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Waters Corporation (NYSE:WAT)

Barclays Global Healthcare Conference

March 13, 2013 9:00 am ET

Executives

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

Gene Cassis

Analysts

Charles Anthony Butler - Barclays Capital, Research Division

Charles Anthony Butler - Barclays Capital, Research Division

Good morning. I'm Tony Butler. Thank you very much for joining us this morning for the presentation of Waters Corporation. We're fortunate to have John Ornell, the Chief Financial Officer; and Gene Cassis, who is the Vice President of Investor Relations. The format will be one of John will provide a brief overview with slides of the company. That will probably last, I'm going to guess, 10 minutes or so. We'll take some questions from the audience. If you'd like, we'll stay in here until the allotted time at 9:30, and then we'll move to the breakout, in Point Sienna 2. John, team, thank you for coming.

John A. Ornell

Okay. Tony, thank you very much. And welcome, everybody. Before I begin, I just need to point to you our cautionary statement. We may be making some forward-looking statements and you need to understand the risks and uncertainties associated with those comments. Waters Corporation is an analytical instruments company. We play rather narrowly in the analytical space. In it, is a number of different technologies that represent about a $35 billion market overall. And Waters is a leader in the liquid chromatography, mass spectrometry, thermal analysis product lines within those market segments.

These tend to be market segments that grow maybe a little bit more quickly based on the numbers of applications and customer sets that we sell to than the industry in general. I would say that the LC/MS marketplace probably is a mid-single digit grower, with Waters growing a couple of points quicker than that over the last decade. And thermal analysis is probably a market that is more of a low-single digit grower, but through acquisition and consolidation in that space too, our thermal analysis division, TA Instruments, has grown at about the same rate as the Waters Division. So over the last decade, we've seen this business grow at about 7%, 8%.

If we look at the markets that we serve, we're largely focused on life science opportunities. If you look at the pharma-biotech, in addition to the government academic, that represents about 3/4 of our business overall. So there's a large focus of this business within the life science space. We believe that, that tends to moderate demand over multiple years and affords us the opportunity to grow probably a bit more quickly than companies that are more focused on G&P-centric industries. And certainly, typically a larger focus on government academic, we believe, will not be advantageous over the next few years. So we think we're well positioned to maintain a higher growth trajectory in sales than companies that are more focused in some of these other areas.

If you look at the industrial food and environmental areas, here, a lot of the growth that we're seeing is in the areas of food safety, environmental testing. We've seen some regulations passed recently in the space but not yet implemented. So we think that there's a number of opportunities for this segment to grow for us, perhaps in spite of a slower growth environment overall in the developed parts of the world.

From a revenue mix perspective, about half what we do is recurring revenues. So the instruments and software placements represent about half the business, but the other half of the business is relatively stable in its growth. It's more dependent on the size of the installed base than how many instruments you ship in any one particular year, so I would say there's a bit of stability in our sales outlook as a result of the fact that half of our businesses is recurring.

Another thing I'll point out here is that if you look at what drives our business, probably half our business, again, looked at differently, is due to regulation in the world. So to the extent that regulation becomes -- maintains or becomes a bigger piece of what we see from a demand perspective going forward, for example, in China we see a lot more regulations going into place in the areas of environmental quality, food safety, probably half of what we sell is because it's mandated by various government agencies in parts of the world.

From a geographic perspective, because currency has moved around a little bit in the last few months, we do probably 10% of our business thereabouts in Japan. We do that local currency, so a weaker yen will have an impact on us based on a yen that's now closer to the mid-90s, than 90 when we started the quarter. You're probably looking at another 0.5 point, 1 point of depressed translation in the quarter, probably another $0.01 or $0.02 of impact in the quarter. 30% of our business is done in euros, and there's another 10% of our business that's in the basket of currencies. So about half of our business is transacted in dollars, the rest in the foreign currencies I just explained.

Over the past decade, as I have said, we've seen about an 8% compounded growth in sales. Currency has been a headwind, a tailwind in various years across that timeframe but not meaningful across the entire 10 years. And M&A has been rather small, maybe it's added 0.5 point to 1 point of growth across that timeframe. A number of smaller, more technology oriented acquisitions that don't have a major impact on sales in any one particular year, but afford us to the opportunity to put these products in our portfolio. And many of these companies continue to drive growth within the businesses within which they've been integrated.

Across that same timeframe, operating income has grown a little bit faster than the sales growth, about 11%, as we've been able to leverage our base of cost across this timeframe. A little bit of gross margin improvement and we haven't grown SG&A at the same rate as sales across this timeframe, creating some amount of leverage.

All the way down at the earnings per share line, we've had a focus in shifting some of our manufacturing to more tax-favored jurisdictions across this timeframe and our tax rate has come down. But more importantly, we've had a very significant focus on share repurchases, and from back in 2002 when we began a very constant share repurchase program, we pulled more than 40% of the outstanding shares off the market and continue this year to look at deploying over $300 million of our free cash flow on share repurchases. So it's been a very meaningful driver of earnings growth across that timeframe.

2012 was a disappointing year for us. We had a couple of very good years coming out of the recession of '08, '09, both '10 and '11 -- 2010, 2011, so a double-digit growth for the business. But last year, right out of the gate, we saw customers being very hesitant to spend capital dollars. And we had -- our recurring revenues held up reasonably well, but we had a small decline in our instrument placements and our organic growth dropped to 2% last year. Currency was a couple of points of headwind so our reported growth was flat. On that, we grew just a couple of percent in earnings, still strong free cash flow, just under $400 million, and we continue the share repurchase program.

We did see relatively stable pharma demand even in '12. India was a one area that fell off for us meaningfully and brought that demand down but outside of that, there was at least some amount of stability on the pharma side of the business. Recurring revenue had a very good year. It was the industrial side of the business that overall pulled us down to the reported growth that I talked about. And China, strong throughout the entire process, strong coming into this year. A pretty strong commitment to a Five Year Plan for investment in infrastructure associated with creating a meaningful drug market in that country. We see that continuing as we speak with you today.

And so for 2013, we think about it as a transition year, back to more traditional growth levels. We think that 5% growth is a reasonable target given the markets that we serve and our customers' ability to deploy capital this year, we're looking for a high-single digit growth in earnings per share on that. We think we'll generate somewhere around $440 million of free cash flow. We've got about $325 million of that targeted for the share repurchase program as we begin the year and we're going to maintain that -- relatively conservative capital allocation, which has done us well over the last decade or more. And we look to continue that performance as we make our way through the year.

So with that, I will open it up for Q&A. Tony?

Question-and-Answer Session

Charles Anthony Butler - Barclays Capital, Research Division

[indiscernible] Where do you sell triple quads principally today? Is that going to be the main instrument that's sold out of that mass spec side? And then moreover, out of the UPLC conversion from, if you will, just normal LC, is that conversion completed? Does that hit a nadir of completion and then the overall opportunity really is in pure LC MS placements or UPLC MS placements?

Gene Cassis

I'll take that. As soon as Tony mentioned he had a geek question, his eyes came to me, so I just want to point that. But on the tandem quadrupole side, what we think it represents, approximately half of what people consider to be the mass spec market, so it's the largest segment market in mass spectrometry. We think that the single largest application for this type of technology is in clinical development, so it supports the preclinical and clinical trial efforts within the drug industry. But also, it is the primary technology that's being incorporated into new food safety and to -- into new food safety and environmental regulations. So as I take a look at Waters' participation in that segment of the marketplace, I think we have maybe a disproportionately strong market share in food safety. We've been early in commercializing turnkey systems and we have a distribution channel that has wonderful access to laboratories that are doing that application. I think that we are increasing our penetration into drug development based on superior performance of our new offering in that space, which is the Xevo TQ-S technology. The S technology for us represents a new methodology for getting more ions into the mass spectrometer itself. We have a new ion source that we think affords us the best signal-to-noise parameters that are available for that application. So I think we're encouraged. And John mentioned last year was somewhat of a disappointing year for us in terms of instrumentation growth but as you begin to peel the onion back and look at specific product lines, one of the product lines that consistently grew across each quarter last year was our tandem quadrupole business led by the TQ-S. So it's nice to be starting this year on that very positive trajectory with a meaningful set of data that allows you to do some level of extrapolation and not feel uncomfortable about it. I think the second part of your question, Tony, was on ACQUITY uptake UPLC. For those of you who may not be as familiar with all these acronyms, about 8 years ago, we commercialized a new technology that we called UPLC. And it was based on a rather unique particle geometry. Up until that time, most chromatography processes used chromatography columns that were packed with materials that were 5 microns in diameter or larger. The difference with the UPLC technology is that we incorporate a new particle geometry that has a diameter of less than 2 microns. In the case of Waters' implementation, we have 1.7-micron particles packed in our UPLC columns. Smaller particles afford you more surface area, less spaces between the particles for the separation to get remixed, if you will, but do require some changes in instrumentation, specifically, the instrumentation has to operate at higher back pressures. And also, all of the connecting tubing has to be carefully engineered so that the great separation that happens in the column doesn't get compromised by fluidics post-column that tend to remix things. So I'd say that as we looked at the penetration of this new technology into the marketplace and as you might expect, the first customers that was interested were those people who are doing research work, especially trying to understand the biochemistry of disease mechanisms, and using this technology along with mass spectrometry detection. So I think, at this point, we've done a good job penetrating these research laboratories with UPLC technology. Again, these are the folks that want to see things that haven't been seen before. But then you take a look at what we're doing in the half of our business that's quality control regulated. And I think we're still in the early stages of commercializing this technology into those laboratories. As John mentioned, about half of the laboratories that we service are complying with regulations, they're doing quality control. And frankly, it's not clear that they want to change methodologies if the methodology that they're currently using has already been sort of approved and hasn't presented the company with an efficacy or safety issue. So as we see new drugs coming into the market that have used UPLC as part of their development protocol, we expect that these new drugs will also use UPLC in their quality control. And given that the drug development cycle is approximately 10 years, one could imagine that as we make our way through this decade, we're likely to see more UPLC methodologies in the quality control. But I think that at this point, still, those regulated applications are relatively underpenetrated. But again the R&D applications, I think, there's a good strong foothold that we have there. And most laboratories have been using UPLC in their research processes within the drug industry. Were those the questions, Tony? Thank you.

John A. Ornell

A quiet group.

Charles Anthony Butler - Barclays Capital, Research Division

Yes. Okay. Yes, Shane [ph].

Unknown Analyst

Could you just talk briefly about the share dynamics within the MS market? I think if you speak about Agilent and Thermo, they would say that Waters is losing share in that market. Could you just talk a little bit about that share dynamics?

Gene Cassis

Yes, I'll take that question, again. In mass spectrometry, as we have discussed earlier, we think about half of the business is tandem quadrupole. And the remaining -- the other half of the business represents high-resolution technologies that have been characterized by static trap designs like the Orbitrap and Tof-based designs like QTof. We think that the more expensive segments of the marketplace, so instrumentation that might have a selling price in excess of $300,000 or $350,000, that's probably the segment of the marketplace where share seems to move around quite a bit. We can say that empirically from personal experience because at one point, we probably had 70% to 80% share of that segment in the early days of QTof commercialization. So in that high-resolution research marketplace, we think it represents maybe about 1/3 or 30% of the overall LC/MS market opportunity. People get money -- I mean, many people in government and academia get money through grant processes and they try to find the best solution that either executes their particular application or something that they don't already have in their laboratory. So if you had a laboratory that already had QTof technology, they may opt for a different mass spectrometry physics in order to complete the toolset within their group. So that's a segment where we probably have seen share move back and forth. In the fourth quarter and coming into the first quarter of this year, we actually are somewhat encouraged by the ordering trends that we see for our products that fall into the brand names of QTof, Xevo QTof and SYNAPT. But I think in the 70% of our mass spectrometry markets that we serve that are largely quadrupole based, I think based on the growth rates that we had last year, that at a minimum, our share position is steady. And, again, we don't have complete access to all the data from all our competitors but one could look at our data set, our results, look at -- make some broad assumptions about what's happening in the marketplace and come to a conclusion that we actually picked up share in what we think is the most promising segment of mass spectrometry because it's regulatory driven.

Unknown Analyst

John, when you think about your guidance for '13, do you have -- can you provide a view regionally where you think the majority of that 5% will be or where you may be above that 5% or below that 5%? And obviously, I'm speaking with respect to the emerging markets in Europe in particular. And I always think U.S. is, at least today, probably very difficult to forecast.

John A. Ornell

Sure. Regarding guidance then at about 5% on the top line, looking at it first from the perspective of recurring revenues perhaps versus instrument placements, I would say, if we look at it that way, we see relative consistency of the growth of our recurring revenues. We saw that move at about 7-or-so percent last year. We think something about in that range this year is in the cards. We see pill count driving some of that column usage being rather consistent around the world. We're seeing actually little pick up of demand in India as of late that's supporting that. And the service business continues to do well. So half our business growing at about 7% gets you about 3, 3.5 points of growth overall to the business. And on a base of instruments last year being down a few points, we're really just looking for the instrument volume to kind of get back to what it was in '11 to provide a few points of growth on a pretty terrible base to create 5 points of growth overall for the business. So that's one way to look at it. From a geographical perspective, I'd say, generally, we're looking for the developed economies of the world, Western Europe, U.S., Japan, to be low-single digit growers on a base that was rather anemic to be honest. And we're looking for a continuation in the developing parts of the world led by obviously places like China, India, good business in Korea, Brazil, Mexico, where we believe we'll see at least high-single digit growth out of those economies. So looking at about 1/3 of our business now being in the developing portions of the world growing in the high-single digits and 2/3 of our business on the developed world growing in the low-single digits gets you again close to that kind of 5% overall. So we're a little encouraged as we start the year looking at India out of the gate performing much better than what we saw over the last 1.5 years or so. We see consistency in China, where you always worry about the government spend there, but I would say they've been extremely consistent in applying funds to their Five Year Plan. We're about halfway through that plan as we speak. Just a couple of more years to go before we need to understand what's next in that region of the world. And I think as you look at many of these emerging markets, if you look at the installed base, it's still extremely small versus any developed nation of the world and so we think that even though we've had a number of years of very strong growth there, we still haven't begun to approach what a developed economy looks like and we think there's a lot of headroom in front of us to be able to continue to grow more quickly in those parts of the world. So that's how we come up with 5% overall.

Charles Anthony Butler - Barclays Capital, Research Division

Okay. We'll take any other questions you have at the breakout session. Thank you.

John A. Ornell

Thank you.

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