Waters Corporation (WAT) Earnings Call Transcript & Summary

[ Thanks for ] joining us. I'm Tycho Peterson from the life science team. It's my pleasure to have Udit with us today from Waters. Welcome. Good to see you again.

Same here Tycho. Thank you.

So I promised I wouldn't talk about May trends, so we'll scratch that off the list as the first question. Let's talk about replacement cycle. So I think there's a lot of talk about it. People are looking for signs that it will pick up. Curious to your view on first LC versus MS is it on both ends? And then are there leading indicators? Is it hiring? Is it -- are the things we can kind of pay attention to from the outside that would be indicative of...?

Yes, yes, firstly, thank you. Look, I mean, replacement cycles are as predictable as the history of Waters, right? So you look at the last 15-year history, you would see no quarter being the same as another quarter. But over the long term, instruments, which is what I think what your question is about, have grown roughly 5%. But no quarter has been exact -- no year has been exactly 5%. There's been years that we've been down double digits, there have been years where we've been up double digits. So in 2021, '22, almost 20-plus percent for instrument growth. And roughly 5 years out of that 15, we've been within striking distance of 5%, right? So anything but predictable in the short term, but over the long term, super predictable, and it's going to happen. Now there are 2 indicators that you can look at. You can look at the long-term trends, which is what I said is more predictable. On a long-term basis, on a 5-year CAGR basis, if you just look at our full year guide for LC, we will be flat globally, right? And LC grows 4-ish percent on a long-term basis, and there's about 50 basis points of pricing, pricing is better. So it's actually at a very significant deficit. And I can get into that a bit more. Mass spec will be low single digits, so up to 1% to 2%. And so both -- in both those cases, if you look at the long-term trends, we are behind significantly. And you talked about leading indicators. What you can look at is whenever you look at instrument growth. Recurring revenues actually give you a clue on what's happening with the instrument side and how old the instruments are. And there are 2 indicators there. One is the service revenue and in particular, spare parts, right? So our spare parts revenue has been going up quite dramatically, especially in China in the branded generics segment where customers are running these instruments way longer than they usually would in a regulated setting. And second is our chemistry revenue. Chemistry has been growing high single digits. So that tells you that the instruments are being used. There is no hiatus in production, and it would make no sense if you're producing vaccines and pharmaceuticals that you have a hiatus unless you want to risk the health of your population, right? So I think those 2 leading indicators tell you a lot, right? The spare parts revenue, which we talk about quite openly in our quarterly discussions, and our chemistry revenue, which is growing at high single digits and geographically I mean -- and it's been largely a China issue. And in China too, we see these both growing pretty nicely.

And do you think high single-digit is sustainable for the consumables going on a long-term basis?

It's been the trend, and you can call high single digits, 7%, 8% or 9%. And it's been the trend over the last 15 years. I see no reason for it to change. In fact, there are vectors that make us feel that it's going to be even better going forward, right? So as you look at things going forward, from a consumable standpoint, our chemistry revenue. I mean there are 2 pieces. There's a lot more innovation roughly 70% to 80% of our R&D now goes into large molecules and novel modalities, and we are by far the leader in chemistry. Second, when I think I took over back in 2020, roughly 20% of our chemistry products were going through e-commerce. That number is closer to 40% now, right? So we still have runway there. I mean, you'll recall from my previous role, we used to spend -- we used to have about 75% of our consumables revenue come from e-commerce. So there's ways to go. We've targeted about 55-ish percent in the short term. So ways to go on e-commerce on the commercial side, on the R&D side, a lot of innovation to be had on novel modalities and biologics to effect separations.

We were talking earlier about how there's a lot of short-term thinking in the market. So I'm going to ask you a question about the back half of the year. Just in terms of the recovery, right, if we think about kind of what's implied in the guide down 7% in the first half, now 8% growth in the back half, easy comps. There are some factors there to aid you. But are there other things that we should be thinking about in terms of kind of hitting in the back half of the year...?

Look, I mean, it's not much different than what I told you roughly 4 weeks ago when we when we guided and reaffirmed the guidance for the full year. So it's no different than what I told you then. What we had seen and just to repeat a couple of those things over -- that's quite important. What we have seen is our Q1 came at the high end of our guidance, right? And that was largely due to China outperforming our expectations. And that continued, right? So China has performed better than we had thought. And that basically flowed through the full year number. Second, we had said we're seeing very good trends in terms of order quality way better than what we saw last year. It's just that when you get those discussions happening towards the end of March, they then consummate into sales only towards the end of Q2 or in the second half of the year because it takes 3 to 4 months for these things to consummate, these orders to consummate. So that went into some of the thinking on the phasing of the guide. And so that's the qualitative part. The factual pieces are twofold. One, Waters is roughly 46%, 54% first half of the year to second half of the year. We've guided 45%-55% given what we have today. And that's largely because we said in Q2, given what we talked just about the orders and the timing. We said Q2 will be a step up from Q1 by about 10%. Historically, it's about a 12% step-up. So we took 200 basis points of sort of conservatism there. And that's part of the math. The second is the baseline for the second half of the year is so much lower, right, than it historically has been. And the budget flush last year was a historic low, right? So you have a couple of levers. China coming in a bit better. The orders quality being good, but sort of back half weighted and the baseline mathematically just being that much lower.

I know you don't want to talk about May trends. I'm not going to ask you about that, but you did have your closest competitor cut numbers by $300 million. Anything you're willing to say about your view of that?

I think -- I mean, I think you should ask them why they did what they did. I can just make sort of 3 comments where you could draw differences, right, building upon what I've just said. First, I think our business looks very different than theirs in China, right? We're 70% pharma. I suspect they are much lower. And the pharma weakness we saw last year was exaggerated and it happened much faster, right? And so that's a lower baseline. Second, I think that fiscal year ends at the end of October, ours is -- the financial year is end of December, and that's where the budget flushes. And we had a low budget flush last year. So those are 2 significant differences. And the third is, I think at another conference a few months ago, maybe 1.5 months ago, I was on stage with their previous CEO, and we were blamed for being in resonance in what we're seeing. So maybe that has to do with it as well, right? So I know, Mike, for many, many years, but we never really synced up our answers, but we were blamed for being in complete resonance. So I can guess there's some qualitative reasoning. But quantitatively, there are 2 big differences. China, pharma and the budget flush, not being in their numbers and not being in ours.

Maybe let's touch on China a little bit more. So branded generics, I think on the pharma side, are about half that business. You've got Tier 1 CDMOs, maybe a quarter and then Tier 2 and 3 in other quarter, can you maybe just talk about each of those kind of segments? I think there's a lot of excitement about the generic exposure, in particular in China for you?

Yes. Yes. So pharma, I mean we had said break it down into 3 pieces, right? Biotech, CDMOs and branded generics, the biotech segment and the CDMO segment became dramatically weaker last year, Biotech in Q1, CDMO in the balance of the year. And there is not much more to go right? We're starting to see a nice recovery on the consumables side in both of those segments, but we're not holding our breath, especially on the CDMO side for a capital replacement. So we've said, look, that's the baseline and the consumables piece will grow. The branded generics segment, which is 50% to 55% of the pharma business in China for us, that also went down but due to a different reason due to the anticorruption campaign the government had and that delayed the replacement cycle of LCs quite dramatically. To the extent that 50% of the LC fleet that many of these customers have is overdue for replacement, right? And in the generic segment, you basically are using these instruments 24/7 because that's how you make your money, right? And so they're being used, and you say, "Well, okay, that's all well and good. What other indicators do you have to tell you that that's actually happening, and they're actually using these instruments." There are 2 other indicators. The chemistry revenue continues to go up, so they're using columns with these exact customers. And second, spare parts. Spare parts revenue has been going up. And when spare parts go up, as I said before, you basically are outliving the usefulness of the instrument. So it's a matter of time. So the question is when exactly does that trigger? Is it a violent rebound, not willing to predict any of that, right? It is going to happen because unless you're not willing to supply vaccines and pharmaceuticals to your population, the rebound will come, right? It's a matter of time. I just don't know exactly when the stimulus has something to do with it, I suspect, psychologically, but we are starting to see -- and then 1 last piece, we're starting to see the replacement cycle begin. In Q1, part of the outperformance was due to that, right? We had some large customers in China order really large replacements for their LCs.

I think you're pretty clear stimulus in China is not in guide, but you did bump up from down high teens to down low double digits. So maybe just talk about what incrementally you're...?

Largely due to the outperformance in Q1, right? It's pretty clear that, look, we saw branded generics replacement begin in Q1, some big orders come in, and we basically just used that for the balance of the year. And that was it. Not more than that. And as far as the stimulus is concerned, there's a lot of talk. We know a lot of details about what the government has said. It's now a broader stimulus. It's not just focused on academia and government. Instrument replacement is called out explicitly. There is also a discussion on low interest rate loans. So a lot of different tools being used by the government to give confidence to folks, and I've been to China, I've spoken to lots of my colleagues there. There is a lot more confidence on what's going to happen. It's not yet started to happen. There's a lot of planning, by the way, a lot of planning on how those stimulus is going to get used. So there is some optimism, but I wouldn't say it's starting to show up factually everywhere.

I mean you've done a nice job evolving the portfolio. I guess, as we think about a broader stimulus program over there, maybe just touch on some of the other pockets outside of academia, where you think you've got some outsized opportunity?

Yes, look, I mean, the fact that China slowed down also was a huge opportunity for us, right? I mean, of course, I mean, you know that we're pretty careful on the cost side. So we took the cost down but equally, we redoubled the investment in localization. And it's no mystery Waters was a bit behind on that front versus our key competitors. So we used this opportunity to localize our UPLC portfolio, localize our mass-spec tandem quad portfolio, and that's gone super well. So as things pick up, especially in the pharma segment, especially in the food segment, especially in the Environmental segment, we feel very well placed to compete for those orders. Second, we also -- and I personally believe that innovation in China, especially in automation, especially in AI, is well ahead of many other geographies in the world. We've opened up a collaboration with a local diagnostics player to automate my spec and supply it to IVD labs in China and hospitals in China. And super excited about it. We don't -- we would not have entered that segment on our own. The CapEx is pretty high, but they have the capability with the automation, with the AI tools, with the sample prep. We have the mass spec and the software and the collaborations are going super well. So those 2 things just tell you how we think about China in the future, yes.

Maybe shifting away from that, but it actually prompts another question. Roche introduced, they kind of combined automated LC/MS, just talk a little bit about how you think about that potential path. Is it interesting in particular for the clinical market conversation...?

Yes. Look, I mean, it's great because it verifies what we had assumed that mass spec and multi-analyte assessment and analysis downstream is something that core labs and physicians would require. So it validates our hypothesis, right? And that's terrific. Second, in terms of in terms of pressure one way or the other, we think it's, again, a positive because we actually never intended to enter the IVD segment. We never intended to enter the core lab segment. Our planning was to really stay focused on the specialty segment, which has coexisted with core labs in the NGS space, in the immunodiagnostics space for so many years. So we expect specialty labs and core labs to coexist. Roche is entering there with mass spec with a limited set of analytes. We have over 600 analytes that we can analyze in the specialty segment, mostly focused on endocrinology and other specialty segments. So there are some other interesting developments there. That business has grown from sort of low single-digit growth to double-digit growth for the last couple of years. So super excited about it, and it's a validation of the hypothesis that somebody like Roche enters and downstream and down the line, as I already hinted, we will not enter this market alone, right? As this gets validated by Roche, we will partner with others. We're already partnering in China, and we'll partner with others to provide our mass spec capability. In the meantime, the specialty segment is super attractive. It's growing nicely in the double digits. So that business is doing very, very well.

And just maybe 1 follow-up there. I mean we've seen others in the past trying to introduce combined LC/MS, Thermo did it and why hasn't it worked in the past for some of your...?

I think 2 or 3 reasons, at least when you look at it historically, one, the number of analytes that many of these folks had introduced was much lower than what the core labs might want. And second, the flexibility of their tools, right? And as I said, in the core lab space, we're not going to enter alone. I mean others have tried and others that look and feel like us have tried and not worked. So there's -- I'm not going to sit here and say we're smarter and better than any of us. We've just learned from their experience. We're going to stay in the specialty segment, which is going super well. And we'll partner with others who have a lot more capability in that segment. So if Roche enters probably Abbott and Siemens want to enter, and there are a couple of others who might have interest in that and we'll validate all of that in China already behind the scenes.

We talked a little bit earlier about margins. I think it's just worth spending a minute on that, and I appreciate the fact you said it's not an area you're particularly worried. So maybe I want to probe on that a little bit. You had -- did a good job last year, 65 bps of margin expansion despite kind of the demand drop off and this year, it's kind of 20 to 30 bps. But maybe talk about some of the levers why you're comfortable driving margins long term?

Yes. Look, I mean, a few things. I think historically, with the volatility in our business, I think you're right when you say Waters has not expanded margins, right, enjoying one of the highest margins in the industry is great, but not expanding margins when the growth is going up and not managing margins when the growth is going down is not acceptable, right? So I think that's what we showed last year that when the growth went down, we can still expand margins. And that has to do with a couple of things, right? I mean, our margins are high, not because we have launched many efficiency measures in the past and I'll give you examples in a second, it's because our business model is simple, right? We basically have a very simple recurring business model. Even our instruments are recurring, 70% is mostly replacement, 30% is new segments and products, right? So in that -- and recurring revenues are by definition, recurring every year. So one part of the business recurs every year. The other part of the business recurs every 7 to 10 years, right? So you can manage that with a very low SG&A as long as you as long as you innovate at a reasonable rate. So it's a very straightforward business model to manage, and that's why the margins are sticky and high. The challenge in the past has been in a downturn, we've not taken actions. So this time we did. So that will benefit us. But from an efficiency -- overall efficiency standpoint, I mean, back in 2019, 2020, we did not have a CRM system that we used. Many companies launched that way back, especially in a heavy instrument business. We were still on Lotus Notes. Our ERP system was there for interest. We were paying SAP, but our teams still called each other and say, hey, do you have the product or not. So we've implemented some of those things. If you put it all -- and we have not offshored our IT spend, which we've done now. So if you put it all together, there's at least 300 basis points of sort of efficiency that we can get over the next 5 to 7 years, right? So that -- you take that and you basically look at our normal algorithm, which is if we grow 5-ish percent, which is what we've done over the last 15 years, if we grow 5-ish percent, there's a 50 basis points of leverage. And you take 50 basis points of that 300 basis points every year, that's 100 basis points of margin expansion. And we intend to invest about 70 to 80 basis points of that every year in innovation because we believe that helps us quite a bit to grow and outgrow the market. That leaves you 20 to 30 basis points of margin expansion. So the algorithm is pretty simple. The only difference from the past to now is we are paying attention to when the volume goes up or down and acting accordingly and we've launched a whole bunch of efficiency initiatives that should benefit us.

We also talked earlier about kind of innovation and finding new pockets of growth, finding new markets. PFAS obviously has a lot of attention, $300 million, $350 million market. And I think double-digit durable growth driver. You talked about a 30 basis point swing maybe on EU regulations. Just talk a little bit about how you think you're positioned in that market and how durable that kind of looks?

Look, I mean first just taking a step back, even before talking about PFAS historically, Waters has grown 6%, but there are new vectors as we go forward. And pricing is a bit better than the past, right? So we can just start there. We think about 100 basis points incremental pricing versus the past. On the volume side, there are 3 levers that I'll highlight. One, the overall prescription volume is projected to grow faster in the next 10 years than it has grown in the past. This is IQVIA's data, has to do a lot with GLP-1s and some other new categories in the GLP-1s. We have -- we are the market share leaders. Our columns are specced-in and once the columns get specced-ed in, they're used in QC through and through. Our online at-line HPLC systems called PATROL are used both by Novo and by Lilly and across many, many plants. So we are by far the key leader in that space, so we benefit there. And we think there's a 30 basis points of incremental growth there. Second, in the biologics category, we've talked about that in the past. Innovation has been terrific from our customers, but equally, the characterization tools that customers use are more sophisticated, as they move downstream, that will add to the growth. And Wyatt is a case in point. We acquired Wyatt, Wyatt is basically a 40 basis point -- it's 40 basis point accretive to growth. And third is PFAS is what you just mentioned. It's a category that's just started to emerge, right? PFAS is present everywhere. The regulations are getting more and more stringent. The EPA just announced certain regulations. The EU is considering more regulations. Japan has already sort of implemented some pretty stringent regulations in [ free vector ], and that's going to expand. So we had estimated that market to be $300 million to $350 million in the environmental segment as it goes into food testing, as it goes into testing of -- or as it goes into remediation, that TAM will continue to increase. We have the most sensitive instrument in that space. And what we've done as a company, and we've done this with the clinical business, where we saw growth in specialty. We've done that with the bio-analytical business with the acquisition of it Wyatt and with PFAS equally, we've organized that a little bit separately from the rest of the business to say, look, we'll allocate capital as well as additional resources here. We feel that there's a lot to do to clean up the environment and tissue samples and food samples. And that we have a pretty significant role to play. So very excited about what we can do there.

And how about from an innovation standpoint? I guess, what are you most excited about coming out of the R&D pipeline?

It's fantastic, right? We've done a lot in the last few years. I mean, back in 2020, when I joined, it's not that innovation has stagnated. We had a lot of products stuck in the late stage of our pipeline. So we used that time to say, well, perfect is the enemy of the good, right? We said, "Okay, let's launch a whole bunch of products, and we'll optimize them with our customers", right? And we've done that in several spaces. So with LC, we launched the Alliance iS, which reduces errors in the QA/QC space by 40%. It is by many customers considered the most significant advance in the QA/QC space for high-volume testing. Second, in the mass spec space, I mean, at the ASMS, we just launched our latest version of time-of-flight instruments. This is the Xevo MRT. It's a benchtop instrument that gives you sensitivity at high speed, something that most of our customers were asking for, not just sensitivity that many of the competitors give, but also at high speed in a benchtop version. Prior to that, we had launched the BioAccord, which we repositioned from QA/QC to upstream testing -- simple mass spec for upstream testing. So very excited about what we're seeing on mass spec. And finally, on chemistry, we are a leader in that -- we've been a leader in that space for a long time. Now as I said, about 70% to 80% of R&D goes towards complex molecules, towards novel modalities, our premier column that we launched almost 3 years ago is still growing well into the 20s, right? So really, really good success there. And the proof point is that our biologics revenue, which was 20% of our pharma sales is now over 5%, right? So very excited about what we see. And the last statement I'll make is about informatics. As you know, Empower is the standard of the industry for submitting data to regulators. We have a program called the Empower Super Highway, where we're basically integrating different instruments that customers want to use in the QA/QC space into Empower, right? So LC, of course, is connected to Empower, the QDa, which is a simple mass spec is connected to Empower, a competitor's capillary electrophoresis instruments is connected to Empower, light scattering is now connected to Empower. So over time, we expect Empower to remain the highway by which data is submitted for more and more complex molecules, super excited about this. And there are ways that we will monetize this as things become more and more embedded. So very excited about innovation in the company.

I also love the fact PATROL is back on the...

Yes. I mean, PATROL and SFx. I mean these are the 2 things that I hear about the most because customers have used them historically and say this is great products, why aren't you servicing them? So a lot of work going in that space.

Last couple of seconds here, just debt pay down is a priority, right? You're 1.8x levered. You paused the share repo. How do we think about those dynamics and then appetite for M&A? Obviously, you talked about Wyatt like...

I think just like everything else, rather balanced, right? So growth is a priority. We've already shown with Wyatt even in a difficult environment, we can execute pretty well. So we have a long list of targets that we look at, and they -- it's a 2-way street, right? So you can't just want something, it has to also want to come to you. And those M&A discussions take a long period of time. So those are going on. But in the meantime, I mean, if there's no M&A target, we'll do share buybacks. We think that's a great way to return capital to our shareholders. So really flexible, but very disciplined, right? So we'll look at targets. We'll have great relationships with if it's a private company and only then we will act and that will continue.

Udit, great to see you. Thanks. Take care.

Tycho, thank you for having us.