Waters (WAT) Christopher James O'Connell on Q2 2016 Results - Earnings Call Transcript

| About: Waters Corporation (WAT)

Waters Corp. (NYSE:WAT)

Q2 2016 Earnings Call

July 26, 2016 8:00 am ET

Executives

John Lynch - Vice President, Treasurer and Investor Relations

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

Analysts

Derik De Bruin - Bank of America Merrill Lynch

Tim C. Evans - Wells Fargo Securities LLC

Isaac Ro - Goldman Sachs & Co.

Tycho W. Peterson - JPMorgan Securities LLC

Jonathan Groberg - UBS Securities LLC

Ross Muken - Evercore ISI

Stephen C. Beuchaw - Morgan Stanley & Co. LLC

Sung Ji Nam - Avondale Partners LLC

Bryan Brokmeier - Cantor Fitzgerald Securities

Amanda L. Murphy - William Blair & Co. LLC

Daniel Arias - Citigroup Global Markets, Inc. (Broker)

Steve B. Willoughby - Cleveland Research Co. LLC

Operator

Good morning and welcome to the Waters Corporation second quarter 2016 financial results conference call. All participants will be able to listen only until the question-and-answer session of the conference. This call is being recorded. If anyone has objections, please disconnect at this time.

It is now my pleasure to turn the call over to Mr. John Lynch, Vice President of Investor Relations. Sir, you may begin.

John Lynch - Vice President, Treasurer and Investor Relations

Thank you, operator and good morning, everyone and welcome to the Waters Corporation second quarter earnings conference call. Before we begin, I will cover the cautionary language.

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 for the third quarter and full year 2016.

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, 2015 in Part 1 under the caption, Risk Factors, and the cautionary language included in this morning's press release and 8-K.

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.

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 measures 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, Quarterly Reconciliation of GAAP to Adjusted Non-GAAP Financials, included in this morning's press release.

Unless we say otherwise, references to quarterly results increasing or decreasing are in comparison to the second quarter of fiscal year 2015. In addition, unless we say otherwise, all year-over-year revenue growth rates including revenue growth ranges given on today's call are given on a comparable constant currency basis.

Lastly, as you recall in January of this year, we announced a new integrated structure for what was traditionally referred to as the Waters Division and TA Instruments Division. So, on this call and into the future, we will continue to refer to Waters products and markets and TA Instruments products and markets.

Now, I'd like to turn the call over to Waters' Chief Executive Officer, Chris O'Connell. Chris?

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Thanks, John, and good morning, everyone and thank you for joining us today. Also here for our commentary and Q&A session is Gene Cassis, Chief Financial Officer. As with past earnings calls I will provide an overview of our second quarter results as well as some broader commentary.

I'm pleased to report that our second quarter results exceeded our expectations with revenue growth of 8% against a strong base of comparison, and earnings per share growth of 15% at constant currency or 20% growth as reported. Revenue performance was broad-based across end markets, product lines and geographies, with our key business drivers continuing to provide reliable growth.

Our strong earnings performance resulted from a combination of a robust top line, positive mix dynamics, and disciplined expense management while continuing to invest in R&D and our growth initiatives.

Taking a closer look at our major end markets, our broadly defined pharmaceutical market for Waters products once again led the way with 12% growth in the quarter. We saw solid growth in our core small molecule QA/QC workflows, as well as in large molecule R&D oriented applications.

Year-to-date, the pharmaceutical market has grown 11% for us, on top of a double-digit growth rate in the first half of 2015. Though our growth in the pharmaceutical market continues to be primarily driven by smaller and specialty firms, our largest global customers also increased their business with us in the quarter at a mid-single-digit rate.

Our global industrial sector, which includes sales to the material characterization, food, environmental and fine chemical end markets, grew 7% in the quarter, and represented a sequential improvement compared to the first quarter. Highlights in the industrial sector included double-digit growth in our TA product category, as well as solid growth in Waters products sold to food markets.

Looking at governmental and academic markets, we saw a 4% decline in the second quarter, which was primarily affected by significant weakness in Japan.

Turning to product line dynamics in the quarter, Waters instrument sales grew 7%, with positive demand for core LC and bench-top LC/MS platforms. We are seeing significant traction for our recently introduced ACQUITY Arc System and continued strength in our other core LC offerings. These are workhorse systems that are heavily used in regulated pharmaceutical testing methods and are typically deployed in laboratories that have standardized on our industry leading Empower CDS software. We continue to champion the use of mass spectrometry detection for LC workflows and as part of this we see broader and deeper adoption of our ACQUITY QDa mass detector.

On the research mass spec side, interest for our newest bench-top systems, including the Xevo QTof G2-XS for biologic workflows and our newly launched Xevo TQ-XS for demanding quantification applications, is increasing as we move into the second half of the year.

Waters' total recurring revenue, the combination of service and consumables, grew at 10% in Q2. Our service and support business grew at a 9% rate, with balanced performance geographically associated with increased demand for service plans. Consumables sales were up 11%, with continued strong underlying demand for ACQUITY UPLC columns, protein separation columns and Oasis PRiME sample preparation cartridges.

Our GlycoWorks RapiFluor-MS labeling kits continue to revolutionize the characterization of glycans for biopharma development and quality testing applications. The speed and simplicity of this new analytical workflow and proprietary chemistry kit is helping to bring new protein-based therapies to market more quickly and at the same time presents Waters with future business opportunities for bio QC system sales.

Overall, I'm very pleased with the strength and the stability of our recurring revenue lines as an indication of the depth of Waters's support among high-utilization customers, as well as the financial benefits of these attractive components of our business profile.

Turning to our TA Instruments products, this business was yet another highlight of the quarter, with 10% growth performance. As you may recall, TA launched a new thermal product line called the Discovery Series in the first quarter. While the timing of this launch may have had the effect of delaying new system orders in the first quarter, shipments of the new Discovery DSC benefited TA's growth in the second quarter. The new Discovery TGA system, which is often ordered along with the DSC, will begin to ship this quarter. These new products are being well-received by the market.

Finally, looking at the quarter geographically, we generally saw healthy trends around the globe. North American sales grew at a solid mid-single-digit rate, European sales grew at a low double-digit rate and Asian sales grew a high single-digit rate. Growth in the United States was highlighted by continued strong pharmaceutical demand, partially offset by lower governmental and academic spending. The second half of 2016 should benefit from a combination of new product launches, including our Xevo TQ-XS, our Vion IMS QTof and a new line of CORTECS Columns, as well as expected higher spending by governmental agencies in the coming months.

In Europe, we also saw strong pharmaceutical trends, while overall growth was augmented by better demand for service and mass spectrometry technology. In Western Europe, our business momentum continued smoothly despite the news surrounding the Brexit vote. At this point, it's premature to assess the longer-term effects of the UK's exit from the EU, and therefore our focus continues to be on our customer base and our business operations in the region.

Asia continues to be an area of geographical strength for Waters, highlighted by strong double-digit growth rates in China. And this is off an impressive prior year's performance. Our business in China benefited from strong pharmaceutical sector sales, good balance across end markets and strengthening recurring revenue sales. Our Waters business in Japan grew modestly in the quarter, with strong pharmaceutical sales offsetting a meaningful decline in governmentally funded research spending due to a recent shift of public money towards earthquake disaster relief.

In total, our first half of 2016 was strong, with revenues and profits trending ahead of our initial expectations. Business trends in the broadly defined biopharmaceutical customer base, our core business, suggest a continuation of stability from this end market in the second half of the year.

We have also effectively managed our spending year to date and created operating leverage that can be better seen with neutral currency dynamics, all while continuing to invest appropriately in new innovations and customer support to fuel our growth.

At the same time, we are investing time as a management team to think about the future and how we build on our success in our core business, as well as create new vectors of growth. As I've commented on before, we've embarked on a strategy development process that's providing a framework for ongoing business analysis and long-range planning. In this process, we are aiming to clearly articulate the unique strengths of Waters that have enabled us to generate superior long-term returns to build on these strengths and to ensure that we apply our differentiated skills to compelling new growth opportunities. I look forward to updating you on more specifics in 2017.

Before I turn the call over to Gene for more financial detail, I would simply like to comment how pleased I am with how the Waters team has performed since I began last September. Our leadership team as well as all of our employees throughout the world are focused and are executing. Personally, I continue to emphasize customer and employee engagement as I gain ever-increasing comfort with our unique business model and growth opportunities. The relationships I've established with key customers, my Waters colleagues and our board of directors have been very supportive and energizing. I am excited about our days ahead.

Now I'd like to pass the call over to Gene for a deeper review of the financials. Gene?

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

Well, thank you, Chris, and good morning. In the second quarter our revenues came in at $537 million, an increase of about 8.5%. The impact of currency translation in the quarter was neutral. Our non-GAAP earnings per diluted share in the second quarter were up 20% to $1.58 in comparison to earnings of $1.32 last year. On a GAAP basis our earnings were $1.57 as compared to $1.27 for the second quarter of last year.

The impact of foreign exchange increased second quarter earnings by about $0.06 and without this positive effect our non-GAAP earnings per diluted share would have grown by about 15%.

On the product front, Waters sales were up 8% while TA sales were up 10%. Breaking that down somewhat, LC and MS Instrument platform sales increased by 7% and TA's Instrumentation sales grew by 11% in the second quarter. Our total recurring revenues associated with both Waters and TA products grew by 10% with TA service revenue up 9%.

Looking at our growth rates in the second quarter geographically and before currency translation, U.S. sales were up 5%, Europe was up 12%, Japan up 3% and sales in Asia outside of Japan were also up 10%. Sales of Waters products were particularly strong in China and in Europe. TA product sales showed broad-based strength in the U.S., Japan and in Europe.

Now I'd like to comment on our second quarter's non-GAAP financial performance versus the prior year. Gross margins for the quarter came in at 58.9% versus 57.8% in the second quarter of last year. Year-to-date gross margin percentage is about equal to that of the first half of 2015.

Moving down the P&L, SG&A expenses were up 7% on a constant currency basis and 6% on a non-GAAP reported basis. R&D expenses, including those associated with new product development and incremental investments, grew about 10% in the quarter on a constant currency basis and were up about 7% on a reported basis, this primarily due to a weaker British pound.

On the tax front, our effective non-GAAP operating tax rate for the quarter was about 14%. In the quarter net interest expense was $6 million and our average share count came in at 81.5 million shares or approximately 1.9 million shares lower than in the second quarter of last year, this being a net result of our ongoing share repurchase program.

Turning now to the balance sheet, cash and short-term investments totaled $2.6 billion and debt was about $1.8 billion, bringing us to a net cash position of $843 million. As for second quarter share repurchases, we bought 565,000 shares of our common stock for $77 million. This leaves $275 million on our authorized share repurchase program.

We define free cash flow as cash from operations, less capital expenditures, plus non-cash tax benefits from stock-based compensation accounting and excluding unusual nonrecurring items.

In the second quarter of 2016, free cash flow came in at $136 million after funding $25 million of capital, and excluded from this amount is approximately $3 million of investments associated with facilities expansion.

Accounts receivable days outstanding stood at 76 days in the quarter, inventory levels about flat in comparison to the prior quarter, reflecting typical seasonal patterns.

Now I'd like to discuss our full-year 2016 guidance. Our outlook generally assumes the continued growth in biopharmaceutical end-markets, strong recurring revenue growth and relatively balanced performance across our instrumentation lines. We feel these dynamics support a 6% to 7% constant currency sales increase for the full year 2016. Currency translation at today's rates is expected to be about neutral to sales, again looking at the full-year.

Moving down the P&L, gross margins for the year are expected to be about equal to those in 2015 and come in at around 59%. We expect to manage our operating cash expenses to grow at a rate that's less than our sales growth.

Moving below the operating income line, net interest expense is expected to be approximately $27 million. We expect our full-year operating tax rate to come in at around 14%.

Looking at share buybacks, we plan to continue our share repurchase program through 2016 and at a rate that we expect will result in an average diluted share count of around 81 million shares outstanding.

Now rolling all this together, and again on a non-GAAP basis, full-year 2016 earnings per fully diluted share are now anticipated to be within a range of $6.45 to $6.60. Looking at the third quarter of 2016, we are estimating that sales will grow at a constant currency rate of around 6%. At today's rates, currency translation is expected to add about a half of a percentage point to sales growth in the third quarter. Rolling all these factors together, we anticipate our adjusted third quarter's earnings per diluted share to be in a range of $1.52 to $1.62.

And with that, I'll turn it back to Chris.

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Great. Thank you, Gene. And with that, we'll now open the phone lines for Q&A. We are rarely able to get to everyone's questions, so please limit yourself to one question and one follow-up. And if you have additional questions please contact our investor relations team after the call. And after the Q&A, I will add a few closing comments.

Liz, first question please.

Question-and-Answer Session

Operator

Thank you. Speakers, our first question comes from the line of Derik De Bruin from Bank of America Merrill Lynch. Sir, your line is open.

Derik De Bruin - Bank of America Merrill Lynch

Hi, good morning. Sorry about that. I had the mute on. Hey, congratulations on the quarter, very strong. Hey, just could you talk a little bit more about what you were seeing in the Japanese markets and some of the delays, I mean did that happen relatively late in the quarter, just curious on the dynamics in terms of some of the funding shifts?

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Sure, Derik, maybe I'll just provide a little introduction and then Gene can comment more. It's really a tale of two cities in Japan right now, the core pharma business as we commented has been pretty steady and it was pretty strong, but as we alluded to, there have been some domestic priorities within the Japanese government. And what we hope to believe is a temporary shift of government funding dollars, and therefore we saw a pretty significant fall off in our government business, which really had the effect of offsetting what was about flat growth around the rest of the world in that sector, but obviously brought Japan down to kind of the low single digits as we said. Gene, any more on that?

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

Well, the only thing that I would add to what Chris mentioned is that our TA Instruments group had a strong showing in Japan in the quarter, indicating that there is a hunger for new products there as well as funds to invest for new technology, and this is on the industrial side.

Derik De Bruin - Bank of America Merrill Lynch

And sticking with Japan for just a follow-up, could you remind us on your overall sales exposure there? And just sort of how the strengthening of the yen sort of will impact you?

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

Yeah. Well, the business in Japan has been around 8% of our overall revenues. And as you look at currency translation rates between last year and this year, we've seen 10% plus appreciation in the yen. And frankly, we have a very efficient operation there. So, we – our yen-based expenses are well under control. And so, when you see this kind of fluctuation in the value of the yen moving in the positive direction, there's a significantly positive flow through to our operating income line.

Derik De Bruin - Bank of America Merrill Lynch

Great. Thanks. I'll get back in the queue.

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

All right. Thank you, Derik.

Operator

Thank you. Our next question comes from the line of Tim Evans from Wells Fargo Securities. Sir, your line is open.

Tim C. Evans - Wells Fargo Securities LLC

Thank you. Would you mind talking a little bit about what the government-academic market looked like in the U.S. more specifically, maybe just drill down on that a little bit?

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Sure. Government and academic market in the U.S. was a little bit weak, I would – not nearly as weak as the Japanese market, I'd call it a slight decline and that was actually a little bit stronger than in the first quarter. As we commented, Tim, last quarter in our conference call we've really been looking to the second half of the year for the government and academic markets to be more robust and at this point in time, we hold with that assumption.

Tim C. Evans - Wells Fargo Securities LLC

Got it. Okay. That's very helpful. Thank you.

Operator

Thank you. Our next question comes from the line of Isaac Ro from Goldman Sachs. Sir, your line is open.

Isaac Ro - Goldman Sachs & Co.

Good morning. Thanks a bunch. Chris, just wondering if you could talk a little bit about the differences you saw in the growth rates within pharma between R&D labs versus QA, just trying to get a sense of what's driving the most upside in that customer group?

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Sure. Happy to address that, Isaac. The growth in pharma was pretty broad based and broad based in a few dimensions. First of all, when I look at it, I'm looking at small molecule, large molecule, bioanalysis. Those type of product segments if you will, we saw pretty reasonable growth. We saw a good balance geographically. We mentioned China, Japan, but obviously the U.S. and particularly Europe, which happens to be a pharma heavy market, was solid.

Our workhorse products are as you know, utilized mostly in late stage development and in routine testing applications and methods in the QC phase and that's really seen by the strength of the recurring revenues, particularly the consumables obviously and also the service piece, and so from the standpoint of QA versus R&D I would say, we remained consistently solid in the QA area and that's been a strong line for some time and it feels to me like we're probably doing better in R&D. And a lot of that has to do with broad trends in the marketplace that we see in terms of the increasing diversity of the types of molecules that are in the pipeline, more utilization of mass spec detection in some of those development efforts, which, as I mentioned in the prepared comments, we hope flow through to bio QC type of workflows. So we're really trying to get as granular as we possibly can to understand all the different segments of the pharma market and make sure that we're positioned well in all of them.

Isaac Ro - Goldman Sachs & Co.

Okay, great. And maybe just a longer-term question. You've been at the helm here coming up on a year pretty soon, and I think in the last couple of months you've started to talk a little bit more about ways to leverage the Waters portfolio into the rise in biologics and the whole concept that you could maybe help play a role in the QA process for that category of drugs. And curious if you have an updated view on how to do that. It's obviously a little bit of a straightforward situation with HPLC in small molecule, but I'm wondering if you have an updated view on how to monetize your technology in the large molecule arena? Thank you.

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Yeah. It's a good question, Isaac, and it's really a pretty core question as we look at our long-range planning, and maybe I'll stop short of saying too much because our – we're really right in the middle of lot of that work. But we are indeed, in our long-range planning, trying to break down some of these segments and ask the question what does it take to compete and what does it take to win in terms of the adoption of our technology in small molecule versus large molecule. And clearly, as you allude to, the biologics world is innovating at a pretty feverish pace, and some of our technologies, particularly some of our new integrated LC/MS workflows, appear to have some good traction and provide a nice opportunity to build a nice franchise in that area. And so obviously that's right in the heart of our core business, and it's going to be a strategic priority.

Isaac Ro - Goldman Sachs & Co.

Got it. Thank you.

Operator

Thank you. Our next question comes from the line of Tycho Peterson from JPMC. Sir, your line is open.

Tycho W. Peterson - JPMorgan Securities LLC

Hey, thanks. Chris, I'm wondering if you can elaborate on your comment that demand on the pharma side from large customers picked up this quarter? Obviously, you've done really well with smaller and specialty firms, but you did seem to go out of your way to emphasize growth in the large side.

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Yeah. No. Tycho, I guess what I was saying there is, as you know in previous quarters, at least the three prior quarters that I reported here, we saw probably a more stark difference between the smaller and specialty firms versus the traditional large customers, and I think we've always thought that's actually a strength, because it's a broadening portfolio of customers. We're not really reliant on the traditional large multinational type of big account customers as we may have been five or 10 years ago, and that's been a strength.

That said, other sectors have been stronger than the top customers. But we have seen in recent months and in the quarter, the bigger customers really come back a little bit and get more into that mid-single-digit growth range that I saw. So we were actually very pleased to see that, and I think that reflects trends that I see as I go out into the market and talk with customers, and as you know I'm out and about a lot, and particularly as you get into some of the larger traditional pharma companies, what I see is greater diversities within their own portfolios, chemical entities as well as biologic entities. And so I think that's what's driving it.

Tycho W. Peterson - JPMorgan Securities LLC

And then, on the industrial side, you had a nice pickup there, how much of that was a function of just new product cadence as you highlighted from TA versus end market demand there picking up a bit?

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Yeah, it's a good question. I mean, TA has been pretty solid and really had a good quarter, and I think that's very much a reflection of I'd say two things. First of all is the new products, the DSC and then, beginning to the market to TGA, even though that hasn't launched yet. We also had an easier comparison in Q2 versus Q1 in TA Instruments, but TA has been a very solid franchise for us, and while it can be a little bit lumpy from time to time as a reflection of those types of end markets, over time, TA has provided very consistent growth and profitability and returns for the company. And I'm very excited about TA. I've spent quite a bit of time on the TA franchise in – was just again there a few weeks ago, or earlier last week. And this Discovery series thermal instrumentation platform is going to unfold over the next year and I think should provide us with some good growth opportunities.

So, while TA was the headline, there were also some other sectors within our industrial end markets that were solid. I mentioned the food and environmental business, which is a very global business. In fact, more than half of that business is outside the United States. And some of the trends that we see in China and in other world markets on food continue to underscore the attractiveness of that end market for us.

Tycho W. Peterson - JPMorgan Securities LLC

Okay. Thank you.

Operator

Thank you. Our next question comes from the line of Jonathan Groberg from UBS. Sir, your line is open.

Jonathan Groberg - UBS Securities LLC

Great. Thanks a million and congratulations on a solid quarter. So, Chris, can you – maybe the – one number that maybe surprised me a little bit was the Europe being so much stronger relative to some of the other geographies, up 12%. Can you maybe just talk a little bit about what you – I know Europe isn't one geography, but maybe talk about what you're seeing in Europe? And then any early insights given your presence in the UK and just kind of what people are thinking about and kind of what's embedded in your expectations for the second half of Europe given the decision over there?

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Sure, sure, happy to comment a little on those things. Yeah, Europe was a really good quarter. As you know, Europe is pharma heavy, and we really saw a lot of strength in the recurring revenues there as well as solid instrument business, and so I think what we're seeing in Europe is just a reflection of what we're seeing more broadly on the pharma side.

As we look at the back half of the year, I tend to take at a look at the entire first half and not one quarter in particular, and while we're, I would say, optimistic generally on the pharma market, the – we're more cautious on the industrial and academic markets in Europe in general. So, I'd say, we have a balanced outlook for the back half of the year in Europe that we're really keying off of the overall first half experience.

As it relates to the UK, we're in a unique situation in England as well as in Europe broadly, with a big part of our mass spec footprint in the region, and by the way, don't forget that we also have significant operations in Ireland. So, we really have quite an opportunity to balance a number of considerations over time depending on how the exit plays out, depending on how currencies play out, depending on what trade barriers or trade agreements get struck, what type of tariffs ensue.

Obviously, it's way too early to make any calls. We don't expect the government to invoke Article 50 for some time, probably into early to mid-2017. There is a lot of posturing right now. The new government is just forming in England or in the UK and not really showing its hand. We've done some work with some smart people who are beginning to conceptualize a couple of different possible scenarios. But really it's a stay calm and carry on message in our organization. We've really pushed our team to just remain focused on what we do well and what we can control.

As you know, it's a good end market for us in the UK, less than 5%, but a good end market, that's pretty well balanced between pharma and academic at the top of the list. But we also have a meaningful amount of R&D in the UK and in Ireland, as well as product costs. So in the near-term, we're benefiting from some of the weaker currency. But again, it's a dynamic situation and I'm confident that no matter how it shakes out, we'll have avenues to continue to be successful in that region not just from a commercial standpoint, but also from an operational standpoint.

Jonathan Groberg - UBS Securities LLC

Thanks a lot for the color. And then maybe, Gene, just as a follow up, do you mind for the year, so for the growth rate of kind of 6% to 7% for the year, do you mind kind of – do you mind sharing geographically how you are thinking that's going to shake out now?

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

Yeah. Certainly on a qualitative level I'm happy to. I think that the strength that we've seen in the pharmaceutical end market looks like it has some sustainability. So thinking about the average growth rate for the company, I think it's realistic to think that the pharmaceutical sector will be at or slightly higher than that. We're a little bit more cautious on the government and academic. We're expecting that we'll see some improvements during the second half, but that still has to materialize. And, I would say that we're also a little bit more cautious on the industrial side.

So, looking at it from an end market point of view by application, I think we're most bullish on the continued strength of pharma, and a little bit more conservative on the public spending, and on the industrial side. Although, I think, for TA Instruments that will be a strong half given their new product flow.

Another way to look at our business is also looking at the instrumentation and the recurring revenue. We've had a very strong first half of 2016 on the recurring side, that segment of our business has historically been amenable to trending. So, envisioning that the recurring business will be at or slightly higher than the average growth rate I think is realistic. So, that's some color that I think might be helpful to you, Jon.

Jonathan Groberg - UBS Securities LLC

Great. Thanks.

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

Very welcome.

Operator

Thank you. Our next question comes from the line of Ross Muken from Evercore ISI. Sir, your line is open.

Ross Muken - Evercore ISI

Good morning, guys. Just going back on pharma CapEx or CapEx in general. I mean how would you kind of characterize this cycle versus prior and sort of where we are in that cycle?

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Ross, I'm going to defer to Gene on this to compare it to future cycles, but I want to just continue to emphasize that this market is not static and is dynamic and is developing and I think is quite different just feels to me, I – from all the data I see quite different from the past. And, I think, an interesting hypothesis and question is, is there less cyclicality, if you will in the market now, because of the increased diversity both geographically of the customer base, the type of firms, as well as the type of molecules that are comprising the world's pharma pipeline. And so, that's what we're obviously continuing to dig deep on, but maybe Gene can draw a broader historical perspective on this.

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

No, I – and Ross, you have lived through these cycles also, as you've covered the space. And as Chris mentioned, as we become less reliant on our top customers for a high percentage of our pharmaceutical sales, I think, there is a good argument to say that the cyclicality might not have quite as much of highs and lows to it.

If I look at our recent performance, we've considerably expanded our pharmaceutical footprint in Asia with both China and India performing strongly and then within the U.S. and Europe, the shift to more generic manufacturers and more specialty pharma, also take away some of those big cyclical swings that we've seen with prior replacement cycles or with a big activity on the M&A front. So, I think, I'm just echoing pretty much what Chris mentioned, but hopefully that's helpful.

Ross Muken - Evercore ISI

Well, I appreciate it. And just quickly, Gene, on the guidance from the original forecast, can you sort of breakout operational versus FX outperformance or differential?

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

Well, yes, I mean if I take a look at where we are year-to-date, so for the first half, we are still seeing a little bit of a drag from FX. If you recall on the first quarter call, we had about an $0.08 headwind that we dealt with from FX, and in the second quarter, we made up $0.06, so net, we're still $0.02 headwind for the half. Now, I think that we could easily see that go to neutral or slightly positive as we move into the second half.

I think one of the factors to consider is to look at currencies that are outside the majors. Obviously, we're benefiting from the stronger yen, but there are some secondary currencies that might provide us a little bit of headwind to do some offsetting and it's on that basis that we're thinking that for the full year, FX will be neutral to the top line and close to neutral, maybe a little bit positive on the EPS line. So frankly, this is the first year in many where you're able to see the true ability of the company to grow its top line and to get operational leverage without having to cut through all the noise that FX has historically provided us.

Ross Muken - Evercore ISI

Great. Thanks, Gene.

Operator

Thank you. Our next question comes from the line of Steve Beuchaw from Morgan Stanley. Sir, your line is open.

Stephen C. Beuchaw - Morgan Stanley & Co. LLC

Hi, good morning, everyone and thanks for the time here. Just one clarification and then one bigger picture question for Chris. First, Gene, I wonder if you could give us a sense for where the strength in TA is manifesting geographically just as we try to get back to an apples-to-apples view on geographic trends.

And then for Chris, within your thinking and the discussions around the strategic plan and what you want to present sounds like in 2017, can you give us any updated thoughts on what the binding constraints are, as you think about capital deployment? Are you confining these discussions and thoughts to smaller tuck-in deals? Are you confining them to accretive deals? Are you constraining any potential impact on margins? Any evolving thinking there would be very helpful. Thank you.

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

Okay. Well, first to say a little bit about the TA strength that we're seeing, I think it's very encouraging to see that we're seeing the most strength in our largest markets, including Europe, Japan and the United States. One of the things to consider as you begin to look at the TA business is the effect that we have not only from this new Discovery launch, but from all of the additional technologies, that TA has been adding in recent years.

In the quarter, we just got a little bit of tailwind from M&A. Right now, our guidance assumes that most of the growth that we have from TA will be organic, as we look at the second half of the year. So, clearly, the markets that are most receptive to new technologies and material characterization, the more developed markets, Europe, Japan, the U.S. are the ones that are showing the greatest promise, as they quickly adopt the new Discovery series. Was that – does that answer your question, Steve?

Stephen C. Beuchaw - Morgan Stanley & Co. LLC

On TA, yes, it does. Thanks, Gene.

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Yeah. Stephen, just on the strategy process, maybe a couple of additional comments, and certainly, it's been a very energizing process for the team to build on where we are today, to start think about a framework for the future, and one thing I remind everybody internally is as well as I'll remind you externally is that, it's a process, it's an ongoing process of continuing to refine our focus on what makes us unique and different, and how we win in the markets that we choose to play in with the emphasis on choice.

And, obviously the first question in any strategic plan needs to be a really granular characterization of what your core business is, and a plan to make sure we're maximizing our performance and our effectiveness in our core business. And then, obviously to look at things that we can uniquely offer to our other growth markets and gain scale in those markets.

As it relates to the question of capital deployment and any as you said, binding constraints, I think it's probably premature to comment on that. The priority is growth, of course, growth in revenue and growth in profits. And, we're going to look at the overall growth equation and frankly try to balance some long-term financial objectives to balance growth profitability, the right investments. And, of course, return on invested capital. Return on invested capital is a big priority for me.

As it relates to the role of M&A, I've been pretty clear before and I remain of the same mind that M&A is a tactic that we would employ only as a way to execute our business strategy. Our aim is to be primarily an organic innovator, and to not only retain but enhance our position as the industry's most vital organic innovator. We think that's the highest return on invested capital over time.

And, over time, the company has, I think made smart acquisitions, but it's been not a regular part of the business formula. And so, I don't see deviating all that much, although I think as we look forward, we want to make sure we're taking advantage of all means to achieve the goals that I outlined.

So, I think it's going to be a balanced and a pragmatic, and a disciplined and a responsible approach to capital allocation that is really all aimed at making us successful in our core business and very carefully building scale and other big opportunities that can grow over time.

Stephen C. Beuchaw - Morgan Stanley & Co. LLC

Thanks, guys.

Operator

Thank you. Our next question comes from the line of Sung Ji Nam from Avondale Partners. Sir, your line is open.

Sung Ji Nam - Avondale Partners LLC

Thanks for taking the question. So, Chris, maybe if you look at your instrument business, historically I think for the developed markets, a lot of the growth was driven the replacement cycle of your install base. I was curious as to if you might be able to assess where that might be, or do you think there is a significant driver coming from further market expansion?

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Sure, it's a fair question, Sung Ji, and we do have a healthy replacement cycle. Obviously in our core routine methods, there is a natural replacement cycle. I wouldn't say there is anything out of ordinary right now in terms of where we're at. At the same time, we do look to expand our technology into new work flows earlier in the development process, and geographically as more companies get in the game, particularly in some of the emerging markets. So I think we're trying to achieve as balanced as possible an overall portfolio of where our instrument platforms are used and, as we said in the call, also try to be very innovative, and in and the example I used in the call, continuing to emphasize the use of mass detection as a supplement to traditional optical and UV detection in chromatography workflows. We think that has a lot of value to our customers, particularly in some of the more complex larger molecule and bio type of applications, and we look forward to that playing through into more and more routine methods all the way through QC over time. And so that tends to be our focus, and obviously balance our instrument business with a very sharp focus on our chemistry consumables and our service offering.

Sung Ji Nam - Avondale Partners LLC

Okay. And then on the operating leverage side, one of the questions I get a lot is whether there's further headroom for you guys in terms of improving on that. And so, it seems like there are some initiatives underway and was curious as to what the additional levers are and what you guys are actually working on? Thanks.

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Sure. No, that's a fair question. And I think, as Gene stated, now that we're in somewhat more of a neutral currency environment and you're seeing our top line work, you are seeing our desired model for operating leverage, which is first and foremost driven by volume and growth, but also consistent discipline around many levers if you will, up and down the P&L.

In a broad sense, I would say, my goals are to continue to be a premier top line grower on this regard, maintain our price discipline, continue to look for mix opportunities, absorbing our cost with volume and also getting leverage out of our G&A, and ability to scale our sales and marketing efforts, while at the same time making sure we're investing enough and healthily in innovation. We've gradually ticked up our investment in R&D. And I would like to continue to do that as long as I'm convinced that we're getting high productivity out of R&D and spending a lot of time on portfolio management right now in that regard. And I am confident that we're getting good productivity out of our R&D. And so that's an area of investment that we feel we can pay for with a number of other levers over time. And to ideally achieve that optimal mix between growth and modest leverage while continuing to invest to grow. So that's the framework, that's the ideas and we'll put more specifics on that as we move forward.

Sung Ji Nam - Avondale Partners LLC

Great. Thank you.

Operator

Thank you. Our next question comes from the line of Bryan Brokmeier from Cantor Fitzgerald. Sir, your line is open.

Bryan Brokmeier - Cantor Fitzgerald Securities

Hi. Good morning. What percentage of your costs are in British pounds? And are there geographies where you generally have a stronger mass spec business that may be more positively impacted by the pound?

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Yeah. I mean, just maybe I'll start off and Gene can develop it. Right now, we have somewhere between a quarter and a third of our R&D expenses out of our UK facility, and about 15% of our COGS. And so, those are expenses that are obviously well ahead of our revenue concentration in those markets. And so obviously, while the UK is a good commercial market for us, it's really an even more important operational center.

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

I think you said it well, Chris. I would just say that, as you begin to think about currency moves, our ability to sell high-end mass spectrometry into Japan at this time would be a positive for us because we'd be leveraging the strength of the yen and the weakness of the pound.

Bryan Brokmeier - Cantor Fitzgerald Securities

Okay. And besides the weakness in Japan and the slight decline in the U.S., is the academic market weak across the board? And besides improvement in the U.S. in the back half of the year, what other geographical trends are you anticipating? In the academic market specifically.

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

Well, there are some developing markets that tend to be lumpy, that showed some positive growth in the quarter. Bryan, I would just remind you that much of our academic business is centered on research mass spectrometry workflows. So the business tends to be a little bit lumpy, and it tends to be somewhat dependent on our new product launches. So we're very encouraged by what our pipeline looks like from some recently introduced research mass spectrometry programs. And hopefully when we're talking to you about the third and fourth quarters of this year, we can talk about some nice pickup of these research platforms in the public sector.

Bryan Brokmeier - Cantor Fitzgerald Securities

Okay. Thank you very much.

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

You're welcome.

Operator

Thank you. Our next question comes from Amanda Murphy from William Blair. Ma'am, your line is open.

Amanda L. Murphy - William Blair & Co. LLC

Hi, good morning. I just actually had one on the consumables side. So the launch of the CORTECS Columns, it seems like that's been quite successful for you. I was curious as you look at the growth in consumables this quarter or generally over the year so far, how much of it's driven by some of these newer proprietary products that you've launched and general mix shift towards the higher attach rate instruments versus just kind of per instrument increases? I was curious about that.

And then, also, kind of I think you talked a little bit about this, but going forward, what's the opportunity for you on the consumable side in terms of proprietary products?

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Sure. Maybe just I'll start and Gene can add to it. I would say that the current performance is a lot more driven by the second thing you said, Amanda, in terms of kind of a gradual mix shift in our install base towards higher utilization platforms. As you know, our ACQUITY platform, our UPLC platform has a higher attach rate than our legacy HPLC systems; and so, as UPLC continues to gradually grow in its presence in the marketplace, that provides us with a nice opportunity on the consumable side.

I think new products like the CORTECS are still quite early in their phase of adoption, and so there is not necessarily a big tailwind that we're getting from that in the immediate time. But obviously that type of innovation with solid-core technology and the efficiency gains in – across a number of different workflows is a really attractive offering to the market. And we expect to add to our competitive advantage.

Obviously, we have a large portfolio of consumables in chromatography and as you allude to, an increasing presence and interest in kits, like the glycan kits I referred to earlier, like ProteinWorks and some other specialty applications, where we think we can do even more. So, we really like this part of the business, we think we're competitively differentiated on the chemistry side with a significant chemistry expertise at our core. And we're only continuing to increase the emphasis of those development efforts.

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

The thing that I would add to that is, I think, Chris did an excellent job in describing some of the product trends that we're seeing on the consumable side. But as you begin to look at the consumable growth and also look at the service growth, those two statistics are compatible with higher utilization rates of our instrumentation and also the increased number of – the increased installed base in some of our larger Asian markets where we have over a number of quarters exhibited strong double digit growth rates and these growth rates represent significant increases in the installed base, which in turn drive not only the consumables business as Chris noted, but also the service business.

Amanda L. Murphy - William Blair & Co. LLC

Got it. Thanks very much.

Operator

Thank you. Our next question comes from the line of Dan Arias from Citigroup. Sir, your line is open.

Daniel Arias - Citigroup Global Markets, Inc. (Broker)

Hi, good morning. Thanks for the question. Maybe just one for me on forecasting and how the inter-quarter dynamics are playing out for you guys these days. Gene, are you finding that as the business has evolved that there has been any change to the pacing of the orders such that the back-end loading in the last couple of weeks is not as heavy as it used to be or is it kind of the way that it's always been in that respect?

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

That's a good question, Dan, and you know in recent quarters, we've noted that with the recurring revenue growth being so strong and with the linear type of ordering in sales patterns that you see for the recurring revenue. One of the effects there has been to take that hockey stick dynamic that we see with capital purchases that is at the end of a quarter and maybe make it less of a sharp curve. I think that the quarters where we tend to see more of the quarter end pick up are in the first quarter when people are waiting for budgets to be released and then in the fourth quarter when people are making sure that they use their calendar budget before the New Year starts. I can tell you that last year that fourth quarter hockey stick was just a little bit more tempered than it has been in prior years and another dynamic is just the increasing component of our business in Asia, where just historically, this sort of ordering and selling pattern was not as pronounced as it had been in Western Europe and North America.

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

Thanks, Dan. I think we have time for one more question, Liz.

Operator

All right. Thank you. Our next question comes from the line of Steve Willoughby from Cleveland Research. Sir, your line is open.

Steve B. Willoughby - Cleveland Research Co. LLC

Good morning and thanks for taking my question. I just have a follow up and then one quick question for Chris. First off for the follow-up for Gene, Gene to some of your other comments regarding the movement of the yen and your exposure to the pound, I'm surprised that you're not expecting an even larger positive impact from the changes in FX, given your manufacturing R&D exposure in the pound that has moved in the past four weeks or so. So I'm just wondering if you could – given that you benefited from FX by $0.06 here in the quarter, the pound really didn't move until the end of your second quarter, I would have thought that the FX impact would be even larger in the second half of the year. Then I have just one quick follow up for Chris.

Eugene Gene Cassis - Senior Vice President & Chief Financial Officer

Well, there – we did have a $0.06 benefit in the quarter for FX but we did assume that we would have a little bit of benefit. So that was the total. So, the guidance did make the assumption that we would not have the same currency dynamics as we had in the first quarter. So, as I begin to look at the second half of the year, and look at the total effects of currencies, not only the majors but also some of the secondary currencies, I think that envisioning that we can get someplace $0.05 to $0.07 during the second half of the year on FX. If everything stays relatively constant, in terms of the geographic and product distribution of our business, I think that's probably a ballpark estimate that's reasonable and assumed in the guidance that we provided.

Steve B. Willoughby - Cleveland Research Co. LLC

Okay. Thanks very much. And then, for Chris or Gene, I think you sort of alluded to this, Chris, a bit with some of your – you're working on longer-term strategic planning. But just wondering if you had any thoughts or comments as it relates to, you guys are continuing to post pretty strong free cash flow and you obviously have quite a bit of net cash on the balance sheet. So, I'm just wondering, do you have any thoughts on potentially stepping up the share repurchase program that you guys have been doing historically?

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

I think, Steve, that's a fair question, just as it relates to overall capital allocation, and we'll take your compliment that we are generating a lot of very strong free cash flow right now. Obviously, one of the challenges we have is where that cash is located relative to the ability to use it for kind of U.S. purposes, like share repurchase. I think we have a very well-established share repurchase program. We return a significant portion of that free cash flow to shareholders. I think at the – at a leading level in the industry, and so, really for the foreseeable future we expect to continue that practice and obviously, any adaptation to that over time would be carefully thought through and discussed.

So, the question of capital allocation is a fair question. It goes part and parcel with our strategic outlook, and as we get further down the line, we'll put more specifics on all that. But thanks for the question, appreciate it and look forward to the continuing dialogue.

Christopher James O'Connell - President, Chief Executive Officer and Member - Board of Directors

So, with that, maybe, Liz, thanks and I'll move to some closing comments to close the call. So really to conclude, as we move into the second half of the year, and begin to broaden our focus to 2017 and beyond, we are encouraged as we commented today by our first half performance. We're encouraged by the condition of our key end markets as well as by the strength of our product positions. All that said, we do live in a dynamic world and will continue to balance our optimism with a business plan that can adapt unforeseen changes in market conditions, so that we can continue to deliver reliable financial results.

So on behalf of the entire management team, I'd like to thank you for your continued support and interest in Waters. We look forward to updating you on our progress during our Q3 2016 call, which we currently anticipate holding on October 25, 2016. Thank you very much, and have a great day.

Operator

And, that concludes today's conference. Thank you all for participating. You may now disconnect.

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