All right, looks like we're getting started. Welcome, everyone. My name is Valerie Dixon. I'm an executive director in the healthcare investment banking team at Morgan Stanley. Before we begin, I'm required to read off a little disclaimer, so bear with me. Please note that all important disclosures, including personal holdings disclosures and Morgan Stanley disclosures, appear on the Morgan Stanley website at morganstanley.com/researchdisclosures or at the registration desk. This morning, we're pleased to have Chris O'Connell, the Chairman and CEO of Waters, market leader in liquid chromatography, mass spec, and thermal analysis. And Chris, for those in the room who are not as familiar with your equity story, do you want to level set us and kick us off a few minutes of background on the company?
Sure. Perfect. Thank you, Valerie, and thanks for having us to the Morgan Stanley meeting today. It's great to be in New York and with all of you. We're also joined by our Chief Financial Officer, Sherry Buck, and our Director of Investor Relations, Bryan Brockmeier, for any follow-up. But thanks for the opportunity, and I welcome questions from the audience. I'll just make a few overview comments about the year we're in and then the broader picture of the company. So first of all, halfway through the year, I think many know who follow Waters, we had a slow first half of the year with the top line growing about 1%. We had some pretty changeable market conditions coming into the year, particularly in China and in Europe, with a flat revenue in the first quarter.
We did see improvement in the second quarter, as we reported at the end of the quarter, with some improvement in China and stabilization in our core pharmaceutical customer base, which was a little slow out of the gates in the beginning of the year in capital purchases, and as we look at the second half of the year, we commented at the end of the quarter that we do expect improvement in the second half versus the first half. That's based on market conditions getting a little bit better in the second half of the year generally, although still quite dynamic in China and in Europe and some other places.
Of course, the benefit of our new product cycle, which I'll certainly comment a lot more, but it's really a special year for Waters in total with regard to new product development and a nice number of new launches that are coming into the market that we're very excited about. We're taking a balanced view for the next half of the year, as we talked about at the quarter, being pragmatic about some of the end markets like China and Europe in the macro environment that have affected us, but also having great confidence in our market positions and what we're doing to invest for growth for the future. Maybe a couple of just quick points, bigger picture.
For those of you who are newer to investing in Waters, we have a five-point value creation model that really summarizes, I think, pretty well what we're trying to achieve at the company overall. First of all is a focus as a specialty company. We have a lot of different types of competitors, but Waters is known for its specialization and its depth of expertise in core organic innovation strategy. We participate in about 20% of the overall life science tools market with a very unique mix of end markets, most notably pharmaceuticals and biopharmaceuticals, nearly 60% of our mix.
But also quite an interesting global picture as well, with almost three-quarters of our revenue coming from outside the United States and a very nice mix between instruments, which is about half of our business, instruments and informatics, and then recurring chemistry and service business for the other half of the business. Second point is, as a growth company, our core growth strategy is defined by organic innovation. We've increased our R&D spending since I've been here over the last four years, 30% or 40%. We are in front of what we believe is a major new product cycle in many areas of our business, and that core investment in R&D is really fundamental to our growth strategy looking forward, and we'll continue to emphasize that. The third point of our value creation model is what we see as an opportunity for continuous operational improvement.
Yes, we do have very premium margins in the business and industry-leading margins of profitability. That does not reflect any kind of optimization per se, but really reflects the unique mix of our business that I mentioned earlier, and we think we have plenty of opportunity for continuous improvement. And that's really all directed at scaling for growth and making sure that we create the efficiencies and the leverage in the business that allow us to redeploy capital to growing the business and scaling in the future. The fourth point overall is our capital deployment strategy, and certainly tax reform in the U.S. a couple of years ago was a major event for us. Being so internationally oriented with so much trapped cash, we had an immediate opportunity to pivot really from being a capital accumulator to being a capital deployer.
In the most recent quarters, and currently, a lot of that capital deployment activity is really around moving to an optimal capital structure through greater deployment to the buyback, but really, our priority from a capital deployment standpoint is growth, and we look at growth from the standpoint of increasing the R&D spend. As I talked about earlier, we've been doing that aggressively. We've actually been significantly increasing our capital expenditures. This year, our CapEx is double prior year, mainly driven by our new investment in our Taunton Chemistry Synthesis Facility, which is an industry-leading center of excellence for chemistry innovation and chemistry production, which is at the heart of our competitive advantage, and then also, of course, deploying capital selectively to M&A opportunities, and that's a bit of an emerging theme for us.
We're very disciplined and selective about the investments we make externally, but we do see an increased opportunity for deploying capital to our portfolio in that manner. Then finally, the fifth point of our model is really around what we believe is a very special culture at the company. In fact, the culture of Waters really attracted me and the team, and we believe our culture and our team is a performance driver. So the investments we've made to build our organization, to add capability, to add scalability, and really maintain a very unique, scientifically driven, collaborative, customer-focused culture is at the core of what makes us different in the market.
Paying attention to that, investing in that, nourishing our values and the roots, the strong roots of the company while we reach for a greater vision is part of the way we think about value creation. Maybe I'll pause there, Valerie, and open it up to your questions and anybody else in the audience.
Sure. That's a great intro, and you touched on a lot, and I hope we can at least cover maybe 70% of that in the course of the next 20 minutes. One of the things that you mentioned was your biopharma end market exposure, almost 60%. How are you benefiting today from the significant growth in the biologics manufacturing wave?
Yeah. Our business overall at Waters is about almost 60% oriented to pharma, and that splits about two-thirds towards small molecule business, which is predominantly late-stage development in QA/QC with liquid chromatography, and then about a third in the large molecule space. Of course, this is one of the great themes of our time, the gold rush of innovation in this space, and it's really exciting. We made a decision long before I was involved in the company, 15-plus years ago, to really make sure that our analytical instruments would support this vision of biotechnology and large molecule innovation. Innovations at Waters, like the ACQUITY UPLC platform, a lot of the chemistries and workflows that go around that position us very well. We're more focused in the analytical laboratory versus production, but that again speaks to our focus as a company.
And certainly, a big theme in the increasing requirements for quality and the monitoring of critical quality attributes in product development and QA/QC within biopharma has really influenced our strategy around mass spec technology in particular, because we believe, and I think the market believes, that the use of high-performance but highly usable and robust and reproducible mass spec technology for the monitoring of critical quality attributes is a major need of the market. And the BioAccord family of mass spectrometers was designed explicitly for that purpose. So we're trying to make sure our investments are mirroring that overall investment in biopharma and excited about the contributions we can make.
That's great. We'll get to the BioAccord launch later on. But on a related note with the pharma exposure, because of that significant exposure for you, investors like to "read through" your results as a leading indicator for other pharma end markets, exposure for other companies in your peer group. Do you believe that's fair, or are there nuances of your particular applications or specialty nature of your technologies that make you a poor proxy?
Yeah, that's an interesting question. I think most of the companies in the space just have such different mixes of end markets that sometimes it's hard to completely read across, although certainly we have great competitors in different doses, if you will, in different markets. Waters is distinguished in being overall in our pharma business more oriented towards late-stage development and QA/QC and regulated laboratory environments, and a lot of that is because of the position we have in informatics and in chemistries and those workflows that are so strongly entrenched, so if you look at the Empower Chromatography Data System, which is our core informatics package for LC workflows, it's really the industry standard. We have upwards of two-thirds market share or more of the pharmaceutical space for regulated laboratories with Empower.
That makes us really the gold standard for LC and in the future paves the way for being the gold standard for LC mass spec in the downstream regulated laboratories. Of course, we participate in the upstream research and discovery phase as well, but we're a little more oriented towards the operational end of it. There's a lot of activity at all segments along there, and certainly some of the investments we've made to up our game on the research side are coming through as well. We launched an amazing new mass spec-based system this year called the SELECT SERIES Cyclic IMS, which is a bespoke technology for the most demanding research applications, combining LC ion mobility separation in a cyclic format, which leads to very high mass resolution and then time-of-flight detection as well.
So this is a new tool that's now available for the most demanding research environments and is giving us some very interesting exposure into the broader opportunity.
Yeah. Let's talk about these new products. You're at the beginning stages of a brand new product cycle with the launch of the BioAccord and the high-res mass spec, which you just mentioned. For the first few quarters of these, typically if you've been around long enough, they come with high expectations and high anxiety. You're already losing your hair, so we won't attribute that to your launch. But how do you feel about your initial progress? What's been early customer feedback, both positive and negative, on their decision to be early adopters or not?
Yeah. No, it's super questions, and I'll take that stress. I love it. No one has higher expectations than us internally, but it's been fun to bring new technology to market, and they're different. BioAccord is a market development opportunity. It's a purpose-built solution, fit for purpose for a regulated laboratory environment to bring this high-performance mass spec to a much wider user base. And in fact, I was just at a customer on Monday, a major biopharmaceutical customer who's an early adopter of BioAccord, and just seeing their vision and seeing their excitement for the quality of the data, but the usability of the system and how they see that pathway as they look at the world of multi-attribute monitoring and being able to measure in a very simple, fast, compliant manner intact proteins and glycans and full peptide maps and then all the other applications that are coming.
It's exciting, but that's a new market development. That's going to take years to play out. We're seeing a lot of great early signs, and all of our launch activities are creating that excitement internally and externally, but that's a market-building opportunity. On the other end of the scale is the research end and the Cyclic Ion Mobility System. And Waters has a long history originally through Micromass and now our integrated company in bringing new technology, particularly in time-of-flight mass spectrometry to those markets. And there's high expectations there, and we're getting tremendous feedback from those who have used the system because we gave early access to a lot of leading researchers in the development phase. And so we're beginning to see that order activity develop, and we'll see where it goes.
You use the word researchers, but I assume you also mean for clinical applications. Can you talk about, are you seeing more clinical applications for mass spec? Where do you see that market going in the future 10 years from now?
Yeah. Great segue to a different market segment where we've been alluding to pharma, of course, and biopharma and also biomedical research with something like the ion mobility systems, Cyclic. But clinical diagnostics is a space that Waters has been in a long time. Waters was one of the pioneers in gaining IVD labeling for tandem quad mass specs, and we've actually launched some new technology in that space last year with the Renata DX, which is a next-generation tandem high-end tandem quad. We're very oriented in spaces like newborn screening, therapeutic drug monitoring, opioid measurement, etc. But we also have invested in some very high-potential technologies around direct ionization mass spectrometry like DESI and REIMS, and we have always had a MALDI franchise.
The utilization of mass spec technology in the clinical realm is a big opportunity because mass spec as a tool has very high degrees of sensitivity and specificity of detection with great economics because of the multi-analyte capability of mass spec. In the broad scheme, mass spec is going to go a lot further. Systems have to be very robust. They have to be compliant. That's an area we think we can add value because of our sort of compliance DNA really within the company. We've done well. It's not a huge part of the business. Clinical diagnostics is between 5%-10% of the business, depending on how you count it, but it's something that we've steadily invested in and will continue to invest.
Good. Switching gears to recent performance, something you addressed very early in your remarks, but the first half turned it below expectations, and as a result, you've had to lower guidance, your top-line guidance, now to 1%-3% constant currency as the last earnings call. As we sit here, we're two-thirds into the third quarter. Are you seeing any of the factors that led to the weakness in the first half persisting? And what specific actions have you taken to kind of move the company back into the mid-single-digit growth?
Sure. I can't comment on specific trends within the quarter. We'll do that at the end of the quarter, and so I'll refer to my comments from the last earnings release. But certainly, the keys to the second half being better than the first half, which is the comments we had made at the end of the quarter, will ultimately reflect some of the key dynamics that affected us in Q1 and Q2, like the Chinese business and the European markets that got off to a little bit of a slower start, but also our expectation of the impact of some of the new product launches. So we talked about the BioAccord launch. We talked about the Cyclic, the SYNAPT XS, which is our flagship high-end research instrument, very flexible, powerful instrument, and then two tandem quad mass spec systems, the Xevo TQ-S cronos and the TQ-S micro refresh.
And so there's a lot of new technology coming in. It doesn't sort of immediately jump in and change trajectory. It does over time, but we do have an expectation that those have a positive effect on the second half of the year versus the first half.
Yeah. I know it's difficult to take a short-term view here, especially with the new product launches. At this conference on Monday, one of your peers said, "It's actually easier for me to predict our growth range three years out than it is for the next quarter or two quarters." Do you agree with that statement?
That's interesting.
You can point it to share your.
Yeah. I mean, I think the thing we know about that three-year timeframe is all the investments we're making in innovation and what the product flow looks like at that time and how technology gains traction over time. I think we do have confidence that the investments we've made will lead to really good growth. Some of the things I'm guessing a comment like that reflects just some of the very dynamic market conditions in places like China and Europe, and there's a lot of macro uncertainty around Brexit and around trade and tariffs, and that affects markets. Certainly, specific policy initiatives like the 4+7 program in China or the food safety testing infrastructure following the ministerial reorganizations, I mean, those are pretty well-characterized factors that were sort of hard to predict and affect the market.
But we also try to take a big-picture view of those and say a lot of those policy initiatives, for example, in China are ultimately going to lead to market conditions that we find attractive. So price controls and generics, for example, ultimately are being implemented for the purpose of increasing access to medication for their population. And that's a good thing because that'll lead to higher prescription volumes and more testing. And if there's some lumpiness in there in terms of market psychology and instrument purchasing along the way, we've seen those cycles before. We've seen those cycles in China. We've seen those cycles in India. And so we try to keep our eye on the prize and focus on what we control, which is bringing great technology to market and serving our customers.
China represents today, what, 18%-20% of your revenue?
Yeah. Number two country in the world outside the U.S.
Great. Great. Doubling down on that, given the amount of government investment you just cited there, have you also seen local players, Chinese companies building up their own capacities there? How has that affected your business?
Yeah. Not as much in this space. What we've seen is a desire by the government, for sure, by the standard-setting groups like the Chinese Pharmacopoeia and by the competitors there to look at global standards for testing and therefore harmonize on methods and really technology capabilities that are serving most of the markets. Part of that is an increased desire for quality and regulatory oversight in China. Part of it's the desire for those companies to export out of China at some point. And so yes, we do see entrepreneurial activity in certain smaller ways, but it's really primarily an import market right now.
Maybe some competitors do some local manufacturing, but really the technology that's used in the pharmaceutical industry and food safety testing and some of the major categories, clinical diagnostics, as you mentioned, even some of the material sciences is very much oriented towards the multinational companies right now.
All right. We're going to take a pause here and see if there are any questions from the audience. And there's a mic going around for anybody. Doesn't look like any right now, so we'll continue on. You also mentioned in your opening remarks that you're moving from a capital accumulator now to a capital deployer. And as you think about that, how much will M&A play a role in that strategy for you?
It'll play a selective role. Sometimes people think about Waters as a company that doesn't do M&A, but I then remind them we wouldn't be the company that we are today had we not done the Micromass acquisition in 1996 and the TA Instruments acquisition. Now, those were 20-plus years ago, and so Waters hasn't been as active. But what I've been thinking about in that and what the team has been working on is make sure that we see M&A as another element of our innovation strategy. And I think we have the humility to know that we can't invent and create everything in-house that we would like to bring our customers. One example of that is I mentioned briefly the DESI technology.
This is the Desorption Electrospray technology that's one of the most valuable ambient ionization techniques for mass spec and has really interesting implications for a variety of fields, including pathology and research. That technology was created outside of Waters. We went out and acquired it to add to our portfolio of direct mass spec techniques and has a lot of potential. So we did that a year and a half ago. We've made a number of investments, maybe more quietly than most people know, in promising technologies that sit adjacent to our workflows that are valuable to our customers, and we very selectively are now looking at other opportunities. We've built a corporate development function. We have very high standards for strategic logic, financial logic, and overall execution capability.
And so we do see it as a tactic to fulfill our overall growth strategy as opposed to a capital deployment strategy. So we see M&A opportunities as a way to deploy capital to growth, which is our first priority, as I mentioned earlier. But we don't have any objectives around deploying X amount of capital over Y, period. It's more about the opportunity and the ability to enhance our core business and also add adjacent capabilities that are important and vital to our customers' innovation process.
Have you developed a framework or criteria that you're willing to share around the strategic logic of specific targets?
Yeah. I think the strategic logic is really two fold. One is, does the technology or the category or the capability enhance our core business? That's question one. And question two is, is the technology or capability adjacent in a way that helps our customers succeed in a way that we can add unique value? So it sounds pretty general, but it's sort of advancing and investing in adjacencies, advancing the core, but very much in and around the core. From a financial standpoint, objectives are what you might guess: enhancing growth. Of course, return on invested capital is the most important metric over time and looking at dilution accretion profile.
Good. It's no surprise to you, but we're in a premium valuation environment in the tools and diagnostics space, and certainly that's been evident with some of the recent transactions that have taken place 20-plus times EBITDA valuation levels. Has the premium valuation environment, in a way, kept you on the sidelines in recent years, or has that really not been the sole factor? It's really been about identifying something that's going to fit your criteria?
Yeah. I mean, I think it definitely plays a role. We're a little newer to sort of the active engagement in this type of process, so we're getting into it. And there's always a risk-return trade-off, and that return is, to some degree, a function of the economics and the premium valuations. We're not afraid of premium valuations for the right strategic opportunity, and so you have to weigh it in that context as well. But Waters has always been known as a very disciplined company. We're disciplined in terms of how we run the business and allocate capital internally, and we're going to be disciplined about it externally as well.
Great. I'm going to see if there are any other questions from the audience. There are two over here. And to save time, maybe you can state your question, and I'll just restate it for the mic. You're awake.
Sorry. It's very difficult to square what you just said about China with what we are hearing in China in terms of the government pushing hospitals and pharmaceutical companies to really source from China's companies. So how can you be so confident in the next two, three years that effectively you're going to maintain your market position?
Yeah, so if I understand the question, in other sectors, you're seeing the government pushing hospitals and so forth. Our customer base in China is primarily the local pharmaceutical companies, and so our business directly with hospitals is very small and only in the clinical diagnostics sector, and we actually do that through local partners, so we actually have distribution partners that ultimately serve the hospital sector, and it's even in a small way within that small clinical diagnostics sector, so there really aren't any pronouncements or rules around local vendors, if you will, to the industrial segment, meaning the commercial segment or even the government segment around pharmaceutical companies, materials companies, food and environmental laboratories. We're one step removed from the direct healthcare world, if you will, that I think you're referring to.
But it's a good question, and certainly we expect over time Chinese innovators to look at the space and find it attractive, and we'll compete accordingly. There's a question here?
Yes.
I think some of your clients have been somewhat successful in using variable labor costs as a way to kind of manage when they're having periods of success in growth and dealing with how their portfolios are adjusting all the time. It seems that you've been more focused on fixed labor. Have you found any opportunities to kind of think about ways to increase your use of variable labor costs? Variable labor from the standpoint of outsourcing? Exactly. And contractors. Yeah. There are certainly examples within our workforce where we have contractors, and that can flex up and down. You can see that in software development and certainly manufacturing. There's part of the labor pool that is variable in that sense that flexes with volume. And certainly, overall growth affects incentives and variable pay, and so you get a little bit of it that way.
But we're a pretty focused and integrated company. And if the economics ever warranted more contracting, we would look at that. But for us, it's the speed and responsiveness and the impact of our innovation that we're solving for. One example of that where we do have fixed-cost infrastructure is in our chemistry operations. I alluded to it earlier with Taunton, but we have the industry's really premier investment in chemical synthesis. The quality and reproducibility of our chemistries over long periods of time, literally over decades, which are the lifecycle in that business, are so important to our customers that controlling all the way from raw materials to production of chemistry columns is a critical supply chain for us to really control. And that's fixed cost, but it's fixed cost we think has very high returns. Just one other question.
Access to labor, has that been any of an issue? I mean, you work in a pretty discrete type of science, and I think there's issues of digitization that are occurring at the same time. I just didn't know what those forces are doing to getting you easy access to labor. Yeah. It's a good question. I mean, we're pretty broadly participating in a lot of different labor markets. I mean, for example, one critical skill set is software engineering, which is software as a category is actually our single biggest product development spend category. We've opened up a facility, and now it's the number five facility overall for Waters in Brașov, Romania, which is a center of excellence for software talent. It's very stable, very skilled, very scalable. There's other examples like that that we've been creative and enterprising in taking advantage of global opportunities.
But we're also a focused enough company that we're well-known. We have a good brand name, and the scientific talent we're able to attract is usually very high.
Unfortunately, we're out of time. Thank you very much for your contribution.
Great. Thank you, Valerie. Appreciate it.