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Beckman Coulter Inc. (NYSE:BEC)

Q2 2008 Earnings Call

July 25, 2008 8:30 am ET

Executives

Allan Harris - Director of IR

Scott Garrett - CEO

Charlie Slacik - SVP and CFO

Analysts

Bruce Cranna - Leerink Swann

Bill Quirk - Piper Jaffray

Quintin Lai - Robert W. Baird.

Sarah Michael Moore - Cowen

Jon Wood - Banc of America securities.

Eric Christopher - Thomas Weisel Partner

David Lewis - Morgan Stanley

Balaji Gandhi - Oppenheimer

Bruce Jackson - RBC Capital Markets

Tycho Peterson - JP Morgan

Operator

At this time, I would like to welcome everyone to Beckman Coulter's second quarter 2008 Earnings Call. (Operator Instructions)

Mr. Allan Harris, you may begin your conference.

Allan Harris

Thank you. Good morning, and welcome to the Beckman Coulter's second quarter 2008 conference call. On our call today are Scott Garrett, Chairman, Chief Executive Officer, and Charlie Slacik, Senior Vice President and Chief Financial Officer.

Before we begin, I want to remind you that our comments today will include forward-looking statements they are based on the company's current expectations and are subject to a number of risks and uncertainties. Actual results could differ materially. Today's earnings release and our SEC filings identify factors that could affect those results. I direct you to those documents. The company undertakes no obligation to update or revise these forward-looking statements. This presentation also includes a number of non-GAAP financial measures, an explanation of these non-GAAP measures is provided in the earnings release.

And now, with our prepared comments, here's Scott.

Scott Garrett

Good morning. Thanks for joining us. I'm pleased to report excellent results for Beckman Coulter's second quarter and first half 2008. To begin, I'll recall some of the fundamentals and strategy underlying our current results and the future direction. First, Beckman Coulter's superior product development capability has delivered an impressive series of new product introductions, driving meaningful gains in market share.

Second, instrument sales lead the way to share gains and provide the basis for sustainable and predictable recurring revenue growth.

Third, recurring revenue, now representing nearly 80% of our total, continues to grow rapidly at attractive rates of profit and constitutes the best overall indicator of the strength of our business.

Finally, I'll remind you that our goal is to increase net earnings at a consistent rate of about 12 to 13%, while investing aggressively in the growth, quality and operating excellence opportunities that will assure the long-term success of our company and long-term value appreciation for shareholders. Second quarter actions demonstrate the rising strength of our business. As I review results this morning, there are four key indicators that stand out.

Number one, strong total and recurring revenue growth, 15.7% and 13.3% respectively. Number two; immunoassaay momentum. Share gains continue. Immunoassay revenue increased by more than 21%, approximately three times the market. Number three; ongoing expansion in emerging markets; revenue in China and other emerging markets increased by nearly 30% in the quarter. Number four; operating excellence, continuing progress from our one company structure and lean initiatives is yielding opportunities for improved efficiency throughout the company.

And now before reviewing our second quarter results, I will briefly summarize our solid progress for the first half of 2008. Revenue grew faster than other expectations; 17.3%, 12.8% in constant currency. In constant currency, cash instrument sales increased more than 30% and were especially strong in emerging markets. Recurring revenue is up over 13%, continuing a positive trend of consistent growth. Adjusted operating income increased by 12.9%, demonstrating operating expense leverage, partially offset by adverse product mix and inflationary cost pressures.

Adjusted pretax profit increased 13.7%, and adjusted net earnings per fully diluted share increased 12.1% over the first half of 2007 to $1.57, absorbing $0.06 of dilution from our Flow Cytometry acquisition. First half results moved us towards achievement of our full year targets for revenue and earnings growth and enabled us to accelerate investment in important areas of R&D, including our three additional chemistry/immunoassay work cells on molecular diagnostics project, and the UniCel DxH 800 our next generation cellular system.

Now a more detailed summary of second quarter revenue on an as-reported basis, unless otherwise noted. Total revenue was $798 million, up 15.7% over second quarter 2007, up 11.2% in constant currency, and 14.7% on a reported basis excluding acquisitions. Total revenue from clinical diagnostics increased 17% over prior year and more than 12% in constant currency. Cellular analysis growth has been substantially above historic levels, as we have now resolved a backlog dating to 2007. The addition of Flow Cytometry products from our acquisition has also contributed to accelerated growth in the period. We expect growth rates in this segment to moderate over the remainder of 2008 and into 2009 until our DxH launch reaches full deployment.

Continued above-market increases are expected from chemistry and immunoassay, driven in part by clinical automation and the introduction of new work cells in the second half. Revenue from Life Science customers was also up in the quarter, increasing 9% or about 4% in constant currency. As we indicated last quarter, we are pleased with the performance of our Life Science business, but we realistically expect low single-digit growth for the balance of 2008.

Clinical Diagnostics' recurring revenue growth, the best indicator of the overall strength of our business was 14% or 9.5% in constant currency. Recurring revenue growth reflects the combined effect of expanding our installed-base and increasing test kit utilization. As in the first quarter, we made great progress, extending our diagnostics installed base as reflected by cash instrument sales growth of more than 30%.

Now, I will summarize second quarter revenue results by geography. In the United States, laboratories continue to focus on overall quality, productivity and patient safety in their operations as they contend with labor shortages and rapidly growing outreach testing volumes. Beckman Coulter's broad product offering, including highly capable standalone systems, a growing workcell offering and fully automated laboratory solutions, is especially attractive in this environment.

Total revenue in the United States increased 8.2%. Immunoassay and cellular analysis continue to achieve above-market growth and clinical lab automation growth was more than 90%. Outside the U.S., rapidly growing lab testing in emerging markets and laboratory consolidation in developed markets drive demand for productivity and quality. Beckman Coulter's broad and capable product line offers preferred productivity solutions as demonstrated by our above-market revenue increases.

As I review international trends, revenue growth will be stated on a constant currently basis. International revenue was up more than 14%. Revenue from Asia Pacific was impressive, up more than 20%. Within the region, immunoassay was the key driver of growth for diagnostics while centrifugation was the primary contributor to life science gains. Sales in China were a key driver of regional growth, up more than 30%. Cash instrument sales grew even faster, up 60%.

Revenue in Europe rose 9.1% where a slight decrease in life science revenue was offset by solid growth in clinical diagnostics. Within diagnostics, immunoassay and Flow Cytometry posted the greatest gains. Clinical automation also continues to be a factor of success in Europe. We have been steadily placing chemistry immunoassay in workcell systems in combination with our automation. Our newly launched Automate 600 Sample Processing System supports this trend and should sustain positive momentum in the region going forward.

Now, I'll address revenue by product area. Worldwide, chemistry and clinical automation revenue increased 14% in the quarter with especially strong performance in markets outside the U.S. Autochemistry revenue grew over 10% in the quarter. Success in our DxC family of autochemistry systems has put us on pace for a fourth consecutive year of record placements. We are growing our installed base in mid to large-sized hospitals and improving our share in international markets.

Extending our leading clinical automation position remains an important strategic objective. Automation placements bring along additional instrument system sales in every automation account, and automated labs typically generate rapid growth of recurring revenue from increased test volumes.

In immunoassay, revenue was up more than 21% worldwide, two to three times the market rate. Performance in Asia Pacific in emerging markets was robust. Recurring revenue for our Access immunoassay systems increased 21.9%. Our capabilities in technology integration and product development make it easy for to us move from standalone systems to leadership in workcell solutions.

Our workcells combine the full menu of chemistry and immunoassay tests into consolidated systems that bring higher levels of productivity and quality to the laboratory. We commercialized the second workcell in our UniCel line, the DxC 880i in the first quarter of 2008. The DxC 880i combines Beckman Coulter's highest volume chemistry system with our highest throughput Immunoassay instrument and is a driver of productivity in larger hospital laboratories.

We continue to make progress on three additional work cells which should be released before the end of the year. These consolidated systems will give us great flexibility and capability in meeting customers varied test volume and mixed requirements, while providing a total of five price points for customers versus the one or two typical of our competitors.

Our entire installed base of standalone DxI and DxC instruments placed since 2005 are field upgradable to work cells, giving new work cell customers access to the entire menu of 150 tests available on our standalone analyzers.

In above market growth, in chemistry and immunoassay over the last two years, signals great demand for work cell solutions. In the quarter, we were encouraged as new placements of work cells increased by more than 40%.

Revenue in the cellular products area increased 17%, led by sales of Hematology in Flow Cytometry products. Both lines grew at two to three times the market rate in the quarter, driven by a 35% plus increase in cash instrument sales. Heightened instrument shipments in cellular analysis were partially the result of the increase in the production plant to overcome the previously announced back orders arising from supply chain issues and strong customer demand. The heightened level of cellular instrument production and shipments was sufficient to eliminate the back orders.

Sales of recently acquired Flow Cytometry products continue to pick up momentum, contributing 3.5% to overall cellular analysis growth. In Hematology, we are making final preparations for the commercialization of our next generation cellular system, the UniCel DxH 800, targeted for a controlled release in the second half of 2008. We expect a launch of this next generation instrument and follow-on modules designed for mid to large-sized labs to stimulate a replacement cycle beginning in 2009 across our large installed base, and to allow to us compete on the basis of features as opposed to price, which has been a norm in recent years.

In the Life Sciences, revenue increased about 9% worldwide or 4% in constant currency. Robust sales of our life science automation products led the way. These automation orders are typically large and the associated timing of revenue recognition is hard to predict. We do not expect the rate of growth in the first half of the year to be sustainable. With centrifugation and CE based product lines generating more moderate growth, we expect Life Sciences to provide low single-digit growth in the second half.

Now I'll turn it over to Charlie Slacik, who will comment on the P&L and other financial results. Charlie.

Charlie Slacik

Thank you, Scott, and good morning, everyone. A full description of the company's second quarter and year-to-date results is provided in today's earnings release. My comments will be based on adjusted results, which are detailed in the earnings release. As Scott already discussed, we achieved excellent revenue growth in the quarter. Recurring revenue continued to expand its steady rates growing at over 13%, which marks the sixth consecutive quarter of excellent growth.

Compared to the second quarter of 2007, when instrument revenue was also unusually high, the gross profit margin increased about 30 basis points to 46.2%. This represents an acceptable gain in margin given the downward pressure from higher transportation costs, and a mix favoring lower margin instruments and expansion in international markets.

Globally, cash instrument sales were up 25% as were international sales. The mix shift towards cash instrument sales and the continued expansion of our international installed base did put downward pressure on margins but support our long-term objective to increase our penetration in emerging markets to drive future recurring revenue growth. SG&A grew at an abnormally high rate in Q2, due primarily to absorption of incremental expenses noted in the earnings release. They were expenses from our Flow Cytometry acquisition and a payment-related to currency swap extensions.

On a constant currency basis excluding these incremental items, SG&A actually grew only 10.6%. Despite these items, operating income margin was up slightly versus second quarter '07 at 11.4% and EPS was up 18.7% to $0.89.

Turning our attention briefly to the balance sheet, our accounts receivable DSO at 86 days was relatively flat with prior year. Inventory turns have remained relatively steady at around 2.9 on a constant currency basis. As a measure of our progress, towards I will now discuss our first half results. My comments will be based on adjusted results, which are detailed in the earnings release. Revenue increased by 17.3% or 12.8% in constant currency, well above our stated outlook for the year. Based on our performance to date, we are raising our revenue growth target for the year to 12 to 14% given stable currency.

Gross profit margin decreased 100 basis points to 46.1%. It was adversely impacted by product and geographic mix as well as higher transportation costs. First half results reflect a 40 basis point decrease in operating income margin to 10.5%. Total operating expense was 35.6% of revenue compared to 36.2% for the first six months of '07. SG&A was essentially flat as a percentage of sales. We expanded funding for key development programs like [DxN] and extended the geographic reach and capability of our sales and service organizations.

As I mentioned earlier, operating income was negatively impacted by the acquisition of the Flow Cytometry products and the payment related to currency swap agreements embedded in the company's facility leases. Operating results on an adjusted basis absorbed $5.7 million and $4.6 million respectively for these two items in the first half. This is in addition to the $3.6 million incremental non-cash expense, we absorbed in the first quarter, related to changes in retirement investing terms for share-based compensation. Despite these items, operating profits still grew 12.9% in the first half consistent with Scott's earlier noted goals.

For the full year, we are updating our outlook for operating margin to 12%, approximately 12%. This is based largely on two factors; first, above expected levels of cash instrument sales, especially in emerging markets. We expect this product and geographic mix to constrain overall gross margins for the year. And second, moderated growth expectations for the second half of the year in Cellular Analysis and Life Sciences will improve product mix but will be partially offset by cost pressures from transportation and commodity costs, which we estimate will impact operating margins by 30 to 50 basis points for the full year.

Continuing on with first half results, non-operating expense was up slightly versus last year. We expect non-operating expense for the full year to be approximately $48 million. Pretax earnings grew 13.7% for the half in line with our objectives. Turning to taxes. The adjusted tax rate for the first half was 27%, approximately even with last year's rate. First half results include some discreet items related to tax settlements. We now expect the full-year tax rate to be around 29%; essentially the same as last. This reflects our expectations for no significant discreet tax items in the second half.

Net earnings for the first six months were $101.4 million, up 13.7%. Diluted EPS was $1.57 for fully diluted share, an increase of 12.1%. This EPS result reflects a slightly higher six-month average share count versus prior year. But as noted in today's release, we did repurchase 1 million shares during the quarter. We remain on target to achieve our EPS objective of between $3.55 to $3.65 for the full year, with a share count of approximately 64.5 million.

Turning to EBITDA and cash flow; the company's EBITDA performance has been improving steadily since we shifted from operating type leases and phased out sales type leases. As OTL assets have built over the last three years, depreciation and amortization have been closing the gap with our OTL Cap Ex.

In our first half cash flow report, you will see that our 2008 DNA has expanded 28% versus 2007, and during the same period our CapEx level was essentially flat in 2007. This is consistent with our previously stated full-year outlook, which had depreciation and amortization growing 18% to 27%, with Cap Ex growing 5% to 12%. EBITDA grew 16% in the first half, and we are now raising the lower end of our outlook for the full year EBITDA to between $610 million and $630 million.

Cash flow from operations for the first half was $132.3 million, approximately $56 million below 2007, which included the breakup fee associated with the termination of the Biosite acquisition agreement. The balance of the cash flow reduction reflects higher levels of working capital invested in the business, and this is an outcome of our business expansion.

And now I'd like to turn things back to Scott.

Scott Garrett

Thank you, Charlie. In the first half, results surpassed our expectations. We expanded our installed-base, improved our penetration of emerging markets, increased our investment in key product development projects, and made grease progress towards our earnings goal. We also made solid progress on integrating our Flow Cytometry acquisition and implementing our supply chain improvements, further positioning our company for long-term success.

Our supply chain initiatives are well underway across many areas of the company, complemented by our focus on lean Six Sigma. We are making steady progress reducing our footprint and cost structure across the organization. The previously announced relocation of our [centrifuge] manufacturing from Palo Alto to Indianapolis is on schedule for completion by year-end. We continue to optimize our footprint and consolidate our facilities, reducing our US distribution centers from five to two, closing many small facilities, seven, since October 2006; and planning for the consolidation of our two Orange County sites.

In the third quarter, we are implementing a new build-to-install initiative, which will leverage our improved ERP systems and processes to reliably deliver major instrument systems according to customer requirements. Feedback from our pilot programs has been positive, and we anticipate improving customer satisfaction, while reducing our inventory levels as we implement build-to-install. We will continue to share additional details of these initiatives with you throughout the rest of the year.

As we improve our operations, we continue to outperform the market in clinical diagnostics with strength and consultative selling, responsive service and innovative automation leadership. We remain focused on creating shareholder value through growth, quality and operating excellence. Our priorities include sustaining the rapid growth of immunoassay, extending our automation leadership, developing our sample-to-result molecular diagnostic system, commercializing three additional workcells and our next-generation cellular system and achieving still greater efficiencies and operating excellence throughout our supply chain and business operations.

Charlie and I are now prepared to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Bruce Cranna with Leerink Swann.

Scott Garrett

Good morning, Bruce.

Bruce Cranna - Leerink Swann

Hi. Good morning, guys. A couple of things. First of all, Charlie, just on the gross margin impact from transportation costs, if you quantify that for the quarter, I apologize I didn't hear it, but what was the impact on this quarter?

Charlie Slacik

I don't think I gave a specific number on the quarter, but it would roughly be about $2 million, $3 million.

Bruce Cranna - Leerink Swann

And your comment on the second half of the year was 30 to 50 bps?

Charlie Slacik

30, 50 bps for the full year between higher commodity and transport costs.

Bruce Cranna - Leerink Swann

Okay. Thanks. And then can I just spend a minute or two on the DxH 800? Scott, I think you said you're sort of in a controlled launch now or you expect to be imminently?

Scott Garrett

We have several instruments in the field in validation studies, and we expect to start a controlled launch probably in late third quarter to early fourth quarter this year.

Bruce Cranna - Leerink Swann

How many installations you have at present?

Scott Garrett

We're not disclosing that, but in hematology, it's kind of an extension of clinical studies. You have to look for rare samples. And we need a lot of data to validate that we're flagging all the conditions that historically were flagged by the long history of Coulter hematology products. So, we're being thorough. We're being careful. And we're going to do a controlled rollout, because we want to make sure that this is very, very well received and well positioned when we finally launch it with customers.

We have made our submissions to the FDA. We expect that there are no regulatory hurdles that we're waiting to hear about. We're ready to go, and we're going to do it in a very controlled and careful manner.

Bruce Cranna - Leerink Swann

And if you had to guess as to the period of time that the controlled period is or how long would the controlled release period be, I guess, is my question.

Scott Garrett

I think it will probably be in full release sometime in the first half next year.

Bruce Cranna - Leerink Swann

Okay. And then just quickly on O.U.S. trends, which are again really pretty substantial, especially in China. I know it's kind of early days there, but do you have any read on what sort of consumable trail per instrument you might see in a geography like China? And I don't need a whole dollar amount, but I guess compared to maybe something in your experience in the U.S. or --?

Scott Garrett

Yes. Consumables are strong literally placement by placement, Bruce. But as in all markets, there are some very, very large laboratories that are going to be running instruments flat out, and there are some smaller hospitals that are going to use them far less intensively. Our focus is on the big cities and as you know in China, there are lots of those, and in the bigger hospitals in those big cities. So we expect that our consumable stream our recurring revenue stream is going to be very strong and has been quite strong.

Bruce Cranna - Leerink Swann

Those are no reason to expect that it's any different on a per-instrument basis in the U.S.?

Scott Garrett

Not marketedly.

Bruce Cranna - Leerink Swann

Okay. And who do you run into mostly, if you don't mind telling us, in those types of geographies in China, for instance?

Scott Garrett

It's a global industry. We run into the same competitors in China that we run into in New York or Chicago.

Bruce Cranna - Leerink Swann

Okay.

Scott Garrett

Okay. We're going to have to move on. Next question.

Operator

Your next question comes from Bill Quirk with Piper Jaffray.

Bill Quirk - Piper Jaffray

Good morning.

Scott Garrett

Good morning.

Bill Quirk - Piper Jaffray

A couple questions. First off, Charlie, just I guess a quick counter question, why did you call the HCV license out as a one-time? Why wasn’t that -- why shouldn’t we expect that to be expensed over the license?

Charlie Slacik

The HCV license was expenses IPR&D, Bill because its -- where it stands in the development stage. It didn't qualify to be put on the balance sheet as an asset because it's still pretty far from commercialization. So its essentially the full 12 million was considered IPR&D.

Bill Quirk - Piper Jaffray

Okay and then going forward Charlie as we get closer to a launch, is there any change there or is that once you expense that as a one-time item, we're all set?

Charlie Slacik

That's behind us now off the -- in other words it never hit the balance sheet so it will be a zero expense going forward.

Bill Quirk - Piper Jaffray

Okay understood and then Scott, just a couple questions…

Charlie Slacik

I'll just add that there's royalties involved but there's no asset amortization on that, Bill.

Bill Quirk - Piper Jaffray

Okay understood, Charlie. And then Scott, just thinking overall about, I guess, a mix of instrument placements obviously a couple of years ago we had a pretty significant shift from leases, operating leases and now we're seeing cash deals go up substantially, obviously that being a big function of developing markets. If we look out 2009-2010, is this the way that we should think about the business or at some point here should we be thinking that it transitions back to more of a overall stable leasing situation so to speak?

Scott Garrett

Well, the sales in emerging markets often have a dealer involved. And so those are going to be cash sales. And alright as we begin to become more direct in some of the emerging markets, we'll expect that we'll get more OTLs. Now we also had a pretty strong life science first half. And as you know, the life science instrument sales have always been on a cash basis and will continue to be on a cash basis. And one additional factor would be that in the largest of our automation accounts, we're seeing more cash recently as hospitals tend to include the automation installation and the instruments that come with it in the overall construction project that they use when they're building a new lab or remodeling their lab to get it ready for automation.

Bill Quirk - Piper Jaffray

And could you call that out or could you help us think about what -- cause that obviously is a bit of a shift in your more mature markets from where we were, say, a year ago. Is this any way to help us quantify that or think about that a little better?

Scott Garrett

Well, in our automation accounts, we do pull through very, very strong recurring revenue. And so I don't think it's going to be a big factor or a trend that we intend to focus on. I think we'll see a stronger mix of recurring revenue to cash sales in the second half of this year but when we get orders for cash, you know, we're happy to take them. And it does represent for the most part an expansion of the installed base and will lead to the high profit recurring revenue.

Bill Quirk - Piper Jaffray

Understood. And then one just last question for me is that if we look at an overall deal into an emerging market country, can you help us think about the overall margin for a cash sale there versus, say, a cash sale in the states? Is it better, worse? And then are the reagent expectations the same or worse? What I'm trying to get at, Scott, is, if we look longer term, is it more or less profitable for Beckman Coulter to be going into these emerging markets then it would if say you landed a similar deal in the US or even in Europe where obviously we have tighter margin pressure?

Scott Garrett

In an emerging market we do have a dealer involved, so you'll see the cash instrument sales at a slightly lower margin. And then we'll see good recurring revenue buildup oftentimes after we see a bolus of instrument sales. We'll see the recurring revenue come in at slightly lower gross margin, but of course, because we've got a dealer involved, we have lower operating expenses in those countries. That's why I've been asking our investors to consider operating margin as more indicative of our progress than gross margin, because as we do a better and better job in emerging markets, it's going to have a downward pull on gross margin, but in the long run it should have a strong positive impact on our operating margin. We've responded to tenders in some of these emerging markets, where we have to quote big numbers of instruments. And then in usually the year following we see the recurring revenue really start to grow and we get excellent profitability in these countries.

Bill Quirk - Piper Jaffray

And so, net-net one line takeaway here on an operating margin basis is that deal more or less profitable than say a similar deal in Europe?

Scott Garrett

It varies. But it's certainly attractive to us and we intend to go after it.

Bill Quirk - Piper Jaffray

Very good. Thanks much, guys.

Scott Garrett

Thank you, Bill.

Operator

Your next question comes from the Quintin Lai of Robert W. Baird.

Scott Garrett

Good morning, Quintin.

Quintin Lai - Robert W. Baird

Good morning. Congratulations on nice quarter.

Scott Garrett

Thanks, Clinton.

Quintin Lai - Robert W. Baird

I guess continual theme, on the emerging markets here, it sounds like that this quarter most of the diagnostic players had decent quarters. And they all talk about market share gains. One thing that pricing obviously isn't an issue right now; and two, it's more market share into emerging markets and breaking into new areas and that's the market share gain or do you think that there's still some of that taking from competitors?

Scott Garrett

As you know, in our industry, and especially in the developed countries there are switching costs. Customers tend to be very sticky, retention rates in customers are quite high, so market share gains don’t come easily. However, with our automation and work cell strategies, and what I believe is the newest freshest product line in just about every area where we compete, we are successfully taking some market share, even in the developed countries. In China, India, some of the other emerging markets; I think it's safe to say that many of the diagnostics industry competitors are doing reasonably well. But, I do think, that our numbers and our results are the best. So, I think, we're doing quite well across the board, and we have a full pipeline of additional new products that give me a lot of confidence that we'll continue to do quite well.

Quintin Lai - Robert W. Baird

This might be a little bit early, but I guess with the election coming soon, have you taken a look a little bit at some of the agenda form the candidates and any thoughts about the reimbursement landscape potential over the next presidential cycle?

Scott Garrett

That's certainly a lot of talk at the level of healthcare, in looking for ways to curb healthcare costs. I think, our industry is beginning to do a better and better job of characterizing laboratory testing as a very valuable part of the overall healthcare equation. And that more testing is not necessarily a bad thing. It could even be a good thing. Recently, the reimbursement schedule in the US has been a part of some legislation that passed, will allow to be unfrozen and probably tick up a little bit in 2009.

In addition, the competitive bidding experiment that was legislated a couple of years ago has now been killed. So, the idea of hospitals competing with reference labs for outreach, it was really not a very good idea. Outreach is a source of profit for hospitals, and our automation makes every hospital more capable of doing outreach at a higher level of profit. So, we're very pleased that that competitive bidding experiment has been shot down.

Quintin Lai - Robert W. Baird

Thank you very much.

Charlie Slacik

Thanks, Quintin.

Operator

Your next question comes from the line of Sarah Michael Moore of Cowen.

Scott Garrett

Good morning, Sarah.

Sarah Michael Moore - Cowen

Maybe if I could understand the revenue growth rate should moderate in the second half. But should we expect any major differences between Q3 and Q4. Is Q3 potentially a little bit lower just because you're coming off of the strong sequential comps, especially with some of the Flow Cytometry?

Scott Garrett

Sarah, we decided a while back that we're providing guidance for the year. And so, I don't believe it's the smart thing for me to differentiate between third and fourth quarter when I'm reporting second quarter results. There's some seasonality in our business as you've observed for a long time, and you know that the fourth quarter for most companies in this industry is going to be the strongest. So, I don't expect a big departure from past trends.

Sarah Michael Moore - Cowen

Okay. And you talked a little about the hematology launch, and could you just remind us, what do you think the current market growth is there, and historically what happens in the market when you have a new product launch like that in terms of acceleration?

Scott Garrett

Yeah. New product launches do accelerate. Hematology has been probably low to single-digit growth to market overall. Now, there's a bit of a pickup there as the emerging markets become a bigger part of the overall world market. When we come out with a next generation system, it usually accelerates the renewal process for a lot of customers. There are very few next generation systems that are as dramatically different and superior as our DxH is over our LH. We expect to really transform hematology and cellular analysis with the DxH system which will include as many as four or five different modules that will be introduced regularly over the next three or four years. So we're starting with the basic analytical module, which has tremendous capabilities. We'll be adding a slidemaker stainer in 2009. From there, we'll go to a specialty module and a lot of other capabilities, including high throughput and putting it all together with probably the most elegant approach to automation in the industry. And we will be showing, I think, a little bit of the detail on this at the AACC Clinical Lab Expo next week.

Sarah Michael Moore - Cowen

Great. And just one follow-up for Charlie. Can you talk a little about the interest expense line? It's bounced around a little bit the last couple of quarters, and you've got pretty even net debt positions. So, I know some of that has to do with some of the lease interests. Can you just talk about the variability there? That would be helpful.

Charlie Slacik

Debt position really hasn't moved much. We've drawn down a little bit on our facility line, but I think this was an adjustment for some tax interest on a settlement. That's probably what moved it around a little bit this quarter. I think this was a credit there for a settlement on tax interest.

Sarah Michael Moore - Cowen

Okay. Buy in general we should think about that being a relatively consistent line item, no changes to the debt position or intention to pay down some of that debt?

Charlie Slacik

No, as a matter of fact, the one thing that did change during the quarter was we did, if you look at the balance sheet, pay down of about $8 million of our long-term debt. Just because of opportunities in the marketplace, that was selling I think at around 94%, so we will go device and back out that 7% debt and just basically use our facility which costs us about 300 basis points. So, you know it's beneficial. But I wouldn't expect any significant changes in our debt on the balance sheet going forward from here.

Sara Michelmore - Cowen.

Great. Thanks.

Scott Garrett

You are welcome.

Charlie Slacik

Thanks, Sara.

Operator

Your next question comes from Jon Wood with Banc of America Securities.

Scott Garrett

Good morning, Jon.

Jon Wood - Banc of America Securities

Good morning. Scott, any change in the price environment in the diagnostics business in US and Europe?

Scott Garrett

No, Jon. We are very careful to try to understand pricing and local currency, in all our subs around the world. We've been constantly monitoring our overall margins, again, local currency, region by region. We see the margins 2008 to 2007 on that basis is pretty consistent and nearly dead flat.

Jon Wood - Banc of America Securities

Okay. Any enthusiasm for a better environment given the consolidation or is it still very competitive?

Scott Garrett

It continues to be a competitive business and a tough business. We've got very capable competitors, but we certainly like our position. We think that nearly all of our competitors have reason to be somewhat distracted right now. And our team continues to be very, very completely focused on biomedical testing and clinical diagnostics. So we think that creates an advantage for us.

Jon Wood - Banc of America Securities

Charlie, R&D as a percent of sales is tracking about 60 basis points pulled out of prior years. Should we expect that proportion to tick up in the second half or run at about 8.5%?

Charlie Slacik

I think our expectation is to be on that track for the year. The one, I wouldn't call it an oddity but the one thing that is little bit different our P&L you can track that, I think virtually 100% of our R&D spend is in US dollars as opposed to 50% of our sales and almost 50% of our SG&A being in foreign currency as well. So our R&D spend doesn't get the inflation effect of any overseas spend. Even though it's only growing, I think, 10%. That's a real 10%.

Jon Wood - Banc of America Securities

Understood. And then one last, Scott the M&A pipeline has that changed at all, in the last few months I noticed the stock buyback picked up in the quarter, is that any indication of what the pipeline looks like?

Scott Garrett

No. We continue to be very thorough in screening opportunities. As you know, we like the very straightforward tuck-ins that are usually technology oriented. As we see those and they become available at the right price, we'll continue to be aggressive, but we don't have any dependence or plans of acquisitions in the second half it is a serendipitous kind of a system, based on a very thorough screening of the possible candidates.

Jon Wood - Banc of America Securities

Okay. Very good, thanks.

Scott Garrett

Thank you.

Operator

Your next question comes from Peter Lawson with Thomas Weisel Partner.

Scott Garrett

Good morning, Peter.

Eric Christopher - Thomas Weisel Partner

Hi. This is actually [Eric Christopher] filling in for Peter.

Charlie Slacik

Hey, Eric.

Eric Christopher - Thomas Weisel Partner

I was just wondering if you could maybe go into the life science business a little and just talk about, what specific things were driving that, and I believe you said that the growth is probably going to come down just a little bit, so maybe why it's not sustainable going forward?

Scott Garrett

We've had two really strong quarters in life science, and in both those quarters, we had big contributions from Life Science Automation. Life Science Automation tends to often come in very big chunks, and there's usually a timing uncertainty associated with recognizing the revenue, because customers usually sign acceptance agreements saying, okay everything's installed, working, doing what you said it would do. And until they sign that acceptance, we don't recognize the revenue. So I think we had a bit of a kind of a bunching up of Life Science revenue from Automation in the first half, and we just don't see that continuing. I wouldn't rule it out completely, but again, it's hard to predict. So we're being conservative about the second half.

Eric Christopher - Thomas Weisel Partner

Thanks for that color. I guess also, as far as anything geographies or product lines or segments that may be didn't perform as well, that you think could provide upside going forward?

Scott Garrett

There's always room for upside. I think we've got excellent capabilities in a Flow Cytometry, where we're integrating the acquisition and really pulling everything together in to one product line. So I see that as a possibility. We have had a great fist half, so we're looking for everybody to keep it up in the second half. And the strength that we've shown, especially in international markets is something that we expect to continue, but maybe not quite at such a high level.

Eric Christopher - Thomas Weisel Partner

Okay, great. Thanks a lot.

Scott Garrett

Thank you.

Operator

Your next question comes from the line of David Lewis with Morgan Stanley.

David Lewis - Morgan Stanley

Good morning, guys.

Scott Garrett

Good morning, David.

David Lewis - Morgan Stanley

How are you doing?

Scott Garrett

Good.

David Lewis - Morgan Stanley

Glad to hear it. So Scott just taking your lead here on; focusing on EBIT margins, more than gross margins on a go-forward basis and we are willing to buy it. I guess my question would be with even margins coming down 50 bps, it's not certainly overwhelming, but given the dramatic top line performance, you would expect some operating leverage in the business, and I know there's some shipping costs and commodity-related issues going on. But is there anything else from a reimbursement perspective on either the international plan or molecular plan that's preventing the operating leverage that I think you would have thought, you have had by now given this top line performance?

Scott Garrett

There isn't. And I think I'll ask Charlie to give you a little more detail on really what was going on in operating expenses, because there are a few things that might be considered somewhat unusual.

Charlie Slacik

David just maybe reemphasized something. Scott mentioned earlier, it's that, when it comes to the gross margins, what we see in terms of each country, we see steady margins in the US, steady margins overseas within them. Overseas margins are not, especially on recurring revenue, are not much different than the US. Cash [hardware] margins are obviously lower than recurring. So as the mix goes, so strong towards the cash hardware, we'll pull down the overall gross margin.

But going back to the EBIT margin or operating margin that you brought up, there's always going to be items that come up. And we're not trying to make excuses for them, because we thought our profitability was pretty good. But if you look at a couple of the non-recurring type items that were in the first half, DACO pulled down operating income by $5.7 million. Our Yen swap agreement [chalked] a payment in the second quarter pulled done by $4.6 million, and then in the first quarter we had FAS 123 adjustment.

Again all non-recurring items, but those three things together is $14 million. So when we focus on that bottom line growth rate of 12% to 13%, that's still being able to absorb unforeseen things like this. But I think as Scott mentioned earlier, if our primary objective is to build a bottom line growth rate that's very sustainable in that 12% to 13% range, but as we look at the P&L and we look at all the opportunities, whether it's hardware expansion overseas, R&D into DxN, our number one priority is to develop a P&L that has that steady growth rate on the bottom line, that has the visibility and sustainability we'd like to be able to deliver.

As what that really means is investing now for some of those expansion opportunities, whether it's new products or overseas expansion. So, that's how I would characterize our priorities now as getting over some of these humps that I mentioned earlier to still deliverer that bottom line that's fairly steady, and at the same time, investing in the expansion opportunities.

David Lewis - Morgan Stanley

Okay. That's really helpful color, Charlie. Scott, thinking about the competitive environment, if you look back over the last three or four years, obviously, our average immunoassay specifically has been a little weaker. Clearly, in the last two quarters, specifically this quarter, it looks like that business is largely stabilizing. From a share perspective, is it easier to take share from other competitors and Abbott over the last six months and do you think that trend will continue?

Scott Garrett

I think we'll continue to do well, David, because I think more and more, it's going to be harder to sell immunoassay without selling chemistry. And I think chemistry has always been one of our strengths, and our competitors look at it as something that they kind of have to do. It's not something they necessarily want to do. So, our workcell should be a key to that success. Our automation should be a key to that success.

And then there are still a lot of just what I call the intramural fighting that goes on for market share in immunoassay where you're going to have an Abbott system in the account, you're going to have a Beckman system in the account and where we can demonstrate that we've just got a better productivity profile or a better assay and we're going to win the business. And where we have a few gaps in our menu, we might still see our customers running some Abbott tests.

So, lots of ways for kind of a slow shift and some opportunities for a more dramatic shift. I really do like our position a lot. We've got the freshest product line, three more workcells coming on stream in the second half of this year, lots of price points to make sure that customers are getting the very best fit for the laboratory. And I think even very capable competitors like Abbott are going to have a hard time staying with us.

David Lewis - Morgan Stanley

Okay. And just a couple of more quick questions here. The first is on the international markets or emerging markets. What percent of the cash sale growth is specifically coming from China and are you going to the Olympics?

Scott Garrett

We've got plenty of instruments going to the Olympics, I'm sure, but I'm personally not going. We haven't disclosed that kind of a breakdown, David, in the cash sales, but we continue to see a big part of the cash sales going outside the U.S.

David Lewis - Morgan Stanley

Okay. And then, Charlie, last question here. I want to differentiate between your build-to-install European initiative. We were expecting some inventory-driven SAP initiatives for '09 are going to be potentially beneficial. This is separate and distinct from those initiatives and can you help us quantify what could be the potential gross margin implications of either build-to-install or the inventory-driven European initiatives we're expecting more in '09?

Charlie Slacik

The build-to-install is not a cost reduction item. It's an inventory reduction item. We actually just recently turned on the ERP around the world, and we're finally up just about in every location. So, it allows us to manage our inventories a little better now that the system is globalized.

But with that said, what we can now do, as Scott mentioned in our remarks, was we can now start using the system to time our production of our instruments according to not only when the customer orders it, but when a service organization can install it. So, we'll now have a funnel for production that essentially times our production according to when the product can be installed. So that'll allow to us reduce not only our finished goods inventory, but all of the other component and put the raw material purchases timed towards those installation dates.

It's not an easy thing to do, and it's coming along slowly because we certainly don't want to mess up our customer service in the meantime. So we will be implementing and starting to roll this out in Q3. And I would expect to start seeing impact from it in '09 in terms of inventory reductions.

Scott Garrett

Yeah it's been a long time coming but the shift from STLs to OTLs was a part of improving our overall capability to manage our working capital. Now in the installation of the ERP system made possible to consider something like built to install and now with the implementation of built to install, we can really see some results in working capital going all the way back to that decision to get off the STLs.

David Lewis - Morgan Stanley

Great.

Scott Garrett

So a long time coming but we're looking forward to some good benefits and improving customer satisfaction.

David Lewis - Morgan Stanley

Great. Looking forward to it.

Scott Garrett

David we're going to have to go to the next question.

David Lewis - Morgan Stanley

Okay.

Operator

Your next question comes from the line of Balaji Gandhi with Oppenheimer.

Charlie Slacik

Good morning.

Balaji Gandhi - Oppenheimer

Good morning. Hello?

Scott Garrett

We're here.

Balaji Gandhi - Oppenheimer

Okay, yeah. Just one question on SG&A, did I hear you correctly saying it will be flat year-over-year?

Scott Garrett

That was as a percentage of sales.

Balaji Gandhi - Oppenheimer

Correct, right. And I just want to understand if you see more continued strength in cash instrument sales, just want to understand why we wouldn't see that as a percentage of sales maybe come down a little bit?

Scott Garrett

The SG&A items I mentioned a little bit earlier, there are some items in there. Keep in mind -- but approximately half our SG&A is overseas so it does get some currency updraft plus the fact we have a bump up in the rate because the expenses from Dako have a heavy SG&A component in this as well. And the SFAS 123 expense I mentioned first quarter is all SG&A. Not all but heavy components SG&A as well as the end swap costs.

So those things are all pushing up the SG&A as a percentage of sales. We haven't given any guidance and where it should be for the full year but as I did mentioned even including these items, it does bring the SG&A pretty much flat with the prior year as a percentage of sales.

Balaji Gandhi - Oppenheimer

Okay. Those two items you mentioned carry through the next two quarters as well?

Scott Garrett

No. Those were just first-half items.

Balaji Gandhi - Oppenheimer

Okay. Alright thank you.

Scott Garrett

Thanks.

Operator

Your next question will come from the line of Bruce Jackson with RBC Capital Markets.

Scott Garrett

Good morning, Bruce.

Bruce Jackson - RBC Capital Markets

Hi guys. Most of my questions have been answered. You talked about the hospital budget climbing in the U.S. in a favorable reimbursement. Can you just give us a quick peek at Europe and Japan and are there any issues looming out there?

Scott Garrett

Japan continues to be challenging for us, from a competitive standpoint as it always has been and also from a reimbursement standpoint. We're picking our spots in Japan and trying to get some growth in immunoassay and in life science and not really bumping our head against the wall in some of the other traditional products. So I'm fine with expectations in Japan, not overly concerned.

In Europe, our team is doing a great job of putting together the right approach to tenders, the right approach to customers, and they're getting real growth in the business. And we're really pleased country by country with the performance we've been getting in Europe.

Bruce Jackson - RBC Capital Markets

Alright thanks.

Scott Garrett

Welcome.

Operator

Your next question will come from Tycho Peterson with JPMorgan.

Tycho Peterson - JPMorgan

Good morning, guys.

Scott Garrett

Good morning Tycho.

Tycho Peterson - JPMorgan

I appreciate the color that you provided earlier in the life science business. Can you just give us a sense as to, whether some of the growth that you've been seeing is also coming from share gains or gains or market expansion, potential further penetration in the CROs, maybe what some of the underlying market dynamics are like?

Scott Garrett

Sure. We're doing quite well in China with Life Sciences, and continue to have good expectations for the second half. We're doing very, very well in the US market this year. We've had good growth, and that's something we haven't always had, as you know. And we have good expectations in Europe. So, centrifugation is the flagship product line. We expect that to continue to do well. Our family of Capillary Electrophoresis, our CE and CEQ products continues to do quite well as excellent niches in the Life Science market. And then Lab automation, Life Science lab automation is always a bit of a wild card. It's been quite strong. We continue to invest in that product line, and we think it's paying off. So, Life Science in general is a pleasant surprise in the first half, and we would like to it keep going, although we are not expecting it to keep going at quite those rates in the second half.

Tycho Peterson - JPMorgan

Okay. And are you seeing revenue synergies from Dako at this point and pull through from other equipment?

Scott Garrett

Yes. It's just coming together, but certainly we see our overall Flow Cytometry more attractive. It seems as being more attracted now by customers than it was before the acquisition.

Tycho Peterson - JPMorgan

Okay. Maybe just turning a little bit to some of the content initiatives you talked about in the past, and just wondering if we can get an update on some of the things you've highlighted, unstable plaque and maybe prostate, and you know, I still believe that you may be leaving the door open for HPV. I mean, you know you haven’t really talked about it a lot, but is that something that's, you know, of potential interest to you?

Scott Garrett

We've got a long list of assays in our development pipeline, and we challenge that regularly to make sure we've got the best things at the top of the list. We do expect to have some additional product introductions in 2008-2009. We should be seeing things like the new prostate test coming out fairly soon. I think that's -- let's see, that'll be free PSA in the fourth quarter this year, and p2PSA as early as 2009 or 2010. Our pre-eclampsia test, we continue to do clinical studies on, and CPAP A is a good possible for '09. So, lots of truly exciting new tests, and then, we'll also be coming out with improved versions of existing tests and some gap fillers in the process as well.

Tycho Peterson - JPMorgan

Okay. And I guess, finally, one for Charlie. I'm just wondering, you know, given when's going on with the fuel costs, why you haven't passed that through?

Charlie Slacik

I would tell that you that we're working on that. That's something to date that's something we've absorbed, but as we go forward, we're recognizing that, we do have contracts with our customers, and there are GPO restrictions out there. We are working on trying to get more aggressive in trying to pass more of that through. But that's certainly a focus we have going forward.

Tycho Peterson - JPMorgan

And from your perspective, it's mainly transportation, not necessarily input costs?

Charlie Slacik

At this point, it's primarily transportation. And maybe one thing to keep in mind with our business is, we do most of our production in the US, in other words, we don't have distributed manufacturing around the world to any great extent, so we do end up with a lot of transportation moving our products around.

Tycho Peterson - JPMorgan

Okay. Thank you very much. Congratulations.

Scott Garrett

Thank you very much.

Operator

There are no further questions at this time. Are there any closing remarks?

Allan Harris

Yes. Thanks. That's all the time we have for Q&A today. A replay of this call can be accessed on our website at beckmancoulter.com. As for investor relations activities we will be hosting an investor meeting at the upcoming American Association of Clinical Chemistry meeting in D.C., next Tuesday, July 29th. We will be participating in the Thomas Weisel Healthcare Conference in Boston on September 4th; and the Morgan Stanley Conference in New York on September 9th. Please refer to our website for more details on all of these events. This concludes our call this morning. Thanks for joining us.

Operator

This concludes today's conference call. Thank you for participating. You may now disconnect.

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Source: Beckman Coulter Inc. Q2 2008 Earnings Call Transcript
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