Waters Corporation (WAT) Earnings Call Transcript & Summary

All right, folks. We're going to get started. Thank you, and welcome to the Jefferies 2022 Healthcare Conference live edition, back in person. So glad that all of you could be here. I'm Brandon Couillard. I cover the life science tools and diagnostics space. It is my great pleasure to have Waters with us at the conference today. And joining us for this conversation, President and CEO, Udit Batra. Udit?

Hi, Brandon.

Thanks for being here.

Same here.

Maybe to start off from a big picture, it'd be helpful if you could just kind of articulate for us and give us sort of an update on where things stand in terms of the Waters transformation that you've been instrumental in driving the last 18 months since you came onboard. What more is there still to do?

Yes. Firstly, thank you for having us, Brandon. And it's been a pleasure to see several old colleagues in person for a change as opposed through Zoom. Look, it's been a tremendous almost 2 years since I've been at the company. And when I joined, I found a company where we were still deeply steeped in science, very close to customers, but one that had lost a little bit of focus. And we simply brought that focus back to what Waters had been doing historically, right, really focused on customers, focused on technology, but also really along 3 elements of the transformation program, first, on the commercial side, really executing commercially what had made us strong in the previous years; second, bringing a team onboard that could actually sustain the commercial momentum that we had started to get in the early days when I was here; and third, that same team would orchestrate the transformation of the portfolio and the development of the portfolio towards higher growth adjacencies, right? So these are the 3 parts of the transformation program. From a commercial perspective, we instituted 5 commercial initiatives. I think we've talked about those before: instrument replacement, service attachment rates, e-commerce, getting after faster growth segments like contract manufacturing, bed launch processes that has gone super well. It's contributed very well to our growth. Second, our team, 7 out of 9 of us are less than 2 years in seat. I must say I'm ecstatic working with my colleagues. All of them love science. They have experience in operational transformations, and they've done M&A in the past. And this brings me to the third piece, which is setting the business up for growth, and these are the 5 initiatives in the adjacencies that we've talked about also in the past. We have very good traction on several of them already, and they are not theoretical ideas. These are practical extensions of our business model, which really envisage us taking complex instrumentation, simplifying it, attaching good informatics software that assures the customer that anytime a sample is tested, it has complete traceability from the time it enters the instrument to the time the data leaves the instrument, fortifying it with our chemistry and our service engineering team. So that model is now easily applicable to these faster-growing adjacencies. So the transformation program is going reasonably well, and the numbers suggest that they help us grow, I would say, a little bit faster than the peer group. I think there's a lot of discussion on market share, so I won't get into that. But all I'll say is we feel very good about where we are.

In terms of that growth acceleration, the 5 areas initially of focus that you mentioned, which have been the most impactful? And you've also articulated a market growth, big year, call it, 4% to 6%, and that these initiatives would maybe enable you to do a point better. You just raised guidance to like 8% to 9% for this year against a tough comp. Is that a function of market? Or are these internal initiatives actually giving you more than maybe you thought? And what would those primarily be, those areas?

I mean we raised the guidance to 7.5% to 9%, good try, 7.5% to 9% for the full year. That envisages the latter half of the year, roughly 6-ish percent in Q2, 6% to 8%, right? It's a mix of all of the above, right? The market is traversing slightly faster than 4% to 6%, largely due to pricing, right? I mean pricing in the past has been, what, 50 basis points, 75 basis points, in the market. It's a bit higher than that. So that contributes to a faster growth of the market. In that faster-growing market, our commercial initiatives give us at least 100 basis points. And in addition, the new products that we've launched have exceeded our expectations, right? And these are targeted both towards small molecules as well as large molecules, right? Small molecules, Arc HPLC has been launched in the workhorse segment of LC. And in fact, when I joined the company, I was told, look, the high-volume end of the market is something where Waters will not succeed because it's price-sensitive, et cetera, et cetera, a complete nonsense. Customers in QA/QC want the highest-performing instrument, they respond to innovation, and Arc HPLC has done extremely well. In fact, versus last year, we sold 3x the number of units in the same quarter. Second, increased focus on biologics, in particular, the MaxPeak Premier Columns as well as the Premier UPLC instruments, both have done extremely well. And they were targeted towards biologics, in particular, molecules that get stuck to metal surfaces. And we designed a coating that allows you to reduce the adhesion of these molecules to metal surfaces, thus decreasing the processing time tenfold, twentyfold versus previous times, and the customers have responded very favorably to this. And no mystery, it meets an unmet need, right, in the fastest-growing segment in the market. And number three, on the informatics side, just moving away from instruments for a second. On informatics, we launched earlier this year our waters_connect platform for tandem cores, our mass specs with our MS Quan application. A mouthful, but simply said, this software reduces the time of processing by 50% for complex testing. And that's something that our customers have received very well. So commercial initiatives; in addition, our innovation is really, really helping. Now don't ask me exactly what contributes what and if I should break it down further, but from a Waters-specific standpoint, the market is a bit healthier, but these 2 initiatives have contributed better than we thought when we designed it.

Certainly, the highlight of the first quarter was instrumentation growth as it was for most companies but exceptional for Waters. You grew 26% on a plus 45% comp. I looked at the 3-year CAGR, it's at a 17% CAGR, which is not the underlying growth rate for instrumentation. You have lost some share, really seem to be gaining some of that back. You talked about some of the new products. But like what is really underpinning, you think, the growth not just for your business, in particular, but kind of what we're seeing across the industry, if you could speculate on a couple of factors?

Sure. I think let's just take it again in those 3 parts, right? From a market perspective, for the 2 years intervening during the pandemic, you did not see as much investment going towards the base business of many of our customers, right? That's come back, right? So people who are diverting attention towards the vaccines, the therapeutics, are back into servicing their pipelines that existed in the past, right? So that's part of the exuberance that you see in the growth rate. From a Waters-specific standpoint, the instrument replacement initiative has done extremely well, right? And again, as I said, it exceeded our expectations. We basically had a database, and we had said we were going to go after these instruments, 13,000-odd out there that we hadn't replaced in the last several years. In Q1, and continuing on from the journey that we had started last year, it's gone extremely well. And the third piece is new products. And here, especially Arc HPLC, ACQUITY Premier and our mass spec portfolio that has been refreshed, all 3 have done extremely well. Not to mention TA now has secular growth drivers that are significant versus what we had previously, meaning battery testing, or recyclable polymers in particular. So across the board, you see the market doing a bit better, you see our instrument replacement initiative doing well and the fact that the new products have contributed to the instrument replacement and incremental growth has allowed us to command these growth rates.

Have the new products expanded your TAM such that the instrumentation demand is not just replacement, it's not just perhaps new capacity for things that are coming in the pipeline, et cetera, but also kind of opened up new customers or new areas that perhaps didn't exist?

Absolutely. I think 2 concrete examples. One, contract manufacturing, right? So you'll recall that one of the initiatives was to focus on the contract manufacturing segment where, if you take out our pharma business or take the industry's pharma business, roughly 30%, 35% of it goes to contract manufacturers or contract research organizations. For us, that number was short of 30%, right, 1.5 years ago. That number is now in the mid-20s but still far away from the 35% that the industry has. Those are new customers for us. There, the value proposition of Waters has resonated quite well. In fact, one of the large biologics contract manufacturers in China, which is where we started this initiative, came to us and said, "Hey, we don't need your help in getting better cost out of the system, we actually need your help to transfer products from manufacturers to our contract manufacturing sites. Can you help us do that?" And that plays to Waters' strength, right? I mean we have 900 service engineers, now close to 1,000 service engineers, that are technically trained, many with advanced degrees. These are people who have run these experiments as customers or designed our instruments. So they know what experiments are there to be run, and they've helped this particular contract manufacturer transfer many processes from their customers to their laboratories, to the point where we've gone 20-80 with another competitor to now 80-20 in terms of share of the customer. And that model is now being replicated across the globe. So we see significant growth in this new customer segment for Waters, not necessarily for the industry, but for Waters. The second example would be new users, right? So you'll remember the launch of BioAccord. It was envisaged as a product for QA/QC, and we went, right, head first into QA/QC with, I would say, simplified LC-MS workflow. But what we failed to realize is that the biologics processing industry, and the biologics industry in particular, is quite conservative, right? You can't go head first into QA/QC without having set up the methods in early development or late development. We repositioned the product and went after a clone selection in partnership with Sartorius. And that's gone extremely well to the point where BioAccord finally meets the targets that we've set internally and is starting to do very well not just in early stages, at the same time, getting better traction in the later stages. In fact, there's a monograph that Janssen published recently that in the next 1.5 to 2 years, they will be using the BioAccord file in their BLA. This is the first in the industry, right? So that will be quite a dramatic change. So both in terms of new customers and new users with existing customers, we've seen some traction.

One theme from the Analyst Day was certainly your prioritization of future growth adjacencies. Of the 3 main key adjacencies that you're going after, large molecule characterization, clinical diagnostics, buyer separations, 2 questions, which will be the largest in terms of revenue in 5 years, okay? And which will be the highest ROIC in 5 years?

I don't pick amongst my kids. I hope all of them are the highest. And there are 5 adjacencies.

Putting aside sort of batteries and polymers.

And so if I just take the health care one, so 3, and then we talk about the other 2 as well. But if I take the 3, we have a lot of traction with the application of LC-MS in the bioprocessing space, right? And that's the one that's furthest along with the partnership with Sartorius, especially for clone section where we've taken a workflow that used to take 6 weeks and had to be to centralized labs where experts in mass spec would run the experiment to ones where now engineers who have much less training in mass spec, people like me, can run the BioAccord and get their results in less than a week, right? So we've taken 5 weeks out of the process development cycle, and that has gained a lot of traction. And same is true for the late-stage QA/QC. There's a large development program behind it that envisages first with Sartorius using the same data platform from there Ambr platform, which is a multifactorial bioreactor system. With our BioAccord, it envisages a further development of aseptic sampling of sensor technology and data analytics with the University of Delaware. So I feel that one is out of the gates the fastest, right? Now don't ask me if that is going to be the highest potential or some of the other ones will be. Now the one that I feel has the highest degree of difficulty is LC-MS and diagnostics, not because we don't know what we're doing, I mean, there, we have a $200 million business in new bond testing, so we know that we can apply mass spec in the diagnostics space. The challenge is to make it a multiplexed, simple-to-use analytical tool that can be used in the IVD setting, right? So that's a mouthful and a lot of work. So there, we are being super cautious, right? We're basically saying to the team, "Okay, develop the assays and you will get funding as you reach the different milestones." So a lot of discipline being applied on the organic investments. And I insist, in each of these cases, we will push the organic investment first, along with partnerships before we think about M&A, right? So I think that gives you the 2 extremes, right, the bioanalytical characterization, fastest out of the gates; LC-MS, much more deliberate investments and much more careful investment, just given the degree of difficulty of the challenge.

I do want to get to M&A in a moment. But maybe just on China, a little under 20% of the mix. You talked about a 1% to 2% headwind in the second quarter from COVID lockdowns. How is the recovery progressing? Sort of what's the state of the union in China?

I mean, first, just the facts, right, so Q1 grew 17% in China. And the last 2 weeks were sort of the first stages of the shutdown in Shanghai, in particular. And we use the opportunity to open a warehouse right outside of Shanghai where we basically put in all the instruments to service the orders that were being taken, right? So that existed over the last couple of months. Now the early part of the quarter, the first 2 months of the quarter, that lockdown has persisted. But that said, many of the customers have had employees working on site. To some extent, we've had that as well. So activity has not gone to 0. I think press would tell you that the activity has gone exactly to 0. That's just not true. So the activity has not gone to 0. Now in the early part of June, as Shanghai has opened up, we have seen the demand and the shipments pick up quite dramatically, right? So don't ask me if we're going to -- I mean we had said, look, China would be roughly flat for Q2 and then, by the end of the year, we expect low double-digit growth in China. We still think the full year number is intact. Don't ask me if it's flat, if it's slightly down, if it's slightly up, but it's thereabouts. We feel confident that the turn is taking fast. And what I'll remind you is, in China, everything happens fast, right? Shutdowns happen fast and the recovery happens just as fast. And we have a very capable leader who's basically energized the organization in China, and we've seen the turnaround and the growth in China after many years in Waters and the recovery from the lockdown is no different.

In terms of your manufacturing footprint, you make most of your stuff in the U.S. or Ireland. You outsource a little bit in Singapore, maybe a little bit in Germany and U.K. Do you view local China manufacturing as critical to establish over time to be more in China, for China?

I think even in the early stages of the pandemic, when I joined, we had envisaged local manufacturing not because of geopolitical reasons but because of the demand from our customers, right? Economically, it just simply makes sense to assemble things in China and customize the assemblies according to what the customer needs, right? And that plan is now underway, right? So that will anyway see fruition, right? So now do we expand it further? How fast do we expand it? Let's get started, and we'll go from there. But there is a plan to first do assemblies and then go further upstream depending upon what the value and the IP conditions are.

Would there be a natural cost advantage of moving some of that manufacturing out of the West?

I think definitely supply chain. Cost, I cannot judge, right, but definitely, from a supply chain perspective, from a speed perspective. I mean I remember from my previous times at a different place, the customers demanded that we had local warehouses to meet their fast-growing businesses and for their fast-growing demand. And before we could put a warehouse down, we had orders that were there for 6 months serviced out of that particular warehouse. So I have no doubt that will be fully utilized. I have no doubt that the assembly will be fully utilized. And over time, I expect it to improve the service levels in China quite dramatically.

One other theme out of the Analyst Day, you indicated a shift in your capital deployment priorities toward M&A, which has never really been part of kind of the Waters DNA. Why do you need it? What are you solving for? Because it seems like you've got a pretty strong organic story on its own right now. Talk about that and just kind of the availability of assets, deal criteria.

I think, I mean, the deal criteria are pretty straightforward, right? I mean we are very strategic about how we think about M&A, right? I mean, in all honesty, the transformation has gone faster than any of us thought, right? So we had to get going with the M&A strategy a bit sooner than even I had thought about. But we've been at it for about 8 to 10 months now, right? So we've discussed it with the Board. We have clear criteria, basically starting with the strategic fit. And we've been pretty clear about what we're chasing, right? So anything that helps advance our core, anything that helps the trajectory in these 5 adjacencies, be it better technology to do battery testing, be it advancing bioseparations. For instance, we feel that, for bioseparations in particular, we have incredible chemistry and engineering knowledge. A bit of biologics expertise would help, right? And so yes, I mean, if there is something that helps us accelerate that journey, we would look at it, right? So I could go through different examples. In bioanalytical characterization, we have LC-MS. And there are other characterization techniques, there are other sampling techniques, there are data analytics techniques that could help us advance that journey as well, right? So there are ideas there, too, right? So the first and the most important criteria is strategic. Then there's incredible financial discipline. I mean Waters is nothing if we are not financially disciplined, right? I mean somehow I find that there's a lot less discussion on ROIC, but Waters has a very, very healthy ROIC. Our cash flow is very, very significant, if you just look at it as a percentage of sales. And that gives us a lot of flexibility in how we finance the deals. So the second criteria is financial. We would still look at ROIC as a key metric. I mean EPS accretive, let's say, in the 2- to 3-year time frame. And in terms of financing, we would think about a mix of debt and equity, more debt than equity. And Waters' paper is quite expensive. So I think that gives you the strategic and the financial frame of what we are thinking about. In terms of size, I mean it depends.

In terms of margins, investors and most of the analysts, I think, still view Waters as being at peak margins. Number one, are we wrong about that? And number two, are we thinking about it wrong, i.e., you can add, you can create, more shareholder value by driving an extra point or 2 of growth rather than another 50 basis points of margins and that Waters could be a structurally higher grower than we think you're doing and that we're actually looking at the wrong metric?

I think you somehow answered the question in your question towards the end. Organic growth is the best opportunity for us. I mean, as we grow 5%, we have 50 basis points of improvement in gross margin. And then below the gross margin also, we have leverage. So assume that we can get about 100 basis points if we grow 5% to 6% in the top line. And then in the short term, we have said we're going to reinvest 70 to 80 basis points in internal investments and growth, and that's why there's a 20 to 30 basis point margin expansion opportunity. Now I'll remind you, in Q1, despite the geopolitical issues, despite the pandemic still ongoing and the macroeconomic issues, our gross margin grew 40 basis points and our operating margin grew 170 basis points. This is a great business and it is a cash machine, right? So if you grow the top line, the gross margin is high enough and there's a ton of leverage in SG&A, you can continue to expand margins. And it's not because we're milking the business. I mean if you just look at productivity initiatives, we haven't digitized the company in the past. We're just starting to do it. We don't have an offshore capability center like many companies do. So there's a ton of productivity to be had as well. We are far from having optimized the cost structure, far from having optimized the margins. And I think there's an opportunity. But you will not see us squeezing the business, we'd rather see us reinvesting it in growth.

Very good. I wish we had another 25 minutes. Unfortunately, we're out of time. So we'll have to leave it there. Udit, thanks so much for being here.

Brandon, thank you for having us.

Thank you.