12%. On the product front and in constant currency, within the Waters division, instrument system sales decreased by 5% and recurring revenues grew by 8% this quarter. Within the TA Instruments division, total sales increased by 7% versus prior year.

Now I would like to comment on our Q4 non-GAAP financial performance versus prior year. Gross margin performance came in at 60.1%, down modestly from Q4 last year. This decline was largely the result of currency translation as the combination of a stronger British pound and a much weaker yen increased our manufacturing cost and reduced our sales volume, respectively. SG&A expenses were down 1% as a result of net favorable currency translation, continued tight spending controls and lower variable compensation expenses. R&D expenses increased by 5% this quarter.

On the tax front, our effective operating tax rate came in favorable to our earlier estimates at 15.2% for the full year. This reduction was due to a favorable shift in income among our legal entities. And for 4Q, the cumulative full year catch-up benefit of this change lowered our effective Q4 tax rate to 13.8%. In the quarter, net interest expense was $6.4 million and share count came in at 87.9 million shares, 2.7 million shares lower than Q4 last year as a result of our continued share repurchase programs.

Looking at our earnings per share for Q4, our non-GAAP earnings per fully diluted share contain a couple of unexpected items that largely offset each other. First, we had about $0.04 of foreign currency translation cost, about 1/2 of which is the result of rapid currency movements late in the quarter. And second, we had $0.04 of tax favorability resulting from the more favorable mix of legal entity profits discussed earlier. On the balance sheet, cash and short-term investments totaled $1,539,000,000 and debt totaled $1,178,000,000, bringing us to a net cash position of about $361 million. As for Q4 share repurchases, we bought 720,000 shares of our common stock for $61 million. This leaves $643 million remaining on our most recently authorized share repurchase program.

We defined free cash flow as cash from operations less capital expenditures plus any non-cash tax benefit from stock-based compensation accounting and excluding unusual non-recurring items. For Q4, free cash flow came in at $120 million after funding $18 million of CapEx. Excluded from the CapEx cited is $13 million of capital associated with our new U.K. mass spectrometry facility. We expect this facility to be ready for occupancy by the end of 2013.

Accounts receivable, day sales outstanding stood at 71 days this quarter, up 6 days from Q4 last year. DSO was impacted by geographic distribution of our Q4 sales and does not indicate a change in the overall quality of our receivables. In the quarter, and as is typical for year end, inventories decreased by $17 million. So for the full year 2012, sales pre-currency effects grew by 2%, while currency translation reduced sales by 2%. Non-GAAP earnings per fully diluted share were up 2% to $4.93 versus $4.81 in 2011.

Now looking ahead to full year 2013, we expect economic conditions to modestly improve as the year progresses. We believe our strong product lineup, coupled with a favorable base of comparison, should allow us to grow our constant currency sales for the full year around 5%. We generally use foreign currency spot rates when we calculate guidance, but given the extraordinary recent drop in the Japanese yen, we used the prior 30-day average exchange rate of JPY 86 to $1 in creating our guidance for Q2 through Q4. For Q1, we are using a spot rate of JPY 89 to $1. All other currencies were translated using current rates. Using these assumptions, full year currency translation is expected to be neutral to sales growth while depressing earnings per share by $0.10 in 2013 versus 2012.

Moving down the P&L. Gross margins are expected to be about 59.5%, a modest decline due largely to the currency effects I just described. Operating expenses are expected to be up between 3% and 4% from 2012. Net interest expense is expected to be approximately $26 million. We currently expect our full year operating tax rate to be about 15.5%. The expected tax rate will vary by quarter as we account for the R&D tax credit recently reinstated by Congress in Q1. Our tax rate in Q1 is expected to be approximately 14%, and for Qs 2 through 4, are expected to be about 16%. Our full year average diluted share count is likely to be around 85.5 million shares outstanding. Rolling all of this together, non-GAAP earnings per fully diluted share are expected to be in the range of $5.30 to $5.40.

As we think about our expectations for the first quarter of 2013, we expect organic sales growth of about 4% in the first quarter. Currency translation at today's rates will reduce sales by almost 1%, resulting in reported sales growth of about 3%. Our non-GAAP earnings per fully diluted share are expected to be in the range of $1.07 to $1.12.

Doug?

Douglas A. Berthiaume

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

Question-and-Answer Session

Operator

[Operator Instructions] Our first question does come from Daniel Brennan of Morgan Stanley.

Daniel Brennan - Morgan Stanley, Research Division

Doug and John, you've discussed throughout the call an increasing kind of tone of business possibly as, I guess, we exited the quarter. I think Doug, you talked about an ordering trend in high-end mass spec. Maybe if you could just flesh out a little bit kind of the pacing throughout the quarter that you saw and maybe some of this kind of forward visibility on improving demand trends.

Douglas A. Berthiaume

Yes, Dan. I think most of it's qualitative. And I caution everybody to say that it doesn't necessarily reflect longer term trends. We definitely saw an improvement in the fourth quarter in both the drop rate of high-end mass spec and more qualitative things, like demo requests and quotes. So that we see as positive. We see that continuing in the early part of 2013. We're also hearing what I call murmurings of improvement coming from our customer base. What makes it remarkable or notable is that it's different from what we were seeing at this time last year, which was much more cautious. So it's pretty much across the board that we're seeing those qualitative comments as being -- as leading to more optimism than pessimism. Does that cover your question, Dan?

Operator

We can go to the next question. Amit Bhalla of Citi.

Amit Bhalla - Citigroup Inc, Research Division

Just 2 quick questions. I guess, number one, Doug, can you just talk a little bit about the outlook by regions and end markets for 2013? What's the underlying assumptions within the guidance you laid out? And then I have a follow-up question on India.

Douglas A. Berthiaume

Sure, I'll ask John to lay it out. He's got the data right here.

John A. Ornell

Yes, I think as we think about the full year and look at the geographies around the world, the expectation is that developing economies, largely Asia outside of Japan, portions of Eastern Europe, South America, Central America areas that we typically bring in to about the 30% that we talked about as being our emerging market exposure, we're looking for that to continue at kind of a high single-digit rate. We've seen that be better generally than that in actual results, but we tend to target something that's in the high single digits for those regions of the world. And then in areas such as U.S. and Europe, given the base of comparison that we have, we're looking for low single-digit growth this year in those parts of the world, maybe starting off closer to 2% and then closer to 3.5% perhaps. And then Japan, we're looking for a bit more of a difficult slog there, maybe 1% or 2% growth in that region. So that's kind of the outlook by geography.

Amit Bhalla - Citigroup Inc, Research Division

And the end markets? And then I guess, I'll just throw in my India question. You had some pretty easy fourth quarter comps in the prior year. You're talking about some CRO issues. Can you flesh India out a little bit more in terms of the details of what's really happening there?

Douglas A. Berthiaume

Yes, I think what we've talked continuously about in India is that these customers are facing weaker rupee issues, wherein they're challenged by both the capital requests, as well as financing issues, that most of their debt's denominated in stronger currencies, and that challenges their ability to aggressively spend new capital. They've also had regulatory issues that have made them cautious in certain areas. We can pretty much look at almost every item that comes into India in terms of the market share dynamics, and we're convinced that there's no significant market share erosion going on in our business in India. So I know this is getting to be a little bit of a broken record; we're pretty confident that it's going to change. We're not happy that it's taken longer than we expected, but we think we'll see a change in 2013 and we'll see positive results in India.

Amit Bhalla - Citigroup Inc, Research Division

And the question on the end markets?

Douglas A. Berthiaume

I'm sorry, what was that question?

Amit Bhalla - Citigroup Inc, Research Division

The original question was your underlying assumptions on geographies and end markets. I didn't hear anything on end markets.

John A. Ornell

We're looking at pharma to grow kind of in the mid single-digit range. It could be, maybe 6% -- so closer to 6% than 5%. Government and academic, kind of flat, maybe a modest amount of growth as we exit the year but starting off slow. And then the applied markets, including food, environmental, industrial, somewhere in kind of the 3% to 4% range.

Operator

Our next question does come from Isaac Ro of Goldman Sachs.

Isaac Ro - Goldman Sachs Group Inc., Research Division

The first one was just on UPLC. I'm wondering if you could maybe give us an update on where we are, and we're a few years into that product cycle, and wondering how you're measuring the penetration of that technology from an installed base perspective. And then maybe if you could offer some comments on what you're seeing on consumable attach rates.

Douglas A. Berthiaume

Yes, I think we're very happy with the penetration of UPLC in almost all the early stage R&D segments of our market. I will say that it's taken longer to penetrate, although we are beginning to see penetration in downstream applications, particularly in pharma, particularly in mainstream QC. We certainly continue to hear our customers talk aggressively about taking UPLC into those applications. But frankly, up until this time, it's probably been a little more talk than action. We think that has a lot to do with the fact that capital is tough to come by and that it's just tougher to get capital in those large pharma applications. It is true that we're seeing a lot of success in penetration of UPLC in the generic drug manufacturers, and we think that that's a continuing dynamic that will continue to benefit us. In terms of attachment rates, we're happy with the continued strong attachment rates of consumables even at this phase, many years down the track, that we continue to see very high attachment rates of the UPLC consumables. It is true that since we sell braces of these columns with a new instrument placement, that because of the decline in instrument placements that we saw during this year, that that certainly affected to some extent the initial flow of our UPLC columns. But they still held up very nicely in each application.

Isaac Ro - Goldman Sachs Group Inc., Research Division

Okay. So if I can just clarify what you said, it sounded like you were saying we're still maybe not quite halfway through the upgrade cycle on the equipment. Just -- I didn't want to put words in your mouth, but just making sure that's kind of the way you're framing it. And then last one for me was on longer-term tax planning. John, I think you guys have said in the past you have a tax shield I think in Singapore that expires in the near term. Anyway, just plans on what you plan to do there to offset it?

John A. Ornell

Yes, we're going to begin to look at options on that front that runs out 3 years or so down the road. So we'll start this year to think about what incremental product transfers maybe could be done to extend our benefit in Singapore. This -- we can think about what we might do in Ireland as well, incrementally from where we are today. The new product lines that we're developing on convergence chromatography might find a home over in those regions of the world. That might be a bargaining chip that we could use to move another piece of technology and gain something incremental on that front. So you'll hear more about that as we begin to work through that this year in anticipation of that benefit running out at the end of '15.

Douglas A. Berthiaume

We think that we have any number of irons in this fire that will enable us to not see extraordinary increases on our effective tax rate even 4 or 5 years down the road, but those are actions that will play out in the next couple of years.

Operator

Our next question does come from Tim Evans of Wells Fargo Securities.

Timothy C. Evans - Wells Fargo Securities, LLC, Research Division

John, you talked a little bit about the long-term guidance being in effect, and are you referring to the kind of 8% long-term top line and 15% bottom line internal targets that you set for yourself? And if so, what do you see changing about the current environment that would kind of allow you to get back to that level?

John A. Ornell

Well, I think we look at this year certainly as a transition year from a very low-growth environment that is really a point off the line, certainly, from a history perspective, looking at where we've been and where we think we're going. We look at the opportunity that we have with some of the new products that we currently have in our portfolio, others that are coming into play that we think longer-term will add to the growth rate. And we don't believe that the economic environment that we live in today is the one that we're going to live in for the future, 2 , 3, 4 years out. So we do think that we're going to come back to some level of moderating demand in various markets that affords us the opportunity to grow somewhere closer to that 7%, 8% top line as we exit this year and move into next year. So we believe that there's incremental application opportunities for these products, maybe in clinical. We look at the biologically synthesized drugs in the drug pipeline, and think that there's opportunities to, perhaps, overtime introduce mass spectrometry into the QA/QC applications, new food safety opportunities in the States. So there's a myriad of both potential market opportunities that we think longer term allows us to get back to those 7%, 8% top line-type growth numbers that typically have leverage to about 15% growth in earnings.

Douglas A. Berthiaume

Yes. We think pretty clearly that we're coming off a period of -- at least a year, maybe longer than that -- of some of the toughest macroeconomic conditions and some things that disproportionately hurt areas in our sweet spot. We just talked a lot about India, and India alone has cost us several points of growth in the last 1.5 years. So it's easy to kind of look at the well you're down at any particular point, and think the future's always going to kind of mimic that position. We think that for the most part, we're going to be coming out of these tougher market conditions and going into a more normal position, particularly more normal in some of our sweet customer spots.

Operator

Our next question does come from Dan Leonard of Leerink Swann.

Daniel L. Leonard - Leerink Swann LLC, Research Division

Question on the gross margin guidance. Is there anything happening in the gross margin line besides foreign currency? I just would have thought that there would have been some more leverage off of a 5% organic growth expectation on the gross margin line.

John A. Ornell

Yes, that's a good question. And there is one other item that we've highlighted, and that is, is that this year, we're beginning to ship the -- some of the fuller capabilities of our UNIFI software platform, and that is triggering the beginnings of meaningful amortization of capitalized software. So this year, we have about a $10 million to $11 million increment in costs associated with that amortization that's impacting the gross margins as well. Because, otherwise, we would have seen a little bit less of an impact overall in the margin. So between that $11 million and a very unfavorable yen, they combined to provide what's there on -- what I've described.

Douglas A. Berthiaume

That is a non-cash charge, but it still is reflected in our non-GAAP earnings.

John A. Ornell

Right, non-GAAP results. Right.

Operator

Our next question does come from Doug Schenkel of Cowen and Company.

Doug Schenkel - Cowen and Company, LLC, Research Division

I was wondering what levers are available for you to pull at the operating line if things get off to a slower-than-expected start this year? I mean, I guess, I'm just thinking about SG&A as a percentage of sales being down about 180 basis points versus where you were into 2009. The rate of growth in R&D spend really moderated in 2012. You just talked about your longer-term expectations of 7% to 8% top line growth in response to Tim's questions. I guess I'm just wondering how much more you'd be willing to cut in 2013 if you get off to a slower-than-expected start out of the gates. And then conversely, are there areas you've identified where you'd really like to pick up the pace of investment if the year gets off to a better-than-expected start?

Douglas A. Berthiaume

I think -- let me say, Doug, that we have some ability to moderate our spending plans in the face of somewhat weaker conditions. I wouldn't have you believe that we can cut expenses dramatically in the face of a very significant shortfall on revenues. That's why we have looked very hard at our plan for revenue growth, and believe that we can get there because, of course, our spending plans have triggered off that revenue estimate. But we have some flexibility. We have some minor headcount plans, and we have compensation plans that can be tweaked to make up for some reduction. It would take a longer term -- if we see that the longer-term is more unfavorable than we currently believe, that would take us really considering changing the structure of our business. It's doable, but it would take a belief that we don't have right now about the longer-term health of our end markets and we think -- well, it's conceivable that it starts a little bit slower, we don't think that that's what we have in mind for the full year 2013. So -- and is there -- was there another part to...

John A. Ornell

Yes, areas that we might invest in. Was that the other piece, Doug?

Doug Schenkel - Cowen and Company, LLC, Research Division

That's right, John.

Douglas A. Berthiaume

Yes, we've never -- let me restate it. We think that we're investing at the proper pace, given the projects and the opportunities that we have and we don't -- we haven't cut out major projects in R&D in order to protect the bottom line. So within the normal give and take of projects and criticisms of plans and plans that are ahead of schedule and a few that are behind, we're reasonably happy with the mix of programs that we have. I wouldn't say really that if we had an extra $5 million to spend, there's something that crawls up onto the A list. I think we're pretty happy with what we've got going and yes, I suppose you could always use an extra $0.5 million or so. We're in pretty good shape.

Doug Schenkel - Cowen and Company, LLC, Research Division

Okay. And just a quick one and then I'll get back in the queue. A quick one for John. Did you provide guidance specifically on your expectation for instrument versus recurring revenue growth this year? And if you did, I apologize for missing it. If not, would you provide that?

John A. Ornell

Yes, I'd say you've seen relatively consistent growth in service and chemistry revenues across this year, being a very difficult year. So we see that pace continuing. So something in the kind of the 7%-ish range, all in, for those couple of businesses seems reasonable. And then the instrument piece maybe starts off just slightly slower at the start of the year, but for the full year is somewhere around kind of 3%, I would say.

Operator

Our next question does come from Paul Knight of CLSA.

Paul R. Knight - Credit Agricole Securities (USA) Inc., Research Division

On the food safety testing market that you mentioned was stronger, do you think that's due to the 2 rules out for review on the Food Safety Act? Or is it kind of business growth as usual and we might see acceleration later?

Douglas A. Berthiaume

I don't think we've seen anything really coming out of the act yet, Paul. The -- it's still in its infancy, really, and it might be that in the end, it directs more towards imports and it has an effect outside of the U.S. as much as inside. So I think the full effect of that's going to come in the future. I don't think we've seen much impact of it so far.

Paul R. Knight - Credit Agricole Securities (USA) Inc., Research Division

Were you able to quantify how much food safety is of sales?

Douglas A. Berthiaume

I'm sorry, how much food safety is...

John A. Ornell

What percent?

Paul R. Knight - Credit Agricole Securities (USA) Inc., Research Division

Do you think food safety's 5%, 10% or what percent of sales?

Douglas A. Berthiaume

It's about 6% or 7% of sales.

Operator

Our next question does come from Ross Muken of ISI Group.

Ross Muken - ISI Group Inc., Research Division

So I have 2 quick things. So one on the instrument line. The 3% number that you threw out there, John, basically sort of offset the weakness from this year and so, ultimately, the business would not be growing very much since '11. And so, I guess, you look back historically, most times over the course of the cycle, where you've kind of had a pull back in CapEx, we've sort of seen a reasonable recovery on that line in the following year. So I guess, what, other than sort of the macro, would make that not be true this time around, particularly given some of the comps you have on the generics business, which I'm assuming accounted for a decent amount of the weakness?

John A. Ornell

That is a good question, Ross, and I'll say there is potentially some level of optimism that could suggest that that turns out to be the case. I think, though, that as we start the year and think about a -- hopefully something, leaning towards conservative view of the world, coming up with a growth rate that really just brings us back to flat is probably a realistic point of view that maybe has a little more upside than down as the year goes on. But I think just from creating guidance and trying to provide a little more pleasure than pain when doing that, we just felt uncomfortable, suggesting that we were just going to bounce back all in the course of 1 year to do exactly what you're describing. I agree, if you look back historically at times when it's been tougher, almost always, the next year bounce back -- bounces back pretty meaningfully. But we're going to leave that potential as upside, and hopefully paint a view here that feels very realistic to begin the year.

Douglas A. Berthiaume

And Ross, I think it's also true that as you go down our organization, right down to the field level, you'll see much more of that attitude reflected in their expectations, and what they're driving to, that there's really a point of view that says this year could be significantly better. But when you roll it up through the levels of review and you look at the issues from macroeconomic disappointment, I agree with John. It's more prudent to enter the year on a more cautious plan than have to really gear it down later on.

Ross Muken - ISI Group Inc., Research Division

I guess, what was contemplated in the guidance for kind of the macro acceleration? The market as a whole seems a lot more optimistic, and you can argue we've gone through these the last few years. But I think there's some reasons to believe as long as you're up, sort of stabilized and China accelerates, we will see a better CapEx environment. So I guess, what did you actually factor into that forecast? Is it sort of 1Q trends and then a modest amount of improvement? I'm just trying to get the sense for how much...

John A. Ornell

I mean, we're basically saying that Q1 looks kind of like the last 4 quarters that we've seen, really not a lot of improvement coming right out of the gate. But I think it's fair to say that we think on the CapEx side, when you look at instruments, people will begin to feel better about spending capital as demand maybe improves a bit within their business, and maybe we see GDP in various regions of the world pick up a point or 1.5 points as the year goes on and we begin to see people feel better about spending CapEx. As we look at the operating side of what people do, we've seen relatively decent growth in our recurring revenues. We think that continues. It's the willingness of people to -- our customers to spend capital and we think that that gets incrementally better as we make our way through the quarters, but we're not factoring in getting back to normal, I guess, on that front.

Douglas A. Berthiaume

It's definitely true that one of the areas that we're most challenged on in 2012 was the industrial segment of the marketplace, particularly, industrial chemical firms, and that was true worldwide. Certainly, there's a case to be made for that segment of the marketplace to be stronger, and we also think we've got some dynamite systems coming onstream this year that addresses those customer needs. So if you compound that good feeling, you can get more enthusiastic than what we're willing to commit to now. But we're coming off a disappointing period, and it's still, I think, right to be more cautious at this point in the game.

Ross Muken - ISI Group Inc., Research Division

Fine. One last thing. Just, John, remind me, the comp in India in Q1 versus what we just saw in Q4, how much easier is that?

John A. Ornell

Yes, it was down meaningfully in Q1 last year. I don't have that specific number right in front of me, Ross, but the comp is definitely easier in Q1 than it was in Q4, and we're somewhat optimistic that we're starting off a bit better as we look at India coming out of the gate.

Operator

Our next question does come from Derik De Bruin of Bank of America.

Derik De Bruin - BofA Merrill Lynch, Research Division

So could you just talk a little bit about the differences you saw in U.S. versus European pharma in the quarter? Also, just U.S. and European academic. And what, if anything, did you get from a budget flush this quarter?

Douglas A. Berthiaume

John, you want to...

John A. Ornell

Yes. Large pharma -- as we saw in Q3, the large pharma actually did better in Europe than they did in the states. We continue to see a little bit of bias at some of these accounts to spend money in Europe. So it was a little bit of a continuation of that trend. But I'd say between the two, we're not dramatically off from original expectation, and I wouldn't draw the long-term conclusion from what we've seen there. But overall, large pharma did about what we thought, but was, again, bias to Europe. I'd say government and academic really probably continues to do just a little better than we think, than we originally had thought. We really don't see these markets reacting dramatically to the fear of major budget cuts. I mean, when and if they come, and I'm sure we'll see them and life will be different. Fortunately, as you know, our exposure there isn't as great as it is in the space. But we really haven't seen any major reaction in government academic accounts at this stage that would suggest that they're acting ahead of time to cuts that may be coming their way.

Derik De Bruin - BofA Merrill Lynch, Research Division

Okay. And just one quick question, on the UNIFI system that you're launching. Can you just give us a recap on where you sort of are on the broad of that? And the -- obviously, you're capitalizing a lot of the software this year. But could you just give us a recap on that program, and what do you -- I mean, how do you think you see it driving growth?

Douglas A. Berthiaume

Sure. I mean, as most everybody knows, UNIFI is really the culmination of a multi-year effort on our part that really brings all of the disparate software systems that we had in place under one operating system that we, of course, called UNIFI. This was a huge program, and we chose to introduce elements of it earlier. The first elements went in earlier last year with specific systems, particularly bioanalytical software. As we go through this year and into next year, we're really bringing the full chromatography and mass spectrometry elements of this system to the marketplace. So because only very small portions of it were introduced last year, you didn't see the full elements of the financial amortization. This year, as it comes into play, you're going to see that come through the P&L. I will say this is another area where I think we're being conservative in terms of the effect on our overall business because this is a major change in the facility of this software into our customers' applications, and we think, over time, this is going to have a dramatic impact and improvement. We're being cautious, once again, I think, about the early uptake and how it affects our business. But that's why you're seeing this come in a more significant amortization mode as we enter 2013.

Operator

Our next question does come from Peter Lawson of Mizuho Securities.

Peter Lawson - Mizuho Securities USA Inc., Research Division

Doug, just on India, what are the signs you're seeing for a better India, you think, for 2013?

Douglas A. Berthiaume

Well, we're seeing earlier orders activity come to fruition, Peter. We continue to see -- to talk to these customers and to hear their plans, and they continue to be aggressive plans. So we see nothing that says -- if anything, here is one specific area where we think there's pent-up replacement [indiscernible] restrained activity in the past that should manifest itself in higher activities going forward. So in both the generic and in the food area, we're seeing much interest, much quote activity, and we've always believed that this market really is committed to the long-term servicing of the generic drug business, and see nothing that's going to move them on. As they come through this period, they'll resolve the currency issues. They're resolving the regulatory issues, and I think they're ready to move ahead.

Peter Lawson - Mizuho Securities USA Inc., Research Division

And you don't think there could be any share losses during this period for you?

Douglas A. Berthiaume

I'm always unwilling to speak definitively about short-term market share dynamics, but India's one market where all of the equipment really comes in from outside the country, and that data is all public. So we monitor that kind of data, and see no fundamental changes in market share going on in our chromatography world.

Peter Lawson - Mizuho Securities USA Inc., Research Division

And just one last question for John around the uptick in R&D in the quarter. I may have missed this. Is that just associated with the U.K. mass spectrometry coming online, and does that carry through for 2013?

John A. Ornell

Yes, we have a lot of projects spent, and the project activities can move the needle in R&D a few points one way or the other. We've got the new UltraPerformance systems that are taking a little bit more effort in R&D. But I would say that, generally, it's project spent that can be lumpy quarter-by-quarter. Convergence chromatography is the product that we've traditionally spent some R&D dollars on. And we have a host of new products that we'll talk about as the year goes on that we're readying right now for Pittcon and in ASMS that are in a stage now that requires a bit more project spend as well. So it tends to be a little bit lumpy. I wouldn't draw that -- take that 5% and suggest that that's what it has to be into the next 4 quarters, but I'm comfortable thinking the expenses there is in that 3% to 4% growth range that I described earlier.

Peter Lawson - Mizuho Securities USA Inc., Research Division

But that's a little bit higher in 1Q. I guess that flows over into 1Q.

John A. Ornell

A little bit. The other thing to think about there is the British pound. There is some amount of translation that occurs there so you got to keep an eye on that. I don't know that it was a major impact in Q4, but we do have probably 1/4 to 1/3 of our spend that is in Manchester U.K. that does impact that line too.

Operator

Dan Arias of UBS.

Daniel Arias - UBS Investment Bank, Research Division

Just on China, it sounds like things are continuing to be pretty strong there. Can you just touch on demand with respect to life sciences versus more industrially-focused work? How do things look there when you parse those 2 applications out?

Douglas A. Berthiaume

Yes, sure. China, interestingly enough, is a pretty balanced market for us. Whereas India is heavily weighted towards generics, China is more balanced between pharma, bio pharm, food and industrial. And our results in China have been strong in all of those, in both the overall pharmaceutical market and the applied segments. So we continue to see just very good growth across those segments.

Daniel Arias - UBS Investment Bank, Research Division

Okay. And maybe just a question on chemistry. Doug, you talked about the potential for some new LC introductions later this year. So I guess, how important is new column development to grow for you guys? And to the extent that maybe you do bring some new chemistries to market, should we think about there being any margin benefit to those aimed at more protein-based work? Or is that not really something that impacts profitability?

Douglas A. Berthiaume

Well, chemistry is a very profitable segment of our business so it's always something that's worth noting. I do think that there's no significant platform introduction of a new chemistry this year. There are subsegments of our chemistry line, certainly, in our new UPC2 technology, and we have some new offerings in the life science arena, particularly dealing with peptides. There are probably things you'd consider niche offerings. Our whole chemistry line to some extent is made up of a bunch of profitable niches, so it's wrapped up in the numbers that John talked about. I don't think that I'd point you towards anything that's likely to move that needle tremendously in the chemistry area. It's the kind of thing where you wake up 2 or 3 years down the road and you've got a new $10 million or $15 million platform, but it takes a while to build.

Operator

Our next question does come from Tycho Peterson of JPMC.

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

Just a couple of quick ones. I wanted to go back to the comments you made earlier on the academic markets. You talked about them being fairly stable here. I know in the past, you've recently talked about potentially some share gains at the high end of the market, in particular, within this triple quad business. So in your assumptions here, are you factoring in some share shift? Or is it just more of general stability in the end markets?

Douglas A. Berthiaume

Tycho, in the triple quad area, that's not typically the academic market. I mean, we're talking about the pharmaceutical and the applied markets that's the biggest segment for the tandem quadrupoles. The government and the university market tends to be more of the high-end top business that we're doing there, so...

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

Yes. Are you factoring share gains there though?

Douglas A. Berthiaume

Well, I think 2012 in that high-end mass spec area was a tough time for us. We see that moderating a little bit in the fourth quarter and we think that that's a better place in 2013. Again, share gains are something that it's awfully fluid, but I think we're more confident about our business position and positive results in 2013 than we saw in 2012.

Tycho W. Peterson - JP Morgan Chase & Co, Research Division

And then on Japan, you talked about expecting a rebound there, I think, in part driven by currency. Can you just talk to the budget dynamics there? Obviously, in the March fiscal year, do you expect some budget flush this quarter? And do you expect any change in the academic funding environment there, post-March?

Douglas A. Berthiaume

I would say we see -- we anticipate consistent dynamics against what happened in the prior year happening this year, but that's not for a robust growth in Japan. We do think that, consistent with the better economic expectations for the industrial markets, Japan has a significant industrial segment of the market. So as that becomes more competitive, we think that we'll do better. John, did you want to add anything to that?

John A. Ornell

Yes, from the review that we had on Japan, I would say that the likely scenario is that we see a little bit better government budget in Qs 2 through 4 as they enter the next plan year, but nothing that moves us more than 1% in growth. So I mean we're looking at a business that might go from kind of flattish to up 1% or 2%. A lot of that's really just based on comparison.

Operator

Next question does come from Jon Groberg of Macquarie.

Jonathan P. Groberg - Macquarie Research

Just a quick question for me, either John or Doug, on this -- I want to make sure [indiscernible]. On the tax kind of restructuring that you announced, does that have any impact in your ability to repatriate cash and be more aggressive on your buyback?

John A. Ornell

No, unfortunately, this was a Europe restructuring. And while it creates some efficiency there and allows us to prevent tax payments from going up over the next 10 years, it doesn't have any bearing on the repatriation.

Operator

Our next question does come from Sung Ji Nam of Cantor.

Sung Ji Nam - Cantor Fitzgerald & Co., Research Division

I just have a one quick one. Could you -- John, you talked about incremental growth opportunities in clinical diagnostics. Could you maybe talk about kind of what you're strategies are near-term and what your competitive advantages might be compared to others in this market?

John A. Ornell

Well, I would say -- we were talking earlier about the tandem quadrupole. That is an instrument that does fit nicely into this space. So I think we do currently have a very high performance offering out there. We've got a decent footprint that exists in that space. We have a crew here that are looking at potential incremental opportunities on that front. So I would say it is a sector we pay attention to. I think over the long run, there will be some interesting niche opportunities for mass spectrometry to do things that, today -- what chemistry tests are either inefficient or you have to wait too long for the answer. And we'll find some interesting applications over a longer period of time, and we continue to invest in that and think that we have a great offering and continue to -- we'll continue to deploy it this year and beyond.

Douglas A. Berthiaume

Well, we're very optimistic about it. We had a good end of the year in our clinical business, and that might be one area where we see some unlooked for upside in 2013. We've got a lot of interest going using these new technologies in a clinical testing area, and we think that has a robust future.

All right, operator, I think at this point, it's appropriate to bring it to a close.

Operator

Thank you. Today's conference has ended. All participants may disconnect at this time.

Douglas A. Berthiaume

Thank you, all, and I look forward to talking to you again next quarter.

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