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Waters Corporation (NYSE:WAT)

Q3 2010 Earnings Conference Call

October 26, 2010 08:30 am EST

Executives

Arthur G. Caputo – EVP and President, Waters Division

Douglas A. Berthiaume – Chairman, President and CEO

John Ornell – VP, Finance and Administration and CFO

Analysts

Sung Ji Nam – Gleacher & Company

Dan Leonard – Leerink Swann

Doug Schenkel – Cowen & Company

Tony Butler – Barclays Capital

Amit Bhalla – Citigroup

Ross Muken – Deutsche Bank

Stephen Unger – Lazard Capital

Derik deBruin – UBS

Marshall Urist – Morgan Stanley

Steve Willoughby – Cleveland Research

Brian – Jefferies & Company

Tycho Peterson – JP Morgan

Paul Knight – CLSA

Isaac Ro – Goldman Sachs

Quintin Lai – Robert W. Baird

Operator

Good morning. Welcome to the Waters Corporation's Third Quarter 2010 Financial Results Conference Call. All participants will be able to listen-only until the question-and-answer session of the conference. This conference is being recorded. If anyone has objections please disconnect at this time.

I would like to introduce your host for today's call Mr. Douglas Berthiaume, Chairman, President and Chief Executive Officer of Waters Corporation. Sir, you may begin.

Douglas A. Berthiaume

Thank you. Good morning and welcome to the Waters Corporation third quarter financial results conference call. With me on today's call as usual is John Ornell, the Company's Chief Financial Officer; Art Caputo, the President of our Waters Division and Gene Cassis, Waters Vice President of Investor Relations.

As is our normal practice, I will start with an overview of the quarter's highlights and then John will follow with details on our financial results and provide you with our outlook for the remainder of the year, but before we start 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, this time for full year 2010. We caution you that all such statements are only predictions, and that the 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, 2009, in 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 predictions regarding possible future income statement results, except during our regularly scheduled quarterly earnings release conference calls and webcasts. The next earnings release call and webcast is currently planned for January 2010.

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

Douglas A. Berthiaume

Thank you, John. We are pleased with the top line performance of our business in the third quarter. Our consistent order momentum throughout the quarter and continued positive acceptance of our new systems offerings are both encouraging signs as we look toward the fourth quarter and 2011.

For the Waters Division, momentum continued to build in the third quarter and the Division's sales grew organically at 8%. From a product line perspective, instrument systems sales growth approached 10% organically, while our recurring revenues, the combination of our chemistry and services businesses, grew at a mid single-digit rate. This increase in instrument systems sales was highlighted by the continued strong uptake of ACQUITY H-Class UPLC and our high-end mass spectrometry technology.

Looking at our end markets, we saw strong growth from pharmaceutical and chemical accounts in the quarter. Pharmaceutical sales were strongest among medium and small sized firms, with our largest pharmaceutical accounts delivering somewhat mixed results and an overall flattish year-over-year performance. Sequentially, however, sales to these large accounts improved significantly over the second quarter results. So that's a trend that's encouraging as we look towards year-end spending volumes.

Waters Division sales to chemical and applied market segments were up at a double-digit rate, and that was led by our industrial chemical customers. The strong performance by this Group represents both a nice recovery from last year's economically challenged spending levels as well as high interest in advanced research systems, such as our SYNAPT and Xevo mass spectrometry platforms.

Government and university sales were less robust in the quarter as the base quarter in 2009 included international stimulus-related business. A decline in sales volume to government labs was most apparent in Western European markets, while government spending in Asia and in the U.S. fared better. We're expecting the sales to government agencies in Europe will remain under pressure for the foreseeable future, but we are encouraged by the high level of interest for our research systems by government and university labs in the U.S. and in Asia.

Geographically, Asia and the Americas performed well in the quarter. Asia benefited from very strong sales growth in China and India, while our growth in Japan was moderately positive. The strength that we saw in Asia was primarily related to generic drug end markets in India and to overall pharmaceutical spending in China.

Sales in the U.S. grew at a double-digit rate with nearly all market segments exhibiting robust demand. Sales of systems incorporating high-end mass spectrometry technology were particularly strong in the quarter as we began shipping new systems that were introduced at this year's ASMS Conference in the middle of the year.

Early in the third quarter, there were concerns about European economic stability and the impact of potentially faltering national economies on analytical instruments sales. But throughout the quarter, we were reading economic reports and closely monitoring the pace of our business in Europe, and as the summer passed, our concerns about a significant displacement in demand diminished and the demand level not too dissimilar from our initial expectations really materialized.

In Western Europe, government spending was significantly reduced in the quarter, while pharmaceutical and industrial spending held steady. All-in, our European sales growth in the quarter was only slightly negative with Western Europe weakness largely offset by growth in Eastern Europe. We are expecting that government spending will remain weak in larger European countries. However, as this government segment represents a relatively small part of our sales mix and we are very confident in the strength of our new products, we feel that we can at least maintain or moderately grow our European business in upcoming quarters.

Looking more closely at product trends within the Waters Division, there were interesting dynamics affecting our chromatography and mass spectrometry offerings. On the chromatography front, most competitors have now introduced systems that claim performance advantages of UPLC. This is a move that we expected, and frankly, we welcome as we believe that the largest business growth opportunity in analytical instrumentation may involve the broad conversion of a large HPLC installed base of instruments to UPLC-type capability. Furthermore, we feel that if this conversion materializes and we continue to both define and drive demand with new generation UPLC system offerings, Waters is best positioned to increase market share.

Our ACQUITY H-Class is a key enabler in driving UPLC across HPLC market segments. Introduced earlier this year, the H-Class system is designed to allow laboratories, especially those running regulated testing protocols, to smoothly convert from HPLC to UPLC at a rate that best fits with their current workflow demands and their capital budgets. If you look at the third quarter, ACQUITY UPLC system sales were strong with demand growing in the double-digit rates and with higher penetrations in regulated testing applications by our ACQUITY H-Class System.

Recent trends suggest that the H-Class is helping to initiate a long awaited replacement cycle for applications, such as pharmaceutical QA/QC, and we believe that this replacement cycle has the potential to augment LC system growth over a multiyear period. In addition, strong sales of ACQUITY columns indicate continued high attach rates for UPLC columns.

Turning to our systems that incorporate mass spectrometry technology, we saw higher sales growth for our SYNAPT G2 and Xevo G2 platforms. Our Xevo TQ-S, which is a new high performance tandem quadrupole system that was introduced at this year's ASMS Conference, incorporates innovative ion optics that helps deliver industry-leading tandem quadrupole sensitivity for the most demanding quantitative analysis.

I am pleased to tell you that we began shipping the Xevo TQ-S late in the third quarter. We expect to ramp shipments in the fourth quarter to reduce our current order backlog and to fulfill new TQ-S orders that are booked in the quarter.

Our TA Division's organic sales grew more than 20% in the third quarter. As in the Waters Division, sales in the Americas and Asia were stronger than in Europe. In addition, sales growth was balanced across TA product line.

During the third quarter, TA delivered this strong performance at the same time they were introducing a significant new product platform, the Discovery DSC. DSC, for those of you who are interested, is differential scanning calorimetry and it accounts for a meaningful proportion of this Division's overall sales and the new Discovery DSC offers a level or precision, accuracy and sensitivity not available from any other research-grade DSC instrument. We are confident that with the introduction of the Discovery DSC, TA will further solidify its leading market position in 2011.

Though John will soon be walking you through the details of our financial results, I'd like to highlight a few points at this time.

Our financial performance in the third quarter demonstrates the operational strength and versatility of our organization. In the quarter, we delivered an impressive adjusted EPS growth of 21% and have set the stage for full year 2010 free cash flow that's roughly $400 million.

You look more broadly at our business including our plans for capital allocation and I feel very comfortable with the path that we are on. We will continue to stay conservative on the M&A front, we'll make the investments required to maintain our technological leadership and deploy excess free cash toward our ongoing share repurchases, a program that over the past several years has reduced our outstanding share count by more than a third.

Lastly, I want to reiterate our growing confidence in top line growth in the upcoming quarters. We acknowledge the concerns that are prevalent regarding the tightening of global government spending programs and the potential for near-term slower growth in specific countries. However, overall demand in our opinion is continuing to improve and we feel that our products and market positions are sufficiently strong to grow our sales at a higher than market rate as we look toward 2011.

With that, I'd now like to turn it over to John for the financial details.

John Ornell

Thank you, Doug and good morning. Third quarter sales increased by 7% and non-GAAP earnings per diluted share were up 21% at $0.98 this quarter compared to earnings of $0.81 last year. On a GAAP basis, our earnings were $1.02 this quarter compared to $0.79 last year. A reconciliation of our GAAP to non-GAAP earnings is included in our press release issued this morning.

This quarter's GAAP results contain the effects of two audit settlements resulting from concluded audits in the U.K. and with the State of Delaware. The net of these settlements increased EPS by $0.06 this quarter.

Reviewing Q3 sales results compared to Q3 last year, sales were up 9% this quarter before currency translation. Currency translation reduced sales growth by 2% this quarter.

Looking at our sales growth geographically and before foreign exchange effects, sales within the U.S. were up 11%, Europe sales were down 3%, sales within Japan were up 3%, and sales in Asia, outside of Japan, were up 28%.

Turning to the product front, within the Waters Division, instrument systems sales increased by 9% and recurring revenues grew by 6% this quarter before foreign exchange effects. Within our TA Instruments Division, sales continued to grow strongly and increased by 21% versus prior year.

Now I would like to comment on our Q3 non-GAAP reported financial performance versus prior year. Gross margin performance came in at 59.4%, a little lighter than expected, but up 40 basis points from Q3 last year. Gross margins were depressed a little this quarter, largely as a result of a product mix shift as we built a backlog of our higher margin tandem quadrupoles.

Foreign exchange translation was slightly less favorable than earlier anticipated as the stronger British pound reduced gross margins, but this was partially offset by a stronger yen this quarter. SG&A and R&D expenses increased about as expected and grew by 5% and 6%, respectively, this quarter compared to prior year.

Our full year effective income tax rate came in better than projected at about 17%. A continued shift in estimated production levels in favor of our operations located in lower tax rate geographies reduced our anticipated full year tax rate by about 1%. The year-to-date effect of this change in the third quarter brought the quarter's rate down to 14.5%. This provided about $0.04 of benefit to our Q3 EPS.

On the balance sheet, cash and short-term investments totaled $837 million and debt totaled $792 million, bringing us to a net cash position of about $45 million. On the stock buyback front, we continued to purchase our shares in the open market, and during the second quarter we purchased 1.1 million shares of our common stock for $65 million.

We define free cash flow as cash from operations, less capital expenditures, plus any non-cash tax benefit from stock-based compensation accounting, and excluding unusual non-recurring items. For Q3, free cash flow remained strong and came in at $84 million after funding $26 million of CapEx and adding back $1 million of non-cash tax benefits from stock-based compensation. Comparable free cash flow in Q3 last year was $102 million.

Accounts receivable days sales outstanding stood at 77 days this quarter, up 6 days versus Q3 last year. This quarter's shipments occurred later in the quarter as newly released products ramped up heavily in September and skewed our DSO comparison. We expect to see this metric improve as we exit the year.

Inventories were up $30 million from year end. Foreign currency translation increased inventories by $5 million and the remaining increase is related to an inventory build associated with the ramp up of our new products and the typical midyear inventory increase in preparation for larger Q4 shipments. Inventories are expected to drop back to more normal levels by year end.

As we look to the close of the year, our sales momentum continues to build as our new products continue to gain traction and customer demand continues to recover from the depressed levels we saw last year. The combination of generally stable demand across Q3 and into early Q4 and the order build coming into the quarter give us confidence that we should see our currency neutral sales grow between 7% and 8% for Q4.

This growth assumption contemplates the continuation of the sales trajectory we have seen through three quarters and adjusts for a bit stronger base of comparison in Q4 last year where business conditions began to improve. Currency at today's rates should add about 1% to sales growth in Q4.

Moving down to P&L, we expect gross margins on newly released products to be favorably affected by product cost reductions this quarter and current foreign exchange rates should provide for a favorable translation environment as well. Additionally, product mix is expected to be much more favorable in the fourth quarter as we significantly ramp up shipments of our new tandem quadrupole mass spectrometer. Gross margins in Q4 are expected to be between 60.5% and 61%.

Operating expenses are expected to grow at a slower rate than sales growth and net interest expense is expected to be approximately $3.5 million. And as I mentioned earlier, we expect our operating tax rate to be approximately 17%. Our fully diluted average outstanding share count for Q4 is currently estimated to be about 93 million shares. Rolling all of these together, we currently expect our non-GAAP earnings per fully diluted share for Q4 to be in the range of $1.28 to $1.33 per share.

For the full year then, we expect organic sales growth of about 8%, currency translation at today's level is expected to be about neutral to sales growth for the full year and our full year non-GAAP EPS is expected to be between $4 and $4.05 per fully diluted share.

Doug?

Douglas A. Berthiaume

Thanks, John. At this point, Amy, I think we can open it up for Q&A.

Question-and-Answer session

Operator

Thank you, (Operator Instructions). Our first question comes from Marshall Urist, from Morgan Stanley, your line is open.

Marshall Urist – Morgan Stanley

Yeah, hey guys, good morning. The first question is on your comments about the LC business and increased competition there; I would love to get a little bit more detail on exactly what you are seeing in the market in terms of customer purchasing decisions. Is there a greater evaluation of this system and how is that exactly impacting both the competitive dynamics and customer purchase decisions?

Douglas A. Berthiaume

Let me answer what I think you're asking, Marshall. We are seeing a number--in the last year or so, we have seen more of our competitors meaningfully start to talk about UPLC. However, in almost all of those cases, we continue to see our customers go through many of the same evaluation procedures, long-term evaluation procedures that they went through with ACQUITY for us many years ago. So the actual uptake in the competitors we still think is pretty slow, but it's clearly changing the share of mind with customers to focus more on the UPLC technology rather than the traditional HPLC technology. We're clearly seeing more and more examples of our customers saying to us things like, 'We are not going to invest any more strategic monies in HPLC, we're only adding more technology in the UPLC arena.'

What is particularly encouraging is I'd say in the last two quarters and particularly in the third quarter where we have traditionally seen a greater level of uptake of ACQUITY in the front end of both development activities and R&D, and less uptake in the regulated applications in pharmaceutical QA/QC, we're now seeing a much stronger uptake in that downstream activities in QA/QC and that, of course, has a higher preponderance of instrumentation there and that's why you hear us to be optimistic about the long-term dynamics of that move into UPLC in those regulated applications.

Marshall Urist – Morgan Stanley

That’s great, that’s helpful. One more on--you mentioned you have improving confidence on top line growth into next year. It would be helpful if you could talk about – if you could give us a little bit better insight into what's driving that, in terms of what you are seeing across some of the major end markets and how much of that are you seeing today and what should we start to think about for next year?

Douglas A. Berthiaume

I'd say what we are seeing from our field surveys and from our customer discussions is kind of a constant-- maybe a constant improvement, but I would say at least a level of confidence about the current pace of activity and the expectation that the slope of this business is going to continue as they go into 2011.

I think if you look at it geographically, I'd say, what you see now is pretty much what we expect, maybe improving a little bit as we move into 2011. We continue to see very strong conditions throughout Asia. We continue to see strong conditions in the generic drug accounts in India, and we see a fairly significant improving situation in the Unites States, where in the past 12 months we've moved from low single digit activity levels, moving up towards the double-digit activity levels. If you look at it from a product and technology perspective, the reaction to H-Class is probably the single most important thing on the chromatography side. We are very, very pleased with the reaction that we've had from that, from our traditional HPLC customers. I think there's no question with that offering, we're well ahead of the competitive offerings.

In the same way, coming out of ASM, as in particular, with both our high-end QToF like SYNAPT and G2 applications, and importantly, with this new TQ-S tandem quadrupole, our initial reactions on the part of both our accounts and competitive accounts makes us pretty confident that those products have strong legs going into 2011. So, geographically and in product position, we you look at it from a customer point of view. We're still probably most cautious about government spending, particularly in Western Europe, but outside of Western Europe that government academic community continues to look reasonably robust to us.

Marshall Urist – Morgan Stanley

Great, and then just one very quick follow up…

Douglas A. Berthiaume

Excuse me Marshall but I’m being warned that there are many, many people in the cue so I’d like to try to keep this to one question if possible and then back in the cue?

Operator

(Operator Instructions) our next question comes from Ross Muken of Deutsche Bank, your line is open.

Ross Muken – Deutsche Bank

Thanks, can you tease out a bit more of what you're seeing across Europe, whether it's country-specific in the U.K. or in Germany or in France or it's across the entire western portion in terms of demand, both from government, academic, as well as from pharma and your industrial apply customers?

Douglas A. Berthiaume

Sure, I think it's relatively homogenous across Western Europe while not totally universal. I wouldn't point to any of the large territories being meaningful points off the line. They are all kind of in that flattish overall demand arena. I think, interestingly, if you look at the pharmaceutical marketplace, it's important to know that a lot of those pharmaceutical customers are outsourcing significant parts. You probably saw that Sanofi Covance announcement of earlier this quarter. And that's just one example of big pharma moving some of their operations to third-parties and in many cases, to non-Western Europe geographies. So, they are moving it into Eastern Europe, Poland, Czech, and in some cases, into Asia. So, the capital is still maybe coming from the big pharma in Western Europe, but we would score that revenue outside those traditional areas. So, it gets a little bit hazy when we talk about how did big pharma react in a particular quarter versus specialty pharma or third-party testing laboratories. We know that that dynamic has been operating and probably is operating at a higher degree because we are doing very well with some of these outsourced third-party testing laboratories. So, that just muddies the picture a little bit. In the applied markets, we're seeing pretty good performance in the European theater, and again, we're most cautious about those things that rely on government spending. It remains to be seen just how much available government money there will be as we go into 2011. Right now, we'd say we're thinking whether the current momentum is going to continue.

Ross Muken – Deutsche Bank

Just one quickly on the government and academic side, and that's mainly touching your mass spec business. Is it something where if we look at the order trends, we were trending along nicely and you had a stimulus benefit, and then come sort of the disruption we had late Q2 and early Q3, we just saw a disruption in the order pattern as well and it continued or how would that order trajectory look over into the summer and then out of the summer?

Douglas A. Berthiaume

I'd say Western Europe hasn't been strong all year. So I'd say what we're talking about is a little bit of nuance. Clearly, it does affect our higher end mass spectrometry significantly, but I should warn you, we had an excellent quarter worldwide in high-end mass spectrometry. So, whatever it did to us in Western Europe was more than offset by strength in those applications outside of Western Europe.

Ross Muken – Deutsche Bank

Great, thanks Doug.

Douglas A. Berthiaume

Okay.

Operator

Our next question comes from Tony Butler with Barclays Capital, your line is open.

Tony Butler – Barclays Capital

Doug, who were the initial customers who were ordering the H-Class and to what degree have you been able to gain traction outside of historic Waters customers and would you also guess or guesstimate as to whether or not they are using HPLC columns or UPLC columns principally?

Douglas A. Berthiaume

I would say that our best estimate is that 25% or so, maybe a quarter of our H-Class orders are going down to customers who have not ordered HPLC from us before. So that's a pretty significant dynamic. I would say early on they are all ordering UPLC columns traditionally with the order. I would say our experience is most of them are running HPLC methods at this stage of their transition because what they tend to do is transfer their existing HPLC applications to the new instrumentation as they work in the future towards moving into a UPLC universe. Again, the great benefit of this technology is that you can put your old methods on there and yet eventually still move up to the UPLC platform.

Tony Butler – Barclays Capital

Thanks Doug.

Douglas A. Berthiaume

You’re welcome.

Operator

Our next question comes from Amit Bhalla with Citigroup, your line is open.

Amit Bhalla – Citigroup

Hi, good morning. I wanted to just get a better understanding of the pharma comments you made. You said in terms of your larger accounts you were starting to see a rebound. I guess I was a little bit surprised given that you are in the summer months and you were seeing that quarter-over-quarter increase. So, can you just talk a little bit more about that?

Douglas A. Berthiaume

Frankly I was a little surprised too, because, again, our field was reasonably optimistic coming into the quarter that we'd see some of that, but I was a little more skeptical. It's been somewhat difficult to call the pattern of big pharma capital spending. We're seeing more diversity in a lot of these large accounts in terms of when they are releasing their capital budgets and we are seeing particularly in the past 9 to 12 months we had several big mergers going on and the pace at which they resolve their organizational strategies and their spending strategies varies. One of the things we saw this quarter was that some of the companies that were undergoing those merger activities came out of it earlier and started to spend some capital with us. I'd say that might have been the single most positive dynamic that spending that we thought might come earlier in the year didn't come and it started to come in reasonable amounts in the third quarter from those large pharma accounts.

Amit Bhalla – Citigroup

Okay, and just a quick follow-up, just in terms of Europe, can you just quantify the exposure in terms of product in some of the geographic areas in Europe and just tell us if the weakness was greater in the third quarter versus the second or was it similar level of weakness?

Douglas A. Berthiaume

I’m sorry, quantify it based on product do you mean?

Amit Bhalla – Citigroup

Geographically and product, if you could, in terms of Europe just so we understand the exposure and was the weakness in this third quarter greater than the second quarter?

Douglas A. Berthiaume

Yeah, we had a little bit weaker Western Europe activity in the third quarter, but not materially so. And I'd say the most notable issue was high-end mass spectrometry in the government supported customer base. That's where we saw a lot of issue. On the other hand, we did have some build in backlog because of our introduction of the new triple quads that will benefit our results in subsequent quarters. I think we should move on to the next question.

Operator

The next question comes from Jon Wood with Jefferies, your line is open.

Brian – Jefferies & Company

Hi it’s actually [ph] Brian Cleud for Jon Wood. Have you assumed your major pharma business will grow organically in the fourth quarter?

Douglas A. Berthiaume

I think our results anticipate that it will grow. Some of that is because we didn't have a terribly strong big pharma quarter in the fourth quarter of last year, but yes, our model anticipates, we will see growth in the fourth quarter.

Brian – Jefferies & Company

Alright, and then assuming current FX rates persist, will FX benefit your margins in 2011?

Douglas A. Berthiaume

Versus 2010?

Brian – Jefferies & Company

Right.

John Ornell

Yeah, there'll be some quarterly issues as you look back to where currencies were across the quarters, but right now the currency environment is relatively favorable. So, I would say that you have generally good margins in the current environment that we're in and you're just going to have quarterly comparisons that will need to be accounted for as you go back and see where rates were across the quarters of the base year.

Douglas A. Berthiaume

But generally, it's favorable as we look from this point with the yen around 80 to the $1.

Brian – Jefferies & Company

Thank you.

Operator

(Operator Instructions) The next question on cue comes from Quintin Lai with Robert W. Baird, go ahead.

Quintin Lai – Robert W. Baird

Good morning. With respect to recurring revenues, could you talk a little bit about the pacing through the quarter, was it fairly steady or did it start off a little slow and then better?

Douglas A. Berthiaume

I think in the --if you look at our recurring businesses, it's really almost equal measures in terms of gross revenue from the part of service revenues and consumables, the columns. The service revenue is a slower growth than the consumables business and I think what's positive is that our consumables business has built momentum from the beginning of the year. Again, the service business is a little bit bigger than the chemistry business, but that chemistry business driven I think by the success of UPLC, the H-Class and the ACQUITY technologies, as well as the return of things like the generic drug business in India, so that our sample prep business is growing very nicely, so that business started off reasonably strong in the quarter and continued at a good pace, so I think it's very encouraging. Last year, during the downturn our chemical business, which as you may remember, is our most profitable in terms of its operating margins, slowed and now we're seeing a very positive track that I think continues as we go into 2011.

Quintin Lai - Robert W. Baird

Super Doug, and then John real quickly, the tax rate, 17%, is that a good long return of tax rate into next year?

John Ornell

Yeah, I'd say, based on what we see today, we've begun to transfer some of the H-Class production to Singapore and much of that has yet to come. It's likely to offset perhaps a shift away from alliance in the future, but I think it's going to work. That provides for a build of production in Singapore. This is likely to keep our rate above where it is today, other things being equal.

Quintin Lai - Robert W. Baird

Thanks.

John Ornell

You’re welcome.

Operator

Our next question comes from Tycho Peterson with JPMorgan, your line is open.

Tycho Peterson – JPMorgan

Hi, good morning. John, maybe one for you. Can you just touch on some of the gives and takes on the margin line this quarter between mix and price and other factors.

John Ornell

Sure, I'd say on the margin line, the big issue here really was the significant reduction we had in the quarter of shipments of our high-end triple quads. We've been changing out demand to the new TQ-S so that we've been shipping many fewer of the legacy product, obviously, as we've been building a backlog as this product has been making its way from R&D into production. So, the lack of that bolus of high-end triples in the base caused about almost a 50 basis point reduction in our overall margins in the quarter versus a traditional mix in the base year.

The other thing, the other piece, which is a little bit more of a net, is that we did see a bit of a strengthening of the pound across the quarter versus where we started. That raised the cost of some of the high-end mass spec coming out of the UK upon translation. That was offset to some extent with the strengthening yen, but the net effect of both of those was to reduce our overall margin associated with FX by about 10 to 20 basis points. So, between those two, that's the difference between a 60% margin that we had been running closer to versus a 59.4%.

John Ornell

Tycho, just to border a little bit on that, what we saw in the quarter was a little bit unusual in terms of the timing of the currency moves in that the yen, in particular, and the euro strengthened significantly late in the quarter. The pound was a late in the quarter dynamic also. As we look at how much of that dynamic winds up in the inventory at the end of the quarter, how much of a sales effect flows through to bottom line is a simultaneous equation, all of that came together to be a little less favorable than we might have expected. We think that all washes through in a more positive dynamic in the fourth quarter and as we go into next year.

Tycho Peterson – JPMorgan

Oka, and then just one follow-up on your comments on pharma before, Doug. You talked about I think in your prepared comments H-Class kick starting the replacement cycle. Is this fairly consolidated by customer at this point or are you anticipating a broader replacement cycle here with the idea that you'll see more standardization in potentially larger orders come through across the pharma base.

Douglas A. Berthiaume

Yes, I think the answer is we expect to see larger orders in the future as – because these customers don't want to have multiple forms of technology in one laboratory. So they'll tend to move in a more aggressive fashion. That's what we've begun to see, and if we are right, I think we'll see that at a higher level as we go into next year.

Tycho Peterson – JPMorgan

Thank you.

Operator

Our next question comes from Steve Willoughby with Cleveland Research, your line is open.

Steve Willoughby – Cleveland Research

Hi, thanks for taking my question. Really just two things on backlogs. I was wondering if you could comment at all regarding where your backlogs stands today compared to the 9% internal growth you posted today with backlog growing or shrinking this quarter. And then the backlog for the new Xevo units, I know you said you started shifting late in the third quarter, but how long do you think it will take to work through that backlog? Is it the fourth quarter or is it into next year as well?

Douglas A. Berthiaume

We should substantially move through the backlog in the fourth quarter. Of course, if orders substantially outpace our current expectations, we may drag that into next year, but that would all be very good news for us. In terms of the third quarter backlog dynamics, we did-- our order rate was higher than our sales rate, we did grow the backlog, which is relatively unusual for us in the third quarter. We originally thought we would ship more of these units in the third quarter. The hidden message you see, the third quarter could have been a little bit better. We had a few, I'd call, minor issues from the middle of the quarter on that we delayed shipping for about three or four weeks that we hadn't originally planned on. Those shipment issues have resolved themselves. They weren't significant and that's why we are confident as we go into the last part of this year.

Steve Willoughby – Cleveland Research

Great, thanks very much.

Operator

Our next question comes from Isaac Ro with Goldman Sachs, your line is open.

Isaac Ro – Goldman Sachs

Good morning, thanks for taking the question. First, I wanted to maybe focus a little bit more on gross margin. I think you identified about 60 basis points of gross margin impact this quarter versus a year ago. Gross margin was actually down sequentially about 90 bps off a higher base of revenue. So I'm wondering is there anything in there related to the manufacturing redundancies for H-Class, and if so, could you maybe quantify how that rolls off going forward?

John Ornell

On the H-Class, there were a few components that had higher cost early on than they will originally. Those costs are being looked at and I think generally pulled out in the fourth quarter, but certainly early into next year those penalties will go away. We also have somewhat higher cost in some of our newer products; the high-end QTof has a slightly higher cost that we're pulling back out. So there are a number of new product issues that did contribute a little bit to the lack of margin consistency, if you will, versus what you saw in the first half of the year, but the expectation really was to be at about 60%ish gross margin for the quarter and that was just based on the mix that we had expected that was, as I said, really significantly different only on the triple quadrupole.

Douglas A. Berthiaume

The other dynamic, again, we would kind of splitting hairs here a little bit, but with the very strong hardware piece of our business that kind of reduces a little bit the consumables mix and our consumables gross margins are substantially higher than our hardware gross margins, so that mix cost you against the traditional levels that you have seen on the margin, that hurt your gross margins a little bit.

Isaac Ro – Goldman Sachs

Okay, thanks. So it's fair to say there was no material competitive pricing dynamic here just to follow-up on Tycho's question?

Douglas A. Berthiaume

No I'd say nothing – you always see one offs, and in one geography you might be seeing some strange quotes or something, but you see that every quarter and we didn't see anything that would point out as being a significant dynamic in the third quarter.

Steve Willoughby – Cleveland Research

Great, thanks.

Operator

Our next question comes from Paul Knight with CLSA, your line is open.

Paul Knight – CLSA

Over those geographic breakouts the U.S., Europe, Japan, ex-Japan and was that organic?

John Ornell

Yeah, the percent that I gave you for each of the geographies was stripping currency out. So those would have been neutral from a currency perspective.

Paul Knight – CLSA

It was Europe at plus or minus 3?

John Ornell

Minus 3.

Operator

The next question comes from Derik deBruin with UBS, your line is open.

Derik deBruin – UBS

Hi good morning.

Douglas A. Berthiaume

Good morning Derik.

Derik deBruin – UBS

You commented that you're seeing growing confidence in top line growth and particularly as you look at your market position as we head into 2011, I'm just curious, I kind – your confidence in growing above trend in 2011. So I see trend for these analytical instrumentation businesses, the market in general has about being mid single digits. So when you say above trend, are you talking high single or double digits potentially? Can you just talk about what you need to see in the market to move from a high single digit number to a double-digit number and how that will flow through? I am just curious on how you're seeing the financial model building on this?

Douglas A. Berthiaume

I'd say your base data that you cite, is pretty close to ours. We see the market being mid single digits and we're growing in the high single digits. I think when you hear us about growing confidence, we're growing confident about our ability to sustain that high single digit level of business and what would it take to get us more confident over and above that is a sustained picture that the H-Class is having the broad effect in the marketplace of moving the HPLC market more aggressively into a UPLC phenomenon. That's probably the single most important element I think.

We're seeing very nice dynamics in that, but if it's as good as we think it is and is broad, then that will move that picture up. We're also in the front end of what we think is this mass spectrometry, particularly the relatively higher end mass spectrometry. We are seeing--even with a relatively weak Western Europe picture, we are seeing record intake of orders on high-end mass spectrometry. It's very strong reaction to our new products and so, we're really only seeing about a little over a quarter of that. As we move into next year that dynamic could be very significant. I think that's most of it.

We've seen a quarter and a half of strength in the U.S. market, if we're right and that momentum continues a pace, then you're going to see full year of that dynamic next year. We anticipate that the U.S. applied markets in the food and beverage area has a great deal of opportunity for us. We're well positioned in some of the key thought leaders and then the regulatory environment to take advantage of that and that could be a smooth affect on us worldwide as some of those programs come together. I'd say we are anticipating that the strength that we see in Asia continues. I think that's a fair conclusion. It's not without certain risks, but I think it's not a huge risk that we'll see much disruption to the momentum that we're seeing in Asia.

Operator

Our next question comes from Steve Unger with Lazard Capital, your line is open.

Stephen Unger – Lazard Capital

Hi good morning. Doug, on the TQ-S, could you talk about what type of buyer is the early buyer there and what types of applications, and then do you think that the core drug development labs, that market is opening up?

Douglas A. Berthiaume

It is a very fair question, Steve. Art Caputo runs that business. He is here. I'll ask Art to chime in here.

Arthur G. Caputo

Steve, the target for the TQ-S is predominantly the regulated bioanalysis marketplace where what we try to do is put together a very highly sensitive unique triple quadrupole that performance-wise when combined with our front-end sample preparation total system solution enables us to make substantial inroads into the clinical tests and regulated bioanalysis marketplace. It also has a high applicability in the food safety segment and many of the industrial segments. So the mass spectrometry market, the high-volume workforce capability is high-end triple quadrupole. That's the single largest segment and this fits right into that sweet spot with very differentiating capabilities in terms of its sensitivity. Combine it with our systems solution which puts us in a very unique position in the marketplace because of the expanse of our full range of capabilities we think we've got something that offers a substantial competitive position in this segment.

Douglas A. Berthiaume

So, early on, the response to that has been strong both from the more traditional Waters account and early on from customer that haven't been used to buying tandem quadrupole from us. A little early in that conversion, but I'd say the early signs are very positive, Steve.

Stephen Unger – Lazard Capital

Great, and then just one follow-up. Do you think that the step up in the activity of inspections is helping drive – just by the FDA – helping drive the H-Class?

Douglas A. Berthiaume

It's hard to tell. I'm not prepared to say that we see strong evidence of that.

Stephen Unger – Lazard Capital

Got it, thank you.

Douglas A. Berthiaume

You’re welcome.

Operator

Our next question comes from Sung Ji Nam with Gleacher & Company, your line is open.

Sung Ji Nam – Gleacher & Company

Hi, thanks for taking the question. Just quickly, in terms of the overall strength in the mass spec business, do you attribute that to market share gain or the overall strength of the market?

Douglas A. Berthiaume

I think our overall mass spec performance had to above perform the market in recent times. I'm not saying that others couldn't have had a good quarter, but we had an outstanding – particularly on the order side of the equation. Again, it's very hard to measure market share and dynamics in any one quarter. So I'm not going to beat our chest too high. We'll look at it over the next four or five quarters and that will give you a better feeling for the relative market share dynamics.

Operator

Our next question comes from Doug Schenkel Cowen & Company, your line is open.

Doug Schenkel – Cowen & Company

Hi good morning. My understanding is that H-Class is not available in all geographies in Q2 and Q3, particularly I don't think it was available in certain emerging markets, including India and China. Assuming this is correct, were these launched yet in these markets, and if not, when will they be launched and how do you expect to manage the transition away from Alliance, given Alliance has done quite well in these markets?

Douglas A. Berthiaume

I think you are wrong in those assumptions. Art, do you want to…

Arthur G. Caputo

That is incorrect. Actually H-Class is what we would describe within our organization as a zero lag launch, which meant that product was introduced worldwide within a three-week time period. Within that three-week, every field person was trained, every demonstration lab was equipped with demonstration units and the product was available for delivery within 30 days. So, it was a broad-based introduction, we've seen broad-based sales in that product, and to be totally frank, the ramp up in adoption of that product, a large piece of that was – keep in mind we had about seven years of the traditional ACQUITY being sold globally and that product basically in that phase was utilized to establish the transition for methods into the routine and downstream applications. The arrival of H-class was essentially looked on as an excellent implementation tool that could do both, HPLC or UPLC, and enable that implementation and we saw that largely from a broad base. Some markets are slower to adopt newer technology like this as you get into some of the emerging markets, but we have sales across every segment globally with that particular product.

Doug Schenkel – Cowen & Company

Okay, thanks for that, thanks for clarifying. Just one more, quick one emerging markets. You guys have done quite well in India and China over the past few years, but I think a lot of this is attributable to really the Waters Division versus TA. At what point does TA growth in China and India become more of a point of emphasis is the opportunity as a percentage of sales up?

Douglas A. Berthiaume

I think the TA opportunity is – don't forget, the India marketplace for us is heavily weighted to generic drug manufacturers and that's almost exclusively a Waters Division opportunity. The other opportunities for TA in India are in industrial applications and those are smaller served markets for us. So, you would never expect TA to have anywhere near the same size business that Waters has. On the other hand, the China opportunities are significant. In fact, the TA growth in China, as well as in other areas of Asia, is very strong, probably the strongest part of the geographies in the last two or three quarters.

Doug Schenkel – Cowen & Company

Great, thank you.

Douglas A. Berthiaume

We have a few people still in the cue. We’ll stay on for another couple of questions and try to cover them all recognizing that we’ve gone a little past our traditional stopping time.

Operator

Our next question comes from Dan Leonard with Leerink Swann, your line is open.

Dan Leonard – Leerink Swann

Hi, thanks for staying past time. Just one quick question; it looks like you are expecting gross margins to tick down just a touch in 2010, perhaps due to the new product issues and FX. Once these new product issues have been worked through, should we expect --?

Douglas A. Berthiaume

Dan, I'm sorry. Can you frame that? When you say, tick down in 2010. You're talking about the fourth quarter or for the full year?

Dan Leonard – Leerink Swann

For the full year. When you put your gross margin guidance in the fourth quarter number, the full-year number is down a touch than in 2009.

John Ornell

Probably closer to being flat, not down.

Dan Leonard – Leerink Swann

Anyway, how should we think about gross margin going forward?

John Ornell

I'd say that, as we look at the basic comparison that we've been creating in 2010, we're looking at being able to continue to move products to Singapore. We have a transfer in place for the new TQ-S into Ireland. So, our traditional capabilities of being able to move higher volume products to our larger manufacturing facilities where we can gain some economy of scale will provide for our traditional 20 basis point improvement year-over-year. I'd say currencies where they are today, they stay where they are on a full year basis is likely to continue to be a bit of upside to that as well. So thinking of a modest expansion in gross margin as we look to next year would be my starting point based on what I see today.

Operator

Our next question comes from Jon Groberg with Macquarie, your line is open.

Jonathan Groberg – Macquarie Capital (NYSE:USA)

Thanks guys, I’m good. Thanks for taking the question.

Douglas A. Berthiaume

Alright, great. Thanks Jon.

Operator

At this time, there are no other questions.

Douglas A. Berthiaume

Thank you all for participating today and we look forward to the end of year call in January.

Operator

Thank you for your participation. You may disconnect at this time.

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Source: Waters CEO Discusses Q3 2010 Results - Earnings Call transcript
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