Now that we're in the air, it's almost a no-brainer.
Good morning, everybody, and thanks for being here on day one of the Morgan Stanley Global Healthcare Conference. I'm Steve Beuchaw, the firm's Tools and Diagnostics Analyst. It's my pleasure to have Chris O'Connell here from Waters. Before we get into the conversation, though, two things. One, I want to remind everyone that all the disclosures relevant for this conversation are available on the internet, at morganstanley.com/researchdisclosures. Most of our time this morning will be Q&A, but I think Chris has a couple of comments he wants to make to open up the discussion.
Sure. Well, thank you, Steve, for having us to the Morgan Stanley meeting. It's good to be here in New York. We also have Sherry Buck, our CFO, and Bryan Brokmeier, Head of Investor Relations here. Maybe I would just start out by reiterating our high-level five-point value creation model at Waters, especially for those of you who are newer to the story. First of all, Waters is a very focused company, with a core strategy around specialty, advanced specialty measurement technologies. So we are very selective about the markets we participate in. We participate in about 20% of the overall life sciences tools market, with particular emphasis on pharma, material science, food safety, clinical diagnostics, and biomedical research. These are very attractive markets, and that also is true when you look at us geographically.
More than 70% of our business comes from outside the United States, and we tend to be very focused in the markets we participate in. There have been, for a long period of time, attractive market dynamics on both the pharma, life sciences, and industrial side of our business, and certainly, as we reported our last quarter, there were some puts and takes in various parts of those markets. We're not going to get into an update of that until our next quarterly earnings call, but as we look forward into the future, we believe that we're positioned very well in what we believe are structurally attractive markets. The second main point for us is around our core strategy, our core growth strategy around organic innovation. Organic innovation is clearly my number one priority as the CEO.
It's where I spend the majority of my time and emphasis within the company, and I'm just very, very excited about the pipeline we're building for future innovation, both at a product level but also at a core technology level, in terms of the building blocks for next-generation platforms and next-generation products. Historically, we've gotten the vast majority of our growth from organic innovation, and that will continue. We have some exciting new technologies coming to market sooner rather than later as well. We've commented on the BioTOF biocharacterization system for really a what we see as a next leg of a growth opportunity in biomolecules development and QA/QC, which builds upon our success and our core business in the pharma in the small molecule pharma business historically.
The third main point of our value creation model is around the opportunity we see in the company for continuous operational improvement. We do have a very attractive margin structure of the company, which very much reflects the mix of businesses, the attractive mix of businesses that we're in that are unique to Waters. And I commented on those earlier. But we also think we have continuous opportunity for improvement in the efficiency of how we run the organization. And so we have a comprehensive program to continue to gain those efficiencies so that we can deploy our investment dollars back into the growth initiatives in the company. And as always, we try to balance growth, investment in the business, as well as profitability. Fourth, from a standpoint of capital allocation, we pride ourselves and will continue to focus on being very disciplined allocators of capital.
U.S. tax reform for us was a major positive event in really unlocking our balance sheet and giving us an even more visible trajectory for capital deployment. Our number one priority for capital deployment is growing the business. It's our R&D, it's capital investment, purposeful tuck-in acquisitions where they make sense. And we've deployed capital to all those factors recently. Certainly, we're spending R&D at a good clip, at or above the rate of revenue growth in the first half of the year. We in the first half of the year announced the largest capital investment in the history of the company in the Taunton Precision Chemistry operations, which is core to our innovation and production.
And we also did a small tuck-in technology acquisition of DESI technology, DESI imaging technology mass spec, earlier in the year, through a company called Prosolia's IP and technology base. And so we continue to prioritize that investment in the business. But also, we've had the chance to delever the balance sheet a little bit since tax reform and enhance our buyback program overall. So really deploying capital to all three of those. And then finally, the fifth element is a very sharp focus on our performance-oriented culture and management team. In fact, just last week, Steve, we celebrated the 60th anniversary of Waters. And it was a great way for us to reinforce to our employees the values and the deep roots of our company, and the continuous focus on a very purpose-led, values-driven organization.
I spend a lot of my time as well on investing in and developing the management team. We've made significant investments in our people over the past several years. We've added new skill sets into the company to augment the strong people within the company. And I feel as good as I possibly can about the breadth and the depth and the skill set of the management team that's driving Waters forward at this point. So you know, those are the big highlights from my standpoint in terms of our overall framework for ongoing value creation. And look forward to hearing your questions and getting into a discussion.
Thanks, Chris. Well, you've made my job a lot easier by laying out a lot of the topics that we can go into a little bit more detail on. The first broad-based topic that I'd like to touch on is the bridge from first half of the year to second half of the year. There are a number of things that, in the outlook, we've anticipated would look a little different in 2H relative to 1H. The first thing that I might want to talk about naturally would be demand in the pharma category. In the first half of the year, and certainly not the first time that we've seen this, it's typically a more seasonal business. The first half of the year, budget releases in pharma were a little slower.
Can you remind us, you know, why that is, and why it is that we're looking for the second half budget releases, particularly from your, your pharma customers and, in some cases, in early-stage R&D, you know, why we think those are going to get better?
Sure. You know, speaking of the first half dynamics, there were really two major considerations that we talked about in our last earnings call. One was obviously the India situation, which is more of a market-specific set of factors that you know, slowed down our India business for part of last year and the beginning part of this year relative to structural reforms in the Indian economy that introduced new mechanisms such as the GST tax system that diverted investment from a lot of our Indian companies towards systems and implementations, and also slowed down capital deployment early in their new fiscal years. You know, that is a you know, bump in the road in what's been a great market in India for a long time. But because India is so heavily oriented towards pharma, that affected our overall pharma number worldwide.
The other part of it that you alluded to was really in some of our larger pharma customers, particularly in the United States, where budget releases were a little slower in the first half of the year than we anticipated, and we saw that pattern a little bit in 2017. Certainly, some of the leading indicators to us early in the year that we mentioned before, around quoting activity, around utilization of chemistries and service and recurring revenues, you know, at least, you know, gave us, you know, some sort of a belief that the dynamic could be different in the second half, and we saw that last year. Of course, the next time we'll update on that will be at our next quarterly earnings call.
You know, one of the things that's difficult to understand about India as a market, it being such a global company, you're not just exposed to India, right? And the generic and spec categories there, very much global. So to the extent we see Indian pharma company revenues slow down, in part because there are other players in the world popping up, is the right way to think about it that even if we have the India space specifically slow down, other parts of the world fill in the gap. Is that the right way to think about it as a global player?
I think yes. Broadly, that's a very good way to think about it. The best ultimate metric that we try to focus on and that this topic focuses on is end-market patient access to medication. And clearly, you know, over the past several decades, there's been an absolute revolution in patient access to medications. And by the way, that access growth and access is not just in the emerging markets, it's in the developed markets. A very big market share of that generic drug business has really accrued to some of the Indian multinational companies, some of which are Indian companies and some of which non-Indian companies operating in India. That's been a major engine for pharmaceutical production. And yes, it's true that other markets can take up some of that demand over time.
And it's also true that some of those India companies are actually doing more outside of India. There's a number of examples of our customers, and some of which I visited very recently, who are building plants even in the United States and participating more directly in our domestic market, not just as an importer, but as a local manufacturer. So it's very much an interconnected world. And, ultimately, you know, the performance of our business will reflect that end-market volume of prescriptions, volumes of patients who have access to life-changing medications.
I wonder, before we transition, if you could talk just a little bit about commercial execution. Early in the year, you guys realigned the sales force. My sense is you don't think that that was a major variable. Can you talk about how you think commercial execution, competitive dynamics, how you're thinking on those topics is evolving over the year as you, you have more and more experience seeing how things are going in the field?
Yeah. Commercial execution, I think, has always been a focus, in the company, a focus of mine. And Waters has a long track record of very strong commercial execution in multiple parts of the world. And so, you know, we are continuing to invest, you know, in that area. You know, sales operation function is one example, of a core skill set that we've added to over the past couple of years and really building a framework for how we invest to expand and leverage our channel, our scientific expertise for the benefit of our customers. To your question, in Q1, we made a, you know, a minor comment around some delays in hiring some kind of expansion positions, in the U.S., that may have contributed to a little bit of the softness in Q1.
But as you and I have talked since then and some of your follow-up questions, you know, it's important to create context that some of those changes were in the broad scheme of things, very minor changes. You know, I've run all types of sales organizations over my career, and I can tell you that some of that work is really more incremental. It's not wholesale changes in our commission, commercial execution model or how we go to market. But it's really adding capacity for the growth we see ahead. I have great confidence in our global commercial leaders and what we're doing to advance our own capability and really get after the changes that our customers are expecting from us, in terms of the technical and scientific capability to serve their changing needs.
When we think about the combination of considerations and the first half, second half bridge specifically for pharma for Waters, we feel good about that progression.
Again, you know, like I said before, the dynamic on pharma, you know, was in the first half driven by India plus, you know, some U.S. large customer purchasing activity that just got off to a little bit of a slower start. You know, at that point in time, you know, we made comments around so sort of some of the things we see as lead indicators. Just to say that that was the update then, and we'll wait for further updates as we get deeper into the year.
So you mentioned earlier that I think you might have characterized it as your primary focus as CEO is innovation.
Yep.
Let's go there. Yeah, we've heard a few comments, and they're still fairly early stages about a product that I think you've referred to as BioTOF, which might give you an opportunity to leverage your technology in the new spots. But my sense is that there might be more. There might be more in the pipeline for the next 12-24 months. Maybe I just open the door to you to talk about, you know, innovation and the extent to which you think it can drive better position, drug into new markets, and maybe drive a replacement cycle.
Yeah. Sure. You know, I think innovation is everybody's favorite topic within Waters. It's what we pride ourselves on, really leading technology advancement in the space and also application science. And both of those are important because it's the core technology elements that lead to increasing performance of the instrument, which we've always tried to lead on. But I think, moreover, the different needs of different customers in the market, while we leverage technology across markets, are becoming more and more application-specific. You know, we've made some of the most important evolutions in how we approach innovation, recently, sort of evolving from a bit of a sort of technology component focus where components like LC mass spec and informatics and chemistry sort of operate somewhat independently to much more of a systems orientation.
One of the reasons we've talked about BioTOF in that context is it's a good example of what we're trying to do in innovation, which is to push new technology, but also in a package that is far more integrated at the system level where a lot of the system validation testing is, you know, done in our factory as opposed to in the laboratory environment, where there's a level of robustness and ease of use and performance that all ties together in a better package to meet the changing needs of the market. You know, that product we mentioned is very much oriented towards the operational workflows of late-stage development, method development, and QA/QC in the emerging large molecule space. You know, Waters made a huge and very successful bet on small molecule pharma QA/QC a long time ago, decades ago.
When you look at the package of HPLC, Alliance, you know, and Empower chromatography data systems, chemistries, UV detection, that's really become the standard of measurement, if you will, for late-stage development QA/QC in pharma. And we see a whole nother wave coming with the large molecule world mass spec-based systems can take over a lot of the workload in these operational workflows. But there has to be so much more built around it in terms of compliance, reproducibility, that current research-grade instruments get after a little bit but don't quite solve in the market today.
Is this an initiative that can drive incremental revenues in the next two years, or does it take more time to get this type of technology integrated into the development process and FDA validation processes for drugs that are maybe still in the pipeline?
I mean, I think there, you know, we expect a system like that to have an immediate, you know, impact. We haven't provided any guidance as to, you know, how big that is. But you know, like many products in this field, to your exact point, they do take some time to work their way into method development and different application workflows. Obviously, with a new system like that, we're going to be targeting some specific applications that we have not enumerated yet. You know, the breadth of those applications will, to some degree, determine the slope of the uptake. But you know, we presented a little bit of first-cut data at the ASMS meeting earlier this year on the BioTOF system. And we've continued to gain further confidence through customer sampling activity, you know, in the potential.
But, you know, I don't want to make it all about one product platform because it's really more of a sign of what's to come, relative to, you know, platform technology and some of the underlying technology components that get us to there that are then going to give us an ability to enhance our innovation cadence over time.
We're more than halfway through our time here with Chris. I'll open it up to the audience if there are any questions. If you do have a question, please let us get to you with a microphone. If you do not have questions, there's more coffee outside. Okay. So we've spent most of our time on pharma-related topics for the obvious reason. But if I think about over the last couple of years, why Waters has been able to grow, effectively, I think TA and your broader, industrial, quasi-industrial exposure is probably an unappreciated part of the story. Now, for TA, to some extent, it's been a new product story. To some extent, it's been, hey, you know, the markets after a tough stretch actually got better.
Can you talk us through the balance there and, and maybe take it one more step and, and give us a sense for how you think about incremental TA product contribution over the next year or two?
Sure. No, absolutely right. Spot on that what's happening on the TA instrument side of the business, which I think is an underappreciated part of the franchise to your exact point, Steve. You know, it's a combination of a fantastic new product cycle with the Discovery family of thermal analyzers. It's a complete refresh, really new platform for every element of the thermal line from the DSC to the TGA and gravimetric analysis and a number of the different components. And that in combination with favorable end-market conditions, both, you know, across really all segments of some of their core material science focus of chemistry, chemicals, polymers, and inorganics. And you see these type of workflows in both the industrial heavy industrial sector as well as the consumer product sector, who are taking on these technologies to drive innovation on core materials.
I think the broader opportunity that we see, building on the success of TA Instruments, is leveraging actually the full suite of Waters technology from TA-branded instruments to instruments on the Waters technology side that are very oriented towards polymer science, such as the APC and LC-MS, to have a value proposition for those engaged in innovation in material sciences. What is probably a lesser-known part of the Waters story is that the number two end market in the company is actually material sciences between the product suite on the chemical, material side of Waters and the TA Instruments on the thermal rheology microcalorimetry side. And you know, that's a space that you know is maybe harder to define in specific terms, say like a pharma QA/QC lab.
I can tell you the pace of innovation in material science, you know, from the academic realm to the corporate and industrial realm, has never been higher, across many applications. You know, we actually find the material science opportunity to be a very attractive growth platform for the company.
Is it reasonable to think that a new product flow can be as much of a contributor over the next two years in that category as it was over the last two years?
Yes, because, you know, again, the nature of rolling out new technology, even the thermal line, which is not completely, you know, there are seven or eight or nine different platforms within the thermal line, not all of which are in the market. The bigger ones, of course, are DSC, TGA, but there's many more. And then there's a process of accessorizing, if you will, these instruments to provide new capabilities for specific measurements that our customers are trying to do. You know, and obviously, the success of that product strategy is going to have something to do with, you know, how the end markets shake out over this period of time as well. But, you know, we're, you know, we really are in a sweet spot in TA on that innovation story and want to continue to feed that funnel.
Just to complete the thought here on this particular market, years ago, you guys had a bigger position in GC-MS. I think I de-emphasized at one point, and now you've announced an entry to go back into that space, a space where there's one, you know, fairly dominant market leader. Can you talk about your strategy in GC-MS? How much of it is about winning in technology? How much of it is about leveraging your call point?
Yeah. So first of all, the system you're referring to is the GC-MS/MS system. And it's not a GC. We're not getting into the core GC business, per se, but we have a mass spec system that's built upon sort of some of the standard platforms that are already in the market on the GC alone side. That particular workflow is very, very important to some of our end market customers, particularly on the food safety side. And so, you know, food, which is another great business that, you know, falls broadly into the industrial category, you know, we have a more limited product portfolio.
Historically, as you point out, we've been very successful with the GC-MS/MS system and wanted to reintroduce that just because of the important, you know, needs of those customers and to give us more surround sound in the other products we're trying to sell into that channel.
Surround sound. I'm going to steal that term. Thank you. I want to talk a little bit about China.
Yeah.
Which is a strange choice because nobody else seems to want to talk about China these days. There's a lot going on there. It's been a remarkably strong first half for the tools category in terms of demand from China. But of course, the headlines we all know continue to keep questions on the forefront about the macroeconomic growth in the region and the potential impact of any tariffs. To some extent, it's what we already know. To some extent, it's unknown unknowns, if you will. Can you frame that up for us? You know, one, when you look at the underlying drivers for growth in China over the last 12 months, do you think that those are very much intact? And two, how is your thinking evolving on the impact of tariffs?
I think you called out a potential $0.01 per quarter impact. How is that changing the more we learn?
Sure. So, first of all, just as a you know point of fact, China is now about 17% of our worldwide business. So it's actually the number two country for Waters outside of the United States. It's been a tremendous success story. It's actually moved from 6% of our business to 17% over just a 10-year period. We have a large number of people in China. We have actually a quite diversified participation. In fact, it's the only major geographic market in the world where, you know, the pharma business is not at the corporate average. It's actually about 10 points less than the corporate average simply because of the bigger participation relative to, say, other geographies in the food safety and even the material science parts of the business and also having a very interesting growth trajectory in clinical diagnostics.
So China is actually a very broad-based story for Waters. And you know, it's one that's been provided good growth over time. You know, even to and including the first half of this year, China was very steady as she goes and a good growth contributor even on tough comps. You know, obviously, a lot of headline noise there. But some of the fundamental underlying drivers of you know, the secular transition of China from a manufacturing economy of the world to a local innovation economy and all the government policies that are trying to support that in terms of investments in core infrastructure for the biopharmaceutical business, in terms of the value chains for food safety, in terms of the industrial investment activities. It's actually fairly easy to look at the government policies and see how that might ultimately drive investment across these different sectors.
And we pay a lot of attention to that, you know, from a tariff standpoint. It's a little bit of a cloudy picture. Obviously, none of us like to see the rhetoric going back and forth, you know. The impact this year has been somewhat immaterial. We'll obviously try to study up on that to anticipate what 2019 might look like when we get to that point. But, you know, we don't export out of China at Waters. What we import into China largely comes from other countries besides the United States. And so there's been a little bit of a less of a consideration for us on the China tariff side. Obviously, some of the raw material tariffs coming from other parts of the world, steel and otherwise, you know, are also a question, but that's not necessarily related to China per se.
But at the same time, you hear these, the rhetoric back and forth. You also hear very positive comments from China about the kind of environment they want to have for multinational companies. In fact, there was even an article in the paper this morning about some recent, comments from the, Chinese president, Xi Jinping, about, you know, actively encouraging U.S. and other multinational companies to continue to invest in China. So I, I see an intent, there in that market to, to broaden, and to continue to invest in growth. And, and we're going to control what we can control, and continue to try to leverage the good opportunities there.
As we think about the uncertainty for 2019, is it more direct effects or more indirect what it could mean for the global environment?
That's a good question. I don't know that we've thought that all the way through, you know, but, you know, I would say, you know, the indirect effects and the broader macro trends of growth in the economy would always be a bigger determiner, you know, than a particular set of tariffs, which, you know, could be more next year than this year. But, you know, those are still relatively small in the broader context of our business.
I believe we have a question in the audience.
Hi. Maybe using pharma as an example, can you just kind of walk us through what are the characteristics of the segments that you choose to compete in? So what makes them attractive versus those that you don't? And then what kind of market share do you have and what makes the share kind of so stable and sticky over time?
Sure. It's a good question because, you know, pharma has many different subsegments, and we do all our planning around different markets within there. You know, as I alluded to earlier, really long ago, Waters made a huge bet on the regulated workflows in pharma in method development and QA/QC. And that's where we have really the strength of our franchise, particularly on the small molecule side and some of the technology components that we have, really being best in class, highlighted by the Empower Chromatography Data System, which is very much the informatics standard for sort of regulated workflows there. That has been a big priority for the company for a long time.
That's why we want to replicate, you know, our strong leading market position in that space, you know, with our next-generation set of technologies that more directly address the needs in biomolecules, like I alluded to earlier. So that's really the core of the core. You know, we've had less focus, for example, on the discovery side of the business. We've got some very good technology and leading positions in some application spaces within high-resolution mass spectrometry for some of the more discovery and biomedical research. But that's been less of a core emphasis. To your question about economics and profitability, when you're in these operational workflows in later-stage development in QA/QC, you get a high instrument utilization. You get high rates of recurring revenue. For us, that's chemistry and service and even aspects of the informatics. Those are very attractive.
Those are, you know, more profitable than, you know, the business overall. So, you know, we want to obviously serve our pharmaceutical customer needs, in a variety of different ways, but there are definitely subsegments in there where we have our strongest franchises, and we'll continue to invest.
That does bring us to the end of our time. Thank you all for joining us, and thanks, Chris, for being here.
Thanks, Steve. Appreciate it.