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Executives

Douglas A. Berthiaume – Chairman of the Board, President & Chief Executive Officer

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

Analysts

Tycho Peterson – JP Morgan Securities

Quintin Lai – Robert W. Baird

Isaac Ro – Leerink Swann & Company

Derik deBruin – UBS

Robert Hawkins – Stifel Nicolaus

Ross Muken – Deutsche Bank Securities, Inc.

Doug Schenkel – Cowen & Company

Marshall Urist – Morgan Stanley

Jonathan Groberg – Macquarie Capital (USA)

Waters Corporation (WAT) Q2 2009 Earnings Call July 28, 2009 8:30 AM ET

Operator

Welcome to the Waters Corporation second quarter financial results conference call. All participants will be in a listen only until the question and answer session of the conference. This conference is being recorded. If anyone has any objections, please disconnect at this time. I would like to introduce your host for today’s conference call Mr. Douglas Berthiaume, President and Chief Executive Officer of Waters Corporation.

Douglas A. Berthiaume

Welcome to the Waters Corporation second quarter financial results conference call. With me on today’s call is John Ornell, the company’s Chief Financial Officer and as is our normal practice, I will start with an overview of the quarter’s highlights, John will follow with the details on our financial results and provide you with an outlook for the full year. 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 make various forward-looking statements regarding future events or future financial performance of the company. In particular, we will provide guidance regarding possible future income statement results of the company, this time for Q3 and full year 2009. We caution you that all such statements are only predictions and actual events or results may differ materially.

For a detailed discussion of some of the risk and contingencies that could cause our actual performance to differ significantly from our present expectations see our 10K annual report for the fiscal year ended December 31, 2008 in part one under the caption business risk factors. We further caution you that the company does no obligate or commit itself by providing this guidance to update predictions. We do not plan to update predictions regarding possible future income statement results accept during our regularly scheduled earnings release conference calls and webcasts. The next earnings release call and webcast is currently planned for October, 2009.

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 measure is attached to the company’s earnings release issued this morning. In our discussion of the results of operations we may refer to pro forma results which exclude the impact of the 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

The demand patterns that we talked to you about in April largely continued in the second quarter. Overall, our business with industrial accounts, firms closely tied to the production of chemicals that are used in the manufacture of consumer goods was the weakest. Similar to the first quarter, our pharmaceutical end market showed modest decline in line with the company’s overall sales results. On the bright side, we continue to enjoy strong growth from our combined government and academic customers.

Our sales in the quarter were down 4% on a currency neutral basis and we were able to deliver 3% earnings growth due to favorable product mix, disciplined price and cost controls, favorable currency translation and leverage from our share repurchase program. To look at the top line, our recurring revenue, the combination of our service and chromatography chemicals businesses grew more modestly in the quarter while the decline in our instrument business was more moderate than in the first quarter.

The slower second quarter year-over-year growth rate for our recurring revenues primarily due to a tough comparison with the prior year’s quarter. We feel that the 2009 half year growth rate for our recurring revenue is more indicative of underlying demand and we expect mid single digit currency neutral sales growth for our chemistry and service business during the second half of the year.

Looking more closely at instrumentation, we attribute the quarter’s revenue decline to weak demand from industrial chemical accounts and from some developing countries. We believe the weakness in industrial spending is related to global recessionary pressures while declines in developing countries, most notably India and Latin America seemed due to a combination of economic factors and the residual effects of weakened local currency.

Similar to what we saw in the first quarter, demand for high end and application focused systems were stronger for more routine analysis instruments that are often purchased to replace older systems. Customer interest was strongest for research mass spectrometry and ACQUITY UPLC instruments. If you look at our end markets, overall pharmaceutical sales volume declined modestly in the quarter and was in line with the company’s overall performance while weaker industrial sales were offset by stronger government and university spending.

Sales to our top pharmaceutical customers, our 15 largest drug accounts, were up in the second quarter and showed some acceleration from the growth we witnessed in the first quarter. We were particularly encouraged by more broad adoption of ACQUITY UPLC by these firms. Geographically, our fastest growing major market was China where sales to government agencies, universities and applied markets were all strong. In India, the declines that we saw in this quarter were not as severe as in the first quarter and there are some indications that we are likely to see some continued improvements in the second half of 2009.

As I mentioned earlier and now speaking specifically for the waters division, we continued to see stronger demand for research oriented instrument systems. ACQUITY UPLC shipments grew in the quarter and were positively impacted by broader adoption of the technology by large drug companies, a trend that we believe will continue throughout the second half of this year. Sales of ACQUITY column, the family of chromatography consumables specifically designed for our ACQUITY UPLC systems suggest a continued near complete column utilization rate for the installed base of ACQUITY systems and were up double digits in the quarter.

Sales of our newly introduced Xevo mass spectrometry systems researched instruments that offer advanced performance and ease of use with space saving bench top designs were also strong in the quarter. At this year’s ASMS conference we introduced a new high end mass spectrometry platform called the SYNAPT G2. We feel that the G2 has the potential to redefine performance standards in research mass spectrometry and displays alternative high resolution geometries with its unique combination of high speed, high resolution, high mass accuracy and proprietary shape characterization capabilities. We booked several orders for new SYNAPT G2 systems in the second quarter and plan to begin shipments in the fourth quarter of 2009.

Our TA instruments division core thermal product lines were again affected by industrial chemical manufacturers continuing to rein in their spending. In addition, the division had a tough prior year comparison. We believe that we are either maintaining or gaining market share with our TA product line and are encouraged by sales growth of our life science thermal line. Despite the tough market conditions TA has successfully maintained high profitability through disciplined pricing policies and prudent expense control.

Earlier this year we announced the acquisition of Thar Instruments, the world leader in super critical fluid chromatography, a separation technology closely related to HPLC that primarily uses more environmentally friendly carbon dioxide as the [mobile] phase. I’m pleased to tell you that Thar delivered a strong second quarter sales result and that plans are proceeding to further leverage Thar technology in the second half of 2009.

Customers are increasingly interested in reducing chemical waste and running their labs in a more green manner. Thar’s SFT technology in combination with the dramatic solvent savings enabled by ACQUITY UPLC have allowed Waters to assume a leadership in cost effective and environmentally friendly laboratory technology. Companies such as Thar represent the type of firm that Waters is targeting on the M&A front in that it is close to us technologically, profitable and has top line potential to be accretive to our overall growth rate.

Before I turn you over to John for a look at our financials, I’d like to qualitatively say a few words about our outlook for the remainder of this year. I’m cautiously optimistic about the second half of this year as I feel we have likely already seen the worst effects of the weak economy on our instrumentation demand and have now experienced three sequential quarters of fairly stable pharmaceutical spending.

Jumping ahead to the fourth quarter, we will anniversary the onset of the economic troubles that have pressured our industrial segment and should begin to see benefits of stimulus related governmental spending in the US. Though consolidation in the pharmaceutical industry and uncertainties related to governmental healthcare proposals could impact future business, we’re not currently feeling that these issues are likely to pressure our second half results.

Some of the sales growth that we will see in the fourth quarter will come as a result of orders for new mass spectrometry instruments and we have already booked or anticipate booking in the third quarter. Specifically I’m referring to systems that incorporate our new SYNAPT G2 platform. Again, researchers are very excited about potential for this new technology on their scientific workflow and some are opting to wait for fourth quarter deliveries rather than to accept shipment in an earlier time of a less capable instruments from either us or our competitors. So the timing of G2 shipments will result in lower sales of high end mass spec in the third quarter, our outlook for the fourth quarter and the full second half of 2009 is now better than we could have expected prior to our ASMS launch of the SYNAPT G2.

Generally, we expect that the market conditions that we have experienced in the first half of ’09 will extend in to the third quarter. Operationally, we will continue to carefully control our spending and continue our efforts to improve efficiency. On the R&D front, our new product pipeline is very strong and we plan significant new product launches in the coming quarters.

In closing, despite current challenges, I feel we are close to seeing an improvement in our business. In the second half of this year the combination of our new mass spec platforms, continued penetration of the LC market with ACQUITY UPLC and reaching the anniversary of the beginning of last year’s economic slowdown give me confidence in a stronger finish to 2009. Longer term 2010 and beyond, we believe we are poised to deliver advanced instrument systems to our customers, return to a top line growth that’s more consistent with our history and generate superior earnings growth and cash flow for our investors.

Now, I’d like to turn it over to John.

John A. Ornell

Second quarter sales declined by 9% and non-GAAP earnings per diluted share were $0.78 this quarter compared to earnings of $0.76 last year. On a GAAP basis our earnings were $0.72 this quarter compared to $0.82 last year. Our GAAP results this quarter contained a charge for exiting rented facilities at our TA Instrument site in Delaware. A reconciliation of our GAAP to non-GAAP earnings is included in our press release issued this morning.

Reviewing our Q2 sales results, sales were down 9% this quarter with currency translation representing 5% of this decline. Looking at our sales growth geographically and before foreign exchange affects, sales continued to be soft in the US and Europe where sales declined by 6% and 4% respectively. In Japan, sales grew by 5% versus a weak base of comparison last year and sales to Asia outside of Japan grew by 1% against a strong base of comparison.

Turning to the product front, within the waters division instrument system sales declined by 8% and recurring revenues grew by 2% this quarter. Recurring revenues were somewhat softer than anticipated this quarter and through the half are on plan with 5% growth. We believe the consumables demand might be a bit more variable this year but should still be around mid single digit growth for the full year. Within our TA instruments division sales declined by 12% versus prior year.

Now, I would like to comment on our non-GAAP financial performance. Gross margin continued to be very favorable versus prior year and came in at 60.3%, up 210 basis points. This improvement was again heavily affected by continued favorable foreign exchange dynamics this quarter. Year-over-year the Yen continued to provide a positive translation benefit of our Japanese sales with no offsetting local manufacturing costs impacting our cost of sales. In the UK we have more local production and a larger service cost base than local sales providing for significant margin improvement given the relative weakness of the pound.

Additionally, we experienced favorable product mix as a higher proportion of our sales came from chemistry and service where productivity was high given the headcount and cost controls in place. SG&A expenses declined by 8% this quarter compared to prior year as a result of our actions to control expenses and currency translation effects. We continue to take a strong position on expense control and plan to continue to hold back on discretionary spending in response to the depressed economic conditions we face. R&D expenses declined by 11% this quarter as a result of currency translation effects on expenses in our UK R&D group.

We currently expect our full year operating effective tax rate to be approximately 18.5%. The slight increase in our rate from Q1 is the result of an anticipated shift in income in to higher tax rate jurisdictions. The impact of this change resulted in an operating effective rate of 19% this quarter or a $0.01 reduction in earnings for the quarter.

On the balance sheet, cash and short term investments totaled $506 million and debt totaled $631 million bringing us to a net debt position of about $125 million. On the stock buyback front, we continue to purchase our shares in the open market and during the second quarter we purchased one million shares of our common stock for $45 million. We define free cash flow as cash from operations less capital expenditures plus any non-cash tax benefit from FAS 123R accounting and excluding unusual non-recurring items.

For Q2, free cash flow was $63 million after funding $36 million of cap ex and excluding a $6 million lease termination charge relating to our new TA facility. Capital expenditures this quarter included $18 million of facility costs related to our TA instrument site. Comparably without this outlay cash flow would have been $81 million this quarter versus $89 last year. Accounts receivable day sales outstanding stood at 74 days this quarter, two days better than last quarter but up four days from Q2 last year. Inventories were about flat this quarter as we adjusted manufacturing plans to align with demand.

As we look to the second half of the year we currently expect difficult economic conditions to persist. We will continue to hold back where possible on discretionary spending but doing so could become more difficult as the year goes on so I expect a modest additional spending increase will be required later in the second half of the year. Gross margin as a percent of sales should be less favorable as the year progresses as beneficial foreign exchange dynamics diminish and as instrument shipments become a larger proportion of sales later in the year.

So, for full year 2009 we believe our recurring revenues will likely grow at a mid single digit rate for the year while instrument demand is expected to be down between mid single and high single digits for the full year. Overall, we are expecting full year sales to be down between 2% and 4% before currency effects. Foreign exchange translation will reduce 2009 sales growth by about 3% at current rates. Therefore, on a reported basis we are expecting sales to decline between 5% and 7% for the full year.

Moving down the P&L, we expect gross margins to be up from 2008 as a result of the factors I described earlier. Currency translation benefits have been discounted as I said earlier and product mix will become less favorable as instrument sales volumes increases. For the full year, we now expect to see a margin improvement of around 150 basis points. Operating expenses are expected to decline at a rate about equal to the sales and our operating tax rate is expected to be about 18.5%. Net interest expense is expected to be in the neighborhood of $11 million and our fully diluted average outstanding share count for the full year 2009 is currently estimated to be 97 million shares.

Rolling all of this together, we currently expect non-GAAP earnings per fully diluted share to be in the range of $3.28 to $3.38 per share with sales declining between 5% and 7%. For Q3 we expect our currency neutral sales to decline at a rate comparable to the first half results. Any potential sequential improvement in customer demand this quarter could easily be offset by a shift in to Q4 of orders associated with stimulus spending and Q4 shipments of our new high end mass spec system.

At current exchange rates, currency translation will reduce sales growth by about 3%. Considering these factors non-GAAP earnings per fully diluted share for the third quarter are expected to be between $0.74 and $0.79. For Q4 we expect our currency neutral sales to be about flat and currency translation to increase sales growth by 1%. Non-GAAP earnings per fully diluted share are expected to be between $1.01 and $1.06 for Q4.

Douglas A. Berthiaume

Operator I think we can open it up for Q&A now.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Tycho Peterson – JP Morgan Securities.

Tycho Peterson – JP Morgan Securities

I’m wondering if you can kind of elaborate on your pharma comments around ACQUITY. You’ve talked in the past about standardization, I’m wondering if this is a process that’s been accelerated at all with these deals closing or just if you could provide additional color around what’s going on with ACQUITY at pharma? Is this mainly in the QC labs or any additional details would be helpful.

Douglas A. Berthiaume

I think where the most positive, most encouraging is related to those broad based applications closer to QC than in the traditional ACQUITY stronghold in R&D. We saw one particular very large domestic pharmaceutical company, I think I’ve talked about it before, I mean last year we saw a European based large pharmaceutical company basically decide to go across the board to UPLC and we saw a similar dynamic domestically this time. So, even in a time of tough instrument placements we’re seeing ACQUITY continue to grow year-over-year.

That’s largely a pharma dynamic. So, I think what you’re seeing is penetration in to those more – the benefits of the UPLC on the research side have been overwhelming. The cracking more deeply in to the regular QC side where companies have got to face the issue of how many do they change out, do they change them out all at one time particularly at a time of reduced capital spending is a tougher sell, we’re seeing progress on that front.

Tycho Peterson – JP Morgan Securities

You talked in your comments as well about some of the deferred orders for the new SYNAPT system, I guess I’m just trying to get a sense as to how big the magnitude is here. Is this something that was significant in this quarter and maybe some color on what you’re expecting for the third quarter ahead of the fourth quarter launch?

Douglas A. Berthiaume

Well, we just showed it at ASMS really the beginning of June so we weren’t even able to demo it until that time. We’re now demoing it very extensively and I’d say the customer response has been as strong as any instrument we’ve introduced in the last five years. So, I would say we’re very, very enthusiastic about the customer response. We have seen a number of orders already in the second quarter, we’ve seen that accelerate in to the third quarter.

It needs to be clear that we’re not going to ship any of these in the third quarter. Our production plan doesn’t really start shipping until the fourth quarter but we’re reasonably confident we can ship a substantial number in the fourth quarter. I would say our financial forecast tries to draw a midline in that fourth quarter expectation. It’s very possible that this could be a defining factor of exceeding that number if we’re successful in getting as many manufacturers in to the marketplace as we think. That’s probably as strong as I can talk about G2.

Tycho Peterson – JP Morgan Securities

Then just one last one on capital deployment, can you talk a little bit about the outlook on M&A versus buybacks? Obviously with some of the deals we’ve started to see it looks like the valuation gaps come in a little bit so if you could just talk a little bit on priorities there that would be great.

Douglas A. Berthiaume

I think valuations certainly came down across the board last year. Valuations in the past six months have clearly come up a bit in our industry. Our idea of what suits Waters appropriately in the M&A front hasn’t changed from the low valuation to the high valuation, we still like our core capabilities, our core businesses. We’re absolutely convinced that we could do some accretive mergers that are larger than the mergers we typically do but we’re not convinced that two or three years down the road that we can grow that consolidated business at the pace we can grow our core competencies.

So, that’s the conundrum, you can deploy more capital but in the end you have to wake up in the morning and be happy with who you’re living with and we’re not convinced that the larger ones that we have kicked the tires on satisfy those objectives. So, we’ll continue to do the Thar kind of deals, the targeted smaller technology deals or some bolt ons. We’ve done some bolt ons to our testing businesses that we’re very happy with. It doesn’t deploy a huge amount of capital that way and so we’re left with buying in more of our stock in all likelihood.

John A. Ornell

For the year, if you look at the buyback program, we’re just over $100 million at the half way point. We talked about executing about $200 million for the full year so we’re pretty much on plan to meet that original expectation.

Tycho Peterson – JP Morgan Securities

John actually just one housekeeping on the tax rate, have you quantified the potential impact of the Obama proposal?

John A. Ornell

Until we get to the point where that’s somewhat clearer as it makes its way through Congress, it’s difficult to quantify that. Some very early views of that would suggest that perhaps based on some of the deductions that perhaps won’t be allowable in the US going forward that it could be a 300 to 400 basis point impact on us but it’s very early. It’s still up in the air, I don’t think we can really nail that down to a specific number at this point in time. I think I’ve heard others in our space quantify it similarly, I don’t think based on our starting point that we’re going to be impacted dramatically different from others in the space. But, I’d quantify it somewhere in that range based on what I know today.

Operator

Your next question comes from Quintin Lai – Robert W. Baird.

Quintin Lai – Robert W. Baird

With respect to kind of the industrial side could you delineate you talked about price discipline, is it that the customers that are buying are not price sensitive and is it just no projects so there is no buying and then as it comes back is it more binary or is there kind of elasticity of demand as well?

Douglas A. Berthiaume

I think there’s relatively little elasticity Quintin. In times like this, I think we’ve seen certain competitors struggle and in the end try to use price to disgorge orders. I think in many cases the desperation tactic over a long period of time and most of our instrument businesses experience has taught us that price isn’t a long term determinant of how these customers react. They are much more concerned with service, support, continuity and that price falls relatively low on their list which is not to say that in any one circumstance, particularly if it’s a university account of certain others that somebody might not squeeze an order out with a large discount.

We have a golden rule that we treat our customers with the respect that they deserve and we live to our worldwide contracts and it’s very, very rare that we wander outside those discount guidelines. So, I think our customers respect that and in the end it holds us in good stead. I don’t see us losing significant orders to price competition in this environment. I think it’s substantially a case that those customers are not releasing any capital money, or any capital money is probably a little bit strong but there are substantially diminished capital budgets.

That may improve largely because of the weak base in the fourth quarter. I don’t see that improving very much in the third quarter. I do see from the people, particularly TA and the people who are most focused on those industrial chemical accounts in the US, that it is not getting worse but it’s not very good. So, I think we’ve seen the bottom of that but I wouldn’t expect you to see any light at the end of the tunnel until possibly the fourth quarter.

Quintin Lai – Robert W. Baird

John, just to reconfirm, the pro forma EPS guidance you updated $3.28 to $3.38, that seems to be an increase from your last guidance, is that right?

John A. Ornell

Yes, the upper end of the range is higher by $0.08 and we narrowed the range as well because I think we’re feeling a little bit more confident in the second half of the year and hitting these numbers so there’s a $0.10 differential, $0.05 a quarter which is a little bit closer to where we’ve been historically in trying to call the bottom line. So, it is raised as a result of expectations really more in the fourth quarter as a result of the stimulus spend and some of the shipments of the G2 that we talked about that we’re a bit more confident about as we said today.

Douglas A. Berthiaume

And we were at the high end of our guidance in the second quarter Quintin.

John A. Ornell

That’s right.

Douglas A. Berthiaume

We think on balance there are probably more things that could go right for us in the second half than wrong.

Quintin Lai – Robert W. Baird

So the outlook plus the G2 even offsets kind of what looks like to us a little bit higher tax rate and share count then?

John A. Ornell

Yes, that’s correct.

Operator

Your next question comes from Isaac Ro – Leerink Swann & Company.

Isaac Ro – Leerink Swann & Company

First thing, on the pharma and markets I think you kind of mentioned in the beginning comments that it was down a little bit and then later you said it was sort of sequentially stable. So, I was wondering if you could give us a little more color on what you’re seeing there maybe between demand for equipment versus the utilization of the consumables. Then, given that you are taking that sort of higher guidance outlook for the rest of the year, what’s your level of confidence in the fourth quarter as a lot of these mergers close that you won’t see any disruption in that underlying business beyond the stimulus and the SNYAPT catalyst that you talked about?

John A. Ornell

I’d say on the pharma business in total while overall the pharma business was down slightly in the quarter, the trends that we saw in large pharma where we’ve said that we’ve seen some sequential stability in the results, we actually saw some growth in the first half of the year and that accelerated a little bit in the second quarter. I would say that we’ve talked about weakness in large pharma for a few years here so the effects of the economy I would say are a little bit different on this group of customers than industrial chemical and more GDP centric type businesses.

The large pharma accounts, at least for us at this time we would say feel more stable, feels like the interest in the ACQUITY, the interest in the new mass spec products will continue to allow us to see growth in that segment of our business. Outside of large pharma the other accounts are still under pressure, some of the generic accounts CROs continue to struggle for us but all in we’re looking at a low single digit decline for that group of customers with large pharma really being the best performer.

Isaac Ro – Leerink Swann & Company

Then if you could maybe walk us through as I look at sort of forward quarters on the gross margin line aside from currency, how should we think about blotchy years in ACQUITY, the progress you made in maybe growing the gross margin on maybe that product line and now that it’s at full scale here, how much head room do you think you have left considering the potential move in the Singapore manufacturing?

John A. Ornell

I’d say that if we look at the all in margins on the ACQUITY product we started off, as you know, somewhere in the 50s, we’re in the low 60s at this stage and we’re at the point now where we’re looking, as you know, moving that product to Singapore, that is in the early phases of the move. There’s nothing from a technology perspective that would prevent it from moving in the mid and high 60s across a few years as we make that transition and ramp up the production in Singapore.

So, for that product alone I would say there’s definitely some margin improvement that would could expect as these transitions occur. As we think about gross margins on a year-over-year basis as we start thinking about next year, you certainly have to take in to account the fact that we’ve had some pretty significant improvements in margins associated with currency. So, currency movements could to some extent offset whatever that pickup could be.

Isaac Ro – Leerink Swann & Company

The last one here on sort of fourth quarter assumptions, did I hear you right in assuming that you have some expectations for stimulus orders to be booked in that quarter.

John A. Ornell

Yes, they’ll be booked in that quarter but they’ll also be booked – some were booked in the second quarter, more in the third, we talked about it but yes, they’ll be booked and shipped in the fourth quarter as well. The expectation is that that stimulus spend will lob over in to next year as well. So, it’s a multi quarter impact where the beginning of it for us we believe will be in the fourth quarter.

Douglas A. Berthiaume

We’re seeing a huge amount of quote activity related to stimulus spending Isaac and we’ve also seen pretty clearly some delays in orders that probably would have come through without stimulus money but some of those academic government accounts are waiting for the stimulus money to take the place of some of their own internal monies. So, it’s hard to imagine that all of this quote activity doesn’t make its way through shipments in the latter half of this year. Frankly, we’re not counting on a huge amount of that in terms of our sales expectations, that could be another piece that if we’re conservative there that may turn out to be a little bit better than we’ve baked in.

Operator

Your next question comes from Derik deBruin – UBS.

Derik deBruin – UBS

What did Thar add to Q2 and then on a further note, what’s the latest in terms of the acetonitrile trial shortage?

Douglas A. Berthiaume

Acquisitions added in total about 2% in the quarter and about 1% for the first half results. So, Thar was successful for us, we’re looking at continuing to ramp that technology up through the second half of the year, being able to sell that under the Waters umbrella seems to be an opportunity that is at least on plan for us as we look at the second half of the year so acquisitions look like they’ll continue to be a small add or two to sales across the second half.

Derik deBruin – UBS

And do you see the acetonitrile shortage, has that shown any signs of being elevated?

Douglas A. Berthiaume

Not substantially at this point. There are some forecasts that those plants are coming back a little bit on stream but even if it does come back on stream Derik I think the attention on the acetonitrile, the risk of supply is still very high in the minds of our customers and together with this whole green initiative I think has swung our accounts to really paying attention to solvent consumption and solvent usage. So, while the absolute status of acetonitrile might get a little bit better, I think from our point of view it still works to our advantage that they’ve had to go through this.

Derik deBruin – UBS

I’m just trying to reconcile the comments here, so the organic growth is lower and the expenses are going to tweak a little bit higher in the second half so I guess is there going to be a big change in some of the below the line items to kind of get you to the higher end of the guidance range?

John A. Ornell

If you look at the second quarter, the growth without M&A is down 6% which it was in the first quarter too so I’m not sure what you’re comparing against.

Derik deBruin – UBS

I was just basically saying that if you kind of look at it for – well, I mean because you changed your fx impact from down 4% to down 3% fx impact on the top line.

John A. Ornell

That’s right, that’s in the third quarter and then by the fourth quarter fx is actually positive. The big difference in the second half really is the fact that in the fourth quarter we anniversary if you will the recession to some extent and where we grew in the base about 7% a quarter across the first three quarters and the fourth quarter we were organically flat. So, we’re expecting to be flat on that base with a percent of sales pickup from fx so fx and the anniversarying of the recession if you will, is really the delta in the second half that makes it different from the first half. We’re really not saying that the pace of the business if you will dramatically picks up in that guidance.

Operator

Your next question comes from Robert Hawkins – Stifel Nicolaus.

Robert Hawkins – Stifel Nicolaus

Can we go in to a little bit of detail about what’s behind the consumables decline and maybe what’s happening in some of your end markets it didn’t grow as fast as you guys thought?

Douglas A. Berthiaume

Sure, the consumables business was a little bit slower in the second quarter than it was in the first. First quarter we had a calendar dynamic that gave us several extra days. In the second quarter we had a relatively strong base where we had some customers placing large standing orders in last year. So, when you look at 2009 I don’t think the actual customer demand pattern was all that different between the second quarter and the first quarter but the reported results were slower sales growth. That’s why we think the second half is kind of an average of the first and the second quarter.

The real demand pattern, what we talked about pretty much in the first quarter, customers have run fewer samples, they’re looking at various ways to save expenses across the board and I don’t think that dynamic is going to change too much in the second half of the year. We’re not expecting a seat change in the way our consumables and service business operates in the second half and probably we think we have a somewhat brighter picture for next year but we’re not anticipating that in the second half.

Robert Hawkins – Stifel Nicolaus

Then you mentioned that industrial demand in TA is bottoming and you said there might be a little bit of light in the fourth quarter, does that also translate to the industrials for the Waters division? And, when you’re talking about this demand, is it kind of the usual seasonality related to people just kind of finishing out the year and spending the money that they didn’t spend already or do you think it’s kind of a real recovery demand that you’re getting a sense of?

Douglas A. Berthiaume

Speaking specifically about TA, as we monitor requests for quotations and demo activity, we saw that dynamic flatten out at the end of the first quarter and as we moved through the second quarter, we saw our internal statistics improve. Now, that didn’t manifest itself in orders and sales in the second quarter but we think that’s an early indicator that customers have hit their bottom and are looking to improve in the second half. Now, that’s off a much lower run rate so we’re not declaring victory on that but it’s better than [inaudible].

You get in to the fourth quarter and clearly you’ve got a lower base because you’ve got the dynamic of the financial crisis and the demand reductions in the fourth quarter so, you’ve clearly got a lower base to compare against. I also think it may be more important in the pharmaceuticals and the life science areas but the fourth quarter of ’08 you saw a massive reduction in confidence and people took early action to just carve back on their spending and it was as fast as I’ve ever seen in this industry.

I think it’s all together possible that you’ll see just the opposite happen at the end of this year, that people get more confident, they’re not cutting back on capital spending, they may not get as ebullient but I think it’s very possible that you’ll see some end of the year money. That’s kind of certainly what we’d hope to see, we’re not banking on that in our forecast but I think you could see that in the industrial accounts but particularly you could see it in the science area too.

Operator

Your next question comes from Ross Muken – Deutsche Bank Securities, Inc.

Ross Muken – Deutsche Bank Securities, Inc.

Could you talk a bit about some of the end of year expenses that are going to be needed as growth reaccelerates in to 2010 and sort of how you’re thinking about some of the different lines that might have changed this year whether it’s salaries or bonus or other and how we should think about modeling that as we enter 2010?

John A. Ornell

I guess I would say first off where we have held back on some of the service side of the business is probably one that is going to get some of the most attention. There’s been a headcount freeze in place across the organizations with rare exceptions of some locations outside of the US where we’ve had to keep up with increased demand, so adding some service headcount in the field in support of that business is probably one of the first areas we’ll start looking at.

There was a full pay freeze in place based on the conditions this year. We’re going to have to reassess that based on market conditions for next year. I mean, that’s certainly another area that we’ll look at. Some of the more discretionary items on travel and meetings and that type of spend. We can be a little bit more conservative depending on how the economy picks up as we move in to next year. So, I wouldn’t say at this stage that there’s going to be a huge sum of increase spend across the board that’s going to be dilutive if you will, to the earnings growth should we have a modest increase in the top line, but it’s very early on to be able to quantify that.

Some of these expenses will begin in the fourth quarter, there will probably be some amount of service heads that we’re just going to have to put in place but I think you’ll see a rather modest increase in expenses as we exit the year. It’s really more a budgetary planning cycle affect for next year that we can talk more about perhaps on the October or January call.

Ross Muken – Deutsche Bank Securities, Inc.

From a market perspective, you noted India was weak, that’s been a function of currency, that started to unwind a bit, has that shown any signs of life or is that sort of still in a difficult fx comp scenario? Then, to that effect, are you seeing any sort of change from the zero demand there or anywhere else inclusive of the US?

Douglas A. Berthiaume

Ross, the second quarter was a bit better than the first quarter. We anticipated it was going to be a relatively short term dynamic and I think that’s what we’re seeing. We anticipate that the third quarter will be better than the second quarter and the fourth quarter will be better than that. I think it will be 2010 before we see a relative return to normalcy but the encouraging thing about India as their actual shipments of generic drugs have continued to grow robustly quarter after quarter so I think there isn’t too long that they can put off the instrumentation of that kind of growth and I expect that we’ll see the second half significantly better than the first half.

Ross Muken – Deutsche Bank Securities, Inc.

Just because I’m getting a bunch of emails here even though I think I may have it John, in terms of the sort of top three things that changed on the guidance line to get to the new EPS range, I mean it seems like fx improved and you have a slightly better outlook than the back half but can you just sort of delineate the three key changes to sort of get us there again? I’m sorry, I just feel like people are a bit confused.

John A. Ornell

I meant the upper end of the range was raised by $0.08 and the improvement there is fx on the top line and currency is going to be favorable now by the time we get to the fourth quarter. That wasn’t the case before. We’ve continued to hold back on spend to a larger extent perhaps than I had originally estimated as well. The benefits on gross margin continued in the second quarter, not at the rate they were in the first but better than I had originally anticipated in to the second. So, I would say those factors coupled with the G2 release and the early excitement on what we might deliver in the fourth quarter made us feel much more confident in the numbers that we’re rolling up for the field on the possible shipments on the high end mass spec later in the year are probably the biggest factors.

Operator

Your next question comes from Doug Schenkel – Cowen & Company.

Doug Schenkel – Cowen & Company

Sorry to beat a dead horse on guidance but I just went back to look at the transcript from Q1 to make sure I wasn’t missing anything and in fact it doesn’t look like I did. On the Q1 call you guided the street to expect full year constant currency growth of down 4% to up 1%. You’ve revised that to down 4% to down 2% for the full year so again, assuming this is an apples-to-apples comparison, you maintain the low end of the range but you lowered the high end of the range. I just want to make sure that we’re not missing something here. Is there some specific end market where you are actually taken a more conservative stance?

John A. Ornell

The answer there is that the financial guidance that I provide on the earnings line is more associated with the bottom of the organic sales range and to the extent that we had gotten anywhere near zero or plus one, we would have gone well over the earnings per share guidance that was provided. I did not want to create a financial model at the bottom line that assumed we had gotten all the way to the top of the organic sales range so I typically try and construct the earnings at the bottom line somewhere near the bottom of the expectation for organic growth, that’s the difference.

At this stage, just based on where we’ve landed in the third quarter, it’s less likely that we’re going to get to that plus one so we’ve been I’d say more realistic in what the full year expectation will be on the sales range and the continued profitability of sales even when they decline in the mid single digits is encouraging enough that we’re able to still leverage positive earnings growth through the first half in the earnings guidance and for the second half in reality we’re looking at earnings per share relatively flat with prior year to get to that $3.28 to $3.38 number.

From that perspective you could say that the earnings flow through is more conservative in the second half than the first, much of it associated with a currency environment that’s getting slightly less favorable from a gross margin and the bottom line flow through perspective.

Doug Schenkel – Cowen & Company

In the past you’ve talked about a 1% fx move equating to about $0.05 at the bottom line on a full year basis, is that still a good rule of thumb?

John A. Ornell

I’d say once we get passed this year and currencies behave the way maybe they historically have that’s probably right. That wasn’t true for the first half of this year, we haven’t had the full amount of pain on the currency line because of the fact that we’ve had a positive Yen, a negative Euro and an extremely negative British Pound dynamic, all of which have leveraged to better flow through at the gross margin line. To the extent the currencies behave more normally and move in the same direction to the US dollar, the rule of thumb you described is accurate it just hasn’t been accurate this year.

Doug Schenkel – Cowen & Company

Then one last question, Doug you in your prepared remarks talked about at a high level about returning to top line growth in 2010 that resembles your historical norms. How dependent is this on a rebound in industrial and what is the risk to this target associated with big pharma consolidation?

Douglas A. Berthiaume

In terms of big pharma consolidation, if we see a major change in existing dynamics, I suppose that’s a wild card. For the already announced mergers I don’t think it means too much to our expectations. I think 2010 I’m frankly probably a little bit more confident in my heart than I am willing to put down on paper right now. We’re seeing real demand reductions in 2009 that with all of the dynamics moving for us, I think if you just go back to 2008 dynamics you’re going to see mid to high single digit growth.

We continue to see strong demand coming out of Asia and frankly I don’t see a whole lot that’s putting that at risk. I think India returns to a more normal dynamic next year which coming off this base could be a substantial piece of growth. Our Latin America business I think we’ll actually see a better return in the second half of this year but better dynamics next year. The key question marks are Western Europe and the United States which are the major pieces of our business.

Coming off this year I’m more confident that 2010 is going to be better. But, it remains to be seen. The industrial piece has been terrible for three quarters now specifically related to this industrial chemical business, specifically kind of tied to the consumer, to the auto industry or auto derived demand. You’re guess is probably as good as mine in terms of have we seen the worse of that or do we see another year of that. I frankly think it’s hard to imagine that you could see another year as bad as 2009 and I’d project that it gets better in 2010.

Operator

Your next question comes from Marshall Urist – Morgan Stanley.

Marshall Urist – Morgan Stanley

On the gross margin line, do you guys mind in the quarter just walking us through the moving pieces in terms of currency contribution year-on-year and then what sort of changed sequentially from the first quarter?

John A. Ornell

If you look at the gross margin improvement of about 210 basis points, the Yen was up on average about 7% year-over-year, that’s a couple of million of benefit, there’s not cost of sales associated with – you don’t need protection in that country so there’s about 60 bips improvement associated with that. In the UK we have about $10 million or so of cost greater than sales. The currency movement there was about 20% year-over-year within the quarter, that’s another couple of million dollars of improvement, a 120 basis points coming from currency and there was a little bit of spill over affect from capitalized variances in the first quarter so maybe about 150 basis points or two thirds or so of the improvement that we saw in gross margin was associated with these currency dynamics that I’m describing.

Beyond that the service margins continued to be much higher year-over-year as you saw in the first quarter and that along with some cost reductions in mix were another 60 or so basis points. Versus the first quarter the Yen was up closer to 10% to 12%, the Pound was off almost 30% instead of 20% so these benefits were just greater just because of currency movements within the quarter but still on a year-over-year basis very significant.

Marshall Urist – Morgan Stanley

Then you alluded to this before, so should we think about as you restaff on service, is that a second half ’09 or is that in to 2010?

John A. Ornell

It’s going to be more of a 2010 event. You’re going to continue to see – and, even that could take a while to staff that up a bit. You’re unlikely to see the service piece of this benefit decline substantially between now and the end of the year.

Operator

Your next question comes from Jonathan Groberg – Macquarie Capital (USA).

Jonathan Groberg – Macquarie Capital (USA)

I guess just looking again kind of as a lot of people saying okay let’s get past 2009 looking in to 2010 and John giving your comments around gross margin, it sounds like you’re kind of on track with the ACQUITY move to Singapore with the puts and takes, and I know it’s kind of a first blush but would be your expectations with respect to gross margins on a year-over-year basis between 2009 and 2010 just kind of given what you know?

John A. Ornell

I think currency aside I guess I would say that the product movements that you described hopefully some growth in instruments next year versus this year to help cover some of the inflation on that front would certainly allow us to provide some organic improvement in gross margins on a year-over-year basis. Though, I have to say on the fx side, just given the outstanding performance of currency and kind of that perfect storm we’ve talked about coming through the first half of the year, it’s just unlikely from my perspective that that’s going to repeat itself or be in a position where we’re going to see that it doesn’t create a difficult base of comparison that’s probably going to eat away a significant amount of that organic improvement or more than that.

I mean that has yet to be proven so I’d say for what we can manage on the gross margin side, I’m feeling very comfortable that we can deliver an improvement next year and it’s really going to come down to what the basket of currencies will do to us and that’s not something that’s easy to predict this early on.

Jonathan Groberg – Macquarie Capital (USA)

So just kind of flowing that through and your commentary on cost as you move to 2010 and assuming as Doug said that you got some of the [inaudible], I mean historically you got quite a bit of leverage on mid to mid high single digit organic growth. Is it fair to say that moving in to 2010 expect a little less kind of earnings leverage relative to your history?

John A. Ornell

I mean that’s probably fair to say. I mean, we’ve done a lot of belt tightening certainly this year and so we’ve created a difficult base of comparison from that perspective. I don’t think we can ask the business to grow without some amount of investment next year so keeping in the traditional two or three percentage point gap between the growth in sales and the growth in expenses if we’re going to be somewhat cautious on the top line as we move in to next year is going to be a bit more difficult. So, I think it’s fair to say that we’re going to start off with a cautious perspective.

We hope that we’ll still be able to continue to provide some leverage between the growth in expenses and the top line. We’ll work to do that but it might not be quite as great as it’s been historically, that’s correct.

Jonathan Groberg – Macquarie Capital (USA)

Then Doug, can you maybe just comment on a couple of end market dynamics, one you mentioned in your comments just recently that with respect to the announced mergers you don’t expect many surprises kind of moving in to next year. I’m just curious kind of what your sales people are saying with respect to those mergers and what kind of gives you that confidence and maybe what’s happening in the QAQC market there on a the pharma side. Then the second question has to do with this merger yesterday or this acquisition of Agilent and Varian and just kind of what impact, if any, you see from that and kind of pricing expectations, I guess of some of the generic and CRO customers you mentioned are under cost pressures.

Douglas A. Berthiaume

On the big pharma side, we clearly saw a little bit of a slowdown when they announced the [sharing] merger for example. But, subsequently we’ve seen very good performance out of the two parts of that equation. So, I think there’s some initial question marks but [inaudible] question marks in parts of those business get kind of grid locked. But, what’s happened is these businesses have for five, six years now been living largely hand to mouth. I think in various parts of the those businesses they’ve realized that they just can’t get more out of their equipment bases then there’s a diminishing return.

Plus, in our particular case ACQUITY continues to gain share of mind as well as share of market and I think partly what you see happening with us in those large pharma accounts is ACQUITY staying strong while other more conventional technologies suffer. So, I really don’t think if you look at that industry broadly there’s too much more that they can [crawl] out of the [inaudible]. I think sooner rather than later we’re going to see some pent up replacement demand and hopefully that pent up replacement demand moves to ACQUITY rather than the more conventional technology.

In fact, we know that’s happening in some cases, the question is does it happen more broadly. If you look at what’s happening in the analytical industry, the tool space, I think there’s clearly companies that are going to want to look to buy sales. I think you see some of that happening. I frankly don’t see how in the particular one you mentioned that the combined entity is going to be more competitive than the two entities on their own. The smaller company wasn’t a particularly competitor in the core liquid chromatography business. I think they probably do more in the GC business than the LC business, not particularly bid in the mass spectrometry world.

Obviously, they have a very strong position in MR. So I don’t see that changing a whole lot of competitive balance in the tool space. Probably they’re going to cut costs out of the combined entity and try to leverage their bottom line. But, that’s from reading the press releases so far.

Jonathan Groberg – Macquarie Capital (USA)

Do you expect on the pricing though, I know that you said – I’m just saying you have generic and CROs, some of the companies that could grow faster do kind of base their services on lower costs, what is your kind of share outlook there? What’s it been? Do you think you’ve been gaining, losing, staying equal in share?

Douglas A. Berthiaume

[Inaudible] you’re talking about Jon?

Jonathan Groberg – Macquarie Capital (USA)

Yes.

Douglas A. Berthiaume

Those accounts are interestingly some of the least price competitive accounts. They’re looking for time to market, they’re looking for standardizing on the thing that gets them in to the market place the fastest. So, if you look specifically in India there are some competitors who try to compete on price. We still have the overwhelming market share and probably the highest priced provider. I just continue to tell you that I don’t see low price competition as being a key determinate of market share in our world. It just has never been the case, on the fringe it does operate in some segments of the market but not largely in the areas that we focus on.

Operator

There are no other questions in the queue at this time.

Douglas A. Berthiaume

Thank you all for being here. We look forward to talking later on in the year. Thanks very much.

Operator

This concludes today’s conference call. Thank you for joining. All parties may disconnect at this time.

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Source: Waters Corporation Q2 2009 Earnings Call Transcript
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