Waters Corporation (WAT) Earnings Call Transcript & Summary

Good morning, everybody. I'm Tycho Peterson from the Life Sciences Tools Diagnostics team at Jefferies. It's my pleasure to introduce our next company this morning, Waters. We've got Udit with us.

Maybe Udit, just to kick it off, you and I were walking in about ASMS and obviously, a lot of new innovation coming in new products. And I think you've really revitalized the portfolio. So I think, maybe, that's a good place to start. Maybe just talk about some of the new introductions and what you were highlighting this week.

Sure. Firstly, nice to see you again, Tycho, and I should never talk to you when I'm coming in because I realize, as I was doing it, that you'll pick one of the threads but this is a good thread. Thank you. Firstly, excited to be here and talk about innovation as a first question. Look, Waters has always been an innovation leader. We just sort of lost focus for a little while and were back sort of putting equipment and instruments as well as consumables and software on podium positions. And what you've seen so far is Alliance iS now defining the category of HBLC with 40% reduction in errors. You've seen our TQ Absolute mass spec. I'll talk about that in a minute and what we did at the ASMS, but that define sensitivity for PFAS testing. I mean it's good to be -- good to look for causality in innovation, but it's good to also have correlation. The PFAS testing regime sort of started around the same time that TQ Absolute came out, and it's become our largest-selling quantitative mass spec instrument and it is leading the industry in terms of sensitivity. Thirdly, on our chemistry side, on our columns, we basically spend now close to 70% of our R&D dollars on biologics innovation there, and that has made a huge difference. Our MaxPeak Premier Columns, that family of columns continues to grow close to 30% after 4 years of launch. We recently launched a new platform of affinity columns. So taking affinity chromatography into LC and helping bioprocessing customers, something that I'm really excited about to its start with a protein A column. And then software. We recently announced that now light scattering is going to be available with Empower, which is a significant step forward in our ambitions on bioanalytical characterization. Now to come to ASMS. As we were walking in, I was talking to you a little bit about how exciting it was to hear some professors talk about our charge detection, mass spec technology, CDMS. It is one of the most meaningful innovations in the area of mass spec in several years according to the KOLs. It basically takes large aggregates and vaporize and puts them into the vapor phase without changing structure. Now what does that mean? That means you can analyze proteins, analyze large molecules intact. That is not something mass spec has been able to do before. It allows us look at structures of viral capsids, it allows us to look at empty versus full AAV. It allows us to look at LNP particles. I'm a big believer in coming at innovation from both sides. You come up with a new technology and let the users figure out what the heck they're going to do with it. And we have people in our company who do that for living. And then on the other hand, you have market-led innovation. And on the market-led side, at ASMS, we introduced the TQ Absolute XR. Why XR, extreme robustness. When you do PFAS testing often after about 2,000 injections with any type of mass spec, you need to go and do service on the instrument. And in high-throughput labs, that is a productivity sync, we've basically introduced our iron waveguide that reduces this fouling of key parts of the mass spec and allows you to do at least 6x more injections, so 2 becomes 8,000 injections in certain matrices, very dirty matrices, like fish tissue, you can go from 2,000 to about 20,000. So still going with that. The testing is still happening. The number of injections basically allows you to run the instrument for longer. And thirdly, at ASMS, we also talked about our chemistry portfolio and talked about affinity chromatography that I just referred to. Very excited with what's happening in the labs and equally excited about talking to it -- talking about it with customers. AMS (sic) [ ASMS ] was really accelerating. I really enjoyed it, but of course, I had to come to an even more enjoyable place here.

Great. Well, thanks for that, and maybe I want to step back a little bit and one of the questions we've gotten a lot is just pulled forward. I think it came up in every single earnings call. I know you talked about the fact you're not seeing it. You had good growth, I think, in the first quarter, pharma up a double-digit growth in instruments. Maybe just talk a little bit about -- because you also talked about pharma is obviously rethinking their own supply chain modification. So maybe just talk about your comfort level that you're not seeing it, what metrics you're tracking to make sure this isn't going to be an issue down the road.

Yes. It's a good question, something that we've looked at very seriously with all the KPIs we have, right? So LCMS grew mid-teens in Q1. And -- if -- in the case of instruments, you can't grow mid-teens with pull forwards in the last few days of the quarter. It doesn't work like this. Basically, we had -- our funnels in the beginning of the year were very strong. And they consummated towards the end of the quarter exactly as planned. So no real change in what we saw in our CRM system and what was delivered. So not -- I mean that's the way we look at it, and that's the way we look at it going forward. So we have a very clear insight into what customers want to do with instruments in particular. I think your question about what pharma is doing, right? In -- and we did the same. We basically built up inventory as fast as we could in the few days that were there from announcement to -- from indication to announcement of the tariffs. What we did see is pharma increased production in Ireland, in other parts of the world where they had production sites and the consumption of chemistry became higher. So they depleted their safety stocks and that has been replenished since. So a bit different for chemistry than for instruments. In the case of chemistry, chemistry did scale with the mad rush to sort of produce more and then bring it to the U.S. as fast as possible in terms of end products. So different type of dynamics.

Is there any way to put some kind of rough numbers around how much inventory is being added versus just moving around the globe?

I wouldn't want to enter a guess.

I guess CapEx has kind of been the other theme, and you're certainly well positioned here. I think we've seen something like over $200 billion worth of announcements for the next 5 years or so. Maybe just talk a little bit about how you're thinking about that. Some of it will actually come, I think, sooner for you for some of the GLP players. So how are you thinking about just pharma CapEx over the next couple of years?

I think the first thing to say, Tycho, is the $200 billion that's been announced, I think 1 has to be careful not to assume that all of it is incremental, right? So some of it is incremental, and we've done some math to see how much of it is incremental versus what the companies had announced previously. Second, you then have to ask yourself, okay, how much of it is relevant to you, as in our TAM, LCMS instruments, et cetera, and our industry, in particular, and then, of course, to our company. We think, overall, -- over the next 5 years, we're looking at a $50-ish million number for LCMS, additional LCMS support if you look at the incremental CapEx that's being spent. So that's very far from the large numbers that you cited, right? I think one has to be cautious and we can walk you through the math at a different time, but that said, the second thing one needs to keep in mind is different parts of the value chain in the CapEx, right? So you're not talking greenfield left, right and center, you can't do that in the short term. But what you can do in the short term is put in fill finish, right? So if you are -- if you have sterile products, you can actually very quickly scale up fill-finish facilities and then that allows you to increase the volume locally. Of course, for us, that means more QC in the short term. Now I will caution again -- I mean, so you don't see me sort of jumping and saying, "Oh, this is a great long-term driver." It's not. In the long term, our business in QA/QC, in manufacturing, in genetics, in CDMO scales with the volume of medicines produced. Unless the additional CapEx increases the volume of medicines produced globally, you're not going to see a massive increase over the long term. You will see a bump and then it will get -- we'll have to catch up, right? So I don't know exactly when that bump comes, right? We have not seen our customers start to order anything new. They've not started to talk about exactly what they're going to do and where. So early days, but a conceptual problem, I would just caution against getting euphoric about, "Hey, there's more capacity coming." There's going to be massive growth for everyone. There could be growth in the short term, but definitely, there will be a catch-up down the line because, I mean, the overall volume of consumption, if it gets produced in one geography versus another leads to a short-term bump, but over the long term, you have to catch up.

And how do you think about that in the context of the replacement cycle, which you've been talking about for a while and you saw it pick up a little bit at the end of last year. So how do you think about that as it relates to some of the new CapEx to?

Completely independent, right? In fact, we were with customers at ASMS who we were talking through with on where they see the replacement cycle. How are they perceiving different parts of the value chain? It's the same as we've talked about earlier, right? Generally, the way to think about the replacement cycle. And again, I think we've done ourselves a bit of a disservice because we're thinking it's a binary event, right? Our business is 70% replacement. And in that 70%, imagine a pool and on the top, there is a wave. And that wave basically correlates with a small fraction of the volume on the top and then that's what changes the growth rates for the business. And then 30% is de novo use, right, completely new use. But on the replacement cycle, in general, from trough to peak, you see a 2- to 3-year time frame. You see 2 to 3 years of accretive growth on top of our long-term average of 5% instrument growth. This time around, we think the cycle will be longer, right? Hence, the peak should be a bit shallower because, I mean, there's pressure still in China, in the generics market. CROs are not recovering. Biotech is not recovering, pharma discovery is not recovering, and there are instruments in those customer segments also that need replacement. On the other hand, the large pharma genetics, CDMO segments are very, very dynamic.

When do you think some of those segments that are lagging will pick up CROs, China generics?

Difficult to tell, right? I mean take it in turn. China generic. So I mean, let's talk about China in general for Waters first, and then I'll dig deeper into this, right? So China for us in Q1 grew 5%. It was largely driven by growth in the academic segment, which grew double digits due -- partly due to the stimulus and the Industrial segment, which grew double digits as well due to the dynamism in the battery segment. Pharma-branded generics, which is 50% of our business there is still declining mid- to high single digits, right? And that's after several years of decline. And unless the volume-based pricing regime starts to change a bit, we think that pressure will continue, right? For biotech funding, I think you can look at the funding, the funding changes, funding has gotten better, but it's -- the capital has not yet been allocated towards additional equipment, additional capacity. For CROs and others, I think there are other folks who are better place to answer that question. That's such small segments for us. It's not a meaningful discussion.

And you had a good first quarter, you bumped the core guidance slightly higher. You kept instruments unchanged around 5%. Maybe can you talk a little bit about as we think about tougher comps in the back half of the year, some of the gives and takes on the instrument side?

I think it's just arithmetic, Tycho. Look, the first half versus the second half dynamic that you're referring to is an artifact of what we saw in 2023 and not '24. '24 was a normal year. 45% in the first half of the year of sales and 55% in the second half. Normally, that's what Waters used to do pre-pandemic. And when you look at it quarter by quarter, a better way to look at it is a 3-year CAGR. And what you find is the first half and the second half are similar. And if you look at a 6-year CAGR from 2019 as a baseline, it's the same answer, right? So it's an artifact due to 2023, wherein, the second half of the year, we started to see a lot of pressure built up in China. So then '24's second half looked much more -- much stronger than the first half of '24.

Maybe just spend a minute on service. You're up 3% in the first quarter. There are obviously 2 less selling days. I don't know how that specifically impacts service versus consumables, but as we think about a couple of things, the attach rate, you've talked about 500 basis points of improved attach rate you're targeting. How do we think about that in the context of everything going on in pharma? Is there risk they may start to move to third-party cheaper service providers? How do you think about the gives and takes?

I think -- we think it's quite to the contrary. In fact, under times of pressure, pharma actually starts to redouble on people that they trust, redouble down on people that they trust, right? So we see exactly the opposite in terms of service attachment rates and very happy with our service team. We've seen the attachment rate go up 600 -- 550 to 600 basis points since we started the transformation, and we've upped our target to basically 10% instead of 5% over a 5-year period. So we're very happy with where the service team is. In Q1, service grew roughly 3%, basically due to 2 less days in the quarter. If you add that back, it's roughly 5-ish percent, which is lower than our long-term average of 6% to 7%. And that is generally explained by third-party vendors. So multi-vendor service folks who are ordering spare parts from us, they basically depleted a bit of their inventory, you should start to see that come back sooner than later. So very happy with the service team. And in fact, in times of replacement in difficult times also when people are moving sites, people rely specifically on our service team and the case in point is in India, right? The India generics market and generics customers rely on our service team, not just to ensure that the instruments are running well and the service is being done well, but also to prepare them for inspections, right? Several years ago, large Indian generics companies were being targeted or were subject to a lot of 483 and consent decrees, and they never want that to happen. If that happens there, their manufacturing sites have to shut down. So they rely heavily on our service team.

Maybe just pivoting to software and Empower, you mentioned in your opening comments that you've opened it up to the light scattering technology from Wyatt. Talk a little bit about how you think about that opportunity. I think it's the #1 question you had from customers since you acquired the business. So maybe how should we think about that opportunity?

So again, I mean, maybe I make 3 comments. First, very happy with what the team has been able to do, right? I mean it's 1 thing to say that you're going to do something in pre-acquisition. It's another to do at 6 to 9 months faster, and that's fantastic, right? Very happy with what folks have been able to do. And in addition, working closely with customers who had requested this as the #1 request. Now that said, the second comment I'll make is, look, when you think of penetration of new products into QA/QC. Once they're in, it's a wonderful annuity, right? It's a replacement business and you're not looking at replacing 1 or 2 instruments you're looking at replacing tens of instruments. So this is a fantastic value creation opportunity for Waters in the mid to long term. However, this takes time. It will happen customer by customer. So the customers who asked us who had medicines that they were using to characterize the biophysics with light scratching are now going to be able to take it into QA/QC, but I don't expect this to be a massive increase in sales in wired overnight, right? So it will happen over time. And once it happens, then it will become a replacement business like LC. So our intent is to make light scattering into LC. Now there's a lot of work to be done to simplify it even more, right? Light scattering is much more complex in terms of the data that comes out of a light scattering instrument than an LC instrument. And it's going to take some time to continue to simplify it, but the journey has started, and that's really, really exciting. And then lastly, on your question on Empower, think of it again 3 ways. First, short term, we believe that we need to refine our commercial model. It needs to go from an on-prem model, which used to be the case in the 1990s for many software companies to a subscription model, which was in the 2000s, say, 2010 onwards. And now most software is delivered through SaaS. We've started that journey, right? So we've gone from on-prem. We're starting to offer our customer subscription models. It's a significant benefit from a cash flow perspective, right? So we'll talk about it in the rearview mirror as that starts to happen. And customers are actually keen to transition because they don't want the CapEx every few years, they would rather have a subscription. And that has benefits for us as well. Second, we're looking at expanding the applications of Empower across different types of instruments and in addition, offering value-added services to our customers who are on Empower. So cloud-based -- cloud-native applications. Customers often want to know how to integrate peaks much more efficiently using AI/ML techniques. So we're offering that as an additional tool through Empower. We're offering the ability to get full visibility of your instrument fleet, if you are on the right version of Empower, and that's something that customers have been asking. I could go on, but there are several value-added apps that are being built on Empower, something that we hadn't done in the past. And the third is a midterm initiative to take Empower from sort of a code that was written in the 1990s to a modern code so that you can offer Empower as a SaaS product. So lots to do, a nice runway ahead, mostly organic, but maybe through some partnerships and through some M&A, we might be able to accelerate the journey.

Great. We've touched on China at various points in this conversation, but maybe we could just step back a little bit and give us kind of a state of the union there. Obviously, you've had a nice growth driver with China generics. Underlying growth rates for everybody are a little bit lower than they had been historically. So how do you think about long-term durable growth in China? What does it take to get back to normalized growth? And then are you assuming anything around stimulus?

Lots of questions there, Tycho. Normalized growth, let's start there. I think in the midterm, you should assume it's a low to mid-single-digit grower. I mean that's our assumption. I don't assume that China is going to 19%, 20% or 15% like it did for several years from 2005 to 2018 or so to 2020, I think those days are for now in the rearview. There's a lot of structural changes that have to take place, and we can go through them in turn. So that's sort of the headline. If you dig a bit deeper, the segments that are more dynamic now are the innovative biotech segment, right? And that's going to continue to expand. It's a very exciting innovation that's coming out of China. And you can see that as many of the originate -- many of the large pharma companies continue to license products, more so from China than anywhere else in the world, it's not that they are brand new categories of compounds, they're biobetters. So antibody-drug conjugates, the largest number of antibody-drug conjugates that are being produced or developed are in China, right, other types of peptides. Stuff that already exists, there are 20 different PD-L1s in China available already. So if you don't have 1 in your pipeline, you should license it from there and bring it and develop it quickly. Part of the advantage is that the early stage clinical process in China is much less onerous than it is in many other geographies, right? So that makes a development process faster. They've built the talent over the years. So I'm excited about what that's going to lead to. Now that could lead to, of course, a lot of out-licensing into large pharma, which I think is a short-term phenomenon. In the mid- to long term, the translational ecosystem will develop, right, like the rest of the world. And you'll see some large pharma companies develop out of China in -- homegrown large pharma companies develop out of China. So that's pretty exciting, right? And that, over the next 5 to 10 years, should start to create a tailwind for companies like Waters and other companies in the tools industry. Second, other segments in the industrial area, especially the production of electric vehicles and batteries for electric vehicles. I mean, China is by far in the lead, right? Our TA business has the best growth in China. Our rheometers, our thermal analysis equipment is moving downstream. And think again, I mean, we like businesses that can go into high-volume regulated applications. And once that are -- once they're spec-ed in, you have sort of a simple virtual cycle to replace them. And that's where battery testing is heading. And the first place where it will go -- first place where the transition will be made is in China. And in the academic and government segment, given the geopolitical pressures, we expect there to be continued focus on innovation in those segments in China, right? How it comes, remains to be seen, right? Is it a government stimulus? Is it we see money? Is it others that fund it? But I do expect over the midterm, China starts to build other segments than the rest of the world. So excited about what we'll see in the midterm. Short term, I mean, I think we're pretty modest with our assumptions.

And then just around it on the geography, we touched on India a little bit, but you're up over 20% in the first quarter, well above kind of the long-range outlook there. Maybe just talk a little bit about that. And then there's been some discussion about India reducing U.S. tariff rates to 0 and stronger bilateral relations. How could that factor into the outlook there over the course of the year?

Too early to comment on the second part of your question, right? I mean, we'll look at it once the facts are there. I mean right now, a lot of conversations with our customers, many of them are planning for reshoring in different geographies to ensure that there is no disruption in the demand patterns, but nothing really that is concrete. In terms of trends that support the growth in China, right? I mean, over the last 5 years, basically in the forward-looking 5 years, there will be roughly 40% more volume of small molecule generics than there have in the past 5 years. In the past 5 years, our India business has grown in the low to mid-teens -- or sorry, in the high teens. And what we've assumed going forward is low to mid-teens, which is what you just commented on. We think there is a lot we can do in China. And our relationships with the largest generic manufacturers there are excellent.

I made it this far without asking about PFAS. So I guess we'll go there next. 1Q growth was great, 90%. We've seen some new updates from the EPA talking about revisions in the drinking water standards. Talk a little bit about early views of some of the policy changes that potentially could impact that market. And do you think you'll continue to outgrow the market?

I think the policy changes, I mean as you look deeper into what -- and there were 23 or 24 different ideas in the announced policy changes. As you look deeper, there is a demand for better and more sensitive detection, right, and more robust detection. So think TQ Absolute, think TQ Absolute XR. There is a more -- there is a higher demand for remediation, right, from -- and that opens up another segment, industrial manufacturers who have to remediate their existing products, and we're already working with the large industrial manufacturers to help them do it, right? So other segments are starting to open up. The EPA has also said, "Hey, focus on larger chain molecules first." Meaning PFAS and PFOS don't focus on smaller chain molecules. We want to basically ensure that long-chain molecules, which are detectable by LCMS are out of the system first. And then we will start to look at smaller chain molecules, right? So they've narrowed down the PFAS molecules of interest. I mean when you define PFAS, it's over 200 different species. And the list keeps rising, but they've said, look at 2 large chain type of species in the short term. Now that said, our customers, several of whom are in the water testing business in the food testing business or our manufacturers, as I just mentioned, they want to remediate and they want to detect anything and everything that is possible to detect because they believe down the line, the EPS is going to get more stringent. That's where the TQ Absolute has done so well because it detects PFAS at 1 parts per quadrillion, whereas the requirements from the EPA are 4 parts per trillion, which is 3 orders of magnitude less, right? So people are much more focused on sensitivity. They're more focused on a wide variety of different molecules, even though the EPA has narrowed down what they want people to focus on in the short term.

Maybe in the closing minutes, we could hit on capital deployment. You did the Halo Labs deal, talk a little bit about that it's not a huge impact on numbers, but talk a little bit about what that kind of brings the portfolio? And then stepping back a little bit how you're thinking about the appetite for M&A? What are you seeing kind of in terms of valuations on the market?

So, Tycho, Halo Labs is consistent with what we've been very public about, right? What are we interested in? Basically, we have a very simple business model. We take complex instrumentation, convert it into simple systems that have instruments that you and I can use and basically arm it with compliance software like Empower, our chemistry basically moves along with the complexity of the molecules that we're trying to detect and the service team is -- has the highest NPS scores in the industry, and that makes that wheel work. We said, look, early on back in 2021, once we've turned our business around once you've sort of gotten our commercial excellence, our innovation excellence back to where we want it to be, we will start to take this business model into other areas that have similar characteristics. Downstream, high-volume applications that eventually have regulatory barriers, right? And we said, look, we need to strengthen our focus on biologics, so bioseparations bioanalytical characterization. In the bioanalytical characterization area, we first acquired Wyatt. Halo Labs is just the next step, right? And there are several other techniques that belong in QA/QC for detection of large molecules, and we will continue to bring them on either through M&A or through partnerships or through organic development, right? BioAccord is 1 such case, QDA II is another case. For partnerships, capital electrophoresis is the case. So that ambition remains. And we also said we're interested in applications of mass spec in clinical diagnostics. And that's going super, super well. And there will be a time to talk about that as well. We believe that's an area that has similar characteristics to what we see in QA/QC in small and large pharma. And lastly, in battery testing, it's the same. So those are the areas where we feel we want to allocate capital, both to strengthen the core and to strengthen our position in these faster-growing adjacencies where our business model is relevant. And equally, we feel that we've developed a very strong muscle in instrument replacement, in service plan attachment, in e-commerce, in innovation excellence and that is applicable to any company with a similar business model. So we're excited about what we see going forward.

And just to close, how about the buyback? What would it take to turn that back on?

We always look at trade-offs between M&A and share buybacks, and you'll hear more about it as we go forward.

Great. Well, we're out of time. So I want to thank you, Udit, for taking the time today.

Thank you, Tycho.