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Mettler-Toledo International Inc. (NYSE:MTD)

Q4 2012 Earnings Call

February 6, 2013 5:00 p.m. ET

Executives

Mary Finnegan - Head of Investor Relations and Treasurer

Olivier Filliol - Chief Executive Officer

William Donnelly - Chief Financial Officer

Analysts

Tycho Peterson - JPMorgan

Jon Wood - Jefferies

Daniel Arias - UBS

Paul Knight - CLSA

Jonathan Groberg - Macquarie

Ross Muken - ISI Group

Sung Ji Nam - Cantor Fitzgerald

Isaac Ro - Goldman Sachs

Richard Eastman - Robert W. Baird

Derik de Bruin - Bank of America Merrill Lynch

Greg Halter - Great Lakes Review

Steve Willoughby - Cleveland Research

Operator

Good day, ladies and gentlemen, and welcome to our Fourth Quarter 2012 Mettler-Toledo International Earnings Conference Call. My name is Alan, and I will be your audio coordinator for today. (Operator Instructions) I would now like to turn our presentation over to your hostess for today's call, Ms. Mary Finnegan. Please proceed, ma'am.

Mary Finnegan

Thanks, Alan, and good evening everyone. I am Mary Finnegan, I am the Treasurer and responsible for Investor Relations at Mettler-Toledo, and I’m happy to welcome you to the call. I am joined here today by Olivier Filliol, our CEO; and Bill Donnelly, our Chief Financial Officer.

I want to cover just a couple of administrative matters. This call is being webcast and is available for replay on our website at www.mt.com. A copy of the press release and the presentation that we refer to on today's call is also available on our website.

Let me summarize the Safe Harbor language which is outlined on page one of the presentation. Statements in this presentation which are not historical facts constitute forward-looking statements within the meaning of the U.S. Securities Act of 1933, and the U.S. Securities Exchange Act of 1934. These statements involve risks, uncertainties and other factors that may cause our actual results, level of activity, performance or achievements, to be materially different from those expressed or implied by any forward-looking statements. For a discussion of these risks and uncertainties, please see our discussion in our recent Form 8-K. All of the forward-looking statements are qualified in their entirety by reference to the factors discussed under the captions, Factors Affecting our Future Operating Results, in the Business and Management Discussion and Analysis of Financial Conditions and Results of Operations in our Form 10-K.

Just one other item. On today's call, we may use non-GAAP financial measures. More detailed information with respect to the use of and differences between non-GAAP financial measure and the most directly comparable GAAP measure is provided in our 8-K. I will now turn the call over to Olivier.

Olivier Filliol

Thank you, Mary. I will start with a summary of the quarter and then Bill will provide details on our financial results and our updated guidance for 2013. I will then update you on our execution focus in this challenging macro environment. As always, we will have time for Q&A at the end. The highlights for the quarter are on page two of the presentation. Local currency sales increased 2% in the quarter, similar to what we experienced in the third quarter, we had solid growth in Americas and Asia, rest of the world with a sales decline in Europe.

Our earnings benefited from pro-active cost measures. Specifically, our actions in pricing and cost control benefitted margin and drove a strong 20% increase in adjusted EPS in the quarter. I am pleased with our execution in the quarter and the continued progress on our strategic initiatives. Uncertainty remains in the global economy today and we expect conditions to remain challenging in the first half of this year. However, with the benefit of the cost control actions and our margin initiative, we expect to have solid EPS growth in 2013.

Let me now turn it to Bill who will provide an update on our guidance for 2013, as well as cover the financial results.

William Donnelly

Thank, Olivier, and hello everybody. Let me start with additional details and sales which were $657.3 million in the quarter, an increase of 2% in local currency. On a U.S. dollar basis, sales increased by 1% in the quarter which included a negative 1% impact due to currencies. Turning to page three of the presentation, we outlined sales by geography. In the quarter, local currency sales increased by 5% in the Americas and 6% in Asia/Rest of the world, while sales declined by 4% in Europe.

On the next slide, you will see that for the full year 2012, sales increased by 4% in local currency. Breaking that down by region for the full year, sales increased by 5% in the Americas and 10% in Asia/Rest of the world, sales declined by 2% in Europe. Acquisitions contributed approximately 2% to European sales growth for the full year and approximately 1% to total sales as well.

On slide number five of the presentation, we outlined our sales by product area. In the fourth quarter, lab sales increased by 4% and industrial sales increased by 1%, while food retailing was down 1%. The next slide provides full year sales by product area. In 2012, laboratory sales increased 5%, industrial sales increased by 4%, and food retailing declined by 4%. The acquisitions contributed approximately 1% to industrial sales growth for the year.

I am now turning to slide number seven of the presentation where we show our P&L. Let me walk you through the key items. We are very pleased with our gross margins which were 54.3% in the quarter, a 90 basis point increase over the prior year. We benefited from pricing and lower material costs. These benefits were offset somewhat by a negative mix, both geographic and by product. While mix was slightly negative overall, it was better than the mix we saw in the first half of this year. R&D amounted to $28 million, a decrease of 6% in local currency. SG&A amounted to $175.4 million, a 4% decrease in local currency as compared to the prior year quarter.

Lower variable compensation was the principal driver which accounted for approximately a 6% decline in SG&A as compared to the prior year quarter. We also benefitted from our cost measures implemented earlier in the year. Partially offsetting the decline in expenses were additional investments made in emerging markets as well our field turbo program which we spoke about earlier in the year. Adjusted operating income amounted to $153.4 million, which represents 17% increase over the prior year amount of $131.7 million. Our operating margins reached 23.3%, a 300 basis point increase over the prior year level.

Given the environment we are very pleased with our operating income growth and margin improvement. A couple of final comments on the P&L. Amortization was $5.6 million in the quarter. Interest expense was $5.7 million. We lowered our annual effective tax rate for discrete items to 24% for the quarter and for the full year. This is comparable to the 24% effective tax rate we had in Q4 of 2011 and the full year 2011. However, it was below our guidance of 24.5% and the rate we used or recognized during the first three quarters of the year.

Fully diluted shares for the quarter were $31.3 million. Adjusted earnings per share was $3.47, a 20% increase over the prior year reported amount of $2.88 per share. We are very pleased with this strong earnings growth, particularly given the modest sales growth. On a reported basis, earnings per share was $3.35 per share, as compared to $2.91 in the prior year. Reported earnings per share included pre-tax restructuring charges of $5.4 million or $0.13 per share. Reported EPS also includes $0.03 of purchase intangible amortization, and a $0.04 benefit from the catch-up of the reduced tax rate for the first three quarters of the year.

The next slide summarizes our full year P&L. As I mentioned, local currency sales increased by 4% for the year. Our gross margins reached 53% while our operating margins increased 170 basis points to 19%. Adjusted earnings per share was $9.67 per share, a 16% increase over the prior year amount of $8.36 per share. Given the challenging operating environment we encountered during 2012, we are very pleased with these results.

Now let me turn to cash flow. Free cash flow in the quarter amounted to $93.7 million as compared to $77.9 million in the prior year. On a per share basis, this is an increase of 25%. Our DSO was 43 days while our ITO was 4.9 times on an LTM basis. In particular we are pleased with this improvement in our inventory turns. For the year, free cash flow was $254.5 million or $8 per share which is a 29% increase over the prior year.

During the quarter we repurchased 396,500 shares for a total amount of -- for a total dollar value of $70.8 million. For the full year 2012, we repurchased 1.6 million shares for a total dollar amount of $278.7 million. We remain on track with regard to our cost control measures that we announced in the second quarter. As a reminder those measures include the transfer of certain functions to lower cost countries, workforce reductions and rationalizations of certain operations. We expect total restructuring charges to reach the $20 million to $25 million range, and it is primarily made up of severance costs.

In 2012, we incurred $16.7 million of restructuring charges. We remain comfortable with our target to reduce operating costs by approximately $40 million annually when the program is completed. However because some of these initiatives will take time to complete we will not get the full benefits until the end of the next year. The economic environment is playing out pretty much how we anticipated when we spoke during our third quarter call. We continue to believe that the first half of this year will be challenging with sales growth below normal levels. As we look to the second half with the benefits of improving economic conditions, if in most if not all regions, as well as easier comparisons we would expect to show better sales growth levels.

We recognize that economic data released since our last call has been relatively positive. The PMI numbers from China are just one example. We are not surprised with this improving data and we believe that we will eventually benefit from it. However, our business does tend to be late cycle and therefore we will likely see better results in the second half of this year. Given this all as a backdrop, let me cover the specifics of our guidance. We now expect full year local currency sales growth to be in the range of 1% to 3%. We have slightly lowered the top end of our previous range which had assumed previously a growth of 1% to 4%.

This is principally driven by how we see the first quarter coming out, which I will cover in a moment. For the full year 2013, we expect adjusted earnings per share to be in the range of $10.30 to $10.55. This compares to previous guidance of $10.00 to $10.30. For the first quarter, we would expect constant currency sales growth to be in line with the prior year. I realize that this is lower than we achieved in Q4. However, the guidance reflects the late cycle and short cycle nature of our business. Perhaps most importantly, the guidance reflects the fact that we began this year with a lower level of backlog than last year.

Many of you will remember that when we commented on the first quarter of last year, we said that sales growth was greater than order growth. I expect the opposite in Q1 this year. Sales in constant currency will likely be flat but I expect order growth -- orders will grow modestly. Given the sales assumption, we would expect adjusted earnings per share to be between $1.75 and $1.80 during the first quarter. A couple of comments to cover -- a couple of additional points to cover with regard to the guidance.

First currencies. We would expect currencies to reduce sales growth by approximately 1% in the quarter. For the rest of the year we would expect no impact in Q2, a slight positive impact in Q3 and a slight negative impact in Q4. For the full year, we do not expect currencies to impact sales growth overall. Now looking at the impact of currencies on operating profit, we are facing as of today a little headwind for the full year. In terms of the Swiss Franc/euro, we are relatively neutral given the hedges we have put in place. As a reminder we have hedged approximately 75% of our $100 million Swiss Franc to euro exposure. However, we are getting a little hurt with the Japanese Yen and Swiss Franc versus the dollar.

In total, currencies will reduce earnings per share growth by about 1% for the full year. This is based on current exchange rates. A couple of additional points. We have assumed an effective tax rate of 24% for 2013 and that all free cash flow will be used for share repurchases. One last comment, some of you have said that it’s difficult for you to judge how earnings per share growth will be by quarter this year. Specifically, you wanted to know how will the stronger sales growth in the second half of this year versus the first half, interplay with the timing of our cost measures, the impact of higher incentive comp and various other factors.

It’s also difficult for us to forecast precisely by quarter but our expectation is that earnings per share growth during the period from Q2 through Q4, will likely be in the 8% range, that being the mid-point of our full year guidance. So while sales will be back-loaded in the year, I think EPS growth will be relatively consistent throughout. We will provide of course more specific guidance in upcoming calls but I thought these general thoughts may be helpful to you, as I know many of you will be updating your models.

Okay. That covers my comments on guidance and I want to now turn it back to Olivier.

Olivier Filliol

Thank you, Bill. Let me start with summary comments on business conditions. Lab grew 4% in the quarter with good growth in balances, analytical instruments and strong growth in process analytics. Pipettes also had growth while automated chemistry was down. For the year, lab sales were up 5% and I continue to feel good about our market position. Industrial was up 1% in the quarter with product inspection up low single digit and core industrial flat with prior year.

Core industrial was down in Europe and the Americas and up modestly in Asia and Rest of the world. Product inspection is very well in Asia and Rest of the world and have growth in the Americas but was down in Europe. I also point out that industrial had strong comparison from the prior year. As expected, retail was down in the quarter with strong project activity in the United States offset by declines in Europe and Asia/Rest of the world.

Now, looking at geographies. Europe was down 4% in the quarter, a little better than we expected the last time we spoke. Retail was down double-digit with modest declines in lab and industrial. Americas was up 5% in the quarter, a little better than expected, driven by strong project activity in retail. We have good growth in the lab and industrial was up slightly in the Americas in the quarter. Finally, Asia and rest of the world was up 6% in the quarter pretty much on track with what we expected. Lab had double-digit growth while industrial had mid-single digit growth and retail was down. That covers my comments on the business.

Although market conditions are challenging, we believe we can continue to grow faster than our underlying markets. Execution is key to achieving continued share gains. Let me provide some examples of our focus areas for 2013. Our sales and marketing programs reflect the continuous improvement mentality of our Spinnaker philosophy. Through this, we are able to move sales and marketing to higher levels of excellence. As you saw in 2012, we have shown our ability that our programs through a more challenging macro environment and ensure that our front-end resources are directed to best opportunities in the markets. As we move into our fourth wade of Spinnaker marketing initiative, we expect to continue to innovate and expand our sales and marketing efforts. Service tends to do better in terms of economic weakness and have the additional behind of keeping us in close contact with our customers, especially in regulated environment such as food and pharma.

In 2013, in conjunction with our Blue Ocean program we will continue to globalize our service business, which will further our efforts to increase service productivity and efficiency. We are also focused on increasing the sales of services at the point of instrument sales. For example, providing standardized ‘service’ with ‘product’ and continuing our efforts to globalize our service offering are important to increase the service attachment rate.

Launching innovative new product is critical to expanding our market leadership. Important as well are the integrated marketing campaigns for product launches. We have a strong product pipeline including an enhanced offering for basic weighing in laboratory, new entry level type (weights), robust solutions for industrial hazardous applications and a new platform for x-ray, to name just a few. We believe these products will allow us to continue to gain share.

2012, marked our 25th year of manufacturing operations in China. We have an excellent market position in China as well as our other emerging market countries. We consider this leading position a competitive advantage given the growth expectations for these markets in the years to come. We will continue to extend our presence in China as well as we move into more second tier cities. Our emerging markets presence is much broader than just China. We will continue to grow our presence in these other emerging markets as well.

As you heard from Bill, we made great improvements in our margins in the fourth quarter. We believe we have additional levers to pull to continue our strong track record. Pricing is one lever, and execution is key to our accomplishments in this area. While our price increase for 2013 will be lower than 2012, it will still be an important contributor to margins. Supply chain initiatives surrounding low cost country sourcing, supplier consolidation, and various product de-proliferation efforts will also be important contributors in 2013. Our margin initiatives also include an increasing number of lean initiatives to improve productivity and manufacturing and other processes.

Finally, we believe that our Blue Ocean program will provide the foundation for further margin improvements at Mettler-Toledo. We have begun to see initial benefits in our Chinese and Swiss operations in terms of more transparency and integration in our supply chain, an improvement in inventory turnover and benefits in other areas. While we won't gain full benefits of our Blue Ocean program until more worldwide operations have completed implementation, we are pleased with the progress to date.

In 2013 we are very focused operational initiative and will continue to make significant investment for the long-term. We continue to make important investments in employee training and leadership development, product development and front-end resources in emerging markets. We will also achieve another milestone with our Blue Ocean program as the majority of our operations in U.S. will go live in the first half of the year.

In summary, our markets are challenging but we believe we can continue to execute well. Our cost structure is in good shape today but we will continue to closely monitor the environment for signs of further slowing. We expect business conditions in China and our other emerging markets to improve later in the year. The west is primarily a replacement business. We know a customer can defer but ultimately they will need to replace their instruments. It is important that we stay in front of them so we have the opportunity when they do purchase. While we are concerned with the global environment, we feel good about our market position and ability to execute our strategic initiatives. We believe we grow faster than our underlying market and continue to gain share. We also believe we are making the necessary strategic investment for our long-term growth.

That concludes my prepared remarks and I want to ask the operator to open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Tycho Peterson from JPMorgan. Your line is open for you now.

Tycho Peterson - JPMorgan

Maybe just the first question on the guidance adjustment. Bill, I understand your comment on the first quarter about sales being flat but orders growing a little bit modestly. Just talk about how much of that varies by geography? Is this kind of an assumption that Europe is going to get a little bit worse in the first quarter here?

William Donnelly

Actually, I think it's probably as much China as anything. The reduced backlog we have is almost completely attributable to Chinese industrial. And if you kind of go back to our Q1 call a year ago, we talked about that impact that that had in terms of last year's Q1 sales being a little bit more than orders. We would expect to have actually half way decent order growth -- better order growth in China, but relatively flat sales growth. Let's say mid-single digit, low to mid-single digit order growth in China but sales growth to be flat and we will end up with more backlog than we had before.

So, I think we kind of feel that China is for us pretty much bottoming out. We'll see what happens more broadly economically, but with our late cycle industrial stuff we now see in terms of lead generation and other topics that things are already going better. Some of the things that you guys see in external economic factors we start to see internally in the business, but it won't necessarily translate to sales growth we think, until the second quarter.

Tycho Peterson - JPMorgan

And then maybe just rounding out the geographic commentary. U.S. trends, some of your peers have baked in sequestration assumptions. Can you just talk about what you're assuming in the U.S. market here for the year?

William Donnelly

In terms of the first, our business in total is maybe not as exposed as some of the peer group companies in terms of that topic. The exception would be our pipette business and we would expect to have modest growth in our non-government funded related pipette business pretty much offsetting what we see in the rest. And we're not looking at double-digit decline but modest declines in some of the academia and government funded areas.

Operator

Your next question comes from the line of Jon Wood from Jefferies. Your line is open for you now.

Jon Wood - Jefferies

So, Olivier or Bill, could you call out the China numbers in the quarter. And Bill from your last comment, it just sounds like what's changed is China inflects a little bit later in 2013 than you might have thought last quarter, do you still expect double-digit growth in the second half of '13 in China?

Olivier Filliol

So, let's quickly go and look at the China number in the quarter. So, China grew 3%. This was a little lower than what we expected when we spoke last time. Lab continued to do well with double digit growth, while industrial growth was low single-digit, and retail was down. We do expect that Q1 will be in a similar situation and maybe even a little bit worse and then Q2 becoming better, as Bill highlighted before. It’s going to certainly take into the latter part of the year that things improve. We see early indicators like productivity and lead generation that support this, but being late cycle will certainly depend on that. What we also see that government changes that we had in China takes a while until we benefit from this. We also expect now another round end of the first quarter where government will confirm their mid-term five year plans that will also give us more clarity where we have our growth opportunities. I feel the team is reacting very well but fact is, the rebound of China for us takes a little bit longer than we expected, for example what we expected last summer.

William Donnelly

I think one other thing I'd add and maybe this is as much, Jon, in response to Tycho’s questions as yours is, the other thing and I hadn't focused on much that between Q1 and Q2 at least the way we measure working days, you have about 2% less working days in Q1, about 2% more in Q2 and it is balanced for the full year. And I think that little bit impacts it. But in terms of the adjustment on the top line it has more to do with how we see backlog here as we enter the year.

Jon Wood - Jefferies

Good color. And then, Bill, could you go through the major gross margin buckets, obviously pretty good in the fourth quarter, and then any changes you see in that raw material pricing mix bucket for '13 at this point?

William Donnelly

Sure. On, again, a weighted average basis across the business, we finished the fourth quarter at 2.9% net realized price increases. That helped the gross margin about 140 basis points. And then material costs were down 2.4% for the quarter which was just short of 2% for the full year and that translated in the quarter to about a 60 basis point improvement. And of course that adds up to more than what we showed and kind of what's left over is what I would describe as mix and other, to get to the 90 basis points. Now in terms of the trend, we would expect maybe not 90 basis points in Q1 but we've built in to get to the EPS growth we described. I think we built in about 70 bps of gross margin improvement in the first quarter.

So, continued good trend. I think that the first couple of quarters of the year should continue to have, let's call it, outsized versus our long-term trend on gross profit margin, closer to the second half trend than the first half of last year because I think there is some comp to OpEx as well and then that will more moderate in the second half. On material costs, we feel pretty good about material costs at least for the first half of the year. I think what will be interesting to see is as with these PMI numbers and other topics improving in China, I think you could start to see raw material inflation starting in the summer time. But we feel like we are on top of the cost structure currently and top of the margin topic and that should be good for the next couple of quarters while we have some more modest sales growth.

Operator

Your next question is queue comes from the line of Dan Arias from UBS. Your line is open for you now.

Daniel Arias - UBS

Bill, you guys look like you're seeing the benefit of the cost actions here. I'm curious whether what you've done so far has been more focused on shifting operations to different regions or more taking down headcount and rationalizing some of the business?

Olivier Filliol

To maybe recall, end of Q2 last year we recognized that things will get more difficult and so we initiated two programs in parallel. One program was expanding on something that we had started already earlier to respond to the strengthening of the Swiss franc where we addressed more structural and fundamental things in our business. Where we also looked at ways to move certain positions in lower cost countries, outsourcing certain functions and go a little bit more fundamental at these things. But of course these are demanding projects, need very good preparation and accordingly also take multiple quarters until we have the full benefit.

In parallel, we launched also in Q2, broader cost management initiatives that went pretty much across the world, across all the units, and basically reflecting also the lower expectations in revenue growth for the remainder of last year and certainly also for this year. And these programs that we launched with the second program were faster to be implemented most of that is done, it’s performance based topics. It has (affected) certain headcounts, but it’s very much across units across the world. More focused, of course, to the western units. It is actually dominantly into western units, certainly also Europe.

So these two programs, I definitely feel that we are benefiting from them, not just in the short term also in the long term. It’s making us more cost competitive and allows us to afterwards reinvest in the business when the markets pick up again that allows us to do strategic resource shifting. For example, if business picks up again, we are going to invest in emerging markets in more thoughtful way as the western market, of course, we are going to continue to be very cost conscious.

William Donnelly

I think the bigger, maybe two Dan, some of the bigger projects, they take longer to implement. So some of things we work on this year, even into next year, are some of the more complex ones as well. So, there is still work to do in the program.

Daniel Arias - UBS

Thanks for that detail. I guess, going back to the gross margins, just given the disparity that we are seeing here between Europe and the rest of the world, are you thinking any differently about the way that that dynamic impacts margins in '13 than you did last time or is the outlook for that generally the same as it was in 3Q?

William Donnelly

I think in the first half of the year we will probably see a trend that's somewhat similar to -- I mean we clearly parted them, the price increase and the material cost numbers impacts on margins add up to more than the total margin. So a big part of that negative mix is actually European related. Our European business as we spoke to you many times is largely replacement in nature and so we'll see the benefits of easier comps in due course and get a better mix there. But I think we still have a couple of quarters yet of that mix topic.

The other area where we sometime have mix topics is as emerging markets pick up, so China is -- our lab products have higher gross profit margins than our industrial products and China has a bigger mix of industrial. So as that starts to pick up, that will be a little bit of a -- it will have some impact on the second half as well. But I think at least for the next couple quarters, we think long-term margin is going to be a good story but maybe in the next couple quarters it will be especially good.

Operator

Your next question in queue comes from the line of Paul Knight from CLSA. Your line is open for you now.

Paul Knight - CLSA

You had talked about the emerging markets outside of China being a priority. Which are the most important to you?

Olivier Filliol

So, if we look at the emerging markets, half of it comes from China and then the other half comes from multiple countries. And actually we have a whole group of countries including India, Brazil, Russia, Southeast Asia. They are all in the range of 1% to 3% but all actually very nicely contributing to the overall mix. But none of the other ones would particularly dominate. And to give you a little bit of flavor about how we performed on these ones. We had Brazil, for example, that did very well in Q4. We had Southeast Asia that continues to do very well. Eastern Europe was up modestly. Russia was, however, down.

Paul Knight - CLSA

And could you, Bill, quantify the currency impact of last year and what you expect this year in total?

William Donnelly

So, let me start with the top line. So for the top line on a full year basis, currencies reduced sales by, let's call it 2.6%, and then in terms of 2013, it's practically zero but with some headwind in the first quarter basically offset by a benefit in the third quarter. 1% each.

Paul Knight - CLSA

And the EPS total, I’m sorry?

William Donnelly

So on the EPS, on a full year basis, we had about $0.5 million. So, think about that as $0.015 for the full year. And a reminder, we had a big plus in Q3 and the rest of the quarters we had relatively smaller minuses. It's actually a bigger number next year. It's a headwind of about $5 million before tax. If you want to put a tax rate on that, that's maybe something in the area of $0.12 per share. One of the bigger changes that you guys know is related to the yen but it's a few other factors as well.

Operator

Your next question in queue comes from the line of Jon Groberg from Macquarie. Your line is open for you now.

Jonathan Groberg - Macquarie

So, Olivier, you mentioned that you thought the price increase would be a little bit less in '13. Sorry, I didn't hear the quantification. I think, Bill, you quantified what it was in '12, but what do you expect it to be in '13?

Olivier Filliol

We expect 100 to 150 basis points for 2013. This is less because as talked on it last year with you guys, we had a lot of attention to it. We did media price increases before and we certainly benefited from an environment that has a certain inflation and that allowed us to go for higher increases. This year, we feel that the environment is more challenging to go with too high price increases because it is not a real inflation on a worldwide basis and material costs are not necessarily going up. So, that's why we feel this year it’s going to be more modest.

Jonathan Groberg - Macquarie

And, Bill, from your comments on the materials cost for the year you expect them to be kind of flattish. Is that what you are currently expecting?

William Donnelly

I think we will even do a little bit better than flattish unless the impact of material like steel into the China is really strong in the second half. I would like to think that maybe not the 2% benefit we got this year, but I think a 1% benefit is realistic.

Jonathan Groberg - Macquarie

Okay. And then just if you kind of -- the operating margin line or EBITDA line if you want to, what are you expecting, I am just trying to see from -- kind of playing with the numbers here -- but what are you expecting at the EBITDA line in terms of margin expansion. And if I can briefly, what is your expectation for share counts given your stock keeps going up?

William Donnelly

Sure. So, we should get about 50 basis point increase in our operating margins, kind of the way Mettler measures them. And if you think about that in terms of incremental margins, you're talking about 46%, let's call it, mid-40s or so. And then actually on a currency adjusted basis it's probably even 10% more than that. In terms of outstanding shares, by the end of the year we should be around this level of 30.9 million shares or so, and that's about a 3% decline versus the average of this year.

Operator

Your next question comes from the line of Ross Muken from ISI Group. There line is open for you now.

Ross Muken - ISI Group

I just want to get back to the revenue line in sort of the order trends or at least what you saw in terms of the pacing throughout the quarter. Given the macro backdrop you sort of laid out what most figures are looking like, and with a lot of broad customers across even the industrial complex are talking about it, it's clearly a better picture there. I know you are sort of later cycled but did you see something with the orders? Was it the chunkiness, was it certain parts where maybe there was very specific kind of lack of visibility? I am just trying to get a sense for sort of what's changed over the last two-three months since the original take and how that's kind of trended directionally through the end of 4Q and then the very early part of 1Q, although I know it's not a great indicator because it's January?

William Donnelly

I think I'm going to get to the different pieces of your question, Ross, but come back to me if you think I kind of missed it. So, from our point of view we finished the year with less backlog than we expected. Sales as you know in Q4 came in a little bit biter. Orders may be modestly worse but the combination when we kind of looked at things, I think we're starting this year with, let's call it $25 million to $30 million less backlog than we had a year ago. And if you translate that into a sales number, you're talking a little bit more than 1%. And if we look at actually our lead numbers, we actually feel relatively good about the recent trend, particularly the one place we're most anxious on was China. We do think that we're going to have, what we saw in January was excellent, but I think we shouldn't jump to too many conclusions I guess.

I'm sure you guys heard from other people that the Chinese New Year is moved to February, last year it was January but our order growth was very good. But I think even adjusting for that impact what we saw in January was probably not so bad, and I think kind of pointing to this trend that we would expect order growth to be better in Q1 in China than sales growth and actually that's really a statement for the whole company but in particular driven by what we expect to see in China. So I think really the thing that triggered it mostly for us is that we finished with a little bit less backlog, we recognized what, despite maybe having some modest order growth in the first quarter, that the sales growth has realistically got to be flattish. And when we kind of translated that out for the full year, we decided to move the midpoint of our guidance down by about 50 basis points for the full year.

Ross Muken - ISI Group

So I guess just on the full year, which is what I was more referring to versus Q1 because I understand the dynamics there. I mean, where are sort of the puts and takes in that level of assumptions because again I realize what the near term trajectory looks like but one would think given the macro there is probably some upside optionality, I guess, in the back half forecast. And so if I paint a picture where China continues to kind of gradually improve at the rate we've seen and the U.S. sort of holds in there and Europe gets no worst, where do you see the most sensitivity in the business to where, if we look back nine months from now we were like, wow, that ended up being a lot better than we thought?

William Donnelly

I think you could make a bull-bear case for pretty much every region. And I think in the case of let's say the western world the different governmental risks that are out in both sides of the pond go away and that, or let's say, don't come to the forefront and investment cycle improves. And as a late cycle company we benefit from that more in the second half and our customers, because our business there is a lot replacement cycle, that they return more quickly to their normal replacement cycles, then that would the upside in that part of the world. I think in China it’s very much that things pick up a little bit faster than we anticipate that us thinking that we are mostly not going to see this till the second half we start seeing more in the second quarter than we expected to and it’s a little stronger in the second half.

If you think about like if we start out flat, Ross, in Q2, one way to get to the full year high end of the guidance would be 0%, 2%, 4%, 6% kind of progression by quarter. And to us that seems sitting here today, that would be a good accomplishment from where we are now. So, yeah, I guess kind of sitting here today and Mettler is the way it is on guidance maybe with our relatively small backlog where we have a tough time projecting that optionality you described although we certainly understand the point. And sitting here today, we think that that's probably a reasonable expectation.

Operator

Our next question in queue comes from the line of Sung Ji Nam from Cantor. And there line is open for you now.

Sung Ji Nam - Cantor Fitzgerald

So, I guess going back to Ross's question, in terms of your better outlook for the second half or the latter part of the year, is that really largely driven by China essentially or I'm just trying to get a sense of.…?

William Donnelly

No, we think the comps get easier in the west. So we think we'll be reporting better growth rates in the second half in every region. I think really I apologize and sometimes these calls, if our explanations got off-track. The adjustment to show zero sales growth in Q1 which somehow translate a little bit to us, moving the midpoint of our revenue guidance down by 50 basis points. China was maybe the biggest impact on that. In general, we see that the second half will be better in all regions. We think that the comps get easier in all regions. We think that generally the economy will be improving in all regions and we think in China there is the additional impact that some of the government related projects we expect to see more benefits in the second half of the year.

Sung Ji Nam - Cantor Fitzgerald

And then in the past you talked about roughly 30% of manufacturing coming from low cost regions and 40% of sourcing from low cost regions. I was wondering after the current cost control measures, after that's been completed, would that change those numbers significantly or?

Olivier Filliol

Not that significantly. What you see is that every year the number goes up by a few points. This is a continuous and a gradual thing. It's not that we are moving a whole plant or so through these restructurings to a low cost country. Actually, in contrary, we are a little bit more focused now on certain services, to move services we do software development more out of low cost countries. So, it doesn't necessarily impact the manufacturing and the sourcing ratio. By a few points, yes, but it's not a big way for a big trip.

Sung Ji Nam - Cantor Fitzgerald

Okay. And then if I could squeeze in one more, Olivier, I think you talked about, that you had identified, you guys had identified some cross-selling opportunities within your pharma end markets. So I was wondering if you could maybe talk about that end market. I think it's roughly a quarter of your sales and I know it crosses both the lab and the industrial businesses but just curious as to how that segment and market is performing.

Olivier Filliol

Yeah. When we look at this market we look at relatively broad but often the question is referring to pharma, and when we think about pharma often we think big pharma. The big pharma market is not particularly robust and has certainly challenges, but the way we need to look at it is account by account. Certain accounts continue to invest, certainly also invest in automation solutions. There is also good demand for compliance related upgrades and investments. But then again it’s target or account specific. So then there is this other life science accounts like CROs, biotech, smaller pharma. And their growth is actually in general, okay, and particularly if we look on a global scale. And then within this life science market of course, there's also NIH and academia. However, that's not really significant for us. This is a market that is challenging but again not very significant. So, if I take the whole life science market, big pharma depending on the different accounts then the others CROs, biotech and (inaudible) actually solid for us.

Operator

Your next question in queue comes from Isaac Ro from Goldman Sachs. And there line is open for you now.

Isaac Ro - Goldman Sachs

Just wondering if you could maybe give us any updated views on free cash flow and CapEx this year. Trying to scrape around here for any leftover questions.

William Donnelly

We expect a solid improvement in terms of our free cash flow. We should be, let's call it in this $270 million range, something like that. And in terms of our CapEx, we should even be modestly down off of 2012 levels, something more like $92 million versus $95 million-$96 million last year. And maybe the one variable in that area, Isaac, would be how currency plays out. A lot of our CapEx as you know is outside the United States. In terms of the share repurchase program -- in terms of use of cash flows, we would expect to continue to repurchase shares equal to our free cash flow and estimated option proceeds.

Isaac Ro - Goldman Sachs

Great. And maybe just a follow-up on the CapEx side. I mean, if I look over the last, I don't know, five or six years, it's been a relatively modest trend upward but as you pointed out, maybe down this year. Is this kind of a new run rate or are there other maybe special items like Blue Ocean in the next couple of years that we should keep in mind for '14 and '15?

William Donnelly

I think Blue Ocean is incrementally a, I struggle to remember what the 2013 number would be, but it's a number of at least $20 million I would say in terms of incremental CapEx related to Blue Ocean. And maybe it could be $25 million. And so if you pull that out, we right now are half pregnant on Blue Ocean in the sense that we have incremental operating costs and incremental CapEx. And sometime after 2016, I think you'll start to see both of those coming down as well as each year than a little bit more on the benefit side in terms of the business case behind Blue Ocean. So, there is like both of those effects going forward after that.

Operator

Your next question comes from the line of Richard Eastman from Robert W. Baird. There line is open for you now.

Richard Eastman - Robert W. Baird

Bill, the cost take out that you identified for the full year like, I think it was $17 million, is where you're at against the $40 million, ultimate $40 million number?

William Donnelly

Yeah, I think we're estimating $15 million to $20 million in previous calls, correct.

Richard Eastman - Robert W. Baird

Do you put some of that back to work in '13? In other words, are we, looking at this year-over-year, that number should continue to grow by $5 million a quarter. But shouldn't that generate more to your incremental margin than what you identified?

William Donnelly

I think that there are three things to think about in terms of the, let's call it the cost structure piece. So, first of all, Rick, we're going to go from that, let's call it 17 number, up to eventually $40 million. But the $40 million will gradually get there and we don't get the full benefit till the end of '14, so let's assume you're seeing that in '15. So, it's not exactly $5 million per quarter. Then the second impact that you have is that our variable compensation. So we budget a certain level of variable comp bonuses, commissions, these type of topics. And part of our cost gains in 2012 was that we didn't hit our targets so we paid out less than budget. So now in 2013, we go reset back the budget on these plans and that's an increase of about $15 million, so you largely have the incremental cost savings of 2013 being offset by higher variable compensation. Now, did you have another part to that question or did I kind of get the whole thing?

Richard Eastman - Robert W. Baird

No, I think you got the whole thing right there. I mean, that was quite frankly, it was kind of $15 million missing, I mean just from the straightaway calculation. Then could I just ask, Olivier, you gave kind of some nice commentary on the services side of the business but could you identify the service piece. I think, you discussed service and consumables being about 27% of sales, but how big is the service piece? How did it end the year and what's the targeted growth rate there for '13?

Olivier Filliol

So, if we take purely the service business excluding consumables, it’s about 21% of total sales, and in the quarter we grew about 4%. In general, I expect service to outpace product sales, so we should rate better. And this is particularly also true in environments like we have right now, service is a more steady business, more resilient to the economy. And the other factor I would add to services, it’s a very important competitive advantage that we have. None of our competitors have the breadth and the depth of our service force and it allows us to be really in close contact with customers whenever they plan to have replacements of an installed base at all. So, it’s a good business to have.

Richard Eastman - Robert W. Baird

And that’s, if I remember right from previous comments that you made, that provides an upward bias to the EBIT margin as well, doesn't it? Service that comes in higher than the consolidated EBIT?

Olivier Filliol

Yes, it has an above group average profitability.

Richard Eastman - Robert W. Baird

Could you just -- what's the starting spot on the attachment rate for service to the hardware or the product sales. I mean is it 40% or, I have no idea?

Olivier Filliol

It varies heavily by country, also by business but in particular also by country. You have big differences there. We have actually certain countries that do exceptionally well to have service under contract. We do it at the point of sales initially and then really put it on the contract in other cases. There is a mentality in a country where it's more break-fix and we have more of a challenge to really bring it under contract. So, I can't give you a global number but--

Richard Eastman - Robert W. Baird

Is it a low number, 20% or what's like a outlier?

William Donnelly

20% would be a number, but remember that's the percentage we have under service contract. We would actually service a larger percentage of our installed base.

Richard Eastman - Robert W. Baird

Okay, so that's under contract. Okay, that's fine, I was just trying to get a reference point. And then just the last question, I know you guys are right. I wouldn't doubt, Mary, but I'm surprised that with the euro at 1.35 that we're going to still take kind of a negative currency sales hit for the full year or flat, because by July or so, I think we're comping against a 1.26 something number. So the yen has that much impact, the strength in the yen?

William Donnelly

Rick, even I am scared to challenge any of Mary's currency analysis. So, I think, we could probably take it offline when we talk later. I think of course there's yen and a few others there. I think it's the other currency that's driving. It's the little guys that are driving it more than the euro. But I’d have to take it offline.

Operator

Next in queue, we have the line of Derik de Bruin from Bank of America. There line is open for you now.

Derik de Bruin - Bank of America Merrill Lynch

Just a couple of clean up questions. I guess, if, Bill, your model says that you sort of get the -- let's say we do get this acceleration that to get to that high end of your organic revenue growth guidance, that 0%, 2%, 4%, 6%. So we go into 2014 sort of with that 6% organic revenue growth number. So, now that you've taken all these costs out of it, how does that sort of impact your operating model? You previously hit the 5%, 10%, 15% kind of growth model. Now, as you're taking other cost out, what is the -- I mean you did 2% organic revenue growth quarter you did 20% earnings growth. I'm just curious, how does that translate when you look back and do you have to add any incremental cost back to the business?

William Donnelly

I think the way to look at it kind of a good guidance is, hey, if we're growing mid-single digits we should be able to still deliver incremental operating margins north of 30%, relatively consistently. Maybe one quarter or another that could be a mixed topic that puts it up or down, but if we can push that number in periods of time to, let's call it, high single-digits, I think you'll see more than that drop to the bottom-line. But I think in terms of this balancing of investment, I think Olivier could speak to this maybe more, but I think we try to find the balance in how we do it, but we want to invest for growth because we think over the long-term our ability to improve our long-term organic growth number is probably the biggest way in which we can generate shareholder value.

Olivier Filliol

It's lesser than we need to add the cost back to the franchise, I think it's more than we want to do the strategic investment. And, of course, we are holding back with certain investments for several -- adding a lot of sales force in growing, emerging countries. At this stage we are more cautious. If we see that business momentum comes back we would certainly redo programs like we did a year ago with our filed turbos where we strategically add headcounts, where we feel we can accelerate the growth, gain market shares in an accelerated way.

Derik de Bruin - Bank of America Merrill Lynch

And I guess under, like a normal business environment, do you sort of envision the business is sort of like a 4% to 6%, 5% to 7% consistent organic revenue growth there?

Olivier Filliol

Yeah, the 4% to 6% is a reasonable assumption. That's what we exactly kind of predict across an economic cycle. So at this stage the economic cycle is certainly more in a difficult stage so we expect less, and if things improve we have a good chance to have succeeded. But across the economic cycle 4% to 6% is the number that we work with.

Derik de Bruin - Bank of America Merrill Lynch

And then just two quick questions for Bill. Bill, guidance for interest income expense for 2013 and if I missed it, forgive me, but expectations for gross margin improvement year-over-year?

William Donnelly

Okay. So, let me start with the gross margin. We should have 30 basis points, maybe a little bit more for the full year and that would be more weighted though to the first half of the year. And so it will be better than that in the first a little less in the second half. And then in terms of the interest expense, we should be somewhere in the $22 million range. And then interest income for us is a really small number so I think it's few hundred thousand.

Operator

Next in queue, you have the line of Greg Halter from Great Lakes Review. That line is open for you now.

Greg Halter - Great Lakes Review

I noticed that the research and development expense was down in the quarter. I wonder what your thoughts are there in '13 and whether or not that impacts or what kind of impact that can have on new product innovation?

Olivier Filliol

Let me quickly take the second part so that Bill can look up the number for 2013 assumption. R&D expenses varies by quarter and it depends on product launch, major product launches that we have. And certainly also kind of depends on the overall pipeline. This is not a reflection that we are reducing the investments or slowing down our R&D efforts at all. There's another effect that plays here that we are increasingly also leveraging low cost countries for R&D efforts. China in the meantime actually is very important for us to give our product, but India plays also an increasing role. We have leverage in India very much for software development and so we reduce the costs in terms of output level. We certainly don’t compromise on that one.

William Donnelly

So maybe a couple of things. We'll get some modest growth, let's look at a couple of percentage points in 2013. And maybe one other thing that I would add to what Olivier said is that, as you guys know the biggest chunk, the biggest center we have for R&D is Switzerland and we're always giving you guys local currency numbers. And in Switzerland, hey, there's just not been much of an environment for inflation. Whether that be salary or other types of inflation and so a big piece of our, even though we have the same number of people producing arguably at higher productivity levels because we've invested a lot in tools for R&D, software tools and other tools for R&D the last couple of years, we don't think that in those core, particularly lab area, that we're losing anything there.

Greg Halter - Great Lakes Review

Okay. And that leads into my next and final question is, what percentage of your revenues for 2012, the full, year came from new products? If you have that.

Olivier Filliol

It's actually a number that we don't talk about specifically. It's actually also difficult to measure. But a good indication is in the range of 20%. I don't think that it changed too much from one year to another, but it's actually a good indication.

Operator

(Operator Instructions) Your next question in queue comes from the line of Steve Willoughby from Cleveland Research. Their line is open for you now.

Steve Willoughby - Cleveland Research

There has been a lot of great detail on the call so far and you may have covered this already sort of in pieces, but I was wondering where on the expense side with the high-end or the midpoint of the organic growth coming down a little bit but EPS going up, what has kind of changed in your thinking as it relates to expenses?

William Donnelly

I think we have a little bit more confidence on the gross margin side in part due to the second quarter now. Q3 and Q4 both had very good gross margin expansions we expect to report that again in Q1. So, I think that's one factor. And then on the operating expense side we are assessing also where we are in terms of the different cost management programs we have. So, we have a little bit more information in that regard as well.

Steve Willoughby - Cleveland Research

Okay. And then just a final thing was on, you mentioned a little bit of an uptick in the U.S. retail business. Is that something that has multiple quarters behind it do you think?

Olivier Filliol

No, it was rather specific to Q4, had also some previous year comparison topics in it. But, no, I wouldn't read too much into that.

Operator

And presenters at this time there are no further questions in queue. I'll turn the call back over to you.

Mary Finnegan

Thanks, Alan, and thanks everyone for joining us tonight. Just a quick reminder on Friday, July 26th we will have an investor meeting in our Baltimore Auto Chem business. I'll have more details for you in the next coming quarter but just wanted to remind you. Of course, as always, if you have any questions please don't hesitate to give us a call. Hope everyone has a nice night. Thanks. Bye bye.

Operator

Ladies and gentlemen, thank you for your participation on today's conference call. You may now disconnect.

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