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Waters Corp. (NYSE:WAT)

Q2 FY08 Earnings Call

July 22, 2008, 8:30 AM ET

Executives

Douglas A. Berthiaume - Chairman, President and CEO

John Ornell - VP, Finance and Administration and CFO

Analysts

Ross Muken - Deutsche Bank

Quintin Lai - Robert W. Baird

Doug Schenkel - Cowen & Company

Tycho Peterson - JPMorgan

Derik deBruin - UBS

Isaac Ro - Leerink Swann

John Groberg - Merrill Lynch

Operator

Operator

Good morning. Welcome to the Waters Corporation's Second Quarter 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 any 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 - Chairman, President and Chief Executive Officer

Thank you. And good morning and welcome to this Waters Corporation's second quarter financial results conference call. With me on today's call is John Ornell, the company's Chief Financial Officer and as is our normal practice, I'm going to start with an overview of the quarter's highlights, and John will follow with details on our financial results and then provide you with our outlook for the second half of the year.

But before we get going, I'll like John to cover the cautionary language, please.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

During the course of this conference call, we will make various forward-looking statements regarding future events or future financial performance of the company. In particular, we will provide guidance regarding possible future income statement results of the company, this time for Q3 and full year 2008. 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 31st, 2007 in Part-1 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 October 2008. During this call we will be referring to certain non-GAAP financial measures for reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measure is attached to the company's earnings release issued this morning. In our discussion of the results of operations we may refer to pro-forma results which include the impact of purchased intangible amortization and retirement plan, transition changes, and prior period adjustments.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Thank you, John. Our financial results for the first half of 2008 I think truly highlight the strength of Waters business model. With are technologically focused and yet market diversified in global strategy, we've demonstrated an ability to prosper in a very tight spending environment, maybe the toughest conditions that we've seen in our industry in recent years.

Through the first half of '08, we've grown our sales volume by 13%, our adjusted earnings by 24%, and generated exceptional free cash flow. Needless to say, I'm pleased with our first half performance, and I am encouraged that 2008 will be another successful year for us.

If you look at the recently completed second quarter results, we experienced a continuation of the trends that we saw here in the first quarter, accompanied by some improvements that we had noted were already materializing when last we spoke. Our business in Europe improved as some delayed capital budgets were released early in the second quarter. And globally, our chemical product sales rebounded from the weakness in the first quarter that was primarily associated with fewer selling days.

Generally speaking, the key drivers of sales growth in the second quarter were strong demand from developing markets in Asia, continued expansion of our industrial businesses, and another impressive quarter for our TA instruments division.

Overall, there were few surprises in the quarter. Demand from our pharmaceutical customers, which is a market segment that's been under pressure, was in line with our expectations and was just about flat with the prior year's results. On the other hand, our industrial, chemical, food testing and environment testing segments also had double-digit increases in sales.

And it's interesting to note that the general economic concerns that we are all hearing about in the news are not reflected in the demand that we're seeing from chemical producers. For the Waters Division, instrumentation sales growth was pretty evenly balanced between chromatography and mass spectrometry.

ACQUITY UPLC and Tandem Quadrupole MS systems were faster growers, especially outside the classical pharmaceutical applications. Interest in Synapt based systems continues to be strong, primarily for life science applications, such as proteomics and metabolite identifications. And we anticipate a strong second half for these systems.

Sales growth from our recurring revenue products, including service and chemical consumables positively impacted the quarter's results, as ordering rates for our chromatography columns and sample prep devices rebounded to more typical low double digit rates.

Geographically the US and Western Europe were positively effected by strong chemical analysis demand, offsetting weak sales from large pharmaceutical accounts. It's important to note that pharmaceutical sales were particularly strong in the second quarter of 2007, and that this year's second quarter results to our largest pharmaceutical accounts were sequentially higher than in the first quarter this year.

Asia, ex Japan, continued to see strong double-digit sales growth, with all major markets growing nicely. In Japan, we saw an expected modest improvement in our business, due primarily to industrial demand for our new products. On the new product front, I'm pleased to tell you that we enjoyed a very exciting ASMS this year, as we showcase significant new chromatography in mass spectrometry techniques.

Highlights include our new Xevo Tandem Quadrupole Mass Spectrometers and a preview of our TRIZAIC microfluidic trial base UPLC platform. The Xevo system offers researchers new levels of performance and convenience not before brought together in a tandem Quadrupole system. Incorporating features that enable rapid instrument setup, a new performance optimized ion source and a proprietary scan wave feature for enhanced qualitative analysis. The Xevo defines a new category of tandem Quadrupole systems. And we plan initial customer shipments of Xevo this quarter, and I'm pleased to tell you that interest in this new system is very encouraging.

TRIZAIC is the new UPLC platform, offering nanoACQUITY chromatographic performance and microfluidic tile format. It's an industry first, TRIZAIC delivers the separation capabilities derived from small particle i.e. ACQUITY packing materials including high-efficiency and fast chromatography and a compact and easy-to-use consumable that's designed to seamlessly integrate with our CINAPS [ph] and Xevo mass spectrometers. TRIZAIC is different from chip-based chromatography platform and that it's compatible with small particle packing materials and the results pressure is that these particles generate.

We plan to begin shipment of integrated TRIZAIC MS systems next year. Our TA Instruments division delivered another stellar performance in the second quarter. The division saw a balanced growth geographically and benefited from initial shipment of the performance leading ARES-G2 rheometer that was introduced at the Pittsburgh Conference. TAs prospects for the second half of 2008 looks strong, as we anticipate a continuous ramp in demand for our new products, including the ARES-G2 and microcalorimetry systems from recent TA acquisition.

Over the past few years, TA has demonstrated an ability to rapidly and successfully integrate new instrument technologies into its product line. Given this track record, we will continuously look to acquire new product lines and technologies to accelerate the expansion of TA's business, and we will share more information on this front in the near future. John will walk you through the P&L in some detail; however, I would like to point out that we have continued to improve our operational efficiency through product cost reduction programs and expense management. These improvements in combination with our share repurchases have led to superior profitability and faster earnings growth.

Through the first half of 2008, we have delivered a record level of free cash flow of more than a $190 million. The period cash flow provides us with a flexibility to further enhance the value of our company, through accretive acquisition, share repurchases or the retirement debt. Looking towards the second half of 2008 and into 2009, I'm encouraged that we'll be able to maintain the momentum that has benefited us for the first six months of '08. So we expect global economic conditions are unlikely to improve in the near term.

We feel that our strong product position, the continuing expansion of our businesses in the developing world and the sustainability of our recurring revenues in total position us very favorably for the future. However, understanding the economic and political uncertainties that all companies are facing in the coming quarters, we will remain cautious in our financial outlook and will pursue a balanced strategy that will involve the continued commercialzation of our new instrument systems and technologies with a careful eye to growing profitability and maintaining a high level of cash generation.

With that, I would now like to turn it over to John.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

Thank you, Doug, and good morning. Second quarter results delivered 13% sales growth and 27% growth in non-GAAP earnings per diluted share. Earnings per share were $0.76 this quarter, compared to $0.60 last year. On a GAAP basis, our earnings were $0.82 this quarter, compared to $0.59 last year. A reconciliation of our GAAP to non-GAAP earnings is included in our press release issued this morning.

Included in our income statement this quarter is an $0.08 EPS benefit related to a cumulative adjustment of prior periods. For several years, we have been capitalizing and amortizing software development costs on our US books [ph] and tax affect the net income statement impact of these items at US tax rates. We recently realized that because of all of the economic rights to this capitalized software reside in one of our Irish subsidiaries, we should have tax affected their net impact at Irish tax rates. Across a 10-year period, the cumulative impact of this overcharge is $0.14.

Additionally because these capitalized software amounts were accounted for as a US asset, it was not amortized in appreciated euros across the same time frame, which resulted in understating our cost of sales by $0.06. The net impact of this correction is then an increased earnings this quarter of $0.08. These amounts are immaterial to all prior periods and, therefore, have been recorded as a prior period adjustment this quarter. On a going forward basis, the impact of this change will be a decrease in our tax rate this year of nearly 1% and an increase in cost of sales that will reduce our gross margin by nearly 25 basis points. The net P&L impact for 2008 is essentially neutral.

Turning now to our operational performance for Q2; sales grew by 13% this quarter with currency providing 6 percentage points of growth. Looking at corporate sales growth regionally and before foreign exchange effects, sales in the US were up 6% this quarter and within Europe, sales were up 3%. Sales within Japan remained somewhat soft and were down by 6% and sales in Asia outside of Japan remained strong and were up 22%.

Turning to the product front, within the Waters division, Instrument systems grew by 3% against a very strong base of comparison. Our service business grew by 11% and chemistry had 11% growth as well. Our TA Instruments division had another strong quarter with sales up 15% versus prior year, resulting from strong new product sales.

Now I would like to comment on non-GAAP margins and expenses, excluding the items noted in this morning's press release. Gross margin remained strong this quarter and came in at 58.2%. Versus prior year, margins expanded by about 140 basis points. We continue to benefit from product cost reductions, favorable product mix and currency translation. SG&A expenses grew by about 10% this quarter compared to prior year, and were heavily influenced by currency translation.

R& D expenses grew by 16% as new product introduction costs raised our spending somewhat this quarter. We currently expect our full year effective tax rate to be about 17.5%. To adjust year-to-date taxes within the second quarter, our Q2 tax rate is 16.9%. The decline in our full year effective rate is principally the result of the capitalized software adjustment I previously described. On the stock buyback front, we continue to repurchase our shares in the open market, and during the second quarter we purchased 1.25 million shares of our common stock for $77.6 million. Fully diluted average share count was 101 million shares for the quarter.

On the balance sheet, cash and short-term investments totaled $831 million, and debt totaled $984 million, bringing us to a net debt position of about $153 million.

We measure free cash flow as cash from operations less capital expenditures, plus any non-cash tax benefit from FAS 123R accounting and excluding unusual nonrecurring items. For the quarter, free cash flow was $89 million after funding $18 million of CapEx. Comparable free cash flow in Q2 last year was $91 million, and for the first half of 2008 our free cash flow is up 12%.

Accounts receivable days sales outstanding stood at 71 days this quarter, equal to Q1 last year. And without currency effects, DSO improved by about three days versus prior year.

Inventories increased about $10 million this quarter with currency translation comprising $3 million of the increase.

Now, I would like to turn to our outlook for the remainder of 2008. Our second quarter sales results were in line with our prior expectations, and we believe the current business conditions remain comparable to those we assessed last quarter. Therefore, we continue to believe that we will be able to deliver sales growth in the range of 6% to 8% before currency effects. Currency at today's levels should add about 5% to growth this year bringing our overall growth to 11% to 13%.

Moving down to P&L; for the full year, we expect gross margins to improve by about 120 basis points, as a result of improved production efficiencies on higher production volumes, favorable mass spec sales mix, product cost reductions and continued favorable foreign currency translation effects.

Operating expenses are expected to grow at a rate above/equal to sales. We will moderate our spending on additional resources to keep our expense growth aligned with actual sales volumes. We expect our tax rate to be about 17.5% for the remainder of 2008, incorporating a lower tax rate on capitalized software costs.

Net interest expense is expected to be in the neighborhood of $20 million.

And our fully diluted average shares outstanding are currently estimated to be about 101 million shares for the full year.

Rolling all of this together, we currently expect non-GAAP earnings for fully diluted share to be in the range of $3.25 to $3.35 per share, where sales growth is between 11% and 13%. For Q3 we expect sales growth of 11% to 12%. Gross margins should continue to see significant improvements versus prior year. And operating expenses are expected to grow at a rate comparable to sales.

Earnings per fully diluted share are expected to be between $0.73 and $0.77 for the third quarter. Doug.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Thank you, John. And operator, I think at this point we could open it up for Q&A.

QUESTION AND ANSWER

Operator

Thank you. [Operator Instructions]. Your first question comes from Ross Muken with Deutsche Bank.

Ross Muken - Deutsche Bank

Good morning, gentlemen. Congratulations on a good quarter.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Thank you.

Ross Muken - Deutsche Bank

I wanted to talk about the developing market, specifically China. There was a recent GDP report that was slightly below trend over the last several quarters. And you guys obviously had really nice growth this quarter, 20% plus. Are you seeing any sort of slacking of demand there and where would you characterize the different pockets of strength or weakness within that market?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Russ, we're seeing -- I'd say we've seeing remarkably consistent demand from China for a while now. In the second quarter, there was remarkably no change from the last several quarters. Actually, in China, I'd say it's a pretty balanced mix across our typical applications, including pharmaceutical.

But I would say the strongest areas continue to be in what we classify as industrial applications, environmental, food and beverage are particularly strong, and food and beverage, it's both in quality evaluation and in regulated export type of applications.

A lot of soft drink applications growing in ample, Southeast Asia marketplace, so I'd say it's -- and that's what we've seen consistently. I'd say it didn't particularly move in the most recent quarter.

Ross Muken - Deutsche Bank

And, you know, as we look to the consumable piece of the business, you saw a nice rebound off of Q1 levels. Can you talk about sort of the differential there? Was there any impact from more selling days in the quarter or was that just purely sort of demand related making up for some of the weakness we saw in Q1?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

We think that the weakness that we saw in the first quarter was largely due to calendar items, the timing of Easter and the way the yearend fell versus the way the first quarter ended, losing a couple of selling days on top of Easter. It might have been just a smidge of formal weakness that creeps in there, but by far we thought it was calendar items.

And, in fact, the second quarter largely returned to our traditional low double-digit growth rates across those product lines. So we're pretty confident that the first quarter was the anomaly and that our business in that area is pretty predictable going forward at this current rate.

Ross Muken - Deutsche Bank

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

Operator

Quintin Lai with Robert W. Baird.

Quintin Lai - Robert W. Baird

Hi. Good morning. Congratulations on nice quarter as well.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Thank you, Quintin.

Quintin Lai - Robert W. Baird

With respect to the European, I guess return to spending from some of your big pharmaceutical customers, did you see just a gradual increase or did you see kind of a make up from Q1 and Q2? And can you talk a little bit about, you know, do you see -- is it drug discovery, is it moving to CROs or any kind of color on that return?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Yeah, I wouldn't have you believe that Europe is all that different from what we're experiencing across the pharmaceutical marketplace. We did see -- because we saw some specific orders that we thought were delayed in the first quarter. We did pick those up in the second quarter, so that, you know, helps us believe that our sales intelligence is working. But overall, I'd say the Euro phrama market is pretty consistent with the US pharma market and that's very cautious.

Quintin Lai - Robert W. Baird

And then, with respect to gross margin, I think that as input prices -- input costs seem to be going up, like steel, copper, resin costs, you've been able to still, in fact, if anything, increase your gross margin expansion expectations.

So tell us a little bit about how you are dealing with the cost of the input prices for you and what is the pricing environment for your products to be able to pass that through to your customers? If you need to.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

I think it's a very fair question. I would say we're seeing some pockets of strength in producer pricing and, you know, certainly in the freight area, anything that requires fuel, we're certainly hearing rumblings and we've seen some real increases. In some areas, where we deal with some reasonably rare metals in our products, we're seeing some movement to higher pricing.

But it represents a relatively small part of the overall inputs to our product line. And I would say what you're seeing is the continual focus on driving improved processes to the ACUITY product line, to a lesser extent on a number of our other product lines.

But also the fact that as our new mass spec products come online, they're inherently better margins and as they take up a better overall level of the sales volume, that's what here John referred to as product mix, a lot of that is happening in our product line as these. As we drive efficiency through the plants, we're getting just a better, you know, gross margin mix of the existing sales volume.

So that's -- we've been talking about that with ACUITY. We continue to focus on it, that when we introduced it, it's at a high point in its cost structure and we continuously move that along and that's really what you're seeing, combined with some benefit from the foreign exchange -- you know, the weakness in the dollar.

Quintin Lai - Robert W. Baird.

Thank you for that. And then last question and I'll jump back in the queue, for the second half of this year, your tax rate assumption, so should we just assume kind of that 18.5 or 18.6 range?

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

No. As we go through the second half, we're currently expecting about a 17.5% rate, Quintin. And that incorporates the going forward effect of the cap software. So that's offset by a slightly higher cost of sale associated with higher amortization costs, the FX piece of the amortization costs. So 17.5% rate for us now is the rate we expect to see for the future.

Quintin Lai - Robert W. Baird.

I see, so what we saw here in this quarter continues on for the next couple of quarters, then?

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

Yes, yes.

Quintin Lai - Robert W. Baird.

Okay. And then when does that anniversary, then, Q1 of next year?

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

Well I mean next year we'll have to reassess again what the rate will be just given the mix of income across legal entities. But until the situation changes with cap software and perhaps there's a different mix of how much is being capitalized versus amortized, the 17.5% rate is likely to stay at least for the next couple of quarters or perhaps a longer.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Yes. As we look at next year for that the effect of cap software in and of itself, we don't think that's going to be a significant dynamic in moving that 17.5% tax rate.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

Correct.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

So, if everything works out in our plan, and you know, tax rates are not the easiest thing as we're seeing to forecast, all other things being equal, we'd expect it to be around the 17.5% next year, also.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

That's right.

Quintin Lai - Robert W. Baird.

Okay. Thanks.

Operator

Doug Schenkel with Cowen & Company

Doug Schenkel - Cowen & Company

Hi. Good morning. And thanks for taking my questions.

Doug Schenkel - Cowen & Company

Good morning.

Doug Schenkel - Cowen & Company

In a seemingly tough raw material environment, you increased your expected year-over-year full year gross margin improvement from 100 basis points to 120 basis points. You pointed to mass spec as one driver to why you expect the gross margins to improve year-over-year. Does this imply anything about changes in end market dynamics or your market share expectations for the full year?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

No, not really. I mean, you know, we think it's a tough marketplace out there and we think we've got new -- good new products, so I wouldn't shy away from saying we think we are doing better than many others in the marketplace. But I think the margin dynamics just are kind of as we explained it, foreign exchange is better, the efficiencies in our existing product lines are better.

And as we've introduced in the mass spec area, you know, with the new products came in with a better cost configuration than the old products and we didn't have to trade down on price, so we just have the better gross margin dynamic as they take up a bigger share of our mass spec volume. So that's really what's happening there.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

And as Doug explained earlier, you know, the impact of commodity pricing really hasn't come through in our cost of sales in a big way. So I'm certain in other environments or other companies that is much larger issue, but for us, it's just isn't right now.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

The reason, how that affects our business is to factor in why we are cautious in getting more exuberant about the potentials to grow faster, we think the cost dynamics may affect our customers a little bit more than they affect us, and that's why we continue to look a little more cautiously at our top line growth, but we don't think it's going to have a material impact. It does have an impact, you know, we do have a lot of travel costs, our sales force travels and so we've factored that into our budget estimates, but we think it's in there at a reasonable level.

Doug Schenkel - Cowen & Company

Okay, that is helpful. And then maybe another guidance question. Could I just confirm that there were no changes in your year-over-year expectations for pharma demand incorporated in to your new guidance? And as a follow up to that, keeping in mind the recent announcements from Roche-Genentech to have a bar, can you talk about how consolidation in big pharma and biotech may impact demand and pricing moving forward?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

I think in general the level of potential consolidation going on in big pharma isn't as material as it was, you know, when Pfizer bought Pharmacia or Warner Lambert or when Glaxo bought Wellcome and others. So I think the level that we're looking about well, could influence those companies in their…their investments. You know Roche owned half of Genentech anyway. I don't think it's likely to have a huge impact there.

So, you know, overall, I'm not feeling all that bad about what's likely to happen on that score, but we're forecasting the second half to be conditions along the lines of what we're seeing now. We're not expecting a robust improvement in the pharmaceutical world.

I would tell you that some of the pharmaceutical accounts are talking about a better second half, but they have delayed investments and that they think they'll be investing in the second half. I can also tell you we're not taking a significant amount of that to the bank in our forecast. So if it happens, I think we'll benefit from it, but it's… I think it's still a tough environment for those larger pharmaceutical accounts.

Doug Schenkel - Cowen & Company

Great. And if I could just ask one more question and then I'll get back in the queue. You talked about strong indications in terms of demand for Xevo. Could you share anything in terms of which end markets have been… in which end markets were you seeing the strongest interest?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Interestingly enough, as you probably know, our market share in the Quantitative Bioanalysis segment isn't that great, hasn't been for the last, five or six years for a number of reasons. Some restructuring on the part of some competitors. I think a lot of those traditional accounts have started looking at alternate suppliers.

So we're seeing a great deal of interest in some of those traditional pharmaceutical markets, about Xevo in particular, and I think, you know, some of it's just being careful on their part, and I won't say that we are seeing a lot of that manifest itself in real business yet, but it's an encouraging sign.

Sailing [ph] that its Xevo basically now operates… incorporates some significant qualitative features into what traditionally has been a more quantitative set of customer applications. We're seeing interest in the academic world, in the governmental world, as well as in our classical applied markets in food and beverage and environmental.

So it's encouraging, but I think it will be another couple of quarters before we can really point to tangible business that I can report, yeah, we think we've taken some share here.

Doug Schenkel - Cowen & Company

Great. Well, thanks again for taking all the questions.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

You're welcome.

Operator

Tycho Peterson with JPMorgan.

Tycho Peterson - JPMorgan

Hi, thanks for taking my question. Maybe just actually asking Doug's earlier question in another way on the competitive front, are you seeing anything meaningful in terms of share shift, in terms of, you know, competitive bid activity picking up or anything out of the ordinary?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

You mean specifically in pharma or --

Tycho Peterson - JPMorgan

Yes. Both pharma and academics, so…

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

I would not say anything on the competitive front, Tycho, that's of real note. I would say just in the pharma world, as I said, we're seeing customers that say they want and need instrumentation, but they have delayed. I can say in one or two cases as we've gone into the third quarter, early on we've seen some of that business fall in.

But I wouldn't say that it's… it reflects a big difference in what those accounts are doing competitively or they're looking for more quotes. My anecdotes on the triple quad side are just that, anecdotes and, as I say, I think we'll have to see that play out over the next six months.

Tycho Peterson - JPMorgan

Okay. And then with regards to the carry over from last quarter, you had some orders that got pushed through and then the Easter impact, could you just quantify the impact of what that was and then also, the margin contribution this quarter from FX mix and cost reduction.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Well, I think the calendar effect was largely on our consumables and service side of the business, and that… all in that business went from about 7%, I think, growth in the first quarter to low double-digits in the second quarter. So…and low double digits is what we always kind of expect out of that business because it's very reliable and predictable, and so we thought 2 to 3 points kind of was the effect on that consumables business in the first quarter.

Tycho Peterson - JPMorgan

Yeah.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

It's much tougher call. We intuitively thought there was some effect on the Instrument side, but not as quantifiable and it's a lumpier consideration. In terms of the…

Tycho Peterson - JPMorgan

The margin contributions, and just the relative impact of FX and cost reduction.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

FX was --

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

About a half.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

Better than half, just better than half in the quarter. Currency was a little better than I thought it would be, versus the initial expectations, so we ended up with a bit more of an impact from FX this time around and then the cost reductions in the mix are probably about equally weighted, you know, maybe 20%, 25% each, something like that.

Tycho Peterson - JPMorgan

Okay. And then you had at PITTCON introduced something for the QA, QC market with the patrol [ph]. Are you still kind of thinking that's a longer term, couple of year ramp there, are you seeing anything from a regulatory standpoint?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

No, we actually didn't budget for… anything meaningful this year. We're still working with thought-mirror [ph] accounts to really work on the sampling end of it and making sure that we can reliably in a rugged environment deliver the kind of performance that they need.

So we didn't anticipate that was going to be a big dynamic this year. I would suggest probably into the second half of '09 when we'll really…we are hopeful that we can bring that to a reliable ongoing source of revenue.

Tycho Peterson - JPMorgan

Okay. And then finally, just for John, did you say the normalized tax rate was 16.9% in the quarter?

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

No, the run rate tax -- the tax rate going forward that we should use is 17.5%.

Tycho Peterson - JPMorgan

Okay.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

16.9, takes into account the impact of adjusting the year-to-date rates within the quarter, so for the second half of the year, 17.5 is what we're expecting.

Tycho Peterson - JPMorgan

Okay. So what was the normalized tax rate, then, for the quarter?

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

17.5.

Tycho Peterson - JPMorgan

17.5, okay.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

Because of the catch-up, because the first quarter's rate was 18.6 and we want to bring the year-to-date to 17.5. We had to bring the rate down in the quarter to 16.9. Okay. So 17.5 is the rate we should think about for 2008.

Tycho Peterson - JPMorgan

Great. Thank you very much.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

You're welcome.

Operator

Derik deBruin with UBS.

Derik deBruin - UBS

Hi, good morning.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

Good morning, Derik.

Derik deBruin - UBS

You know, your TA business has just continued to just outperform beyond all expectations. You know, and you've done -- you've tucked in some nice acquisitions in there and done like that. I guess -- talk a little bit more about that market and other acquisition opportunities out there and, I guess, was the 21% -- I mean was there any acquisition in the number this quarter?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

15%. The growth rate for TA we said was 15%.

Derik deBruin - UBS

Okay.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

And there is probably a couple of points, maybe, of rollover M&A in there, it's rather small.

Derik deBruin - UBS

But then for the overall business, it's like 13.5% for the overall business?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Oh, yes. Absolutely.

Derik deBruin - UBS

Okay. What other opportunities are there out there in the TA markets?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

There are a number of opportunities. I would characterize them. They're not huge sales revenue acquisition opportunities. They tend to be on the smaller side. There are some that are maybe in the 40 to $50 million revenue side, but I wouldn't say we have many of those targeted right now.

There are a lot of applications that surround these industrial markets that are available for augmenting our current product line. So, you know, this is one area where I think on average doing one or two things a year is imminently doable.

They'll tend to be on the smaller side. That's the -- but they keep this business, I think, predictable double-digit grower over the long term. If you just look at the product lines and the applications that it's serving, this business continues to bring new products, particularly the new rheometer product. It's a leader in the marketplace and a lot of natural growth just from upgrading the installed base that hasn't seen a new instrument here in a while. So I think the next two, three quarters are very predictable from the source of growth that is driving the business today.

Derik deBruin - UBS

Okay. You've done about -- your growth margin is up 120 basis points this year. How much more room is there when you start looking out at 2009? I mean is there another 100 points variance there over the next couple of years?

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

I don't if I would quote a 100 basis points. I'm little too conservative I think to predict anything of that nature. I mean obviously we've had the benefit of foreign exchange. We're going to anniversary that. You could argue next year, so it's unlikely that you're going to see the improvement again associated with foreign exchange.

But on the other hand, I would say that on the product cost side, you know, we continue to identify opportunities for cost reduction on the ACUITY product, some of which you've seen, some of which is still in the works. We've recently transferred a couple of our HPLC detectors to Singapore, they're ramping up. So, we're going to see some cost reductions from those.

So I'd say from the normal course of business, outside of foreign exchange, you know, that 10, 20 basis points of improvement that we generally look for every year, I'd say looks very positive, given the opportunities that we have on the cost reduction side.

And I do think, as we look at the chemistry business going forward, to the extent that the installed base of ACUITY continues to grow, we're likely to see that being beneficial to our growth rate on the chemistry products, which will likewise improve margins. So I think, a little bit of that mix will continue.

The product cost reductions look good for the next couple of years. I don't think that translates perhaps -- you know, maybe we're talking 40, 50 basis points, it's not going to be 100 basis points and then currency is anyone's guess I'd say at this stage.

Derik deBruin - UBS

That's helpful. I guess in the -- you know, where have you seen your biggest pockets of growth from, in Asia? Has it been mostly the industrial, chemical, from that standpoint?

And is that across – and then between TA business, let's just talk about the Waters specific business. Where has been the greatest market growth is coming from in that market?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Well, if you look at region, our countries, outside of Japan, we've seen strength almost everywhere. And it's somewhat geographical. If you look at the smaller markets like Thailand, Vietnam, we're certainly seeing a lot of food analysis business there.

If you look at Korea, you know, we see a lot of industrial applications, but also a good mix of pharmaceutical. China, as I said before, is a very balanced mix across pharmaceutical applications, food and beverage, governmental labs.

So I'd say, you know, China is kind of across all the fronts and that's the biggest marketplace for us in Asia. India is principally pharmaceutical and that continues -- that pharmaceutical market continues to grow, a good double-digit basis. So I'd say India is the most homogenous of all of our markets.

Derik deBruin - UBS

Some people have raised some questions about does China slow after the Olympics and how cyclical is the food safety analysis as people get worried about food prices and things like that, have you heard anything to suggest that those markets could potentially slow?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

First thing is, I don't think any of our business has been affected really on the upside from the Olympics. So it's not like we've got a big bolus of business that's coming in for that, other than maybe some environmental testing in general, you might say is influenced by, you know, the Chinese wanting to clean up their environment.

But most of what we're seeing is much more infrastructure, has more of a long-term feel to it. We don't -- if anything, I think we think the food safety opportunity in China is much bigger. We think the soft drink analysis and testing market is bigger, both in China and throughout that area.

So, you know, it's -- you can't ever tell in these somewhat command economies what the command will decide to do, but I think it's going to be awfully hard to radically change the path that they're on in a lot of these applications. We get no sense that they're tapping out, certainly not in the next couple of quarters. And I wouldn't say we're seeing any advance signs of it.

So your guess and others' are as good as ours in terms of what the '09, '10 pretends, but I think it's going to be tough for them to move out of this cycle that they're in.

Derik deBruin - UBS

Thank you very much.

Operator

[Operator Instructions]. Isaac Ro with Leerink Swann.

Isaac Ro - Leerink Swann

Hi, guys. Thanks for taking the questions, sorry about that. Real quick on new product introductions, such as Xevo and TRIZAIC. Can you talk a little bit about how customer evaluation times might be changing relative to the total capital spending environment you mentioned?

And then secondly on those products, how do you think margins compare on those systems relative to your corporate average for instrumentation?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

The margins will be -- will not negatively influence…

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

About average at the introduction. Yeah. With longer term opportunity to improve.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

That's right. I'd say in the evaluation side, it's bimodal. In applied markets, it's -- we don't think -- again, we're early on in the introduction. We don't think it's going to be particularly long, because what we're really offering is a new capability with the qualitative capability in Xevo.

In the Quantitative Bioanalysis market, I think that's likely to be a more traditional evaluation process. So that's one reason why I was saying it's going to be another six months before we probably have a good feeling in that marketplace, how this is going to shape up in terms of market share.

Isaac Ro - Leerink Swann

Okay, great. And then just taking another look at maybe lateral impacts of M&A and the drug industry, can you maybe talk about how your business with CROs has increased either as a percentage of your total customer base or on an absolute basis in recent years? For example are you doing more business with a measurably larger number of CROs today or just doing more business with the same larger players in that market?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

I'd say in general in the western world, our business with CROs has been the strongest part of our pharmaceutical industry or one of the strongest; generics have been very strong too. And for the most part those CROs have been the same names that you would have recognized five years ago, they've just been growing much faster and they've been investing in instrumentation much faster.

The place where we've seen new…and some of it's, you know, just different corporate names, is in Eastern Europe and in India where you're seeing new CROs come on the scene and new business opportunities there. We don't disclose particularly what those CROs grow, but your assumption is correct, it's been growing in the double digits consistently and it's been a strong part of the pharma business.

Isaac Ro - Leerink Swann

Great, and lastly on…just in the first quarter call, I think you mentioned a major pharma customer that delayed or having a specially delayed capital spending cycle in the first quarter. Can you see whether or not that customer or if it was a group of them had snapped back in the quarter or at least normal…

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

I'd say in specifics that was related to Europe, and we did as I said before, that business did come in. We're seeing similar kinds, you know, it's always a question of something moves out of the first into the second, so something move out of the second into the third?

We've seeing perhaps even a little bit more of that kind of anecdote at the end of the second quarter and, in fact, we've seeing some of that business come in already in the third quarter.

So we're kind of monitoring that very closely because it's possible that that business could turn a little bit more favorable than we think. But we're very cautious about taking one or two data points and thinking that this war is won.

Isaac Ro - Leerink Swann

Got it. Thanks so much.

Operator

John Groberg with Merrill Lynch.

John Groberg - Merrill Lynch

Thanks for taking the call. Congratulations on a very solid quarter. Can I ask John, I need a couple of clarification questions? What was your contribution from acquisitions? I know you had a Calorimetry acquisition, and then also what was the...

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

That added maybe a couple of percentage points to the 15% TA, without it might have been 13.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

It is less than a point.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

It's well under a point for the full corporation.

John Groberg - Merrill Lynch

Okay. And the FX impact of the bottom line. I know you talked about the gross margin impact, but can you quantify?

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

It ends up being about a penny for every percent on the top line, so it's around a 6%ish bottom line impact for the quarter.

John Groberg - Merrill Lynch

$0.06, you mean?

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

Yeah.

John Groberg - Merrill Lynch

Okay. And then if I got the numbers right, you said US and local currency grew 6, Europe 3, Japan was down 6, and Asia was 22%. I think in Japan you had easier comps from the second quarter of '07 relative to the first quarter. Just curious.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

They get easier across the year. The second quarter was still a bit more difficult. I mean in constant currencies, Japan grew 8% in the second quarter; the minor 6 was pulling currency out. And then comps the get considerably easier in Q3 and Q4. Our expectation would be that Japan should flatten out to show some growth as we move through the second half.

John Groberg - Merrill Lynch

I'm sorry, so the numbers you gave were the negative were… the 6% included currency, then, and in local currency Japan grew 8%?

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

Whenever I talk about regional growth, I talk about it stripping currency out, so --

John Groberg - Merrill Lynch

Because the Japanese currency…

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

(inaudible) benefit of currency went down 6%, but, again, if you just looked at it in Yen, it would have been an 8% increase.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

No, no. Let's make sure. In standard currency, in Yen.

John Groberg - Merrill Lynch

It was down 6%.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

We thought [ph] 6%.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

Because of the Yen strength.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Because you had the Yen strengthening, that raised the translated numbers to grow.

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

Correct.

John Groberg - Merrill Lynch

I am sorry, that's right.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

So you were right John. So in real organic terms, Japan was not -- it wasn't down as much as it was in the first quarter.

John Groberg - Merrill Lynch

Right.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

And we think that's the trend. It will improve in the second half of the year.

John Groberg - Merrill Lynch

My overall question there on Japan was it looks like it's improving, but still kind of difficult, so I was trying to get an update on that.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

I think we share that. We think the worst is behind us. We had some very tough comps coming into the year. You know, Japan pharma in particular, is not strong, but we're seeing the applied markets and the chemical analysis piece to be reasonably optimistic.

John Groberg - Merrill Lynch

Okay. And what was your… you mentioned the growth. What's kind of your split now between the overall pharma, life science, everyone defines it and industrial chemical? Where do you see that kind of in your internal plans? Where do you see that being, you know, a few, three to five years from now? It sounds like you're really focusing on expanding that industrial chemical piece of your overall exposure.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

That's true, but pharma, broadly defined pharma is a trade class. It's still the largest piece of our business. So that represents all in about 60% of our worldwide revenue. But it is true that food and beverage, environmental and those applied industrial markets are growing faster today.

You know, I'd still say we see real opportunities for good, solid growth in the pharmaceutical market, maybe not from, you know, the traditional largest pharmas, but including CROs, including the developing markets of eastern Europe and in Asia and in generic drug manufacturers, there's still… we grew that business in the first quarter.

It was flattish in the second quarter, and we still see opportunities for real growth going forward, particularly there comes a point when a lot of these companies that have delayed and delayed and delayed have got to invest in more of their replacement products. So we think there will be pent up replacement in demand even in some of the accounts that are pretty weak right now.

John Groberg - Merrill Lynch

But for you guys, I mean historically I guess, I think it has been 75% life science, 25% more industrial. Is that… is that either via acquisition or where you're focusing growth? I know what you said, but do you anticipate that changes?

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

No, I think you include the government academic when you get up to the 75% level.

John Groberg - Merrill Lynch

Sure.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

You know, so the 60% I was talking about is just pharmaceutical. We're still at about that 75% level if you include government academic applications.

John Groberg - Merrill Lynch

Okay. And my question was more just three to five years, either via acquisitions, where you focus your acquisitions or what's your --

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Absolutely, I think you can say that right now we see that industrial world, we see TA in specific kind of outgrowing our Waters business right now, and we're focusing our acquisition activity there, but it would just be wrong to think that that 75% is going to go to 45% or something like that. It -- on the fringe, industrial will probably grow faster in the next couple of years.

John Groberg - Merrill Lynch

Okay. And you don't have some kind of, I don't know if you had an internal three to five-year target of what you'd like that mix to be, I guess, is kind of --

John Ornell - Vice President, Finance and Administration and Chief Financial Officer

No. I'd like that pharmaceutical world to go back to double-digit growth.

John Groberg - Merrill Lynch

Okay. And then last question, you know, Doug, you defined this as one of the most difficult spending environments in some time, but you still put up a good quarter. I'm just curious, did the timing in the quarter play out differently than it has for you in the past? I know a lot of your sales come in kind of in the last three weeks to a month.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

I don't think, you know, materially so. I would say, you know, at some points in the quarter, like all quarters, it looked like it would be better and then maybe a few of those large accounts that have been talking about, you know, that we really thought were going to buy this quarter pushed out into the next quarter or two.

So if you had talked to me at one point in the quarter, John, if I were willing to say anything to you, of course, I might have been a little bit more optimistic, but, you know, that happens to some extent in a lot of quarters, so I just think what we're seeing is that in the large… particularly large pharma accounts, you get one piece of that constituency saying we've got to spend, we've got to move these projects ahead and then as it comes time to actually spend the money, they get a little bit more cautious sometimes. We think that that could change, but it hasn't changed significantly at this point.

John Groberg - Merrill Lynch

Okay, great. Thanks a million.

Operator

Sir, at this time I show no questions.

Douglas A. Berthiaume - Chairman, President and Chief Executive Officer

Well, very good. Thank you all for taking part in this and we'll look forward to talking to you next quarter.

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Source: Waters Corp. Q2 2008 Earnings Call Transcript

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