Great. Well, welcome. Welcome to the afternoon session here on day one of the UBS Global Healthcare Conference 2019. My name is Dan Brennan, I cover tools, diagnostics, and the pharma service space. Very pleased to be joined on stage with the CEO of Waters Corp, Chris O'Connell. We also have Sherry Buck in the audience and Bryan Brokmeier as well. So we want to make this as interactive as possible. I obviously have a long list of questions, but about halfway through I'll stop. I'll look around the audience, see if we can get anyone to answer. Before I introduce Chris and have him kick it off, just for any of the analyst disclaimers, Please go to our website at www.ubs.com. And I think that with that, Chris, welcome obviously. Very pleased to have you here.
If you wouldn't mind, I think Chris is going to lead off with some opening remarks.
Great. Thanks, Dan, very much, and thanks to you and Tim and Rob and the UBS team for having us. It's good to be at your meeting. I'll just make a couple of quick overview comments on the near term and maybe a little bit in the long term, and Dan, then let's go where you want to take the conversation. I'd love it to be just that, a dialogue with anybody in the room who would like to ask a question, but just briefly, in terms of the short term, we got off to a little bit of a slower start than we had expected in 2019. In Q1, we reported about a flat revenue quarter for our Q1.
That was really driven primarily by some discontinuities in the China market that I'm sure you'll want to get into a little bit, where we're concentrated pretty heavily in the generic pharma space as well as the food testing business, where some important government policy changes are working their way through the system that ultimately will have a great benefit on the tools market, but has created some disruption in the short term, and so what's been a juggernaut of a business in China for us for a long time, took a little pause and was 4% down for the quarter, and I'm sure we'll get into that quite a bit.
Secondarily, Europe got off to a little bit of a slower start to the year as well as TA Instruments, largely with some very large global customers being more cautious on capital purchasing coming out of the chute in the year. Q1 is typically our smallest quarter of the year. It's about 20% of our business overall. And we've seen this pattern before a little bit. So really, as we look forward to the rest of the year, we've taken a balanced outlook and taken into account some of these macro factors recovering over the course of the year and moderating some of our guidance. But really, at the same time, some of the things that held us back in Q1 have really been historic strengths of the company where we have very strong market positions, very good opportunity to grow in the future.
And we're just working our way through those factors as we get into the quarter and the year. On a slightly broader note, I just wanted to continue to reiterate our enduring five-point value creation model that really provides the framework of focus for the management team. The first point, of course, is our very well-differentiated specialty focus in what we believe to be very structurally attractive markets. We compete in about 20% of the overall tool space and are oriented towards spaces that are driven by rising rates of innovation as well as rising rates of regulatory compliance requirements. And we think we're very well positioned in those spaces and continue to invest in a very focused way. Really, on that point, our second philosophy and practice is to orient our growth strategy primarily towards organic innovation.
Over the past five years, we've increased our spending in R&D by about 40%, and we're at the very beginning phases of what we believe is an entirely new and very exciting product cycle for the company. We've been investing intently. We're working our way through some fantastic technology evolution and are excited about what's to come. Of course, the headlines in 2019 so far have been the BioAccord launch for the biopharm monitoring space, which is a new space, and then we're shortly to launch our latest entry in high-resolution mass spectrometry at the ASMS meeting here in a couple of weeks, the Cyclic IMS high-end mass spectrometer, and there's more to come as well. Third point in our value creation model is around our focus on continued operational improvement, and we think we have opportunity across the board to get more efficient as we scale the company.
As you know, Dan, our margins are industry-leading. But by no definition does that mean we're optimized in any way. In fact, we think we have plenty of opportunity along both the innovation processes, the operational processes, and the commercial processes to improve our efficiencies and then, in turn, devote that resource back into growing the business. And as always, we'll try to balance growth, profitability, and investment back into the business. The fourth point is really capital allocation. And U.S. tax reform early last year was a game changer for Waters. And now we have access to our worldwide cash flows. And we've really reasserted our capital deployment along three core dimensions. Number one, growing the business. Number two, optimizing our balance sheet. And number three, returning capital to shareholders.
Of course, growing the business is priority one through R&D, CapEx, and highly disciplined M&A, which we've increasingly tried to build capability around. And then, of course, on the last point on capital deployment, we did announce a big new buyback program that we're working our way through as we migrate over the course of the year to a two and a half times capital structure, leveraged capital structure. Final point I'll make on our five-point value creation model is critically and really the bottom line for us is our people. And operating with a performance-oriented culture and management team, we continue to make huge investments in the people side of the business, both in terms of developing a rich pipeline of talent internally, but we've also gone outside and brought in a number of exciting incremental skill sets into the company.
Waters is a remarkable culture with 60 years of track record and a lot of focus as a company, and we're just continuing to invest in that side of it and preserve what's an outstanding culture, but really build on that with an even broader, more diverse, and inclusive leadership culture, so anyway, maybe I'll pause there and open it up to your questions.
Great, Chris. Thank you for that. I have some big picture questions, but I thought maybe we could actually jump right in a little bit to some of the topics that kind of got surfaced after a competitor's first quarter or second quarter result that was a little bit less stellar than people had hoped. So one thing that came up there was this idea that small molecule seems to be a slowdown in kind of spending on small molecule on the instrumentation side broadly, U.S., Europe, and the like. So I know you've spent time at your investor days segmenting out Waters business between small molecule and large molecule and you've given us some color. But maybe could you just speak a little bit to the small molecule side?
Remind us about how big that business is for you today, kind of what trends you've been seeing overall on small molecule and in particular on the instrument side, the LC side. Maybe speak to some of those topics and kind of level set kind of where the market is.
Sure. So just to ground the overall numbers, about 56% of our revenue overall is in our pharma business. And that's really the core franchise for Waters. And somewhere between two-thirds and three-quarters of that business is small molecule oriented, depending on where you're at in the world. We saw a couple of different dynamics affect our business in the first quarter. And they're actually quite different from each other. Certainly, the China dynamic with the 4+7 program on the part of the government to pilot a competitive bidding process for generic drugs in about 30 different therapeutic categories in four major cities and seven provincial cities really put a pause into that generics market in China. And our mix in generics in China is something a little bit greater than our overall mix around the world. So that was a factor.
For the rest of the world, really the biggest part of the small molecule business is still with the large multinational companies. And what we commented on in the quarter was that between Europe and the United States, we saw a bit of a conservative spending pattern out of the gates in the year. This has actually become somewhat typical, and we have great visibility into the purchasing plans of our biggest customers on almost any year we roll into. And we remain confident that those purchasing dynamics will play out over the course of the year. But there's just a little bit of a mixed macro environment right now and a little bit of probably extra caution. We also saw that on behalf of some of our larger industrial customers as well coming out of the chute.
As I mentioned before, believe that that will work itself out over the course of the year. The small molecule business is quite steady, actually. You can see that if you look at our recurring revenues of chemistry and service, that it kind of chugs along irrespective of capital purchasing cycles, whether those are mini cycles within a year or broader cycles. The inescapable fact is that access to life-enhancing medication is rising around the world, particularly in the generic category. So the ultimate metric for us is the activity level around prescription volume, pill count, and quality control testing that goes with that business.
Given that Waters is so oriented towards method development, process development, and QA/QC with about 85% of our total pharma revenue at that deep end of the process, we were confident that as the activity levels rise, as patient access to medication rises, that there'll be a continued steady stream of demand for our technology and our consumables.
And is there anything, Chris, on that front? As you mentioned, generics versus branded. But when you think about the developed world, U.S. versus China, is there anything? I agree, you've seen this happen year in, year out. There's some lumpy quarter that happens and people get nervous and then it usually works itself out. But when you think about this kind of small molecule instrument, is there anything unique now on LC, whether it be on the generic side or the branded side, or that you could speak to given that yourselves and a competitor both saw something in the first part of the year that seems maybe a little bit atypical that you're both seeing something?
Yeah. I can't comment on competitor patterns. I can only comment on our own. And for us, what we saw in Q1 was very much a function of top pharma. If we exclude the China piece, top pharma and the dynamic early in the year. As you know, we have a pretty unique mix of business, both in the developed geographies, but also we talked about China a little bit, but India, for example, went through a period over the last year, year and a half where they saw kind of a pause in capital spending. That appears to be coming back after two solid quarters in India. But there are a bunch of mini cycles there. I think in terms of the core underlying HPLC franchise, it's really robust.
I give a lot of credit to the Waters people two decades ago who really set up and created the standard of measurement, if you will, with HPLC, with the various detectors, the optical detectors that we use, with our chemistries, and with, frankly, the bottom line, which is the Empower Chromatography Data System, which is very much the industry standard for compliant laboratories in development and QA/QC. That measurement model is extremely robust. As you know, it gets specced into method. And when those methods move from innovator drugs into the generic realm, the companies that are producing those medications continue to live by that method. So we see great stability over time. And we see that really in the form of our chemistry and our service business on a routine basis.
And then the HPLC equipment can go in these mini cycles depending on where you're at in the world.
Okay. Great. Maybe just one other question on kind of, well, I'm sure we'll have many on this topic, but one more directly related to kind of this maybe uncertainty, if you will. Is there anything like how do we think about drug pricing as a potential cloud, if you will, possibly overspending? Is that something that you've heard or your sales teams have heard come up at all as we head into the 2020 election? Is that something that could cause a pause? Or you're a couple of steps removed. So I'm just wondering, you could argue drug pricing concerns could cause pharma to want to innovate more. So they want to spend more with the innovator. So how do we think about drug pricing if, in fact, it could become any factor in terms of the demand dynamics?
Yeah. It's interesting to watch that. And I think we all know drug pricing is not a new topic. It comes in waves. And so the industry has seen this. And there are other industry kind of macro questions around consolidation that come up from time to time. I think the bottom line for us is that to the extent those affect the psyche of our customers, we obviously pay close attention. But at the end of the day, whether it's the pricing question or the consolidation question, the ultimate aim of the pharma companies in managing through that is to increase their volumes.
If pricings come down but volumes go up, that actually helps our business because we're a volume-driven business with 85% of our pharma business in late-stage development and QA/QC to the extent that some of these macro dynamics affecting the pharma industry result in more volume, which we think there's a constant march towards in terms of patient access, both in developed markets and emerging markets, that'll ultimately benefit us in terms of testing volumes in chemistries and service and in capital equipment.
Okay, and then maybe kind of peeling back a little bit kind of to a higher level question right now. When you think about you kicked off the conversation laying out your five-point plan. When you think about the business, when you came in to run it, what Waters looked like and kind of what Waters is going to look like going forward, can you maybe compare and contrast, and obviously, the idea of a 60-year company isn't to rock the boat. It's to take what's there and maybe improve upon, innovate, change a little bit, but how would you articulate what Waters under Chris O'Connell is going to look like as we go forward that might look a little different than the past?
Yeah. Well, thanks. First of all, it's been a really fun three and a half years there. And I think there's the nice way I look at it is you always want to look at a great company and say, "What about it should be enduring? And what about it should evolve?" And there's really a list on both sides of the equation. I mean, certainly, there's some very enduring aspects of Waters in terms of the core values of the company and the focus and the integrity of the company, the disciplined market position, the strategy, the specialty-oriented strategy, our enduring principles. But at the same time, there's a pretty significant transformation underway at the company right now, really headlined by innovation.
Probably the biggest changes in the company right now are in the R&D function as we bring together previously distinct product centers into much more of a systems orientation to really take full advantage of what we do well in terms of building a system that can incorporate chemical separations, mass spectrometry, informatics, chemistry, everything we can do well. The BioAccord is a great example of one of the first outputs of that effort. I mentioned earlier the increased investment in R&D. We have aggressively developed the organization. Our pipeline, as we sit here today, is better, certainly, than it's ever been during my time. I think as we get into the pipeline evolution, it should be a historic improvement in pipeline and cadence and ability to produce a reliable pace of new product introductions in terms of both follow-on innovation, but also new platform innovation.
I'd say the second thing that's quite different now is access to capital, and obviously, tax reform gave us an opportunity to really rethink how we allocate capital and gave us a chance to do a lot more both internally with R&D, with CapEx. We're doing a lot more with CapEx right now to build scalability into the company and also to take a more forward-leaning approach to M&A. We're not going to ever set a particular dollar number and say we're going to deploy X amount of capital in a given year just to do M&A, but we have built a corporate development function, and we are more active in saying, "How can we increase the value of our technology and our workflows with our customers by adding from the outside?" We've made a bunch of minority investments. We've done a couple of small acquisitions.
But that's another way to deploy capital for growth. And that's really what we're doing. So I think the third element of what's really quite different right now is the whole talent development framework. We've got an unbelievable employee base, and we're investing to accelerate careers and to broaden the company's capabilities in a variety of different ways inside and outside and building a management team that can really take Waters to the next level. And that's what we're trying to do. We're trying to be the very best of who we are uniquely, but to add dimensionality, depth, and in a more reliable investment program into the company. And I think that's going to result in consistent, reliable growth long into the future.
Great. So maybe we could jump over to China then. Obviously, you kind of mentioned it in the prepared remarks, but obviously, it's been bumpy not only from global macro and tariffs, but certainly particularly to yourselves and a few of the tools vendors. So maybe can you speak to what, if anything, you've learned so far on this 4+7? I know at the time of the quarter, it seemed like it was somewhat of a bit of a surprise, kind of the magnitude of the spending pullback that's occurred, not just for yourselves, but for some of your competitors.
Maybe upon further due diligence, give us an update on how we think about how much of the impact might have already spread beyond these 11 cities that have already implemented it and kind of how we think about maybe the possible degradation and growth going forward as China and all the generic companies over there kind of deal with the potential pricing ramifications.
Yeah. So the 4+7 program was announced late in the year. It really became visible in December. And we just didn't have a good feel for what would happen as we got into the year. And we really didn't see it until later in the quarter when typically we would see a pickup in spending. And specifically as then the program, the bidding process actually went underway. I actually just got back from China about a week ago, so ran right over there, spent time with the team. We've got a terrific team, a terrific franchise. And I think we're gaining more insight every day that goes by on, "Okay, what are these drugs that are going through?
Who are the companies that are winning, that are losing these tenders?" I think the good news is that we have continued to see, as we reported in the quarter, a steady demand for the underlying service and consumables part of the business. So that tells us the installed base is heads down, working away, growing the business. And there's just a bit of a pause in the market as companies participating, but also those on the periphery are watching to see how this plays out. I think because of the uncertainty at which pace that we may come back at, we did do the prudent thing relative to our guidance and put a little more modest guide out there. But I think the bottom line is the generic pharmaceutical business that is clouded, if you will, by the 4+7 process at this point is a growth business in China.
The aim of the government is to increase access to their population to drugs, and as that works through the system, we'll see some pent-up demand building that will release over time. In terms of what each company is doing, in terms of those who are winners and losers in the initial round of bidding, they're looking at their overall portfolios because if there's a company that lost a particular drug, they've got other programs, and the winners then are figuring out how to gear up, so it's all in the name of growth and advancing prescription and pill volume, and ultimately, we'll see the benefit of that in the capital.
I mean, is it possible to at least opine about the extent or duration of this kind of program? Kind of as we get to the end of fiscal or calendar 2019, I assume these effects could last into 2020, but then you're going to have an easy comp. Any color about the potential duration of this kind of program weighing on results in China?
No. I don't think we have a lot on that right now. There's been no guidance that we can pick up of any kind as to what comes next. Whether this was a pilot and then nothing, or whether it's a pilot that does more, I think the government has to figure out if the view is worth the climb in terms of this type of an initiative. It's not unusual to see the government pilot various purchasing-type mechanisms all in the name of growth, and there's just a lot of wait and see, so we've got a lot of good business in China, though. We talk about the 4+7 or the food safety piece that's delayed a little bit of that business, but at the same time, our large molecule business was on an excellent growth trajectory in the first quarter.
Our clinical business, our biomedical research business, there's a lot of other levers to pull in China, and that's what we're focused on doing.
Right. Right. Okay. And then maybe just one more just on the food testing side, if you don't mind. Sorry, I know we're spending some time on this, and this was on the quarter, but since it did come up as well from another player who obviously had talked about this a year ago, and then suddenly you talked about it now. It's hard to get visibility on kind of how quickly this transition occurs so that spending can occur again. But is it just a timing issue right now? I mean, is the underlying demand still there? And just as soon as this ministry gets aligned that they can start buying product again? Any way to help us think about that timing issue?
Yeah. I mean, the ministerial reorganization was happening at this time last year, and we anticipated there'd be some shuffle. It's become clear through that process that the government wants to move a lot of the food safety testing from government-oriented labs to the private sector. That's a really good thing because that'll ultimately provide scalability in the system, which will lead to more testing. And what we know about China and the food supply is that there's a rising concern of contamination and quality and safety and transparency in the entire food value chain. And LC and tandem quadrupole mass spectrometry, in particular, are two very useful tools. We're more narrowly focused on those. Some other people have a broader range of technologies in there.
We saw only a modest kind of sign of this last year because a lot of the capital spending, which had been planned, did play through last year. But it was really in the noise, and so we covered it with other things. We saw a much bigger effect of that in Q1 of this year, particularly as budgets came into the year more locked up, particularly in some of the newer segments of who's going to pick up a lot of this testing. So we've got a very good position in food testing. It's definitely a great growth market. We're actually over-indexed in China food safety testing relative to global food safety testing. We have a larger portion dedicated in China. It's a growing, rising market. And obviously, as we get more visibility into how we think it'll play out, we'll let you know.
Okay. So I mean, maybe shifting over to R&D and the BioAccord, and then you're going to be at ASMS. So obviously, you can only reveal what's already been kind of disclosed. But it's interesting because you clearly highlight how, not revolutionary, but how critical this R&D change has been. The BioAccord, I think you've been very excited about, but kept expectations reasonably conservative about what that can mean. Maybe could you just speak a little bit more to the BioAccord and the opportunity and the size there in any way for us to help think about this future innovation that we're about to see coming out of Waters and what that can mean for the company?
Yeah. So two great examples. BioAccord, and maybe the reason if we've been a little bit circumspect about how that rolls out is because it really is a market development game. This is a new category of high-performance mass spectrometry in a regulated laboratory environment for method process development in QA/QC. There is some mass spec in that area now that's really repurposed research-grade instrumentation. But we want to create a scalable platform to ultimately do for large molecule what HPLC plus Empower did for small molecule that could provide us decades of growth. And that's what's happening. The trend is to multi-attribute monitoring, and the world needs a simple, robust, regulatory-compliant, high-performance mass spec system to do multi-attribute monitoring in biomolecules. And we're leading the market there. It's going to take some time to build that market, but it's going to be very powerful as it develops.
We're seeing a lot of the good early indicators of everything from leads to demoing to quoting. We're excited about what's to come there. On the other end is high resolution, where we haven't had a new entry in some time. We've now got the cyclic ion mobility system, which is going to be the most premium product we've ever launched in the space. It is something that people began to see a little bit of at last year's ASMS, but has become more well-known. Now there's papers out on it. We're excited to show off the very high end of research-grade mass spec. That's going to, it's certainly something that's giving our team a lot of energy and really our highest-end research collaborator customers.
Great. Well, unfortunately, we're out of time. We have a lot more to go through, but that's about it. But Chris, thank you very much for bearing with all the questions and being up here on stage with us. And thank you all for being in the audience and listening.
Great. Thanks, Dan. Appreciate it.
Have a great day.