Good morning, and welcome to the Waters Corporation Fourth Quarter 2010 Financial Results Conference Call. All participants will be on listen only until the Q&A session of the conference. This conference is being recorded. If anyone has any objections, you may disconnect at this time. I would like to introduce your host for today's conference, Mr. Doug Berthiaume, Chairman, President, and Chief Executive Officer of Waters Corporation. Sir, you may begin.
Thank you. Good morning, and welcome to the Waters Corporation Fourth Quarter and Full Year 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, the Vice President of Investor Relations. As is our normal practice, I will start with an overview of the business highlights, and John will follow with details on our financial results and then provide you with our outlook for the first quarter and for the full year 2011. Before we get going, I'd like John to cover the cautionary language.
During the course of this conference call, we will make 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 Q1 and full year 2011. 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, 2009, in Part One under the caption Business Risk Factors. We further caution you that this 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 April 2011. During this call, we'll be referring to certain non-GAAP financial measures. A reconciliation of the non-GAAP financial measure to the most directly comparable GAAP measure 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, for Waters, 2010 was a year where we saw a broad recovery from nearly all of our end markets and strong customer acceptance of key new instrument systems. Following a challenging business environment in 2009, we started the year confident in some improvement but remained somewhat cautious in our outlook as much uncertainty certainly remained regarding the strength of the recovery. However, early in the year, we did embark on significant new product initiatives designed to strengthen our market position and to establish a foundation for a multi-year total refresh of our product portfolio. This aggressive plan started with the introduction of our ACQUITY H-Class UPLC system last January and was soon followed by significant mass spectrometry-based systems launched mid-year at the ASMS conference.
I'm happy to tell you that business results in 2010 exceeded our expectations and that our new product strategies meaningfully contributed to our success as we return to double-digit top-line growth for the year, along with close to 20% growth in adjusted earnings per share. Potentially even more significant as we begin 2011, we are seeing a continuation of improved demand and are gaining great attraction from our new system introductions. Looking at the fourth quarter of 2010, our sales and earnings came in ahead of our expectations, with sales increasing by 13% over the 2009 quarter and adjusted earnings per share up by 23%. Geographically, all major regions performed favorably, and there was balanced strength across our major product technologies. We move down the P&L. Our profitability remains strong due to the success of our product introductions, our strong recurring revenue growth, and our continued focus on operational efficiencies.
On the product side, new technology platforms delivered the strongest sales growth, highlighted by record shipment volumes of the ACQUITY UPLC and Xevo mass spectrometers. I'm happy to tell you that our Xevo TQ-S, a tandem quadrupole technology instrument that we introduced this past June, had an impressive quarterly sales performance and that increasing customer interest in this ultrasensitive, performance-leading system has a positive influence on my outlook for overall instrumentation growth in 2011. On the chromatography side, ACQUITY UPLC sales drove growth in the quarter due primarily to rapid adoption of our H-Class system in regulated testing applications such as pharmaceutical quality control. Looking at customer segments in the fourth quarter, we saw mid-single-digit growth in university and government spending as stronger growth in the Americas and Europe was partially offset by weakness in Japan.
Growth in the pharmaceutical and industrial sectors was robust in the quarter, and it was driven by factors that should sustain growth in the upcoming quarters. In our pharmaceutical end markets, we continued to see customers upgrading their labs to UPLC, as well as new business associated with biological pharmaceutical research and development. Sales at our largest pharmaceutical accounts grew modestly in the quarter, while specialty, generic, CRO, and biotechnology firms all grew at a double-digit pace. For our industrial end markets, and looking specifically at the Waters Division, we generally enjoyed nice double-digit sales growth. While the industrial chemical industry continued to recover from depressed spending levels in 2009, a trend that we've seen throughout 2010, it was our applied markets where we saw the greatest strength, especially in the area of food safety testing.
On the topic of food safety, many of you have read about new regulations for food testing that are to be implemented in the U.S. We are optimistic that these new regulations will present us with an opportunity for new sales in the coming years, and we've been working along with the U.S. FDA to assist in the future implementation of new testing protocols. The sales growth in food safety that we saw in the food quarter was primarily related to strong demand in Asia. In the U.S., we've begun to see significant interest from food manufacturers related to future regulations, and expect that food applications will, though from a relatively small base, be a growth driver in the U.S. in 2011 and beyond. I'd now like to focus on new product initiatives that will impact our business in 2011.
As I mentioned earlier this morning, UPLC and advanced mass spectrometry systems have helped drive instrument systems growth for Waters in 2010. The introduction of the ACQUITY H-Class UPLC early in 2010 was potentially the most significant product launch in Waters' recent history, as it catalyzed the broad adoption of a new product technology into a large and receptive market segment. I'm referring to labs performing regulated testing and employing HPLC technology. Though we are very pleased by the rapid uptake of H-Class in 2010, we are further encouraged in the belief that this trend, wherein UPLC is displacing HPLC technology, is now firmly established and will offer a multi-year market growth opportunity. With the H-Class poised to help drive the replacement of HPLC instrumentation, we continue to see opportunities to further leverage UPLC technology into new and significant applications.
To that end, this month, we introduced a new instrument system for the characterization of biologics. This system combines an ACQUITY front end engineered with biocompatible service materials and proprietary UPLC columns with a new Xevo G2 Tof mass spectrometer. This new mass spectrometer has unique capabilities designed to optimize comprehensive characterization of biologic pharmaceutical formulation. In addition, this new system includes a new operating system that more seamlessly integrates the software requirements of chromatography and mass spectrometry for labs running validated methods. We plan to begin shipment of this system early this year, and we're excited about its potential to define a workhorse solution for the development and testing of biological pharmaceuticals. The combination of our chemistry and service products, businesses that I often refer to as recurring revenues, grew organically at a double-digit rate in the fourth quarter.
These businesses represent a sustainable differentiating advantage for Waters, especially against competitors that lack the capability to offer the complete solution and the promise of total support to a customer base that increasingly desires that level of assurance. Along with being a point of sustainable differentiation, our chemistry and service businesses have the potential to offer higher growth moving forward than in years past, as more and more customers convert HPLC methods to UPLC and Waters' proprietary columns, and as customers become more reliant on Waters to support new and more technologically advanced system offerings. As we move into 2011, please know that we continue to have a rich new product pipeline and plans for additional and significant new chemistry, service, and instrument system launches throughout the year. I'd now like to say a few words about our TA Instruments division.
TA finished the year with a strong fourth quarter, growing sales at a double-digit pace. The fourth quarter pretty much represented a continuation of the performance that the division enjoyed throughout 2010. While a portion of TA's success can be attributed to the recovery in spending for industrial end markets, a closer analysis of the business indicates that TA's growth in 2010 was driven by additional and more sustainable factors, including the geographical expansion of its user base and rapid uptake of its technologically advanced new products, such as TA's life science-focused biocalorimetry systems. In the fourth quarter of 2010, TA introduced a new research differential scanning calorimetry system, or a DSC. This new instrument, the Discovery DSC, represents the first embodiment of a new instrument platform that will migrate across the TA product line.
We plan shipment of the Discovery DSC system early this year and expect orders and sales to ramp nicely in 2011 based on the very positive customer reception the system has received. Before turning you over to John for a more detailed review of our financials, I'd like to speak a little about our capital deployment and some thoughts about the future. In 2010, we generated over $400 million in free cash flow, and this represents about $0.25 on each sales dollar. During the year, our principal use of cash was our share repurchase program. Throughout the year, we executed the program on a fairly steady course and feel that the resulting reduction in share count delivered significant value to our shareholders. Though we actively looked, we consummated no significant business acquisitions in 2010 and plan to continue our conservative and focused M&A strategy for 2011.
In light of this focus on the long-term organic growth of our business, last week, we announced plans to build a new mass spectrometry facility near Manchester, England. This facility will both expand and consolidate our current footprint in the U.K. When the new facility is completed in 2013, it will house our R&D, manufacturing, and customer support functions that are currently spread across multiple buildings in Manchester. In addition, the new facility will offer state-of-the-art customer demonstration laboratories and training facilities. This investment in the U.K. is indicative of our long-term commitment to attract and retain the best technical talent and ensure technological leadership in mass spectrometry and associated technologies. In closing, I would like to reiterate some thoughts that I cited earlier.
Looking back at 2010, we are all pleased that the economic conditions that surfaced in late 2008 and were existent throughout 2009 appear to be behind us. However, from the strength of our current product portfolio, and in light of the profitable recovery of our business in 2010, it should be obvious that we never stopped investing in the future success of Waters and remained confident in our focused business strategy. At this time, I am optimistic that we can continue the positive momentum that we established in 2010. Early ordering patterns in 2011 and customers' positive receptions to our new system offerings are very encouraging. In addition, we feel confident in our ability to grow our market share in the more developed markets while we benefit from rapid adoption of our tech in developing countries.
With that, I'd like to now turn it over to John for a closer look at our financials.
Okay. Thank you, Doug, and good morning. Fourth quarter sales increased by 13%, and non-GAAP earnings per diluted share were up 23% at $1.38 this quarter compared to earnings of $1.12 last year. On a GAAP basis, our earnings were $1.36 this quarter compared to $1.08 last year. A reconciliation of our GAAP to non-GAAP earnings is included in our press release issued this morning. Reviewing Q4 sales results compared to Q4 last year, sales were up 13% this quarter before currency translation, and currency translation was about neutral to sales growth this quarter. Looking at our sales growth geographically and before foreign exchange effects, sales within the U.S. were up 10%, Europe sales were up 5%, sales within Japan were up 4%, and sales in Asia, outside of Japan, were up 32%.
Turning to the product front, within the Waters Division, instrument system sales increased by 16% this quarter and recurring revenues grew by 10%. Within our TA Instruments division, sales increased by 12% versus prior year. Now I would like to comment on our Q4 non-GAAP reported financial performance versus prior year. Gross margin performance came in as expected at 60.9%. Product mix was favorably affected this quarter from Q3 by a ramp-up in shipments of our new Xevo tandem quadrupole systems. Additionally, we continue to see favorable manufacturing efficiencies and foreign currency translation, while less impactful to our top line than expected, remained favorable to our gross margin performance. SG&A and R&D expenses increased somewhat more than expected this quarter as a result of much improved sales performance late in the year.
The higher sales generated higher variable compensation expenses this quarter as many regions of the world exceeded their targets as we closed the year. The 2009 base of comparison contained little incentive compensation as the vast majority of plans missed targets in 2009. Our full-year effective income tax rate came in better than projected, at about 15.5%. The restoration of the U.S. R&D tax credit and a continued shift in production levels in favor of our tax-advantaged geographies reduced our full-year 2010 tax rate. Versus forecast, the lower tax rate benefited the quarter by $0.06. On the balance sheet, cash and short-term investments totaled $946 million, and debt totaled $766 million, bringing us to a net cash position of about $180 million.
On the stock buyback front, we continued to purchase our shares in the open market, and during the fourth quarter, we purchased 665,000 shares of our common stock for $51 million. For the full year, we purchased 4.4 million shares of our common stock for $292 million. 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 Q4, free cash flow remained strong and came in at $127 million after funding $16 million of CapEx and adding back $6 million of non-cash tax benefits from stock-based compensation and $3 million related to the start of the building project in the U.K. Comparable free cash flow in Q4 last year was $112 million.
For the full year, free cash flow came in a little better than expected at $409 million versus $372 million last year. Accounts receivable, day sales outstanding stood at 67 days this quarter, down 10 days from the start of the quarter and comparable to Q4 last year. Inventories were up $26 million from the start of the year as a result of higher sales volume, increased demonstration inventory for new products, and safety stock on products being transferred to Singapore. Overall, we are very pleased with our financial performance this year and believe we are back on track to consistently deliver on our historical high single-digit top line and mid-teens growth in earnings per share. 2010 saw a return to more normal market conditions in the large majority of our end markets, and our new product positions have been well-received in all of our end markets.
Gross margins have held up nicely this year, in spite of large numbers of new products that generally negatively impact margins. Overall, SG&A and R&D increased about as expected this year as we made small investments in staff, largely in developing markets, and saw variable pay programs kick back in from the depressed base in 2009. All of this led to an improvement in operating income performance this year. Operating income as a percent of sales grew by 70 basis points. Looking below the operating line, our manufacturing strategy continued to benefit our tax rate and leverage from our share repurchase program, in spite of higher interest costs, all aided the full year in EPS growth of 19%. As we think about 2011, we see more stability in our end markets and continued momentum in the acceptance of our new products.
We expect to see high single-digit sales growth for 2011, including about a point of growth from foreign currency translation. Currency fluctuations in the 2010 base periods will likely yield different growth rates by quarter in 2011, but net to about a point of growth for the full year. Moving down the P&L, gross margins are expected to be up about 30 basis points - 40 basis points this year as we continue to be favorably affected by product cost reductions and volume leverage offsetting margin pressure from new product introductions. Currency at today's levels looks to be about neutral to gross margins for the full year. Operating expenses are expected to grow at a slightly lesser rate than sales growth. Interest expense is expected to be approximately $18 million, and we expect our operating tax rate to be between 16% and 16.5%.
This reflects a modest increase from 2010, resulting from an increase in our Irish tax rate from a contractual rate of 10% to a statutory rate of 12.5%. Our fully diluted average outstanding share count is expected to decrease by about 2 million shares in 2011. Rolling all of this together, we currently expect non-GAAP earnings per fully diluted share to be in the range of $4.60-$4.70 for 2011. For Q1, we expect organic sales growth of about 8%-9%. Currency translation at today's levels is expected to add about 1% sales growth this quarter, bringing reported growth to 9%-10%. In Q1, non-GAAP EPS are expected to be between $0.90 and $0.95 per fully diluted share. Doug?
Thank you, John. Operator, at this time, I think we can open it up for Q&A.
All right. Thank you. At this time, we are ready to begin a Q&A session. If you would like to ask a question, please press the star one and record your name. We ask that you ask one question per analyst. To withdraw your question, press the star two. Our first question comes from Marshall Urist at Morgan Stanley.
Good morning. This is Neha Sahni stepping in for Marshall. The first question we have is regarding your gross margin guidance in 2011 and whether you could give any more detail regarding your thoughts about the impact of product mix in mass spec and LC, please.
Yes. What we're expecting on the margin front is improvements associated, first off, with just manufacturing volume increases. The expectation is that we'll see higher levels of instrument production that generally supply leverage in our manufacturing facilities, and thus an improvement in gross margin from just volume. We're also expecting a higher mix of the triple or the tandem quadrupole mass spectrometry instruments in 2011 versus 2010. That will favorably affect the mix from a product perspective on the mass spec side of the business.
And we're also expecting a bit of favorability associated with the normalization of a number of products that have been transferred and ramped up in Singapore in the second half of 2010, that will have a full-year benefit in 2011. So all of those provide for a little bit more leverage in 2011 than we generally expect.
Great, thank you. And just one more question regarding the Japanese stimulus benefit you saw in 1Q 2010, whether you would be able to help quantify that or give us any more details, so we can help think about comps for 1Q 2011.
I'm sorry, could you repeat that?
Oh, sure. We were just hoping to get more details regarding the Japanese stimulus benefit you saw in 1Q 2010 and how that might affect comps—
Sure.
—in 1Q 2011. Thank you.
Yeah. We had a very strong finish to Japan's fiscal year in Q1 of 2010. You are right, there were some stimulus dollars there. We are expecting Japan to have a modest decline, actually, in the first quarter, and that is incorporated into the guidance that I provided you.
Great. Thank you.
Next question is from Ross Muken in Deutsche Bank.
Hi, good morning, guys.
Hi, Ross.
We saw some really strong results out of some of the large chemicals houses this morning, and generally on a lot of the industrial end markets, we continue to see a bit of a pickup on CapEx spend. In terms of as we enter 2011 from that customer base, what's sort of the thought in terms of the continued momentum we've seen and your belief that we can kind of sustain this sort of above-average growth in the beginnings of an uptick in the economic cycle?
Ross, all indications are that we're going to see a continuation of good conditions in the industrial chemical sector. We're certainly seeing strong indications of that through TA, both in terms of quotes and early ordering dynamics. That tends to be cyclical, as you know, but I think this cycle shows no signs of dropping in 2011.
Great. Maybe just quickly, in terms of what you've seen in China specifically. Obviously, your ex-Japan growth in Asia was quite strong. If you sort of look at the various customer bases there, is there any specific area where you saw outsized growth there in India, or was it really kind of broad-based on the healthcare and industrial businesses?
Well, the answer is it was kind of broad-based. It was very strong continued in China. But, I think, every area in Asia continued strong. If there was a weak point, it was in a small territory. I mean, India, China, Taiwan, Korea were all quite strong. China continues to show sustainable strength across a broad series of applications. It's not just pharma in China. A lot of food safety, a lot of environmental spending. It was probably our strongest quarter in China, and that was tough because the whole year was strong. If anything, we built momentum in China as we went through the year.
Great, and congrats again.
Thank you, Ross.
Next question is from Doug Schenkel of Cowen and Company.
Hey, good morning, guys.
Good morning, Doug.
In talking to you guys, I'd say throughout at least the second half, if not a little bit earlier in 2010, you guys made it very clear that if the demand trends remained as strong as they were developing throughout the year, that you would have to build out the sales and support infrastructure a bit. Your guidance suggests that this is indeed the plan for 2011. Would you be able to, I guess, first confirm that, and then maybe talk about geographic areas where you may be disproportionately directing hiring, which may be demonstrative of where demand is expected to be strongest in 2011?
Sure, Doug. I think clearly with the increase in the organic growth rate, we've seen some pressure in terms of infrastructure spending or organizational spending. Where that affects us typically the most is in the service organization, where you uptick that level of instrument placements, and there's just only so many instruments one service guy can deal with. While we came into 2010 cautiously investing in that area, we definitely held back. As we went through the year, we upticked in that area. I'd say if you look at any one departmental area of spending, it's going to be the service force that probably takes a bit of a disproportionate investment. It's also true that the sales force in these developing areas are expanding, too.
China, Korea, India are growing faster, where areas of slower growth, particularly like Western Europe, are not getting much in the way of investment dollars. So that trend is kind of baked into our guidance for 2011. We still think our operating expenses will grow more slowly than the top line. We are probably a little bit cautious on that spend rate in terms of our estimates. Maybe it will not happen quite so fast as we currently anticipate, but we do not want to be surprised on that front. So, that is what our estimates anticipate.
Okay. No, that is helpful. If I could sneak in one more. Alliance still accounts for, I believe, the vast majority of your LC installed base. Almost a year into the H-Class launch, I guess, what percentage of the Alliance installed base do you think is realistic to be targeted for conversion? Is there a goal that you have targeted for conversion that is embedded into guidance for 2011?
Well, currently, Alliance represents about half of the chromatography shipments. So ACQUITY has really come up in terms of the current level. When you look at our worldwide business, India is certainly an important area for Alliance, where those generic accounts have tended to stick with the traditional technology that was in the regulated methods that they adopted. Interestingly, we are even seeing in India, what is the early phase of a move to the new technology in ACQUITY, and we think that is likely to pick up steam, although I still think that Alliance is going to be the predominant system of choice in India because of regulatory factors. I think what you are going to see over the next couple of years is that 50/50 split is going to move inexorably to something like 80/20 being ACQUITY. That is certainly what we are seeing in the developed markets.
We are seeing customers tell us things like they will not buy any more HPLC, they are only going to buy UPLC. I think they mean it. I think the case for UPLC is so strong that we are seeing it move in that direction.
Okay, that's great. Thanks for providing that color.
Next question is from Peter Lawson, Mizuho Securities.
Hey, John. I just wondered if you could talk to the lower-than-expected tax. What drove that benefit?
Sure. There was a reenactment within the fourth quarter of the U.S. R&D tax credit. That's not quite half of the benefit that we saw, but it was meaningful to the quarter that was reenacted retroactively for 2010 and for 2011. So that's a going-forward benefit as well. Beyond that, we had significantly higher volumes of products coming both out of Singapore and at the end of the quarter, out of Ireland as well as the Xevo TQ-S, the new tandem triple quadrupole, was transferred to Ireland and ramped up nicely at that facility. So it was both of those factors that contributed to the benefit in the quarter.
Thank you. I wonder if I could get some further color on the large pharma segment. It looks like it's growing. What's holding it back, and is that being helped by Asia as well?
Well, the large pharma segment, if you're talking about the 15- 20 largest pharmaceutical accounts in our base, grew in the fourth quarter, and that was the first time this year that they grew versus the same quarter in the previous year. It continues to be interesting, where we have some accounts growing extraordinarily fast and others not investing very much at all. It's really not a homogenous dynamic going on in those large accounts. We also continue to see a number of those accounts using third parties, using CROs, investing in smaller biotech startups to do some of their early-phase development. So, as I've said time and again, what the absolute measure here of large pharma and whether we're scoring business in a large pharma account or in a CRO can be somewhat misleading as to what their overall investment practice is.
I think clearly the overall pharmaceutical marketplace, we've maintained time and again, is pretty robust. The pharmaceutical customers grew at our corporate average in the fourth quarter. So we're pretty optimistic about that overall account.
Not specifically looking to whether it's one of the large ethicals that is up or down this quarter.
Okay. Thank you so much, and congrats on the quarter.
Thank you.
Next question is from Jon Groberg of Macquarie Capital.
Hi. Thanks for taking the question. Doug, just one question for you. Your net cash or your net debt position is now a net cash position. You've had some dynamics in the industry with some competitors taken out, and I'm just curious. You said steady as she goes with respect to capital deployment, but just curious, as you look at 2011, any desire to maybe be a bit more acquisitive, or should we expect you to continue to be focused on buybacks primarily? Thanks.
Well, Jon, we'd be delighted to be a bit more acquisitive if it could meet our standards. It's highly unlikely that we're going to make anything like a $1 billion acquisition where the return on capitals are negative. Of course, look, when current interest rates are LIBOR plus pennies, and LIBOR is 1% or 2%, it's kind of easy to make many acquisitions accretive. But still, if you put a real cost, the long-term cost of capital on those acquisitions, it's a head-scratcher as to how you make it work over the long term. Any hiccup in doing that injects a whole hell of a lot of risk. So I look at doing that versus a business that's now growing solidly in the double digits, producing cash, and a stock price that's abysmally low, of course.
I'd still rather, if the choice is take high risk on a large acquisition or continue to do what we do well, it may sound boring, but I think that's what you can look for.
Okay. Thanks a million.
Next question is from Amit Bhalla from Citigroup.
Hi, good morning.
Morning.
Question on Europe. I know you've, in the past, made comments of a more cautious outlook on Europe. I was hoping in the quarter you could just kind of parse out Western and Eastern Europe across your different end markets and just talk to us about the outlook there.
Sure. If we look at Europe in sum total, it did overall better than we thought. Kind of as expected, though, Eastern Europe continues to be the star overall, though, in that group. That being said, though, we did see positive growth within some of the larger geographies. Germany and France were actually up in the quarter, as was Spain, surprisingly. We still see pressure in the U.K., Switzerland, the Netherlands had a difficult quarter. We've seen generally an improvement, certainly in some of the larger countries within Western Europe. Eastern Europe, on the other hand, continues to do extremely well. Very good growth in places like Poland, Hungary, Russia. We're seeing a broad series of opportunities in Eastern Europe that don't appear at all to be slowing down.
Our expectation going into next year is to continue to see Eastern Europe drive the overall growth for that portion of the world. But we do expect also to see Western Europe improve as we make our way across the year.
Okay, thanks. Then a follow-up, just in terms of pricing. Can you just comment on UPLC pricing? I believe ASP was probably down in the last quarter, but your volumes have been pretty strong. Can you comment on pricing on UPLC as well as just pricing on the high-end mass spec market? Thanks.
Yeah. No, I think your impression is wrong. The overall pricing of our ACQUITY products has held. Yeah. The H-Class is out there at a premium to the Alliance. The initial UPLC ACQUITY is still at a premium to that. The thing that we're grappling with there is really a mix between the base Alliance, the H-Class that's selling at a premium to the Alliance, and the research-grade initial ACQUITY product. We're not seeing a deterioration in the ASPs across that, but we are seeing a mix change with more sales, obviously, of H-Class, and it's a higher proportion of the mix. Alliance becomes a lower proportion of the mix overall. But it's not a pricing dynamic as much as it's just a product mix dynamic.
Pricing on the high-end mass spec, I believe there is some competitive pricing going on out there?
Awesome. Yeah. I would say on high-end mass spec, the good news for us on that front is that we have recently come out with the Xevo TQ-S. That is providing a very nice margin for the business. You saw the benefit on the gross margins overall in Q4 through shifting that product back into the mix in the quarter. The high-end series of competition that exists with our QTRAP offering, yeah, that is a bit more of a competitive scenario right now. We are very comfortable with our product position. We are holding the margin on those products. Some of the newer high-end TRAP products have a bit more cost than the products that they replaced. So they have a little bit of a margin issue perhaps versus some of the triple quadrupole products that have come out of the gate with some very nice margins.
I would say that the pricing dynamic is pretty constant across the quarter. We are not seeing anything that is more intense or less intense than was there when we started the quarter.
Okay, thank you.
Next question is from Tony Butler of Barclays Capital.
Thank you. With respect to the H-Class, could you characterize the rough estimate on a percentage basis of new non-Waters customers that may be adopting the H-Class? Second, could you also characterize the attachment rates of consumables to the H-Class? I think normally an HPLC may expect something around 30%-40%, but are you seeing a higher attachment rate on the H-Class? Then one additional follow-up. Thank you.
Sure, Tony. Maybe Art can chime in on the H-Class.
Yeah. The H-Class sales, Tony, between a third and a half of our H-Class sales are in fact due to new customers that were not prior Waters customers. We've been quite successful with that particular product of converting new business.
Just to be sure, Tony, that is not a company. That might be a laboratory that had not bought from us before.
Exactly.
Within a customer that maybe has some Waters users, but a new laboratory.
Understood.
The attachment rate, as far as consumables, is holding at about the same rate as our original research offering, which appears to be running in that 80%-90% range in terms of use of UPLC. Now, qualify that in that some of the customers, the purpose for offering the H-Class, does HPLC and UPLC. While a very high percentage, in excess of 90%,'s ultimate intent is to run UPLC on the system, they may spend an interim period doing HPLC while they prepare for the conversion. So in that case, they will use the chemistries that they were using for their prior HPLC application.
Thank you, Art. And Doug, one follow-up, if I may. A number of competitors also speak about food safety in emerging markets. Could you provide some color around the competitive situation? One would argue that it would be somewhat difficult to penetrate in the Chinese market with premium price instruments and high margins. How do you think about that?
I think it is a competitive marketplace, no question about it. I think we have some advantages, particularly in the emerging U.S. market, but it's early there, and time will tell whether what we've done there prepares the path for the future. But we're optimistic about that. In terms of China, across the broad application space, whether it's food safety, pharmaceutical or environmental applications or classic industrial, our pricing in China holds up at the same level, at the same prices, essentially, that we're seeing in the rest of the world. We don't see in-market pricing and, in fact, in-market profitability. If anything, we see it on the plus side. This notion that the Chinese are extraordinarily price. They're value conscious. They want the best products they can get. We find that they want the highest technology products at the same rate that customers do everywhere else.
This notion that they might value price over and above other characteristics, frankly, we don't see it. And boy, at the rate that our Chinese business is growing, it'd be hard to say that we're growing disproportionately slowly.
Thanks, Doug.
Next question is from Jon Wood at Jefferies.
Hey, thanks a lot. John, can you just go through the free cash flow outlook on 2011 and then talk about the elevated spending on CapEx around the Micromass facility? Is that expected to be significant this year, and how will it kind of flow the next couple?
Yeah. For 2011, I think that our free cash flow is likely to approach about $450 million, excluding anything that we might do on the U.K. facility. That would be about $510 million cash from ops and somewhere around $60 million or so CapEx. As it relates to the U.K. building, in sum total over the course of multiple years, that's an $85 million-$90 million or so investment. We've done very little to date, and the expectation is we may see somewhere between maybe $20 million and up to $25 million, depending on how far we get in CapEx in 2011 associated with that building. That would not be included in the numbers I just provided you.
All right, great. Doug, given your cash position and kind of the cash flow outlook here, why not do repurchases more in line with free cash flow at this point? Are you seeing more M&A at current than you did in 2010 on average?
I'd say it may be a little bit richer opportunity. I think it's fair to say we reevaluate the level of our share purchases at least annually. Last year, we used about three-quarters of our free cash flow to do the buyback. It's not inconceivable that we won't take that up a notch, going forward. The board will take up the level of stock repurchases during the first half of this year. So I think it's a fair question, and I think you could look for us to update that as we go through 2011.
Okay. Thanks a lot.
Next question is from Derik de Bruin of UBS.
Hi, good morning.
Good morning, Derik.
Hey, on the H-Class, what is the exchange rate? That is, are you getting a one-for-one swap for the HPLCs or just given the higher throughput for the UPLC, is it more like a two-for-one?
Yeah. It is early right now, Derik. It is a very fair question because the productivity of UPLC is clearly higher than traditional HPLC. We are early in the conversion cycle, so you are seeing, frankly, a lot of these systems go into methods development. At the early phase, the methods development labs have to prove the transition of the method before they move aggressively into those QC applications. So right now, I would say it is not a two-for-one. It is probably more of a one for just buying one or two of these and not necessarily replacing too many HPLCs in their labs. But when we move into full bore into QC, it is probably something around a two-for-one mix.
Okay. I have always worked with the number that about 60% of your overall HPLC installed base is in the QC environment. Is that a fair number still?
Art, what would you say? Is that still currently a fair? It is a little high.
Yeah, it runs between, it's probably in the 30%-40% closely.
Okay. Just one final question. Given the growth of the applied markets, what's your general revenue exposure? How much of your business would you say is dedicated to environmental? How much of it is to food?
John, do you want to—
Yeah. I'd say the environmental piece is probably maybe what? 7%, Doug, overall. Food safety is probably maybe 5%-7%, somewhere in that range.
Great.
Between the two, you're somewhere around 12%, 13% maybe.
Great. Thanks a lot.
Next question is from Quintin Lai of Robert Baird.
Hi, good morning. Congrats on the quarter.
Thank you, Quintin.
Most of my questions have been answered. The success that you're seeing in the uptake of H-Class in the regulated market, are you seeing any opportunities to cross-sell maybe like your new triple quad into those markets now that you've gained maybe some new account traction?
I think it's a very fair question. The regulated drug metabolism and pharmacokinetics segment of the market is a very large mass spectrometry marketplace that is in a period of transition. You got many of these big pharmas looking to outsource some of those products. You got CROs investing in new facilities. It's a period of change in a lot of those environments, and we're coming to the market, I think, with both ACQUITY and TQS that rival the best performance instruments in those applications. There's, I think, a good opportunity for us that still awaits. We're seeing some good symptoms of penetration that could happen there. We're not declaring victory by any stretch of the imagination yet, but I think it's an opportunity to get additional growth that we're not ready to bank on yet, but I think is a real opportunity for us.
Great. Thanks.
Next question is from Isaac Ro of Goldman Sachs.
Good morning, guys. Thanks for taking the question. Just first off, wanted to dig a little bit more into the mixed use of the HPLC versus UPLC columns that you mentioned for H-Class. I'm wondering if you could maybe give us a sense of what that mix looks like today, on a dollar basis, and then how you think that's going to shift over the next one to two years.
I'm sorry, a dollar base, you mean like how much—
Yeah, let me just be a little more clear. I think you mentioned something like 80%-90% of your new H-Class installations are using some UPLC columns, but I'm wondering—
That is right.
—if you could maybe quantify what the dollar mix is between the UPLC versus the HPLC columns today and where that is going to go over the years.
Yeah, they are actually quite close. The average price of a UPLC column runs about, think about it as $500. Whereas you are probably closer to the $300-$350 range for an HPLC column. So there is a premium to the UPLC column. But over time, we think UPLC columns will hold a premium. The fact is that we have seen lifetimes for UPLC columns that are at least equal, in some cases even better than HPLC columns. And the performance, of course, is what is justifying the higher value of the UPLC column.
And what—
We think it will hold over time.
Yeah. If you are looking for underlying growth rates, Isaac, the UPLC columns are by far the fastest-growing segment of our consumables business. We have gone from nothing to almost $30 million of revenue there, and that is a base level that we think continues to grow 30%-40% over the foreseeable future. Whereas the rest of our chemical products, as you know, as a group, grow more in the high single digits to 10% range.
Got it. Thanks. That is very helpful. Then maybe just secondly on the mass spec business, you did mention SYNAPT. I am wondering, you have touched a little bit on new product introductions as the year progresses. Could you maybe walk us through what to expect as we head into ASMS and maybe the rest of the year?
Well, SYNAPT had an outstanding year. If you look at the whole family of high-end Q-Tof, SYNAPT products, it was an extraordinary year for revenue growth there. To be fair, that was more of a late 2009, 2010 dynamic. As we moved later in this year, the TSQ—
TQS.
TQS, excuse me, took more predominance. But we think the high end, and it was particularly strong in the fourth quarter, continues to be very robust. We continue to expand that family of products. Now, our most recent introduction was a single-stage TOF mass spec, that we're very optimistic about for benchtop applications. So I think that's what's going to take most of the new product emphasis this year, as we still think that SYNAPT product line is very young in the tooth.
Got it. Thanks very much.
Next question is from Dan Leonard of Leerink Swann.
Hi, thank you. In the past, you've talked about the ACQUITY H-Class tripling the penetration of historical ACQUITY Classic into the regulated applications. Can you update us on that metric? Did that hold in the fourth quarter? Did that increase? Did it decelerate?
I'm sorry, could you repeat that, Dan?
Yeah. I believe that maybe only 10% of your ACQUITY Classic sales were into the regulated pharmaceutical and quality control applications, whereas the proportion of H-Class sales have been much higher. Can you, I guess, update us on that ratio, please, for the fourth quarter?
Yeah. Basically, what we've seen is it holding. We find the H-Class is now dominated in what you describe as development applications through to the manufacturing QA. The traditional ACQUITY, there's still people using it for whatever reason in the developmental areas. Originally, we had people putting that product into the quality control areas before we introduced H-Class. But the bulk is still holding at 90%, and the primary focus of the traditional ACQUITY is more in the discovery front-end research.
And certainly, in high sensitivity mass spec applications, the traditional ACQUITY is the instrument of choice.
We find most people will use it, prefer the ACQUITY.
The ACQUITY, yeah.
Yes.
Okay, thank you. Then just a housekeeping question for John. John, the $18 million interest expense forecast for 2011, is that a net number, net of any small interest you earn on your cash? So that would compare to the 2012?
That's a net number. It's up a bit year-over-year as we continue to move some of our debt portfolio into private placement fixed interest rate instruments.
Okay. Thank you.
Yeah.
Next question is from Tycho Peterson of JPMorgan.
Hey, thanks for taking the question. Just a couple of quick ones. On TQ-S, you've talked about a pretty broad range of application areas when you launched the product. Can you just characterize where you're seeing the strong interest, whether it's in the applied markets or infectious disease or biomedical?
You want that?
Yeah. The TQ-S is fairly broad in its area of application. So any one particular area doesn't seem to stand out. Being very broadly used, we see it used in the food applications, environmental applications, certainly in the biomedical. We're seeing a very strong response in the regulated bioanalysis area. So it's hard to really draw a specific segment. The performance of the product is such that it has quickly taken on a leading position in what we describe as high-performance triple quadrupole.
We obviously are trying to target, what was mentioned a few minutes ago, very heavily into the regulated bioanalysis area. We see that combined with our ACQUITY position offering a substantial opportunity for us. But its performance has been broadly based across a wide range of applications. Hard to single out any one of them.
Okay. In the prepared comments, Doug had called out the new biologic characterization instrument or solution, I guess. As we think about where you're going from an R&D perspective, you've refreshed the whole mass spec portfolio in the past couple of years, and obviously, you've had some success with the LC products. Is there more of a focus on kind of application-specific methods here going forward and more focused approaches as you've targeted a broader range of customers?
I think it's fair to say that we're doing a lot of work on applications such as biologicals, in particular. I think one of the reasons we focus there is because there's not a pharmaceutical institution around the world who isn't saying that their R&D and their future depends on large molecule versus their traditional small molecule world. Large molecules require different treatments, different systems, different kinds of separations, to do them successfully. So we're clearly looking there, and boy, I think the fact that we introduced this new system is interesting, but we've been having great success in the biopharmaceuticals piece of the pharma market over the last year or two, particularly in proteomics and in metabolomics. We're seeing a great deal of success there.
I think it would be wrong, however, to think that we're not still continuing to invest substantial money in basic instrument systems enhancements, and more than enhancements, but next generations of separations and detection. I think you'll be interested. We're not ready to open the kimono too much on that, but throughout this year and into next year, I wouldn't have you believe that we're just looking at application development. You're going to see a lot of core instrument development also come to the market.
Okay. That's helpful. Then just one last one on pharma. I appreciate the color you gave before, but as we think about the prospect of a replacement cycle, there's obviously a lot going on between these mergers and more outsourcing. I guess, what's your confidence level that you will start to see the replacement cycle pick up over the next couple of years, or are we in an environment where you just don't have that visibility right now?
Well, I would say that I don't think we've seen a lot of evidence that we're in a major replacement cycle as we speak. Maybe a little bit, but I think what we're seeing is the market respond to UPLC and the need to get facilitized on this technology, and I think we're at the front end of that. To some extent, I think that causes some delays within some customers as they say, "Gee, how quickly am I prepared to invest down that road, and how do I deal with my facilities and people issues?" But UPLC has very strong ROIs, and as you know, a lot of these, particularly big pharmas, are extraordinarily focused on ROIs now rather than kind of blue sky new product promises.
So we think that the market is poised to move into a replacement cycle that's going to be somewhat masked by the move to. It's not going to be a classic, "Well, I had my old system, and I've been in the market for five years with it," and people are going to just buy more of those because they're going to be, at the same time, moving to a new technology called UPLC. But we're optimistic, but we're not probably going to formally incorporate that into our estimates until we can prove that we're seeing the beginning of it happening, and that will take a while longer.
Okay. Thank you very much.
Next question is from Steve Unger of Lazard Capital Markets.
Hi, good morning.
Hi, Steve.
Thanks for taking the question. John, as far as recurring revenue growth is concerned for next year, do you expect that to grow faster than instrument sales, given the strong instrument sales in 2010?
Yeah, I think at a high single-digit expectation, you're going to see pretty comparable growth across recurring revenues and instrumentation. Certainly to the extent that we continue to maybe see a little upside from what we're describing, it's most likely to be with instrument placements and not the recurring revenue side.
Got you. Given the strong sales in the quarter, was there a meaningful carryover of orders into the first quarter? How is manufacturing keeping up with demand?
Yeah, I'd say the strength we saw across the fourth quarter was encouraging in that it was relatively consistent, and we've seen that strength continue principally right through the first few weeks of this quarter. So, that trend continues. It's encouraging, and we do think we're kind of back to a bit more normalcy as we look across the various markets and are pretty comfortable that our product positions will allow us to capture some meaningful share here. What was the second part of the question?
Just how is manufacturing?
Oh, manufacturing. Yeah, manufacturing is doing well and keeping up. The good news there is that we've got some pretty robust products that are making their way through the R&D process, through new product introduction, and ramping up nicely in manufacturing. We had a little bit of a delay in ramping up the TQ-S. That's gone extremely well. That product has no further delays, and there aren't any other products that, as we speak, have any manufacturing issues. We're comfortable from a product supply position that we're not looking at issues today.
Congratulations. Thanks.
Thank you.
Next question is from Paul Knight, CLSA.
We're here. Can you hear me?
Yes.
What's your view on Asia, Doug, in terms of is it a secular growth story, or how much of it's cyclical? How much is the customer base there industrial users?
Some segments of the market are more industrial. Historically, Korea has been more industrial. But I'd say that is changing, and the mix of business that we're seeing in Korea is moving more to more of our traditional pharmaceutical life science focus. China is a pretty balanced marketplace with probably a higher percentage of food and food safety and agricultural applications and environmental than we're seeing in other areas of the world. I think that's going to continue, Paul. If you look at the amount of requests we get in China to look at specific environmental projects, testing of river waters, looking at effluent. Not all of them get funded at the pace that we'd like, but a lot of them happen and, boy, we continue to see a lot of new things coming on the plate that weren't there last quarter.
Yeah.
I think the Asia developments, and by the way, I think Latin America is, particularly places like Brazil, are just a smidge behind. Very rapid growth, very clear signals of continuing investment in agriculture, food safety, and pharmaceuticals. I don't see any significant cyclicality in these high-growth markets.
Okay. Lastly, on the interest expense line, is because the cash in bonds is rolling into lower-yielding instruments, is that what's going on?
Yeah. Actually, on that front, the issue is that we have a bank agreement that expires at the end of this year. We've been going through a process of diversifying into private placement debt instruments that have between a five and a 10-year tenure and fixed interest rates between about 3.5% and 5%. We've been slowly moving a portion of our debt portfolio into these fixed rate instruments that have raised the debt cost a bit in the short term, and that's what's causing the $18 million. The dynamic there, Paul, is that, of course, you pay a penalty because under our current agreements, you're paying a LIBOR plus pennies. That's very, very cheap, but it's not going to last forever.
If you stay linked to that until the bitter end, then you're at the subject of long-term interest rates that could be much higher. John has led us down a path of diversifying our debt into more permanent instruments, and we think that was the most prudent thing to do, even though we paid a short-term penalty on the interest cost.
Okay. Thanks.
The last question is from Sung Ji Nam of Gleacher.
Hi. Thanks for taking the question. Congrats on the quarter. I will just ask one question. I was wondering if you could give us more color on your academic segment. Understanding that is not, obviously, your largest segment. But given pretty solid demand, particularly in U.S. and Europe, I was just wondering if there is trailing benefit from the stimulus or what you are seeing there.
Trailing benefit from what? Oh, stimulus?
Stimulus, yeah.
We clearly saw some stimulus benefit last year in Japan. I'd say it was hard to see much stimulus benefit anywhere else in our worldwide business. If it was there, it was indirect and nothing much we could directly point to. Overall, our academic business in the fourth quarter grew in the mid-single digits. It was softest in Japan. That can be pretty cyclical in how the Japanese budgets work. We're a little careful about the academic government business in Europe because we know that budgets are under pressure, and we know that that might make itself felt in lower government support for academic research. Frankly, we haven't seen that dynamic yet, but it's kind of what we're being careful about.
Thank you.
Okay.
I think there are no other questions at this time.
Okay. Thank you very much for being with us, and we'll look forward to talking to you again next quarter.