Good morning. Welcome to the Waters Corporation first quarter 2013 financial results conference call. All participants will be able to listen only until the question-and-answer session of the conference. This conference is being recorded. If you have any objections, you may disconnect at this time. I would like to introduce your host for today's call, Mr. Douglas Berthiaume, Chairman, President, and Chief Executive Officer of Waters Corporation. Sir, you may begin.
Thank you. Well, good morning, and welcome to the Waters Corporation first quarter financial results conference call. With me on today's call is John Ornell, Waters Chief Financial Officer, Art Caputo, the President of the Waters Division, and Gene Cassis, Vice President of Investor Relations. As is our normal practice, I will start with an overview of the quarter's highlights, and John will follow with details of our financial results and provide you with our outlook for the second quarter and for the full year. Before we get going, I would like John to cover the cautionary language.
During the course of this conference call, we will be making various forward-looking statements regarding future events or future financial performance of the company. In particular, we will provide guidance regarding possible future income statement results of the company, this time for Q2 and full year 2013. We caution you that all such statements are only predictions and that actual events or results may differ materially. For a detailed discussion of some of the risks and contingencies that could cause our actual performance to differ significantly from our present expectations, see our 10-K annual report for the fiscal year ended December 31st, 2012, in Part One under the caption Business Risk Factors and the cautionary language included in this morning's press release and 8-K. We further caution you that the company does not obligate or commit itself by providing this guidance to update predictions.
We do not plan to update predictions regarding possible future income statement results except during our regularly scheduled quarterly earnings release conference calls and webcasts. The next earnings release call and webcast is currently planned for July 2013. During this call, we will be referring to certain non-GAAP financial measures. A reconciliation of the non-GAAP financial measures to the most directly comparable GAAP measures is attached to the company's earnings release issued this morning. In our discussions of the results of operations, we may refer to pro forma results, which exclude the impact of items such as those outlined in our schedule entitled Reconciliation of Net Income Per Diluted Share, included in this morning's press release.
Thank you, John. Well, 2013 has started off pretty much as we had anticipated. Demand for new instrument system has improved nicely from the trends we saw throughout last year and has returned to organic growth rates with strong free cash generation that are more in line with our historical performance. Though our reported sales and earnings per share were lower than we had forecast, the shortfall is entirely due to currency translation dynamics, primarily the significant weakening we're seeing in the Japanese yen. Looking at the first quarter, our constant currency sales grew about 5%. Our adjusted earnings per share were up 7%, and we generated strong free cash flow. John will review for you our financial performance in more detail momentarily.
For the Waters Division, our pharmaceutical end markets grew organically at a mid-single-digit rate with strong sales in India and China compensating for slower capital releases among large multinationals. Global government and academic demand accelerated to a high single-digit rate based largely on successful mass spectrometry technology-driven lines. Outside of life science markets, industrial, chemical, and applied markets grew more moderately in the quarter. Geographically, the highlights in the quarter include a return to strong growth in India and the continued robustness of our business in China. The strength in China was broad-based across the applications we address and looks to be sustainable in upcoming quarters. We're also expecting the strength in India to continue as the local currency has stabilized and as production volumes for generic drugs ramp up and as CRO spending increases.
Waters Division constant currency sales in Japan were modestly down in the quarter with nearly all customer categories exhibiting somewhat lackluster demand. This weak demand compounded the adverse effects of the weakened currency. We remain encouraged that sales growth will improve in Japan during the second half of 2013 as governmental stimulus programs kick in and as exporting manufacturing companies start investing due to potentially stronger profits as a result of the weaker yen. In the U.S., and staying on the Waters Division performance, sales were up mid-single digits. We saw our strongest growth in pharmaceutical and chemical analysis segments, while our government and academic spending were somewhat softer. The strength in pharma spending was largely from specialty clinical diagnostics and CRO customers. Spending from some of our larger pharmaceutical accounts shifted into the second quarter due to delays in capital budgets.
In general, our developing markets in Latin America performed pretty well in the first quarter in comparison to mixed results throughout 2012. Our European business in constant currency for the Waters Division was about flat in the first quarter, essentially in line with our expectations. Looking at customer groupings, European government and academic spending was robust in the quarter, while pharmaceutical and chemical analysis both saw a modest decline. The academic strength was in part due to significant mass spectrometry placements for proteomics and metabolomics applications. Our TA Instruments division started off 2013 with a solid mid-single-digit constant currency sales growth quarter. Growth was largely driven by new technology products, with high-temperature instruments beginning to have a more meaningful impact on the division's overall sales performance.
These high-temperature systems, instruments that are used to characterize metals and ceramics, are sourced from businesses that TA acquired during the past couple of years and will continue to expand TA's application reach for years to come. Geographically, growth for TA was largely balanced across major markets. Now I will discuss some product line dynamics that we saw in the quarter. Our recurring revenues, the combination of service and chromatography consumables, only grew modestly in the first quarter, as both our chemistry and service businesses were adversely affected by roughly two fewer selling days in the quarter, and by, in the case of our service revenues, a tough comparison to a double-digit growth in the first quarter of 2012. Chemistry growth was a little weaker than we had anticipated, even in light of the fewer selling days.
However, ordering trends for columns and other chemical reagents have picked up early in the second quarter, and we anticipate the growth rates will normalize towards historical mid-single-digit levels as we move through this year. ACQUITY columns continue to account for an increasing proportion of our overall column business, and this trend is consistent with a steady uptick in UPLC adoption rates. Looking at our Waters Division instrument system sales growth was particularly strong for UPLC mass spec systems. All our major mass spec technology platforms, including Q-Tof, tandem quadrupole, and single quadrupole devices, grew at double-digit rates with strong uptake in pharmaceutical R&D applications. This trend is very encouraging as we can begin to see the positive impact that our new UNIFI operating system is having in driving advanced system offerings and enhancing our competitive position in the marketplace.
On the chromatography front, we saw the strongest growth in orders for ACQUITY H-Class and UPC² technology systems. H-Class benefited from strong uptake when sold along with single and tandem quadrupole detection technology, while UPC² adoption rates continued to steadily improve across a wide array of applications. In March, at the Pittsburgh Conference, customers were very excited to see a new Advanced Polymer Chromatography system, called ACQUITY APC, that we introduced at that venue.
The ACQUITY APC system couples new size exclusion ACQUITY column chemistry with a tailored ACQUITY UPLC system that includes a new high-sensitivity refractive index detector. Developed in collaboration with researchers at Dow Chemical, this new system represents a long-awaited quantum step in analytical capability for researchers developing advanced polymer-based products. We expect to see sales growth impact from this system as volumes ramp up during the second half of the year.
On the HPLC front, we saw consistent demand for our Alliance system. Alliance continues to be the workhorse system for generic drug quality control applications, and its consistent performance over many years has created a loyal customer base, a base fairly unwilling to change their purchase patterns. In that light, we have recently updated our Alliance system to ensure our ability to continue to manufacture and support this system for a number of years. The updated Alliance system offers performance that allows for seamless method transfer from earlier Alliance systems while providing updated electronics and improved industrial design. So, what do I think is in store for us going forward? Well, the simple answer is likely more of the same. I mean stable top-line growth, industry-leading profitability and cash flow, and a conservative capital allocation strategy.
On the product front, expect us to continue to leverage the convergence of UPLC and mass spec technologies to create advanced UNIFI-based application tailored systems. You will see examples of this at ASMS later this quarter, as well as significant new MS innovations. On the M&A front, we will continue to see smaller complementary technology opportunities that fit our profitability and growth characteristics.
It is likely that we will see more activity on this front from our TA Instruments division over the next few quarters as more assets appear accessible. I'm confident that 2013 will be a successful year for Waters and that we will return to top-line growth that's closer to our historical average rate, significantly better than what we saw last year during an industry-wide slowdown. Though we are not seeing economic conditions that suggest a robust recovery in the near term, we sense stability in the market.
This market stability, in combination with the high degree of confidence that I have in our competitive position and in our technologically focused business strategy gives me confidence that we can perform well this year. Now, here's John for a review of our financials and an update on our outlook.
Thank you, Doug, and good morning. First quarter sales grew by 5% before currency translation. Currency translation reduced sales growth by 3%, resulting in 2% overall sales growth. Non-GAAP earnings per fully diluted share were up 7% to $1.07 this quarter, compared to earnings of $1 last year. On a GAAP basis, our earnings were $1.39 this quarter versus $0.98 last year. A reconciliation of our GAAP to non-GAAP earnings is attached to our press release issued this morning. Our GAAP results this quarter contain a one-time income tax benefit from an update of our reserves based on recent significant progress made towards closure in ongoing income tax examinations. As I just mentioned, before foreign currency translation, sales were up about 5%.
Looking at this growth geographically, and again, before foreign exchange effects, sales within the United States were up 6%, Europe was up 1%, Japan was down 2%, and sales in Asia, outside of Japan, were up 5%. ROW sales growth in the quarter was strong. On the product front and in constant currency within the Waters Division, instrument system sales increased by 8% and recurring revenues increased by 3% this quarter. Within our TA Instruments division, total sales increased by 6% versus prior year. Now I would like to comment on our Q1 non-GAAP financial performance versus prior year. Gross margin performance came in about as expected at 59.4%, down modestly from Q1 last year.
As described in our prior guidance, we expect a modest decline in gross margin percentage across the year versus prior year as a result of a weaker currency translation environment and from additional software amortization from the release of our UNIFI products. Additionally, this quarter, growth accelerated for our Q-Tof-based mass spectrometry products, resulting in a mix shift that slightly reduced gross margin percentage and added to organic sales growth. SG&A expenses were up 1% as a result of currency translation and continued tight spending controls. R&D expenses increased by 8% this quarter. On the tax front, our effective operating tax rate for Q1 came in at 12.6%, which contributed about a penny and a half to earnings benefit to our results this quarter versus our prior expectation.
Our tax rate for Q1 is lower than our anticipated full-year tax rate because it includes the R&D tax credit for 2012 that was reinstated in early 2013. For the full year, we expect our tax rate to be between 15% and 15.5%. In the quarter, net interest expense was $6 million, and share count came in at 87.2 million shares, $3 million lower than Q1 last year, as a result of our continued share repurchase programs. On the balance sheet, cash and short-term investments totaled $1.590 billion and debt totaled $1.233 billion, bringing us to a net cash position of about $357 million. As for Q1 share repurchases, we bought slightly over 1 million shares of our common stock for $95 million. This leaves $548 million remaining on our most recently authorized share repurchase program.
We define free cash flow as cash from operations less capital expenditures, plus any non-cash tax benefit from stock-based compensation accounting and excluding unusual non-recurring items. For Q1, free cash flow came in at $113 million after funding $18 million of CapEx. Excluded from this CapEx amount is $12 million of spend associated with our new Manchester, U.K. mass spectrometry facility. We expect this facility to be ready for occupancy in 2014. Accounts receivable day sales outstanding stood at 80 days this quarter, up three days from Q1 last year. In the quarter, as is typical early in the year, inventories increased by $7 million. Thinking about the remainder of 2013, we had slightly stronger organic sales growth to start the year, and current business conditions look to support a continuation of this mid-single-digit growth trend.
On the currency translation front, there has been a general weakening of major foreign currencies versus the dollar, with the Japanese yen leading the way with more than 10% depreciation since the start of the year. Updating our guidance for current translation rates now results in a 2% headwind from currency translation for the full year. Moving down the P&L, gross margins are expected to be about 59.5%, a modest decline due largely to currency translation and software amortization dynamics I discussed earlier. Operating expenses are expected to be up around 3% from 2012. Net interest expense is expected to be approximately $24 million. We expect our full-year operating tax rate to be between 15% and 15.5%. Our full-year average diluted share count is likely to be around 85.5 million shares outstanding.
Rolling all of this together, non-GAAP earnings per fully diluted share are expected to be in the range of $5.15-$5.25. This is $0.15 below our guidance from January and reflects the adverse impact of foreign currency translation at today's exchange rates. As we think about our expectations for the second quarter of 2013, we expect organic sales growth to continue to be in the mid-single digits. Currency at today's rates would reduce sales by about 2%, resulting in reported sales growth of about 3%-4%. This brings non-GAAP earnings per fully diluted share to be in the range of $1.18-$1.23. Doug?
Thank you, John. I think, operator, at this point, we can open it up for Q&A.
If you would like to ask a question, please press star one. Be sure your phone is not muted and record your name clearly when prompted. To withdraw your question, you may press star two. Once again, to ask a question, press star one on your touch-tone phone. Our first question comes from Ross Muken of ISI Group.
Hi, good morning, gentlemen.
Morning, Ross.
So, it seemed like one of the stories for the quarter was a recovery in instrument growth, and I know you had an easing comp there, but it seemed to be even better than most of us were looking for. If you had to tease out, as obviously it seems like more broadly, CapEx demand is soft. If you need to tease out market growth, new instruments, maybe the benefit from India, the different components of what drove you better, certainly than the market, but even better than forecast, how would you weigh that out amongst the different pieces?
Well, it's again, hard to totally characterize what's going in the market for one quarter, Ross, but I think the significant dynamics for us was a quite strong mass spec business pretty much all over. So, we saw good, strong results across every mass spec platform, the tandems, the high-end SYNAPT, Q-Tof line, and the single quads. We also saw a return to growth in India. Now, it's been a while coming, but we finally saw a return to significant growth in India, and we've seen a continuation of very strong business conditions in China. And our results there are probably stronger than most. The U.S. held up pretty well in the quarter, and Western Europe was soft, but not softer than we had anticipated. But I think that all rolled up into a stronger capital position than certainly was seen through most of 2012.
And on the margin line, it seems like all of the issue you've had on pull-through is currency related. I know it's hard to react to short-term changes, but it seems like, given the commentary, particularly out of Japan, we're going to be in for a period of a weak yen now for a while. Is there anything you can do to mitigate that? I know you don't have a lot of cost base in that region, and I'm not suggesting hedging, but on a medium-term basis, do you think about shift the region, or is there anything you could do to basically offset some of that, or we'll just have to live with the incrementals for the year as long as the yen is weak?
Well, our forecast anticipates that we live with it for the year. Within Japan, it should be noted, our Japanese business is a very profitable business. So, even at JPY 100, this business continues to operate very profitably for us, just not as profitable as it was, of course, at JPY 80. And we do not do any manufacturing in Japan, and we do not intend to. So, all of our revenues in Japan, except for the locally sourced service and administrative costs, are exposed to the yen. That is why the flow-through to our bottom line is so significant coming out of Japan. Whereas in Europe, we do a lot of manufacturing in Manchester and in Ireland. So we are more balanced in terms of our costs and revenues in Europe.
What we could see is, if this stronger organic revenue continues for the year, it is conceivable that that would be higher than our current forecast, and that might lead to a mitigation of the yen situation. But we have no intention of now locking in the yen at JPY 100. We are much better over the long term managing in this currency environment, and we will modify our long-term budget and strategic plans. But within a year, it is very difficult to offset this kind of currency move.
Great. Thanks, Doug.
Our next question is from Daniel Brennan of Morgan Stanley.
Hey, guys. Thanks for taking the call. Just wanted to start with some customer, kind of deeper dive, starting with large pharma. Doug and John, maybe can you comment on how much of a drag the slower release of budgets in the first quarter was on your business, and what did large pharma grow in the quarter, and how are you thinking about full year growth from that customer base?
Yeah. I just think in qualitative terms, Dan, it's a combination of what we think of slow budgets and maybe a little calendar effect. It was an unfortunate timing of Good Friday, and we clearly saw some large orders from big pharma that we thought would be late in the quarter that we've subsequently seen flip into the second quarter of the year. So, we have specific evidence of that, and we have what we think of as being a somewhat encouraging qualitative feedback from many of our large pharma customers concerning their plans. In fact, early on, we've seen some of that materialize. So, there's some evidence of it.
We're not taking it all to the bank, but we think the combination of those dynamics probably means that the first quarter, maybe the rest of the year is a bit stronger in that environment than we saw in the first quarter. John, do you want to comment at all about large pharma?
Yeah, I would just say that generally speaking, pharma all in grew mid-single digits. It did well, and that's in spite of the drag that we're talking about with large pharma. So, I think most of that, as Doug said, is really just a lag in the release. As we said, we had a very good start to the second quarter with that group of customers, so it doesn't appear to be a full year dynamic.
Okay, great. Then maybe just kind of sticking with the customers, could you update us on how you're thinking about academic government, industrial kind of growth throughout the year? Certainly, I get the academic and government you said grew high single this quarter, and industrial sounds like it was maybe grew modestly. How are you thinking about the remainder either for those two customer bases? Thanks.
Yeah. I think on the government academic side, the good news is that we have a pretty diverse worldwide clientele of customers. The U.S. wasn't certainly as robust as our customer base in Asia, for example. So, all in, we had a really good start to the year, with government academic, significant shipment of some high-end mass spectrometry products within Europe to some of those customers as well helped. So, I would say, we're certainly above where we thought we'd be through one quarter. Maybe instead of flat for this group of customers, there's a modest amount of growth as we make our way through the year. But, we're certainly off to a good start and better than we would have said as we entered the year. On the industrial side, I would say that we're not meaningfully off of our original expectation.
That still grew at kind of at 3%, 4%, so it wasn't as low as you might think. We're pretty optimistic as we look at the product offerings that we have, the new APC, the TA Instruments offerings, that will extract our share of business from that group of customers as well. So I wouldn't say we're concerned about even the industrial chemical side of the business at this point.
Great. Thank you.
Sure.
Our next question is from Paul Knight of CLSA.
Hi, Doug. It's the most bullish you've been on having TA move on acquisitions. What's creating that level of, I guess, heightened interest on your part?
Well, Paul, a lot of it is that we keep looking hard there. We've got a confident, aggressive management team, and they kind of fit our mold of being in our sweet spot of revenues that range from $5 million - $20 million. Businesses that can easily fit within the infrastructure of the TA division, and probably a little more interest at this stage in the year on a number of these fronts than we've seen. So, it may be making a little more progress. So I could be embarrassed and by the end of the year, we might not have secured the fronts that I think we're working well on. Our forecast, of course, doesn't include any of this, but I feel better at this point in the year about making progress there than probably I have traditionally, Paul.
Yeah. Lastly, I know NIH is a small part, but could you tell how that market was in the quarter and your projection of it?
Well, I think probably like everybody, we think sequestration hurt a bit. The U.S. market in this area wasn't strong for us. But the timing of NIH type of procurement can also be a little hard to read. So it wasn't good, and we're anticipating that it's going to be on the soft side for the rest of the year.
Yeah. Okay. Thank you.
Our next question comes from Doug Schenkel of Cowen and Company.
Good morning.
Good morning, Doug.
My first question is, does your Q2 guidance assume that you capture the revenue you missed out on in Q1 due to the delay in the release of capital budgets? Has a portion of that, maybe even a significant portion of that amount already been recorded?
Well, Doug, I think it's fair to say that we're optimistic that the second quarter returned some of those revenues that we anticipated in the first quarter. It would also be fair to say that our guidance tempers to some extent, and doesn't necessarily include the fact that that will stick for the full quarter. We like to be a little conservative on this front because it's not impossible that we see an end to the quarter flip from the second quarter into the third quarter also. So we try to draw a midline between those expectations. I think it means that we're more secure in this forecast, but it doesn't mean that we've necessarily included a large batch of those orders. I think of it as more—
Insurance.
—yeah, insurance than it is largely reflected in our forecast.
If they were already booked, it would be more than insurance. Is that a fair observation?
Yes. But again, there's no guarantee that some of the things that we then anticipate at the end of the quarter, couldn't flip into the next quarter. So we're feeling good, but we're not going to totally take it to the bank yet.
Okay. One area of clear investor focus recently has been on the pacing of the quarter, specifically what happened in March based on some commentary from other companies. Anything notable or surprising? It doesn't seem like that was the case, but just to be clear, would you guys talk about whether you saw anything abnormal as a result of the sequestration in March and more broadly in some of your cyclical end markets?
Doug, I'd say the only thing that the end of the quarter saw was the timing of Good Friday in our more religious areas of the world. It fell on the last day of the quarter, and we have some reasonably good evidence that probably combined with capital releases and large pharma, swung some timing of orders into the early part of the second quarter. I'd say the only other quarterly dynamic that we're seeing reverse is this whole issue on the consumable side. We've seen a curious dynamic on the consumable side being a slow start to the year.
This isn't the first time, but this was a more unusual dynamic where we saw a very soft consumables business largely throughout the first quarter, and that seems to have turned very rapidly in the second quarter, and that may be uncertainty on the part of some of these large customers. It could be inventory management. We think that that's a one-time quarterly dynamic and have some pretty good evidence that it's already started to turn. That's the only, I'd say, calendar type of dynamic as well as one or two fewer selling days in the first quarter on the consumables front.
Okay. Last question, really a good quarter from an operating standpoint, especially when you adjust for FX. That said, SG&A grew, I believe, less than 1% year-over-year on about 5% constant currency revenue growth. This was against a pretty favorable comp at the SG&A line and follows three quarters where SG&A spend declined about 3%-4% relative to the previous year. How sustainable is this? I assume you get some natural hedge as a result of FX, but beyond that, can you maintain SG&A at these levels moving forward?
Yeah, I think from a model perspective, Doug, we've got about a 3% growth all in for the remainder of the year. There are certain areas of the world that are going to require some level of investment as sales growth is in the double digits in those regions. As we've always said, we hold back as we start the year and making those types of investments to be sure that we're comfortable with the trajectory that we see. So, I think there'll be a modest lift in SG&A as we make our way through the next few quarters. There's a little flexibility in that, but I would say we've been somewhat stingy in releasing some amount of expense in some of these regions where it's needed, and you're going to see that creep up a little bit as we make our way through the year.
Okay. Thanks again, guys.
Sure.
Our next question is from Vamil Divan of Credit Suisse.
Yeah. Hi, good morning. Thanks for taking the questions. One, just maybe high level one, obviously we're seeing some more consolidation taking place in the sector. You guys aren't small, but maybe smaller than some of your peers, and just any sort of updated views you might have there, especially as you think about trying to expand into newer areas such as more of the clinical end market.
I'm sorry, Vamil, you faded at the end of that question. Could you repeat it, please?
Yeah, sorry. Just in terms of some of the consolidation that's taking place, and if you have any updated views regarding just your size relative to some of your peers as you think about moving into some of these more clinical end markets with some of your technologies, how do you see your position versus some of these bigger peers now?
Oh, sure. Probably a timely question. I think, clearly you can look at maybe segregating business strategies in the life science tools area broadly into two categories. One group of companies who drive their strategy, believing that they can get economies of scale and drive their business through acquiring like businesses and driving more business through their distribution organization, versus companies, kind of what I think clearly Waters is, that focus on the needs of a smaller set of customers with a smaller set of technologies and try to optimize that to benefit the customers, and focus kind of exclusively in those areas of their expertise. Obviously, not a perfect cut between those, but I think you can characterize companies as falling in either one of those sets.
I think the companies that have focused on the former, on the distribution side, are characterized by lower growth rates, lower growth in organic earnings, and lower return on invested capitals than companies like us that have focused on the specific needs of their customer set, hone their business, manage their capital spending to a finer degree. Waters has competed over the 30 years that I've been involved in the industry, most of the time competing with larger companies that have multi-technology arms and arms that have competed with one another for capital. We've come out pretty well on that score. I don't think that there's a whole lot of evidence that suggests that there are unusual returns to scale in this industry.
Granted, you have to be competing in a marketplace that's big enough to support your organization, but the chromatography and the mass spec markets are amongst the most sizable in our industry and offer continuing opportunities for us to provide our shareholders with above-average returns. I guess that's how I'd answer it.
All right. Thanks. That's helpful to hear. Just one other one. I know it's a little bit earlier in terms of ASMS coming up in a few weeks now. Any kind of insights you can provide regarding what we should expect there? Anything are you looking at as a big sort of pivotal meeting, or is it more sort of incremental advances that we—
I think at this point, we're not prepared to announce the ASMS, but we'd encourage you to go, and I think it would be a rewarding show.
Okay. All right. Thanks. I'll get over there. Thank you.
Our next question is from Amit Bhalla of Citi.
Hey, Doug. On consumables, when you talked about the potential impact that you saw in the quarter, you didn't discuss competition. Anything on the competitive front that could be impacting the consumable side?
We don't think so. It's a little bit of a head-scratcher, and in that particular area, it's highly unlikely that a new product offering moves things very fast. We certainly have not seen that. We think it's totally a combination of calendar dynamics and unusual slowness in customer activity early on. In places like China, you can see unusual quarterly dynamics where they place their year-long chemistry orders in a lumpy pattern, and we certainly saw some of that during this quarter. I don't think there's much of a competitive dynamic here, and I think the short amount of evidence that we've seen so far in the second quarter supports that assertion.
Okay. On China, I mean, robust performance overall, can you give a little bit more detail by the end markets in terms of performance?
I think the very encouraging thing about China is that it's broad-based. It's across the traditional life science applications, as well as food quality, food safety, and industrial applications. Boy, I'd say, if anything, we see the underlying dynamics in China strengthening a little bit rather than softening. It's broad-based.
If I can just sneak a quick one in at the end. You mentioned in the prepared comments about Alliance and the stickiness there. As you continue to manufacture more Alliance system and demands there, what is the impact on pricing and gross margin for the business? Thanks.
Nothing I said should lead you to believe that there's a significant pricing dynamic or gross margin dynamic. The new Alliance is largely an update of the old Alliance, doesn't really significantly change the pricing or the margin dynamics.
Thanks a lot, Doug.
Okay.
Our next question is from Jon Groberg of Macquarie.
Thanks. One, hope everybody's okay up there in Boston after last week, and everyone at Waters. Doug, just to make it clear, what are you assuming for your exchange rates now for the rest of the year? I think initially you had the yen at JPY 86.
Yeah, we're assuming current rates of JPY 99 for the yen, and the others are just about where they were.
Right.
The big difference being the fact that obviously the yen has depreciated meaningfully across the quarter.
John, if I look at that, it looks like pretty much, if I do that math, given where you were and where it went, it looks like pretty much all the EPS revision is driven by the new yen expectations. You're basically not assuming better organic growth offsets any of that.
That's correct. I'd say, right now we're looking at a mid-single digit growth expectation comparable with what we said in Q1. Yeah, we did come in a little bit better to start the year. That's encouraging. We're talking about new products and opportunities that maybe makes that a little bit better, but I think it's just a little too early in the year to think about moving that number up at this point.
Okay. I just wanted to be clear. On the R&D line, that grew quite a bit obviously as a percent of sales year -over -year. Is that just an anticipation as you were mentioning around ASMS or is there anything in particular going on there?
Yeah. It is mostly timing. We have a fair number of project-related expenses on that line. So a fixed base of labor that is sizable, but the project spend can move that number up and down a few points a quarter. In this quarter, we had a few new mass spec products that required some help from paid units. The project expense timing of that was a little bit skewed towards the first quarter versus what you will see for the rest of the year.
That growth rate moderates over the year, Jon.
Right. Your comment of the 3% was a total OpEx number, right?
Correct.
Okay. Doug, this is for you. If you look at our last couple of years, your net cash position has been building up quite a bit. Is there any reason that you can't be more aggressive there, do a larger buyback, get more to a net debt position? I know you mentioned some smaller acquisitions in TA, but maybe what's the strategy there? Thanks.
Yeah. Well, the net cash position, Jon, is largely driven by the offshore dynamics of our profitability. Like a lot of technology companies, if we remit those earnings from offshore, then we're faced with a large U.S. tax burden. So our tendency is to keep those funds invested offshore. To the extent that we don't generate enough local cash to support the buyback or our capital acquisitions, then the debt markets are more than adequate to support those needs. So it's a balance between those two that you see reflected in our balance sheet.
But so, in the U.S., are you bouncing up against some of your covenants in terms of the U.S. cash flow that you're generating in order to be able to borrow more or to do more of a buyback?
No, not at this point. We are careful to ensure that the pace of the buyback that we do year by year affords us enough headroom as the business grows to be able to continue that type of trajectory of share repurchase. So, thinking that today we might go out and do another $500 million buyback one time and push up against the ceiling isn't something we want to do. The message we want to send is that we have a very consistent program that allows us the opportunity to spend $300 million, $350 million on a consistent basis each year and not bump up against those covenants. You'll probably see us expand our revolver as the year goes on to ensure that we maintain headroom in that lending facility.
Okay, thanks.
Sure.
Our next question comes from Tim Evans of Wells Fargo Securities.
Thanks. I guess one of the themes in 2012 was some pressure at the high end of the mass spec market. I am certainly not getting that sense today. Has that eased? If so, why?
We have definitely seen an improvement in our business at the high end of the mass spec marketplace. We have seen it significantly in proteomics and metabolomics applications. It is coincidental with some technological improvements that we made in a number of those product lines, which we have anecdotal support from our customer base concerning the benefit of those changes. I think it is a little bit better marketplace, a better product offering that we have seen. It also comes together with the fact that the entire mass spec product line is operating very strongly right now. It is noticeable. I do think it is a point. We saw our beginning of this in the fourth quarter and a strong continuation as we go into 2013.
Great. Then just one other quick one real quick. You talked about your expectation for stability and the continuation of the positive trends that you have seen in Q1 from the organic growth side. That seems a little bit different than some of the macro data points. We are getting some weaker PMI numbers even this morning. When you talk about the stability, what are you looking at? Are you looking at orders in hand or are you looking at macro variables?
We are looking at a combination of all those, Tim. We are looking at a rolling average of our run rates, in areas that have been indicative of the future. We are looking at our major geographies and looking at what we call the drop sheets of customers that have asked for quotes, asked for early order indications, indicated interest in our new technologies. In our biggest geographies with the U.S. operating, a little bit on the positive side, China operating on the very positive side, India returning off a period of very low growth with the opportunity to see pent-up replacement demand. I think, traditionally, the overall GDP numbers in our areas do not correlate terribly well with Waters' individual growth dynamics. Obviously, we are not immune from economic activity as we saw in 2009.
But, if you cast out those outliers, our individual markets are a better indicator than the overall GDP numbers. We continue to be reasonably optimistic about what we are seeing in our individual markets.
Great. Thank you very much.
Our next question comes from Isaac Ro of Goldman Sachs.
Good morning, guys. Thanks for taking the question. First off, on ex-U.S. markets, wondering if you could maybe elaborate on Japan and India. In Japan, just wondering how you're looking at the impact of potential stimulus opportunities there as we move into the second and third quarters. In India, could you maybe quantify the magnitude of improvement that you saw this quarter? How much of it was easy comps versus just an underlying improvement in the demand picture?
I think the India question, Isaac, is you can't ignore the fact that we didn't have a great year or quarter last year. We did a little bit better than two years ago, if you want to put it that way, but I wouldn't say that you're on a robust growth dynamic compared to two years ago. But it's still good off a baseline. We still think that there's some pent-up replacement demand in India, and we're encouraged about what those customers are saying, given the current state of the rupee and given the current state of regulatory hurdles in India. So, we think that this kind of high teens kind of growth rate level for India looks sustainable. It in no way kind of is a quantum leap off two years ago, but it's good to see growth in that environment.
The Japanese, we agree with you that we think stimulus spending can improve the situation in Japan as we go through the year. The stimulus amounts are very clearly aimed partly at customers in our segment. So, we think our forecast accounts for a little of that, but we're not going to take it all to the bank, until we start seeing those orders begin to roll in.
Got you. That's very helpful. Thank you. Then just on TA, one more question there regarding your comments on M&A opportunities. You said that there are more assets available. I'm just wondering why that's the case now. I would think that competition is higher, just given the low cost of debt and the lack of growth that a lot of companies are seeing. So just wondering if you think it's an issue where you're more willing to deploy capital there, given your cash generation and your balance sheet, or is it a situation where you see more willing sellers for some company-specific reasons?
I think it's probably more that just we've been so active in that area, and in our world, there are more niche opportunities in that physical properties segment of the marketplace. Whereas in the chromatography mass spec arena, they're much larger companies who are more established. I think in some of these cases, you're looking at companies that are run by older management teams who are ready to perhaps move along. It's not a homogenous set of companies that we're looking at. There are different dynamics driving a number of them, so it's hard to characterize them with a broad brush.
Fair enough. Thank you very much.
Our next question comes from Dan Leonard of Leerink Swann.
Thank you. I was just hoping to get a better idea of how the weaker yen impacts profitability, and my question's a two-part one. You mentioned that Japan is still very profitable at JPY 100 . I'm wondering if it's still above the corporate average on JPY 100 , and if that's the case, when does it fall below? Is it JPY 105? Is it JPY 110? Then secondly, is it correct to assume that the lion's share of your year-over-year gross margin decline in the quarter, the lion's share of that was yen as opposed to the software amortization? Thank you.
John, you want to start on that?
Sure. The Japanese business, even back at JPY 115 , was a very profitable business and not a meaningful drag, even at that level on the business. So, it's the change year-over-year that gets our attention, but when you look at the absolute dollars of profit coming from that business at a JPY 100 translation, it's still a very profitable business.
It probably has to get north of JPY 115—
Yeah.
—to start dropping it below corporate average.
Exactly.
Okay. The second part of my question—
In regards to the gross margin, it's probably a 50/50 split. It's a meaningful amount of amortization. We're ramping up sales, particularly early in the year on those products, so you're having a bit more of an impact to start the year than finish the year. The yen will be more of an impact on margins as we make our way into the second quarter through the fourth quarter, as the yen started closer to JPY 90 and ended up closer to JPY 100 in the first quarter, so you didn't have a full quarter impact. That mix will change a little bit as UNIFI sales ramp up as time goes on, and as we feel the full impact of the yen on margins Q2 through Q4.
Okay. Thank you very much.
Sure.
Our next question is from Peter Lawson of Mizuho Securities.
Hey, Doug, quickly, on the chemistry and recurring business, what gives you the confidence that kind of gets back to a normalized growth level for the rest of the year?
Well, partly, Peter, we've already seen the dynamic change early on in the second quarter. We've also looked at the order patterns region by region and have become more confident that some of the lumpy order patterns for large chemistry orders in places like China, where you don't have the kind of traditional onesie type of orders. You see much more bulk ordering in those territories. We saw an unusual drop off and then a quick pick up. We've looked at the competitive offerings, we've looked at the other dynamics that could change it, and we don't see. We're not anticipating robust sales, but we're pretty confident of a return to the mid-single-digit chemistry dynamics that in even a depressed year, we think we can return to.
The software amortization, why is that an issue now? Why wasn't that anticipated at the beginning of the year?
Oh, no. It was anticipated. The deltas I'm talking about weren't deltas from the guide, it was from last year. We did anticipate that and talked about it coming into play right at the start of the year.
Got you. Thank you. That really helped clarify things. Thank you.
Our next question is from Derik de Bruin of Bank of America Merrill Lynch.
Hi. Great. Just two real quick questions. I know you don't have a ton of overlap in terms of your end market customers with Shimadzu and Hitachi, but have you seen any change in the competitive dynamic with your Japanese competitors now that the yen has gotten a little bit more in their favor?
I don't think in a broad way we've seen much difference, Derik. The Japanese haven't changed their spots from when the yen was JPY 120 to when it was JPY 90. They've always tended to be low price competitors, and we haven't seen. I think they may be taking this opportunity to enhance their own P&Ls rather than think that a further low price strategy is going to do much for them.
That's consistent with what we've heard from some other companies. Just one other follow-up. I guess on the applied markets, you mentioned that growth there was a little bit more modest. Can you elaborate a little bit on this? Was this in food? I'm just curious in terms of what you're seeing there, just that's been such a big driver.
No, food actually was reasonably good. It was environmental applications.
So-so.
Some of the industrial chemical applications were probably more on the soft side.
Okay. You're including industrial chemical in that one? Okay. Great. Thanks.
Our next question is from Tycho Peterson of JP Morgan.
Hey, thanks for taking the question. Just a couple quick ones here. As we think about kind of the back half of the year, are you able to just give us a sense as to how we should think about some of the new products tracking, in particular, the Advanced Polymer Chromatography that you talked about at Pittcon earlier this year?
Yeah. That product is likely, Tycho, to be a rather modest sales product across the second half of the year. It's a rather limited set of customers. There'll be meaningful interest from the Dows, the DuPonts, the 3Ms, and the like, but it's not going to add a point of growth as we look at Q3 and Q4. As time goes on. And the product ramps up. Maybe we get a little more juice from that, but it just isn't a market that is likely to create a meaningful top-line dynamic in the second half of this year.
What could be much more significant is the UPC² that we got a little bit of momentum from late in last year, but really is building momentum as we go through this year. I think the UPC² could be a much more significant dynamic than the APC.
On UNIFI, can you talk about how we should be thinking about tracking the success of that business? Are you able to give us a rough sense of how many customers you have today? I think in your comments you talked about kind of pulling through instrument sales with that as well.
Yeah, I think you see most of the dynamic at this point on UNIFI coming from tailored systems. UNIFI has not launched in terms of its overall chromatography network-based systems. It clearly, with the launch of UNIFI into the high-end mass spec systems, this has been clearly partly what drove the enhanced position in the first quarter. We see clear evidence of that. I think the beauty of UNIFI is that as you go through this year and into next year, more and more of the broad-based chromatography and mass spec applications come under the UNIFI umbrella and offer significant upgrade opportunities, as well as competitive advantages in many of these applications.
Okay. Last one, did you quantify the delayed pharma orders? I know you've talked about it in a number of questions here, but did you actually quantify that?
No, we didn't. It's multimillion dollars, but less than $10 million.
Perfect. Thank you very much.
Our next question is from Sung Ji Nam of Cantor Fitzgerald.
Hi. Thanks for the questions. I was wondering if you could comment on the pricing trends specifically for the mass spec business.
I'm sorry, I lost the last part of that. Could you repeat the question?
Yeah. Pricing trends for the mass spec business.
I'd say there, nothing noticeable in terms of changes in pricing trends in our mass spec business. You can see it, our margins have been the same. Certainly not major price increases, but no significant changes. Yeah, stable prices, I think is probably the way to characterize it.
Okay, great. Lastly, I was wondering if you could maybe talk about if there are any updates to how you look at the clinical diagnostic opportunity, in the medium term, and if there are any updates there?
We're still very optimistic about the diagnostic opportunities. We continue to invest both R&D and early-stage marketing, but I wouldn't say that we have anything to report on any major breaking news on the diagnostics front. We continue to be encouraged about the long-term applications of LC-MS in the diagnostic marketplace.
Great. Thank you.
Our next question is from Steve Willoughby of Cleveland Research.
Hi, thanks for taking my question. Just regarding the improvement in mass spec you've seen, it sounds like it was with some European government customers. I guess, is that something that wrapped up in the first quarter, or is that going to fall over to quarters over the remainder of the year? I know when we talked a couple of months ago, you were expecting instrument growth this quarter to be closer to flattish, versus the 8% you did. I was just wondering what kind of changed or came in better versus what you guys were initially expecting a few months ago?
No, I don't know what you mean by flattish, Steve. We're anticipating that the strength in mass spec continues more or less on the trajectory that it's on. We don't see any competitive dynamic or market dynamic that changes the current momentum in the mass spec world.
Yeah, I think Q-Tof certainly was stronger in the quarter than we anticipated. We thought that mass spec in some total was going to do well, largely driven more by the triple quadrupoles than the high-end. The high-end did do better, but as a group of products, we thought that mass spec would do well, and it actually did a little better than that to start the year.
Hello?
Hello?
Does that answer your question, Mr. Willoughby?
It does. Yes, it is. Thanks.
Operator, I think that will probably be an appropriate point to end the conference call. We've now been over an hour, so I think we'll just thank you all for participating, and we look forward to updating you on our next call.
This does conclude today's conference call. You may disconnect your phones at this time.