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Executives

Douglas Berthiaume – Chairman, President, Chief Executive Officer

John Ornell – Chief Financial Officer

Arthur Caputo – President of Waters Division

Gene Cassis – Vice President Investor Relations

Analysts

Ross Mukin – Deutsche Bank

Quintin Lai – Robert W. Baird

Tycho Peterson – J.P. Morgan

Robert Hawkins – Stifel Nicolaus

Isaac Ro – Leerink Swann

Jennifer Lu for Marshall Urist – Morgan Stanley

Derik deBruin – UBS

Doug Schenkel – Cowan & Company

Patrick for Peter Larson – Thomas Weisel Partners

Jonathan Groberg – Macquarie Capital

Waters Corporation (WAT) Q4 2009 Earnings Call January 26, 2010 8:30 AM ET

Operator

Welcome to the Waters Corporation fourth quarter 2009 financial results conference call. (Operator Instructions) I would like to introduce your host for today’s call, Mr. Douglas Berthiaume, the Chairman, President and Chief Executive Officer of Waters Corporation.

Douglas Berthiaume

Good morning and welcome to the Waters Corporation fourth quarter and full year financial results conference call. With me on today’s call is John Ornell, Waters Chief Financial Officer, Art Caputo, President of the Waters Division and Gene Cassis, the Vice President of Investor Relations.

As is our normal practice I will start with an overview of the business highlights. John will follow with the details on our financial results and provide you with our outlook for the first quarter and the full year 2010.

Before we get going, I’d like John to cover the cautionary language.

John 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, at this time for Q1 and full year 2010. We caution you that all such statements are only predictions and that actual events or results may differ materially.

For a detailed discussion of some of the risks and contingencies that could cause our actual performance to differ significantly from our present expectations, see our 10-K annual report for the fiscal year ended December 31, 2008 part one under the caption Business Risk Factors.

We further caution you that the company does not obligate or commit itself by providing this guidance to update predictions. We do not plan to update prediction regarding possible future income statement results except during our regularly scheduled quarterly earnings release conference calls and webcasts. The next earnings release call and webcast is currently planned for April 2010.

During this call we will be referring to certain non-GAAP financial measures. A reconciliation of the non-GAAP financial to the most directly comparable GAAP measure is attached to the company’s earnings release issued this morning.

In our discussions of the results of operations we may refer to pro forma results which exclude the impact of items such as those outlined in our schedule entitled Reconciliation of Net Income per Diluted Share included in this morning’s press release.

Douglas Berthiaume

Thank you John. Well, for Waters 2009 I think as you all realize was a very challenging year. The year of course started with a high degree of uncertainty in the midst of a global financial crisis, severe recessionary conditions. It was around the mid point of 2009 the uncertainties for our markets began to abate a little bit and a more stable but significantly weaker demand pattern emerged.

During the second half of the year demand appeared to remain fairly stable with some indications that certain segments of our end markets were potentially seeing a modest level of recovery. These second half dynamics continued through the fourth quarter and we find ourselves entering 2010 somewhat optimistic that our end markets will improve, but continuing to feel that the recovery may be slow.

Fortunately we were able to see storm clouds building in late 2008 and we adequately anticipated end market weakness as we designed our 2009 business plans.

Early in 2009 steps were taken to tightly control spending while continuing to support critical growth programs including new product introductions. Now, with the year behind us we can appreciate the results of our business strategy as we were able to grow our earnings, generate strong free cash flow and introduce exciting new products in this most difficult demand environment.

If you look at the fourth quarter, our sales and earnings came in roughly as we had expected with currency neutral revenues just under flat and our earnings per share up 5%. Geographically, our revenues were largely in line with our expectations.

Moving down the P&L our profitability remains strong due to favorable currency translation, disciplined pricing and continued tight expense control.

On the product side, we began shipping Synapse G2 mass spectrometry system in the fourth quarter. As you will recall, this new technology system was showcased at the ASMS conference earlier in 2009 and was quickly well received by the scientific community as offering novel capabilities for a wide array of applications.

In fact, the order ramp for Synapse 2 during the second half of 2009 was stronger than for any previously introduced high end mass spec instrument from Waters, even without significant governmental stimulus orders in the U.S., a topic I’ll come back to a little later.

On the chromatography side, Acuity UPLC continued to displace HPLC system sales and now represents our most popular chromatography platform. In our view, recent competitive introductions in the UPLC product space corroborate the technology and will help accelerate the conversion of the overall LC market to proven sub two micron particle chromatography as pioneered by Waters.

Looking at customer segments in the fourth quarter, we saw a continuation of the trends from earlier in the year. The weakest segment was the chemical industry, a business that’s about 15% of our overall sales. The declines that we saw in this segment were less severe as we anniversaried the onset of the weakness that began in the fourth quarter of 2008.

Our TA instruments division has a large exposure to this industrial segment as many of their customers are involved with production of materials that find their way into automobiles and other consumer goods.

Within our TA division we saw a more moderate decline in the sales for the quarter and order flow dynamics suggest that the demand was strengthening in the quarter. These data suggest that we likely saw the low point of demand from industrial chemical customers in mid 2009 and that a modest recovery has started to materialize during the past few months.

Demand from our pharmaceutical customers modestly improved in the fourth quarter. Factors contributing to increased demand include a rebound in sales in India and small improvements in demand from CRO and generic firms.

Sales to our larger pharmaceutical accounts declined modestly in the quarter. Acuity and IN mass spectrometry continue to account for the growth in pharmaceutical demand but we have yet to see the onset of a return to historical rates of instrument replacement.

Waters sales growth in applied markets including food and environmental testing were affected by the significant business we transacted late in 2008 associated with Melamine testing primarily in Asia and Asian countries. Factoring out the effects of these sales, the applied markets represent a growing business for Waters.

Our sales to government and university labs were flat with last year. However, this result does not fully reflect the demand we saw in the quarter as we built an order backlog for multiple synapses two systems.

Interestingly, our orders and sales in the quarter did not include meaningful activity from U.S. governmental stimulus money. From our perspective, the funding of these programs has been delayed and will likely influence our business by mid 2010.

We remain optimistic that the strength of our research product offering such as our Synapse G2 and Divo Platforms will afford us a fair share of stimulus related spending.

I’d now like to focus on new product initiatives that will impact our business in 2010 and beyond. Earlier this year I discussed with you our new mass spectrometers including the Divo Series of bench top instruments and our exciting Synapse Q2 HDMS and MS systems.

Through 2009 orders and sales for these systems have ramped very nicely and we have entered 2010 with considerable business momentum. Installations of Q2 systems in the fourth quarter proceeded smoothly and we look forward to presentations at this year’s AMSM conference in Utah that will highlight the performance and advantages of G2 technology for a wide range of applications.

2010 and should be an exciting year for Waters and mass spectrometry. As some industry participants work their way through new management structures, and sort out new strategies, we plan to execute our established product and market plans. Our focus will be on continuous innovation and in 2010 we plan to introduce new mass spectrometry systems that will push the performance envelope while broadening the attractiveness of MS technology to a wider base of customers.

On the chromatography front, I’ve spoken to you about the dramatic impact of Acuity UPLC on numerous occasions and earlier this morning, I mentioned that UPLC now accounts for most of our chromatography shipments.

Since introduction in 2004, Acuity has allowed hundreds of organization around the globe to realize improved data quality, increased sample throughput and reduced costs per analysis. With all the proven benefits of Acuity UPLC, many have been quick to embrace UPLC technology.

However, many more have been attracted by the promise of UPLC but remain reluctant to change largely because of their comfort level with existing HPLC systems and techniques. In our industry there is no substitute for working with thousands of UPLC customers to gain insights for product improvements and the ideas for next generation systems and it’s in that light that I want to tell you about our new Acuity UPLC H Class system that we’ve just introduced this week.

Working closely with our customers, we saw the need to provide a bridge to UPLC performance that builds upon the wide spread knowledge and comfort laboratories have with HPLC operation. We feel that Acuity UPLC H Class is this bridge and it has been designed to fulfill the needs of mainstream customers, especially those working in method development and routine analysis laboratories.

It does this by combining UPLC performance with the operational familiarity of traditional HPLC, a combination of high performance and simplicity that we believe will facilitate adoption by a broader range of industries, applications and operators, all of whom will realize the scientific and work flow benefits of UPLC.

I encourage you to visit our website for a detailed description of our new Acuity UPLC H Class as well descriptions of our complete family of application Acuity Systems.

Before turning you over to John for a more detailed review of our financials, I want to share some thoughts about 2010 and reiterate some of our key business strategies.

Looking at the competitive landscape of the strength of our product portfolio in 2010, I believe that we’ve never been in a stronger product position. Our strategy of focusing on our technological strengths and staying close to our customer base has allowed us to protect and growth our market share and deliver superior financial results even in these difficult economic times.

2009 was one of those difficult times and yet we were able to grow our earnings per share and introduce exciting new products. I believe that 2010 will be a better year for Waters than 2009. Most signs suggest that the worst of the recession, in our markets at least, is behind us and that demand for our products should increase.

However, we feel that there is ample reason to manage our business cautiously as we are not expecting a dramatic change in economic conditions and do expect that there may be some lumpiness to the recovery.

Accordingly, we will continue to manage our expenses closely while we follow a proven plan for the deployment of capital.

In 2010 we will continue on the path of globalizing our manufacturing operations that further balances our production capacity with global demand patterns for our products. This strategy provides us with high quality, cost effective manufacturing in tax favored jurisdictions.

Lastly, we anticipate continuing to look for acquisition opportunities that are consistent with our history on this front; smaller technologically focused targets with growth and profitability profiles that are in line with our current business.

We expect that 2010 will be another year of free cash flow, providing us the resources to continue our multi year share repurchase program.

With that, I’d like to turn it over to John for a closer look at our financials.

John Ornell

Thank you Doug. Good morning. Fourth quarter sales increased by 3% and non-GAAP earnings per diluted share were $1.12 this quarter compared to earnings of $1.07 last year. On a GAAP basis, our earnings were $1.08 this quarter compared to $1.01 last year. A reconciliation of our GAAP to non-GAAP earnings is included in our press release issued this morning.

Looking at our Q4 sales results, sales were up 3% this quarter with currency translation providing four points of growth. Without the benefit of currency translation, sales were down 1% versus prior year. Acquired businesses added about two points of growth this quarter.

Looking at our sales growth geographically and before foreign exchange effects, sales in the U.S. and Japan were up 1% and 7% respectively. In Europe sales declined by 5% and in Asia, sales were down 3% against a strong base of comparison which included shipments related to Melamine testing requirements in 2008.

Turning to the product front within the Waters Division, instrument system sales were flat and recurring revenues due to fewer selling days this quarter declined by 1%. Within our TA Instruments Division, sales declined by 7% versus prior year.

Now I would like to comment on our non-GAAP financial performance. Gross margin came in at 60.3% this quarter which is up 140 basis points from Q4 last year. Gross margins benefited from favorable product mix, product cost reductions and foreign currency translation.

SG&A expenses increased 6% this quarter compared to prior year and R&D expenses increased by 1%.

Our full year operating effective tax rate came in at 18.4%, down modestly from Q3 as a result of a shift of income into lower tax rate jurisdictions. As a result, Q4’s pre tax income was effective at 17.1%.

On the balance sheet, cash and short term investments totaled $630 million and debt totaled $632 million bringing us to a net debt position of $2 million.

On the stock buy back front, we continue to purchase our shares in the open market and during the fourth quarter we purchased 907,000 shares of our common stock for $54 million. For the full year, we purchased 4.5 million shares of common stock for $210 million.

We define free cash flow as cash from operations less capital expenditures plus any non cash tax benefit from FAS123 accounting and excluding unusual non recurring items.

Q4 free cash flow was $112 million after funding $13 million of CapEx adding back $5 million of FAS123R benefits. For the full year, free cash flow was $341 million after funding $94 million of CapEx and adding back $5 million of FAS123R benefits and excluding $12 million of payments associated with a litigation provision and lease settlement.

Accounts receivable days sales outstanding stood at 67 days this quarter, up three days from Q4 last year and inventories were up about $5 million from year end last year, largely due to currency translation.

Looking at 2010, we currently expect economic conditions to marginally improve as we move through the year. Geographically we expect that Asia will continue to see overall favorable business conditions and provide solid growth in 2010. In the U.S., Europe and Japan we expect to see gradual improvements across the area as these geographies begin to lift out of recession and grow modestly in 2010.

Product wise we feel we have a strong line up across our technology platforms and are well positioned in our end markets as we begin the year. From a customer segment perspective, we expect 2010 to see sluggish performance from our industrial base customers, mid single digit growth from our broadly defined pharmaceutical customers and near double digit growth from our government and academic customers heavily affected by stimulus spending.

Overall this should provide for mid single digit growth before currency effects. Currency at today’s levels should add about a point to sales growth in 2010. Currency comparisons to sales growth for the quarter we base the comparison will start off more favorable early in the year and become more difficult as the year progresses.

Now I would like to comment on our expectations for non-GAAP financial performance in 2010. Gross margins were heavily affected by foreign currency translation in 2009 which will provide a difficult base of comparison this year. We currently expect margins to start off the year at around 59% and end the year over 60%. These more difficult currency comparisons will provide slower than average EPS growth in the first half of the year.

On the expense front, our efforts to control costs during 2009 again creates a difficult comparison and while we will continue to be cautious on spending, we currently expect that SG&A and R&D will grow at about the same rate as sales as we make modest investments to support growth in our businesses, specifically in our Asian geographies.

On the tax front, during 2010 we anticipate upward pressure on the tax rate from continued success of our high end mass spec products manufactured in the U.K. and downward pressure from the transfer of additional production to Singapore.

At this time, these effects look to principally offset each other and we expect our non-GAAP effective tax rate to remain at around 18.5%.

A continuation of our buy back efforts should provide for a full year of fully diluted share count of around 93.5 million shares. Interest costs are expected to rise somewhat this year and we expect to have about $12 million of net interest expense in 2010.

Non-GAAP EPS for the full year 2010 are currently expected to be between $3.70 and $3.85 per fully diluted share.

Free cash flow is expected to remain strong and should approach $400 million in 2010.

For Q1, we expect mid single digit sales growth for currency translation effects and currency translation at today’s levels would add about three points of growth. Gross margin as a percentage of sales will have the most difficult comparison in Q1 and is expected to be around 59% this quarter. Expenses are expected to grow a bit less than sales for the quarter.

Non-GAAP earnings per fully diluted share are expected to be in the range of $0.75 to $0.79 per fully diluted share.

Douglas Berthiaume

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ross Mukin – Deutsche Bank.

Ross Mukin – Deutsche Bank

I just want to get a quick financial question out of the way. John, what was the day’s impact in the quarter particularly on the consumables business and how many days did you lose year on year?

John Ornell

There was a few days difference. As you might recall at the start of the year we had an extra three days in the first quarter and that principally turned around in the fourth. It’s probably three or four points of consumable service, mostly consumable growth that was impacted, one to two points of growth overall down in the fourth quarter which we picked up in the first.

Ross Mukin – Deutsche Bank

From a more macro perspective, you talked about the idea that you’re not looking for a substantial recovery from any of the industrial players or any sort of meaningful kick in particularly on the chemical side. We’ve seen chemical company results improve fairly significantly. Today we had one of the big players putting up some pretty decent results. In terms of the conversations you’re having with these organizations broadly whether it’s within TA or within the Waters business, is there any sign of hope there or is there just a belief that they’ve built out so much capacity the last few years there’s not really a need for instrumentation?

Douglas Berthiaume

First of all I think you’re right. As we’ve said, I think we saw the lowest point in these industrial companies in the mid point of the year and it’s been marginally better since then. We also have the fact that the first half of last year was so weak that we think the first half of the coming year is going to better simply because of that base dynamic.

I also read the DuPont news morning. They seem to have clearly turned the corner there. That’s a good sign.

TA also saw some underlying improvement in terms of the attitudes of their major customers, their quote rates and in fact, their business rates, so that is a pretty good barometer of the industrial marketplace and they’re feeling cautiously optimistic that that’s continuing as we move into the new year.

So I think there are some good signs. We also see counter signs that they’re very tight with their capital spending. I still think we’re going to see a lot of these big companies in both industrial arena and pharmaceutical arena be slow to open the purse strings in the new year and they’re probably going to wait as it’s become somewhat traditional a little on in the year before they see any major capital releases.

Ross Mukin – Deutsche Bank

As you look back historically, what’s been the sign to say that okay, it’s safe to get back in the water in terms of some of those industrial players from a CapEx perspective and was it two consecutive quarters of GDP growth? Is it six months post the original inflection point in GDP? How should we think about what we need to see from an economic data point perspective and from a top in perspective from some of those players when they actually start to spend?

Douglas Berthiaume

I’d say its six months data on GDP growth. The auto industry is such a big player in the basic chemical production in a lot of these companies and what’s going on in auto clearly went so low and now is coming back. But what the total dynamic is with these large chemical producers is hard to call and overlay into a normal recession.

So I think the worst of that is clearly behind us but whether the six months rule will hold or it could be a little faster, it could be a little slower.

Operator

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

Quintin Lai – Robert W. Baird

With respect to the H class, could you talk a little bit about the timing of the release now instead of waiting and your expectations in 2010? How much expectations of adoption have you built in and how much of the cost going out and promoting this have you also baked into your SG&A?

Douglas Berthiaume

We’ve baked in all of the cost of promotion and the cost of training. Some of that actually happened in the fourth quarter as you would expect because in order to introduce it now, we had to have fulfillment literature and training etc. all in place to be able to launch this.

You can clearly hear our excitement over this new system and we do think it is a very important, exciting launch. On the other hand, I also have to tell you, we’re being fairly cautious in terms of the net overall impact on our business.

So there’s clearly a little bit of a dichotomy there because we have to look at cannibalization. We have to look at the speed of the uptick and so I suppose it’s fair to say we talk a little bit out of both sides of our mouth here. But trust me that we really think this is an important introduction and an important system for us.

Typically, the way companies and Waters business mode in some years past is that you’re really struggling to get a new product to pick on and a typical launch pattern is, you’ve got the product, you’re confident about being able to ship it sometime at the end of the first quarter, you launch it, but you’re still struggling to build inventory and to get the product out there, so you don’t have a very strange order pattern that you can’t fulfill at the end of a quarter.

But that’s always a struggle and trust me, over 30 years in this industry, we’ve talked about it enough and talked to competitors enough to say that’s a pretty typical pattern.

What we do with the H Class is the total fulfillment is done. The training is done. Inventories are now ready to ship and we’ve actually begun to take real orders for the H Class. This is very unusual for a launch of this magnitude so that’s why we launched it when we did.

It was ready. We’re ready to ship it by the end of the first quarter. We’re not going to be in a position to have a large build backlog. Art’s chastising me in the background here when I said by the end of the quarter. Orders taken now will ship in 30 days. That’s our quote pattern.

So we’re very comfortable with it. This launch pattern has been as smooth and as on time as I’ve ever seen in my history here. So we have high expectations. You don’t necessarily see that because of this whole level of confusion in the economic pattern and some of our customers, so if we’re right, I think long term this is going to stimulate our growth rate.

Operator

Your next question comes from Tycho Peterson – J.P. Morgan.

Tycho Peterson – J.P. Morgan

A question about pharma; in your comments you talked about mid single digit growth from pharma for this year and in this quarter it looks like large pharma was down a little bit more modestly, so can you talk as to how you’re thinking about pharma and what’s behind that mid single digit growth expectation for this year?

Douglas Berthiaume

We’re expecting it will improve over the fourth quarter. We clearly saw some weakness in the large pharma’s going through mergers. That was probably a little bit more pain than we had originally expected and so we’re anticipating that will improve a little bit in 2010. Early indications are that that will be the case, but it’s still a forecast at this point.

Was there a second part to your question?

Tycho Peterson – J.P. Morgan

Can you talk a little bit about consumable growth for 2010 and how you’re thinking about that both with Acuity and if you could comment on what consumable pull through will be like on the new UPLC system.

Douglas Berthiaume

I’m sorry, could you repeat that?

Tycho Peterson – J.P. Morgan

You’re outlook for consumable growth for 2010 and any color you can add on consumable pull through on the new UPLC system.

Douglas Berthiaume

The consumables outlook is mid single digit growth. It should be a more, we shouldn’t have the calendar irregularities in 2010 that we had, although we still have the fact that we had the first quarter of last year with the outsize number of selling days, but the calendar itself in 2010 is pretty consistent.

So right now we’ve got a very strong launch pattern in new chemistries, particularly in the new Acuity product line that we’re very enthusiastic about and we think that should deliver that mid single digit growth rate.

In terms of the new system, the great advantage of the H Class is that it allows customers to adopt UPLC at their own pace and allows them to run the traditional system, methods the way they wanted to at the same time being able to lead them on to the greener pastures of UPLC capabilities.

To the extent that they adopt UPLC, we’re highly confident that they will be buying our UPLC chemistries. To the extent that they run HPLC methods, on of the advantages of this is that they can run their existing chemistries. So if they’re on Waters chemistries, they’re likely to continue to run that.

Probably in the early phase of this, it probably doesn’t dramatically change market share dynamics in the consumables business. In the later stages as we think this movement to UPLC it should improve the growth rate even further in UPLC chemistries.

Tycho Peterson – J.P. Morgan

Going back to the original question on pharma spending, is more the growth you’re going to see in pharma from standardization with Acuity across QAQC and application areas?

Douglas Berthiaume

Don’t forget that pharma spend, when we talk about pharma, we’re talking about the all in pharmaceutical industry including India, including generics, including CFRO’s. We saw an improvement in the India generic marketplace in the fourth quarter. We’re pretty confident about seeing a consistent sustainable return to the strong business in India as we go forward.

We’re also seeing generally a stronger condition in generics and in the CRO marketplace. So those are probably more significant to us in terms of maintaining growth in pharma than the large pharma dynamic.

Don’t forget that for years now we’ve been seeing reduced business in the large pharmaceutical that kind of moved into the generic and the specialty pharmaceutical segment of the market.

Tycho Peterson – J.P. Morgan

On your spending guidance, SG&A and R&D growing at kind of the same rate as sales; can you talk about your ability to adjust that as needed throughout the course of the year. Do you feel like that’s kind of an active approach that you’ll be taking, or how do we think about that?

Douglas Berthiaume

I think we’ll have to continually monitor it. We act like a lot of companies. Out of the chute, we’re reluctant to commit to too much head count addition until we see how 2010, is it really going to shape up the way our plans have it. So I think we’ve got some flexibility early on.

I think one of the hurdles we face as a lot of companies do I think is that we reacted so quickly and took significant steps to sustain our profitability in 2009 that it was unlikely that you continue all of those steps as you move forward into 2010.

The dynamic of that is, you have to make up some ground in terms of salaries, merit increases, commissions, that you took out in 2009. So structurally you’ve got more of a hurdle as you go into the new year than you did last year. We think we’ve accommodated that. We think we can manage our way through it, but it does make it structurally more difficult than we saw early on last year.

Tycho Peterson – J.P. Morgan

On the Synapse backlog, can you comment on how that impacted margins if at all?

John Ornell

We talked about the synapse in the fourth quarter being somewhere between $10 million and $15 million of shipments. It was in fact in that range. In spite of that we did fill backlog within the quarter for that particular product and it was a little bit accretive to margins but not that meaningful.

Operator

Your next question comes from Robert Hawkins – Stifel Nicolaus.

Robert Hawkins – Stifel Nicolaus

On the new Acuity H Class, this is really a modification of an existing platform. Is that being built in the U.S. or is that something you can now with this type of launch fast track that to Singapore?

John Ornell

Are you asking about where it’s manufactured?

Robert Hawkins – Stifel Nicolaus

Yes, it’s modifications. I understand it’s a modification of the existing Acuity platform, I guess kind of streamlined and before you’ve had the best practice of engineering, building here, refining the product and then moving it abroad. But this type of modification for some of these more mainstream customers, does it give you the ability to start to process over in Singapore where it’s a little bit more cost effective.

Douglas Berthiaume

Actually the H Class with our experience now in moving product, new designs, the exciting thing about the H Class and what enables us to position it in the marketplace at its value point is that it will very quickly for all intents and purposes, it will be manufactured in Singapore out of the chute.

So that was exactly our strategy and that experience that we’ve had with Acuity alliances and the historical ramp ups that enabled us to do that.

Robert Hawkins – Stifel Nicolaus

Can you remind us what type of product line, what products are being made over in Singapore and how that’s benefiting gross margin? Is that something you can disclose?

Douglas Berthiaume

I’d tell you that principally all of our HPLC products are manufactured over in Singapore. A lot of the detectors even for the Acuity product line are manufactured over in Singapore, so it’s better than half of our production there and the movement of this new technology will certainly tilt the scale significantly towards the majority of the LC production being done in Singapore.

Robert Hawkins – Stifel Nicolaus

You also mentioned further globalization. Do you think that will be Greenfield production facilities or do you think this is going to be through acquiring adjacent platforms?

Douglas Berthiaume

The globalization we talked about in terms of manufacturing, we have no plans to open up new manufacturing sites. Our expansion will be within the existing platforms that we have principally in Singapore and Ireland. As you know, our R&D in the initial runs get done in either Milford or Manchester or Delaware, and then typically get pushed out into Ireland or Singapore.

Operator

Your next question comes from Isaac Ro – Leerink Swann.

Isaac Ro – Leerink Swann

I was wondering if you could comment on the [Triasiac] and where we stand on that platform.

Arthur Caputo

We introduced the product not last’s ASMS be the ASMS before hand. To be honest we did in fact run into some technical difficulties with the chemistry platform. Progress has actually been quite excellent in the last quarter and we fully anticipate to begin delivering product and actually exceeding the claims on the product by ASMS this year.

Isaac Ro – Leerink Swann

In terms of the H Class, in terms of how it manufactures into the pricing environment for the existing QE and broader HPLC market, how should we think where it’s positioned versus those pre existing products?

Douglas Berthiaume

The H Class, if you think about three ranges of product, you have an HPLC at one end of the price spectrum. You have the current Acuity that we’ve had in the marketplace at the other. Think of this as being between 25% and a third higher than an HPLC in terms of its relative price position in the marketplace.

Isaac Ro – Leerink Swann

Sort of a big picture question, I think there was an initial body language out of Washington this morning around State of the Union and how we might see a freeze in discretionary spending items going forward. Clearly the stimulus benefit right now helps but maybe looking past that, do you have opinions on what the government funding outlook might look like in that kind of environment and specifically what you think your contacts hope that it might continue to power upwards even in a flat budget environment?

Douglas Berthiaume

Typically the growth in the NIH budget or flatness in the NIH budget is very hard to see the impact on our underlying business. It obviously exists. It gets dispersed in terms of NIH grants so in the long run it’s always better for us to have the NIH budgets going up. But the kind of environment that’s described, of course we both know that it’s easy to proclaim a price or a budget freeze. Whether it actually happens or not remains to be seen.

But assuming that it does, I think it won’t be very noticeable in our operations, certainly not in the first half or the first three quarters of this year. But it’s rank speculation to think what they actually will do to this budget and when it will occur.

Operator

Your next question comes from Jennifer Lu for Marshall Urist – Morgan Stanley.

Jennifer Lu for Marshall Urist – Morgan Stanley

My question is on gross margin. I was hoping you could just walk us through the drivers of your gross margin guidance and what takes it progressively higher through the year?

John Ornell

If you look at 2010 versus ’09, it’s down modestly overall for the full year principally associated with a less favorable foreign currency environment. The 59% starting point in the first quarter is a portion of the starting point is the fact that we have much lower volumes going through the first quarter than the fourth so you traditionally see this business start off with a somewhat lower gross margin and with a much higher gross margin in the fourth quarter.

So the significant delta year over year is all currency and as we ramp the products that we’ve talked about introducing first here, but ultimately in Singapore, we’ll get more of a gross margin pick up as the year goes on and then in the fourth quarter with the volume lift that we expect to get with the budget flushes that exist at the end of the year pushes the margins well over 60%.

So the absolute difference year over year is the foreign currency dynamic and then it’s mostly a volume and a new product cost reduction type play as we make our way across the quarters.

Douglas Berthiaume

Just remember as John talked about the foreign currency dynamic, the principal reason for the foreign currency effect was the very weak British Pound in the first part of last year and since we do a significant amount of manufacturing in Pounds that lowered the cost of our U.K. manufacturing and improved margins.

The British Pound has strengthened since that point although it does bounce around a little bit. Where it is right now in terms of Pound costs higher than it was in the first quarter of last year so that’s why this foreign exchange affect early impact.

John Ornell

Overall, we’re actually pretty pleased about how we manufacture in local currencies as well as make sales in local currencies. It kind of balances our overall foreign currency exposures, but in that one margin line issue, it does swing from year to year.

Jennifer Lu for Marshall Urist – Morgan Stanley

I was wondering about service margins relative to last year. To what extent is this discretionary spend in terms of building out your infrastructure there?

Douglas Berthiaume

There’s no doubt we’ll be adding at some level service head counts as service grows in 2010. Some of those heads are going to be internationally based, not quite as expensive perhaps as here in the U.S., so there will probably be a slight decline in those service margins, but you’re not going to see a precipitous drop as we make marginal investments there.

Operator

Your next question comes from Derik deBruin – UBS.

Derik deBruin – UBS

I want to talk a little bit about column utilization and basically you said UPLC instruments have basically outpaced placement of HPLC’s. What is going on in the consumable dynamics? I guess I’m just trying to figure out just in the fact that you have longer pull through on both platforms right now and particularly how do you look at the dynamic given that the column of longer life in the HPLC, I’m just trying to figure out what the, and how the H Class figures into this whole method of looking at your consumable stream.

Douglas Berthiaume

Let me give it from 30,000 feet and John can jump in at any altitude that he wants. Don’t forget, consumables is a complex picture for us which is sample prep devices, traditional HLPC columns as well as Acuity.

Unequivocally Acuity columns continue to grow at a very strong pace so our model here that we have more of a razor and blade model with UPLC is clearly playing out. What we’re seeing in terms of our overall consumables business in 2009 is much more related to fewer samples being run in the traditional marketplace, inventories coming down in the sample prep world particularly in places like India where they dramatically reduced inventories.

We’re beginning to see some sign that’s turning around but I think 2009 was a pretty aggressive inventory management cycle. So I think Acuity consumables are playing out largely the way we modeled it and very positively but it still represents a smaller piece of our overall consumables market that our more traditional products and our sample prep products.

Derik deBruin – UBS

Along those lines, I know some of your competitors have introduced UPLC columns. I guess what that is but I would assume because you had the first Acuity columns out, do you still command the lion’s share of your consumables stream platform. What feedback have you heard from other people offering other UPLC columns? Do they perform as well on your instrument and what would make somebody choose a non Waters Acuity column?

Arthur Caputo

If you think about the introduction of lathes system, we had a couple of challenges. We’re taking HPLC which ran at 3,000 PSI up to as high as 15,000 PSI and we’re taking the columns particle size down from three microns, five microns down to sub two. So the big question in the world is how can you maintain the robustness of the system.

So when we designed both the Acuity instrumentation and the column, they were designed hand in hand. The instrumentation contains capabilities that actually monitor the column and it’s what has given the Acuity columns the reputation of being equal but in even more cases, more robust than the traditional UPLC column.

The column itself has electronic devices that actually connect to the Acuity system. It tells you what’s going on in the system. It tells you what’s going on at the separation. So think of this as a fully integrated system.

The traditional HPLC column was a free standing device. It got connected. There was no real system based interfacing between the column and the system. The customers immediately realized this and the psychology in the marketplace right now is that there is no viable chemistry alternative at this time that gives you this whole system’s approach.

And even those companies that are coming in trying to sell instrumentation, for all intents and purposes the viable approach of trying to attach an Acuity column to their system, but they lack all the documentation, the information, the element that has made this combination so powerful in the marketplace.

So for the moment we’re finding very high compliance. Column utilization for Acuity run greater than 90%. The traditional HPLC for almost everybody in the marketplace, 10% to 20% of your columns are used on your system because of the long term availability of all sorts of different columns.

We’ve really changed the game in this marketplace and at least for the moment, it looks like its going to get stronger before it gets weaker.

Derik deBruin – UBS

The mid single digit growth in the consumables and some low single digit growth instrumentation is probably a good way to look at the full year?

John Ornell

Instruments I think will probably be close to mid single digit growth too. Certainly with the new high end mass spec, we’re pretty excited about growth opportunities for the overall mass spec business and I think this new launch that we’ve got here too, should be able to push LC close to mid single digit growth as well.

Operator

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

Doug Schenkel – Cowan & Company

In the context of 2010 sales growth guidance, how much do you expect new instruments including G2 and the H Class to contribute? Is that going to get you a point or two or is that too high or too low?

John Ornell

I think if you look at our first mass spec I would say that the mass spec market should continue to turn around and perform better. I would think that the high end G2 is likely to move our mass spec growth a few points perhaps overall as it continues to hopefully grow near double digit as we make our way across the quarters. Certainly the early indications based on order backlog and customer interest would suggest that’s true.

On the LC side I would say that Acuity even in a poor year, 2009, grew nicely and I think this transition product that we now have that really begins to help people transition from HPLC to UPLC should expand the base against which we can grow our LC products. It’s hard to say what cannibalization will be of perhaps some of the HPLC products, but I think net net , looking at the new product driving at least some single digit growth for HPLC, for LC in total makes sense.

Douglas Berthiaume

I think it’s a lot complicated by market dynamics but if you think one to two points for the H Class and one to two points for the G2, that wouldn’t be far off of what our thinking is.

Doug Schenkel – Cowan & Company

In terms of G2 backlog, can you talk a little bit about how that differs across end markets and geography?

Douglas Berthiaume

In our major geographies, the orders were pretty balanced in terms of our overall geographies and we try to be very fair in terms of what we were shipping across those geographies. Of course you can imagine our field was screaming wanting all of it for their territories but we basically parceled it out pretty ratably across the geographies.

Doug Schenkel – Cowan & Company

Some of your peers have asserted that the visibility on the big pharma end market would improve as the mergers start to close. Is that your view and has that started to happen yet?

Douglas Berthiaume

Visibility is such a nebulous term. We certainly saw less business from those birched entities in the fourth quarter. We had planned on some of that. It was a little big lighter than we had expected.

We don’t expect it to be quite that bad going forward, but I wouldn’t say that the visibility of their budgets and their spending pattern is significantly better than traditionally at this point of the year.

Doug Schenkel – Cowan & Company

I guess the hope would be as it typically does that it would get better over the next quarter or so?

Douglas Berthiaume

Yes. I think traditionally what we’re seeing not only from merger companies is that they’re very slow to release their capital and yet their scientists are all just screaming for increased capabilities. So you’re trying to sort through the noise to get at the signal and sometimes one takes control and other times, the other.

I do think there’s pent up replacement demand in a lot of these companies. We fully expect that over time we’ll see business reflect that pent up replacement demand but we didn’t see it in the fourth quarter.

Doug Schenkel – Cowan & Company

On the industrial end market, if I remember correctly in Q4 of last year the industrial weakness was actually more pronounced within the Waters division, not the TA division. I just wanted to see how that affected year over year comparability in the fourth quarter of this year and moving forward. Is it Q1 where essentially the comps get pretty favorable from the industrial end market within both divisions?

John Ornell

Yes, you’re right. We saw a little bit more of a lag with TA interestingly on that front and Q1 does become the easiest compare of the year for 2010 and as Doug said earlier, just given some of the early indications from this group of customers, we’re expecting that we’ll probably begin to see some positive momentum from that group in the first quarter as we begin 2010.

Doug Schenkel – Cowan & Company

Across both divisions?

John Ornell

Yes.

Operator

Your next question comes from Patrick for Peter Larson – Thomas Weisel Partners.

Patrick for Peter Larson – Thomas Weisel Partners

I was wondering, U.S. stimulus seems to be delayed a bit. You didn’t see too much for sales materialize in 4Q. You now see the majority of the impact in mid 2010. How much slower are funds trickling in than you expected and what are customers citing as the primary reason for those delays?

Douglas Berthiaume

I think a lot of people maybe including us were hoping more than determining in terms of the stimulus spending. I think a number of these grants were affected by different administrative procedures. They had different finalization, different review committees that were set up by technologies so they had to go through separate routes in order to get approved spending.

That might be why you see some elements of technology getting a little bit earlier releases than others. We’re told that particularly the mass spectrometry reviews have largely been completed and that those authorizations are in process and we should begin to see orders late in the first quarter into the second quarter.

Whether you see orders that can be fulfilled and make their way to shipment, probably that’s more second quarter weighted rather than first.

Patrick for Peter Larson – Thomas Weisel Partners

In Japan, what was the primary drover of the growth acceleration in the quarter?

John Ornell

Japan had a reasonably good mass spec quarter so some of those G2 shipments made their way to Japan.

Douglas Berthiaume

It also had a pretty weak base in the fourth quarter of last year. You’ll find that to be a fairly consistent dynamic in 2009 in certain territories, but mass spec and a weak base combined to give Japan a pretty good quarter.

Operator

Your next question comes from Jonathan Groberg – Macquarie Capital.

Jonathan Groberg – Macquarie Capital

If we look at Q1 as where most of the visibility is, but is there anything going on as you saw trends in Q4 that would make you think that it would be any different from historical seasonality now that it seems like economic activity is at least somewhat stabilized albeit at lower levels if you think of sequential, the seasonality between Q1 and Q4 of previous years.

John Ornell

I would say certainly starting off Q1 last year was a pretty dismal environment so from a basic comparison perspective you would certainly argue we have a relatively easy base. That being said though, as Doug pointed out earlier, it’s hard to believe that customers are going to allocate funds very early on this process to spend.

But it would say a mid single digit expectation of growth given that base of comparison and given some of the early signs that we’ve seen in demand volumes would be a realistic place to begin.

We do have on the one hand additionally this new product launch. We’re taking orders. We’ll be shipping on that front as well, but we need to be a little cautious and transition to that new product. So I think there are a number of factors on one side or the other that I think wait, come down to a mid single digit expectation is a realistic place to be based on the run rates we see coming out of the fourth quarter.

Jonathan Groberg – Macquarie Capital

On the acquisition front, was [inaudible] was the only acquisition related revenue, is that correct?

John Ornell

That’s right.

Jonathan Groberg – Macquarie Capital

Any update on the integration with that business? It seems like revenues were a little bit higher than they may have been thought or forecast by others?

John Ornell

I would say the integration is well under way. The volume from that acquisition was roughly on plan. It wasn’t a full two points so it wasn’t quite as strong but I would say the expectation certainly going forward in 10 is to see some meaningful growth out of that organization having spent a lot of this year getting it ready to go.

Douglas Berthiaume

We clearly are in the process of kind of Waterizing the systems offering. Still for most of this year it operated more or less as a stand alone operation. But I think we fully expect benefits on a number of fronts to come in the coming year as we integrate it more fully into the Waters organization.

Jonathan Groberg – Macquarie Capital

On the H Class I think you mention it was going to be priced around 25% higher than HPLC. Can you talk about the pricing environment on HPLC? Was there any degradation given the new products that have been launched by competitors and where that instrument is stalling out and maybe just pricing in general?

John Ornell

When I was talking about pricing of the new product, I think we meant to say that the Acuity has about a 20% premium to HPLC and the new product only has about a quarter of that premium. So it’s 5% to 7% higher, something of that ilk is the HPLC. So it’s a modest premium to go from HPLC to the new H Class, and then there’s another more significant premium to go from the H Class all the way up to the research grade product that we’re currently selling.

Jonathan Groberg – Macquarie Capital

And then generally pricing on the HPLC, has that been pretty stable or has that kind of come down a little bit?

John Ornell

It’s been very stable.

Jonathan Groberg – Macquarie Capital

If you think about there was pretty strong demand of a few years. You come off of this fairly significant recession. What’s your comment around excess instrument capacity generally on the analytical instrument front and what should we be expecting from new products in order to, you broadly talked about some new product lines throughout the year that we should be thinking about to drive that replacement that you talked about that you think there’s some pent up demand. What’s going to make people determine that they have to replace some of the instruments?

Douglas Berthiaume

I think importantly on the market front, what I believe is that it’s becoming harder and harder in the separations industry, particularly liquid chromatography from many secondary or tertiary suppliers to keep up.

It’s very hard to imagine that in the long run they can invest the money to compete across this line on both the engineering requirements to provide UPLC. More and more the data requirements, particularly the important integrated HPLC and UPLC data with mass spectrometry data, so the competitive issue I think really make it tough, and I expect that you’ll see that over the next couple of years.

That’s not to say all competitors can’t do that. There are a few who clearly can. But I think it does mean that the strong get stronger, so I think that has a competitive impact in the industry.

I don’t think in terms of capacity, the capacity in this industry isn’t bricks and mortar. It’s much more of a product cycle capacity than it is, and I think we are at the front end of that cycle right now. I think we’re in good shape.

Jonathan Groberg – Macquarie Capital

You had mentioned that there was pent up demand to replace some of the instruments, presumably when they do so they need a rational for doing so, so I’m wondering from a new product standpoint what we should be thinking about for the year in terms of where and what types of new products to expect.

Douglas Berthiaume

I think the rational, if you think about big pharma and you think about their need to do more for less, they’re under a great deal of pressure on the labor front. The great advantage of UPLC is that in many of these high volume applications, you can replace two or three instruments, traditional instruments with one of ours.

And now we’re going to give them the ability to make that transition much easier by starting off on a HPLC and quickly using the same instrument to ramp up to UPLC’s capabilities. So I think it’s a product that fits dramatically well with the needs of our customer base.

Now to be fair, Acuity did some of that, but it wasn’t easy to make that transition in these regulated applications, particularly in QC. We think that’s what H Class does extraordinarily well and should motivate a more rapid transition in these high volume applications.

I think the other thing that you’re going to see this year, certainly from us is a continuation of this continuous improvement in mass spectrometry. The G2 is not the last innovative mass spec that you’re going to see from us in the next 12 months and the technological playing field probably moves more attractively for us as we get through 2010.

We’ve got a number of industry participants who are going through their own structural reassessments or merger activity on their own. I think all in makes us a more, I think the competitive environment is tilted in our favor a little bit more in 2010.

Operator

Your next question comes from Robert Hawkins – Stifel Nicolaus.

Robert Hawkins – Stifel Nicolaus

Kind of building on what you said here I think it’s kind of interesting. Would the mass spec platform that you build off of, maybe into some of these other end markets, would that be more on side or is this something that you might take the prior G2 and create a more mainstream platform? What’s your expectation?

Douglas Berthiaume

I think you should expect that our high end orthogonal top we’re going to drive the G2 further and probably not see anything revolutionary on that front, but I think you should look more towards the quadruple space in 2010 to expect that we’ll have some exciting things coming forth there.

Robert Hawkins – Stifel Nicolaus

Would it be a fair assumption that the announcement you made about Taiwan and our own FDA relative to some of the quadruple buying there that we may see more of those down the road?

Douglas Berthiaume

I’m not quite sure what you’re referring to in terms of Taiwan.

Robert Hawkins – Stifel Nicolaus

They did, they bought both the LC and quite a few of the systems, for the food, the FDA’s and more government entities.

Douglas Berthiaume

We continue to think particularly in the food safety and those applied markets that they’re robust, particularly robust outside the U.S. and we’re hopeful that the conditions and the regulations build momentum inside the U.S.

Of course with all the spending freeze talk and whether they’re going to pass new regulations on food safety in the U.S., that’s not a big serve market today. We’re hopeful that that becomes a bigger market going forward, but that remains to be seen.

Thank you all for staying with us over a long conference call and we look forward to talking with you again at the end of the first quarter.

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Source: Waters Corporation Q4 2009 Earnings Call Transcript
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