Earnings Call Transcript - WAT Q2 2020

Operator, Operator

Good morning. Welcome to the Waters Corporation Second Quarter 2020 Financial Results Conference Call. All participants will be in a listen-only mode until the question-and-answer session of the call. This conference is being recorded. If anyone has any objections, please disconnect at this time. It is now my pleasure to turn over the call to Mr. Bryan Brokmeier, Head of Investor Relations. Please go ahead, sir.

Bryan Brokmeier, Head of Investor Relations

Thank you, operator. Good morning, everyone, and welcome to the Waters Corporation second quarter earnings conference call. Before we begin, I will 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 commentary on potential market and business conditions the company expects for the third quarter and full year 2020. We caution you that all such statements are only our present expectations and that actual events or results may differ materially. For a detailed discussion of some of the risks and contingencies that may cause our actual performance to differ significantly from our present expectations, see the risk factors included in our annual report on Form 10-K for the fiscal year ended December 31, 2019, in Part 1 under the caption Risk Factors and in our most recent quarterly report on Form 10-Q for the quarter ended March 28, 2020, in Part 1 under the caption Risk Factors, both of which are on file with the SEC as well as the cautionary language included in this morning's press release, including with respect to risks related to the effects of the COVID-19 pandemic on our business. We further caution you that the company does not intend to update any of its predictions or projections, except during our regularly scheduled quarterly earnings release conference calls and webcasts or as otherwise required by law. Next earnings release call and webcast is currently planned for October 27, 2020. During today's call, we will be referring to certain non-GAAP financial measures. Reconciliations of the non-GAAP financial measures to the most directly comparable GAAP measures are attached to our earnings release issued this morning and available on the company's website. In our discussions of the results of operations, we may refer to non-GAAP results, which exclude the impact of items such as those outlined in our schedule titled Reconciliation of GAAP to Adjusted Non-GAAP Financials included in this morning's press release. Unless stated otherwise, references to quarterly results increasing or decreasing in comparison to the second quarter of fiscal year 2019. In addition, unless stated otherwise, all year-over-year revenue growth rates, including revenue growth ranges given on today's call are given on a comparable constant currency basis. Now I'd like to turn the call over to Dr. Flemming Ornskov, Waters' Chairman of the Board to make a few brief comments.

Flemming Ornskov, Chairman of the Board

Thank you, Bryan, and good morning, everyone. I wanted to join at the beginning of this call for two reasons. First, to thank Chris for his contribution to Waters; and second, to discuss our leadership transition process and the appointment of Udit Batra as Waters' next CEO. I want to begin by thanking Chris for his leadership over the last 5 years and for his commitment to ensuring a seamless leadership transition through the end of this year. Over the course of the last few months, which have been particularly challenging against the background of the global pandemic, Chris has kept the team focused on execution. Throughout his tenure, Chris has demonstrated a clear commitment to advancing a new product cycle that has, in part, helped us establish a strong foundation for growth. As you know, on July 15, we announced that Udit will be joining us on September 1. Udit is a highly accomplished executive with more than two decades of leadership and operational expertise in our industry. He has demonstrated a proven track record of delivering tangible financial and operational results as evidenced by his prior roles at Merck KGaA headquartered in Darmstadt, Germany. Importantly, he also has a strong appreciation for our purpose, culture and people. We are confident he will help Waters build on our foundation and usher in our next chapter of innovation, growth and shareholder value. I know Udit is eager to get going, and we look forward to introducing him when he officially joins us in September. With that I'll turn the call over to Chris and Sherry to conduct the earnings call and Q&A.

Chris O'Connell, CEO

Thank you for the kind words, Flemming, and good morning everyone. Thank you for joining us today. Along with Bryan Brokmeier, joining me on this morning's call is Sherry Buck, Waters' Chief Financial Officer. I hope that you and your loved ones are doing well as the world continues to manage through this truly extraordinary time of the global COVID-19 pandemic. It's amazing how much is happening on a daily basis and I wish you peace and fortitude as we all work hard to improve both health and economic conditions for everyone. During today's call, I will provide an overview of our second quarter operating results as well as some broader commentary on our business in the context of COVID-19 and describe the actions we are taking to emerge from this period stronger than ever. Sherry will then review our financial results in detail and update you on our financial actions as it relates to the balance sheet and cost structure. We will then open up the phone lines and Sherry and I will take your questions. To briefly review our operating results for the quarter, Q2 sales declined 12% and adjusted earnings per share declined 2%. While Q2 was expectedly a bit softer than Q1 in terms of year-over-year growth, our revenue result reflected modestly better market conditions than we had anticipated, an increasing impact of new products, as well as strong execution by our global sales, service and operational teams. During the quarter, we also executed well on our plans to achieve meaningful near-term cost savings to ensure our financial strength and flexibility under a variety of recovery scenarios. This combination of higher-than-expected revenue and the timing of our near-term cost actions enabled us to exceed our margin and EPS expectations. As we enter the second half of the year, we are focused on our recovery trajectory and normalizing our operating spend and investment in the business. I am very proud of our team's execution across the business in this dynamic environment. Looking ahead, while risks and uncertainties in our operating environment remain as a result of the COVID-19 pandemic, we believe that our end markets and geographies will see modestly better conditions in the second half of 2020 than they did in the first half. I will provide some additional color on this later in my remarks. As we navigate the COVID-19 global pandemic, we continue to execute against our five-point value-creation model, which emphasizes our unique specialty positioning, organic innovation, operating excellence, disciplined capital deployment and a sharp focus on people and culture. That said, I'd like to focus my comments today on our near-term operating priorities relating to the COVID-19 period that I outlined on our last earnings call. We are making great progress against each of them. First, our top priority remains the health, safety and well-being of our employees and our customers. The deliberate actions and cautions we have taken during the pandemic have minimized the infection rate within our employee population while still enabling the organization to operate efficiently and effectively. Our multiphased safe return to workplace process is well underway with teams returning to our major facilities in several stages. Our second priority is to ensure business continuity. Our service engineers have consistent access to customer sites globally in order to maintain service and install instruments, while our sales reps have less consistent access given the varied pace of recovery across our geographies. Sales force access has been improving, however, as customers continue to ramp up their laboratory operations. That said, our strategic technology investments over the last several years are paying off and have enabled us to effectively serve the vast majority of sales, service, and scientific activities with a hybrid in-person and digital effort. We have been successful getting our experts in front of customers through virtual events and we are restoring normal interactions with sales reps and regional specialists where possible. Operationally, we have confidence in the continuing stability of our supply chain manufacturing and distribution processes. Our third priority is maintaining our financial strength, flexibility and liquidity even in our most conservative forward-looking scenarios. Exiting the second quarter, we are on track to achieve our $100 million cost savings plan for the year, relative to our prior internal forecast. We are nearly complete returning those employees on temporary 90-day furlough to work. We have restored full hours and salaries and we have now reoriented our focus towards investment in the business in the second half to enable our return to growth. Sherry will provide more details on these measures during her remarks. Our fourth priority is to accelerate our recovery by focusing on actions we can control. In particular, we are taking direct action to, a, maximize the impact of our strong new product cycle; b, target our R&D efforts on near-term product introductions; c, service our installed base either remotely or in person as customer labs allow; and d, focus our sales efforts on customer labs that are open to operation. In Q2, we saw an increased contribution from our recently launched mass spec products while launching an important new LC instrument. More on this in a few minutes. Finally, we are continuing to contribute our expertise and capabilities in the global fight against COVID-19. Our customers have responded enthusiastically to our offers of deep scientific and technical expertise across a range of COVID-19 therapy and vaccine candidates under development. In particular, our unique system solutions have been very useful in critical workflows including peptide mapping, glycan analysis and oligonucleotide analysis. While the short-term revenue impact is minimal, these efforts have been deeply appreciated and have greatly advanced relationships across our customer base while also advancing the fight against COVID-19. Now I would like to make a few comments on our outlook. As we outlined last quarter, our planning scenarios are based on a categorization of each geography into one of three phases of the COVID-19 pandemic: containment, recovery and return to growth. We currently believe that all of our major geographies have now transitioned to the recovery phase. As a result, and as I mentioned before, we believe the second half will be modestly better than the first half. However, we don't anticipate that quarterly revenue growth will turn positive until 2021. From an end-market perspective, our largest market pharmaceutical is leading the recovery. Encouragingly, our top global pharma accounts grew in the second quarter and year-to-date. In addition, CXOs and large molecule pharmaceutical customers are recovering nicely, while generic and specialty pharmaceutical customers are still operating with more constrained capital budgets. Looking ahead, though we expect most pharma customers to return to normalized operations this fall, risks and uncertainties certainly remain, particularly in Q4, around meaningful year-end budget releases that we typically see. Our industrial markets are recovering more slowly with customers generally operating under tighter capital budgeting restrictions than in pharma. Notably, because these customers provide less recurring revenue than our pharma customers, returning to normal operations doesn't immediately result in a corresponding return of spending in the form of capital equipment. Within the industrial category, material science labs are operating at a higher activity level than food and environmental labs and we expect them to return to normal levels more quickly. Lastly, academic and governmental markets are lagging corporate customers and are expected to be the slowest to recover. Many academic labs remain closed or only partially open, while governmental business has been significantly impacted by delayed tender activity. Turning now to our geographies. All major regions have transitioned from containment to recovery phase with each seeing steadily increasing customer activity throughout the quarter. A number of countries, including China, other countries in Asia and parts of Europe are moving through the recovery phase more rapidly. On the other hand, the United States, India and remaining parts of Europe are progressing more cautiously through these various stages of easing restrictions. In aggregate, as we look to the second half of the year, we are expecting improved demand across the business in particular for instruments, as we expect a gradual easing of capital spending constraints in all of our end markets. Looking specifically at China, the pharma market is leading the recovery with solid growth in large molecule pharma and CXOs. Generic pharma remains under pressure as customers remain cautious on capital spending in the context of both the GPO program implementation and the COVID-19 pandemic. That said, China’s pharma recurring revenues grew in the quarter across both large and small molecules, which we expect to continue bolstering our confidence that we will see increasing instrument demand over time. China’s food and environmental markets were down in the second quarter, reflecting the continued funding pressure that is impacting government labs, partially offset by growth within independent labs. Elsewhere in Asia, recovery is a mixed picture with strength in certain geographies, such as Korea and slower recoveries in other regions such as Japan and India. Turning to the U.S., we are seeing a dynamic and somewhat uncertain environment with various states experiencing increasing COVID-19 cases over the past several weeks and therefore are seeing rollbacks of previously implemented reopening plans. The pharma market is leading the recovery driven by large molecule customers. Capital spending is slowly, but steadily improving and we are seeing strong customer support for our new products. Elsewhere in the Americas, Latin America remains very soft. Lastly, in Europe, recoveries in the countries of Southern Europe and Northern Europe are lagging those in Eastern Europe and Central Europe. Pharmaceutical markets are recovering more quickly than other markets with QA/QC reporting growth in the second quarter. Our recent European performance has been stronger compared to the Americas, because many European countries have been more effective in managing COVID-19 containment efforts and European customers are adopting some of our new mass spec technology at a faster rate than other geographies as we typically see. Aside from these current market dynamics, we remain sharply focused on our primary growth strategy of organic innovation. We believe we are well-positioned to leverage our robust and growing new product pipeline as demand normalizes and we expect continuing increases in contribution from new products. Looking at the Waters' product line, there is increasing evidence of traction of new products throughout the quarter particularly BioAccord and Cyclic IMS. In addition, we launched six new instruments year-to-date and have received very positive initial feedback. These new product launches are highlighted by the Arc HPLC, a rugged, reliable and modern HPLC system that is a significant advancement and enhances our strong technology leadership position in the core liquid chromatography market. In our TA Instruments product line, the three new products launched last quarter at Pittcon have received strong customer interest. Material science markets have been challenged, but these products are poised to support future growth and market share gains. In summary, though sales in our second quarter continued to be impacted by the COVID-19 pandemic, our revenue result reflected modestly better market conditions than we had anticipated, an increasing impact from our new products as well as strong execution by our global sales, service and operations teams. We also took decisive actions to manage our costs to ensure the largest portion of our 2020 savings plan in the second quarter, which as expected was a more challenging environment than the first quarter. This combination of better-than-expected top line performance, with the benefits of our cost-containment efforts enabled us to exceed our margin and EPS expectations. Although risks remain with the uncertain trajectory of the global COVID-19 pandemic, we expect market conditions to improve modestly in the second half versus the first half of the year, and therefore have accelerated our growth investments to take advantage of opportunities as demand recovers. With that, I'd like to pass the call over to Sherry Buck for a deeper review of our second quarter financials. Sherry?

Sherry Buck, CFO

Thank you, Chris, and good morning everyone. In the second quarter, we recorded net sales of $520 million, a decrease of approximately 12% in constant currency. Currency translation decreased sales growth by approximately 1%, resulting in a sales decline of 13% as reported. In the quarter, sales into our pharmaceutical market declined 10%, sales into our industrial market declined 13%, while academic and governmental markets declined 21%. Looking at our product line growth, our recurring revenue, which represents the combination of precision chemistry products and service revenue declined 3% in the quarter, while instrument sales declined 23%. As we noted last quarter, there is no year-over-year difference in the number of calendar days during the second or third quarters, but there are two additional calendar days in the fourth quarter of 2020 compared to 2019. Chemistry revenues were down 4% in the quarter, driven mostly by weakness in academic and governmental. On the service side of our business, revenues were down 2%, as mid single-digit growth in service contract revenues were offset by a decline in on-demand service revenues and spare parts. Breaking second quarter product sales down further, sales related to Waters-branded products and services declined 12%, while sales of TA-branded products and services declined 20%. Combined LC and LC-MS instrument platform sales declined 24% and TA's instrumentation system sales declined 20%. Looking at our growth rates in the second quarter geographically, and on a constant currency basis, sales in Asia declined 12% with China down 20%. Sales in Americas declined 15%, including a 14% decline in the U.S. and European sales were down 9%. Before I comment on our second quarter non-GAAP financial performance versus the prior year, I would like to update you on the progress of our cost actions in response to the COVID-19 pandemic that we shared with you during our last quarterly earnings call. We are on track to achieve cost savings of approximately $100 million for the year relative to our prior pre-COVID internal plan. We achieved about 60% of our planned annual savings in the first half of the year, which was better than expected as we focused on aligning our operations and investments with our growth challenges in the second quarter. This result flowed through our P&L and is the primary driver for favorable performance in gross and operating margins versus the second quarter of 2019. Looking ahead, while we plan to maintain strong operating discipline through the end of the year, a significant portion of our cost actions were enacted for a 90-day period and are nearly complete. Employees are returning from temporary 90-day furloughs and we've restored reduced work hours and salaries to normal levels. As a result, the second half of the year will not reflect the same level of savings reported during the second quarter, as we reorient our focus towards growth investment in the business in the second half. We anticipate the remaining 40% of our cost savings to be achieved in the second half of the year. This plan reflects our core assumption that the business moves to the recovery phase and business conditions improve in the second half. We're monitoring our business conditions and will adjust our plans as appropriate based on the pace of the recovery. Returning to our second quarter non-GAAP financial performance, gross margin for the quarter was 59% compared to 58.4% in the second quarter of 2019, primarily as a result of our cost-savings actions. Moving down the second quarter P&L, operating expenses decreased by approximately 13% on a constant currency basis and foreign currency translation decreased operating expense growth by approximately 1% on a reported basis. In the quarter, our effective operating tax rate was 15.4% compared to 15.7% in the prior year. Net interest expense was $9 million, an increase of about $3 million as anticipated. Our average share count came in at 62.2 million shares, a share count reduction of approximately 11% or about 7 million shares lower than in the second quarter of last year as a result of shares repurchased through the end of the first quarter of 2020, subsequent to which we paused the share repurchase program. Our non-GAAP earnings per fully diluted share for the second quarter decreased to $2.10 in comparison to $2.14 last year. On a GAAP basis, our earnings per fully diluted share decreased to $1.98 compared to $2.08 last year. A reconciliation of our GAAP to non-GAAP earnings is attached to the press release issued this morning. Turning to free cash flow, capital deployment and our balance sheet, I'd like to summarize our second quarter results and activities. We define free cash flow as cash from operations less capital expenditures and excluding special items. We made good progress in the quarter on our capital expenditure and working capital improvement plan we shared during the last quarterly earnings call and we also remain on track for the full year. In the second quarter of 2020, our free cash flow came in at $175 million after funding $46 million of capital expenditures. Excluded from free cash flow was $23 million related to the investment in our Taunton precision chemistry operation. In the second quarter, this resulted in $0.34 of each $1 of sales converted into free cash flow and $0.30 year-to-date. Our strong free cash flow was primarily a result of cost-savings actions implemented in the second quarter. Turning to working capital, accounts receivable days sales outstanding came in at 87 days this quarter, up 8 days compared to the second quarter of last year and inventories decreased by $8 million in comparison to the prior year quarter reflecting revised production schedules. Waters maintains a strong balance sheet access to liquidity and a well-structured debt maturity profile. We ended the quarter with cash and short-term investments of $356 million and debt of $1.7 billion on our balance sheet at the end of the quarter. This resulted in a net debt position of $1.3 billion and a net debt-to-EBITDA ratio of about 1.8 times at the end of the second quarter. We also have $1 billion available on our bank revolver for total available liquidity of $1.4 billion at the end of the second quarter. In terms of returning capital to shareholders, while our future capital structure target of approximately 2.5 times net debt-to-EBITDA remains unchanged, our near-term focus is maintaining financial flexibility and preserving liquidity. As a result, our share repurchase program remains on hold until we see a more stable and predictable business environment. We expect the actions we have taken will continue to provide us with adequate flexibility under a variety of potential recovery scenarios. Given the uncertainty surrounding the magnitude and duration of the COVID-19 pandemic and its impact on our customers, we're not providing full year guidance. However, there are a few data points that will be helpful for modeling purposes. Due to the timing of our cost actions as discussed earlier, we expect full year operating expense growth in the range of negative 1% to positive 1% year-over-year in constant currency. For the full year at current rates, currency translation is expected to decrease sales growth by about one percentage point and to negatively impact earnings per share by about three percentage points. For the full year, net interest expense is expected to be in the range of $40 million to $42 million, primarily due to lower interest rates. Now, I'd like to turn the call back to Chris for some summary comments.

Chris O'Connell, CEO

Thank you, Sherry. In summary, while the second quarter was challenging as we expected, we were very pleased with our results, which were driven by modestly better market conditions than we anticipated, increasing impact from new products and the strong execution by our team. We are looking forward to the back half of the year, and we are optimistic that the company is well positioned to return to growth in 2021. Before we take questions, I would like to add a few brief comments on our upcoming CEO transition. It has been the honor and privilege of my career to serve as the CEO of Waters Corporation. I have loved every single day working with such inspiring customers and an incredibly talented and committed group of colleagues. Together, we have significantly advanced Waters over the course of the last five years, including: we have transformed our organic innovation engine and established an unprecedented new product pipeline and supplemented our technology portfolio through external investments and tuck-in acquisitions. We have implemented a new capital deployment framework with increasing emphasis on growth investments, while also returning capital to shareholders; and we have significantly advanced the company's talent, organizational capability and technology infrastructure. I will pass the reins to Udit Batra on September 1, knowing that Waters is moving forward from a strong foundation. I extend my warm welcome and best wishes to Udit and my gratitude to our Board of Directors for giving me the opportunity to serve as CEO of Waters. Finally, I want to thank our investors and the equity research community. It has been a pleasure to work with all of you and I wish you the very best. With that, Sherry and I will now begin the question-and-answer session. As we are not always able to get to everyone’s questions, please limit yourself to one question and a follow-up. And if you have additional questions, please contact the Waters' Investor Relations team after the call.

Operator, Operator

Thank you. Our first question comes from Vijay Kumar with Evercore ISI. Your line is open.

Vijay Kumar, Analyst

Hey, guys. Thanks for taking my questions. Chris, wishing you all the best for the next phase of your career. I do feel like part of the story that's missed out here is some of the investments, the new product cycles that we've seen. Hopefully, it will bear fruit over the coming years. Just on the topic of new products, I think there were some comments on the call about how new products came in better than expected in 2Q. I want to make sure I heard that right. And why wouldn't this continue into the back half? Because I think the second half sounded perhaps a little bit cautious maybe on the third quarter CapEx commentary. Is that perhaps due to feedback you've gotten from customers? So, any color I think would be helpful.

Chris O'Connell, CEO

Sure. Well, thank you very much, Vijay, for the comments and the question. And you're right. The heart of our strategy is really the R&D investment that has grown consistently at twice the rate of sales growth over the past five years and is now producing this really great stream of new products. And I made comments on the call not just on products that we have launched like BioAccord and Cyclic and some of the tandem quads last year, but also some new products that are coming into the market now like the Arc HPLC and other systems and more that's coming. So we do have a lot of confidence in the new product pipeline. As it relates to the contribution, yes, you interpreted that correctly that in particular BioAccord and Cyclic have really taken a strong step forward in the second quarter regarding orders and sales. I don't want to quantify that, but we're really, I think, coming into the power curve on those products and I feel good about our pipeline for the remainder of the year. I tried to comment that we do expect a continuation of positive progress in terms of the impact of new products in the second half of the year and an increasing vitality index and an increasing overall contribution that we've seen in the second quarter and we expect to see in the second half. That said, my comments on the market conditions of the second half are important because while we are seeing recovery in all of our geographies and end markets, as you know there are a lot of puts and takes and there are likely to be setbacks. Our assumptions don't assume everything just progresses on a straight line; we do assume different puts and takes and that everything doesn't go perfectly. There is also the question of year-end budget flush and to what extent pharma in particular will release year-end budget. So, that's really the reason for our overall tone on modestly better market conditions. But from a new product standpoint, we believe that story is very much intact and actually getting more exciting.

Vijay Kumar, Analyst

That's helpful, Chris. I have a quick question for Sherry. I believe you mentioned that operating expenses for the year are expected to remain relatively stable in dollar terms. Given that we anticipate revenues may decline in the second half, it seems that the projected growth in operating expenses suggests that earnings could remain negative. I just want to confirm that I understand the earnings outlook for the second half correctly.

Sherry Buck, CFO

Yes, Vijay. Just to provide some clarity on that. So, as you know, we implemented a number of temporary cost actions earlier this year. Many of them were 90 days in alignment, but we have about 60% of that we achieved in the first half and 40% in the second half. And so we tried to give you some data points around the operating expenses. And so we're expecting on a full year a range of negative 1% to positive 1% kind of year-over-year full year on a constant currency basis. So, that's kind of the commentary around the operating expenses.

Derik De Bruin, Analyst

Good morning everyone. Chris, can you remind me what capabilities of the Arc you think will lead to a replacement cycle? I'm trying to compare it to Alliance and wondering if we anticipate an upgrade cycle among your pharma customers for QA/QC. I’d appreciate any additional insights on that. Thanks. I have a follow-up.

Chris O'Connell, CEO

Thank you, Derik. Regarding your question about Arc, we have a very robust installed base with our Alliance HPLC and ACQUITY UPLC systems, particularly in the higher-end market. Over the years, we introduced intermediate technology in the UHPLC category, specifically with the ACQUITY Arc platform. We have developed a new range of Arc products focused on the HPLC market, which facilitates method transfer in any direction, featuring a modern design and interface that aligns with our core business. We believe this will significantly enhance our HPLC franchise and enable a smooth transition for the large Alliance base over time, including both mixed and matched systems as well as new installations. Recently, our innovations in liquid chromatography have largely been within the UPLC category, with notable updates to the ACUITY line. This new development represents a significant advancement targeted at the traditional HPLC market, allowing for complete method transfer in both directions.

Derik De Bruin, Analyst

But I thought that was sort of what the H-class was to begin with. It was basically allowing for method transfers.

Chris O'Connell, CEO

Yes. That's correct. However, this is a more broadly based product focused on the core Alliance space. It is also priced higher than Alliance and serves several key target applications in quality control laboratories, like batch release testing for small molecule pharmaceuticals. This offers much better coverage and facilitates easier transitions in that setting.

Sherry Buck, CFO

Yeah. Hi, Derik, so yeah, as we think about gross margins in the second half. And as you noted there, and in my prepared remarks, we did get a lot of benefit from the cost actions. So, while we still do have some remaining cost actions, they won't be as significantly impacted in the second half. And gross margin really becomes more of a factor of our volumes mix, FX and fixed cost absorption. So, just maybe to look at our first half performance, our gross margins in Q1 were about 55%. Largely that was a pretty depressed gross margin from it being a small quarter. We had some fixed cost absorption and kind of a one-time FX translation. Our Q2 was at 59% and was probably higher, just driven by the benefit of our temporary cost actions. So, if I were to look at a full year gross margin, I would look at it between kind of that high and low of our Q1 and Q2.

Tycho Peterson, Analyst

Hey, thanks. It sounds like Chris maybe just talks a bit more about?

Chris O'Connell, CEO

I think I understood your question regarding the pace of the pharmaceutical recovery and projects across various sectors. I'll start by addressing pharma since it has been one of our stronger categories and has been leading the recovery. I'm pleased to report that recurring revenue in pharma globally was positive this past quarter. While instrument sales were down, the decline was less severe than that of the overall business. We see both activity and investment levels in pharma increasing. Specifically, we monitor our top global pharma accounts, which typically consist of the largest multinationals, and they showed growth this quarter as well as year-to-date. Additionally, we observed investments from CXOs, although the U.S. market has been slower to recover this quarter. The large molecule pharma sector is bouncing back more quickly, while we see some hesitance in capital investment in the smaller generic sector. We have conducted extensive research through surveys of our customer labs, which currently operate at about two-thirds of their pre-COVID levels. However, over three-quarters anticipate returning to normal levels by the fall. One encouraging aspect as we moved through the quarter was that chemistry revenues proved to be more resilient than expected, and service revenues were stronger than anticipated. This suggests utilization of our base and indicates potential investments ahead. Our outlook for underlying demand in both small and large molecule pharma remains positive for various reasons, and we are positioning our new technologies to capitalize on the ongoing recovery in the pharmaceutical sector. Notably, in China, we experienced strong recurring revenue growth in pharma despite facing some pressure on instrument sales. Europe showed positive growth in recurring revenue for pharma, while the U.S. had a slight decline, but overall, the global trend was positive. This is a promising indicator, and if I missed any aspect of your question, feel free to ask again.

Tycho Peterson, Analyst

And then lastly, Chris on China. You had said 90% of pharma was back online last quarter in regards to China. It was still down 20%. So is the pace of the recovery there beyond your expectations or no?

Chris O'Connell, CEO

Actually, China exceeded our expectations, Tycho, in the quarter from an overall revenue standpoint. You're right, about 90% of our pharma customers reported being open for business at the end of last quarter. That doesn't mean they're operating at 90% capacity, but their China customers continue to tick up. And so if I look at our first quarter and our second quarter on any metric whether it's total revenue or instrument revenue or recurring, they were all net positive moving in the right direction by a meaningful amount. And like I mentioned earlier on pharma recurring, China pharma recurring was up strong double digits and pharma overall recurring was up nearly double digits. So that recurring revenue service in chemistry piece was a helpful we think leading indicator of ultimately what will turn out to be instrument demand, although admittedly instrument demand continues to lag, although not nearly as impacted in Q2 as it was in Q1.

Douglas Schenkel, Analyst

Good morning, and thanks, Chris, good luck with your future endeavors. I want to discuss your comments about the second half outlook. Looking at the consensus numbers, it seems investors anticipated at least a small return to revenue growth in the fourth quarter. I understand why you have two additional gains since you're facing a really favorable comparison. You mentioned expectations for gradual improvement throughout the year and highlighted new product momentum during the call. What specifically have you observed or heard that gives you enough confidence to state today that you expect Q4 revenue to decline year-over-year, especially considering all the changes happening right now in late July?

Chris O'Connell, CEO

Yeah. Doug, I think that's a very fair question. And, obviously, it's hard to look out too far in the kind of environment we are in because things change on a day-to-day, week-to-week basis. A lot of our thinking on the back half of the year is just that it's thinking about trends and dynamics over the course of the half. And we do expect better conditions in the second half versus the first, which is why we expect continued positive progress forward. But obviously, we don't ever want to put together a model that assumes everything goes right and all the recoveries are on some kind of a straight line. There is also more uncertainty than usual on year-end budget release. And so even if you look at a quarter like the fourth quarter of a year ago, there was some more typical year-end budget release-type activity. And we think that's probably something that is more at risk this year than typical years, but we'll just have to wait and see. Obviously, we have more visibility on Q3 than we do on Q4 at this point and we'll just continue to try to provide clarity on how we think that's going to shape up as we move through the year.

Dan Leonard, Analyst

Thank you. So could you elaborate on month-to-month business trends within the quarter and maybe what the exit rate looked like exiting June or even early July?

Chris O'Connell, CEO

Hi, Dan. Sure. We generally don't want to provide too much of that and obviously quarter-end activity always has an impact. But what I'd say is that the second quarter, typical to first, had a much lower effect of the typical year-end capital purchasing given the environment, and so there is a little more balance in that sense. But a lot of the interesting insights of that question are probably more on a geography basis and maybe one I'd call out as an example is the U.S., which actually started quite slow because of the level of containment efforts we saw in April and particularly in the recurring revenues of chemistry, but the U.S. was very soft in April and then better in May and actually quite encouraging in June. So we saw that type of progression in a market that obviously went through quite a bit of change in terms of the overall operating environment. I guess the other thing I'd say is that we track service data really, really closely, and things like service case rate, customer access, and that data indicates that customer activity really in all major geographies, starting with China and then across Europe, India and the Americas improved as we move through the quarter, and in many geographies that service case rate data and customer access data is heading towards normalization. So that's probably the best indicator we have of overall activity and access is the ability of the service rep to get in there, and those were consistently better month to month in each major geography.

Steve Beuchaw, Analyst

Hi. Good morning. Thanks for the time here. And Chris, I'd say thanks for all your help in our second time working together in this type of relationship.

Chris O'Connell, CEO

Thank you.

Steve Beuchaw, Analyst

I wanted to ask about a couple of things, just going into a little bit more detail on points that have been addressed on the call. One is China. Chris, I might direct it your way, and the other is on the cost-savings program, which I might direct to Sherry. Chris, as it relates to China, it's a very different operating environment relative to the rest of the world, in part, because of the way they're going about stimulus with a pretty unique approach in terms of the way they're going about monetary stimulus, while at the same time there are some fiscal challenges. Can you talk about to what extent that's weighing in how you think about the back half? And then if you wouldn't mind elaborating a little bit on the commentary around the GPO dynamics in China. I've certainly been hearing the same, but hadn't heard that terminology used there all that much thus far.

Chris O'Connell, CEO

Great. Thanks, Steve. And I'll take the first one and then Sherry can take the second. So, China is a different environment, but is also one we obviously know very well. Historically, exactly what you described on the stimulus side, it's been a boon to the markets there. And what I would say, that a lot of our assumptions for the back half of the year do not anticipate a meaningful change or direct impact of that type of fiscal stimulus, if you will, or monetary stimulus. Obviously, the one factor that would be helpful, as we recover in China, would be for the government tendering to return to some normal activity, which certainly can be related to the stimulus. So that's the piece that's held us back in China. But a lot of the more tangible improvement in market conditions is related to the commercial sector, the business sector, if you will. And so, our assumptions in China just continue to call for that steady ramp back up of, not just customer openness, but customer activity levels in the labs. And let me also clarify and answer the second part of that on the GPO. Just to be really clear what that is. The GPO now is now the common name that we use to refer to the 4+7 program. So the 4+7 competitive bidding process for generic drugs which began as a pilot program at the beginning of last year was originally called 4+7. Now it's commonly known as GPO and it has gone through several rounds. As you know, there was a first national round or what some people called the second round late in 2019, which was the same 25 drugs that had been through the pilot in the 11 4+7 cities. That extended to 27 provinces. And then, there was the third round, or what they call the second national GPO round, which happened earlier this year, actually in January, which extended to 25 new drugs in 32 provinces or all provinces and approximately double the value of total sales going through. As I've said many times, before we think this is a real positive long term in the sense that China is trying to scale its generic drug supply and give many more people access. So volumes are going up. There's been almost an inordinate profit pool there that is targeted. And even with GPO prices, the generic industry's profitability in China is now probably on par with the rest of the world, not ahead of the world. So we don't think it's devastating in any way. In fact, we think it's very much in keeping with the economics of other health systems. And we've been on balance more successful with the winners of these tenders, since they've tended to be larger companies. And so, all of our beliefs about the GPO program, as it rolls forward and even reflects in provincial, kind of systems remain. And we've seen the positivity in terms of our recurring revenue and believe that portends future rising demand for instruments. So, anyway, I'll pause there on the GPO and hand it over to Sherry on the outlook for cost savings into the future.

Sherry Buck, CFO

Yes. Thanks, Steve. So if you look at the cost savings that we took against our original plan from the year, a lot of those had to do around actions around our salaries, hours and adjusting the workforce during this second quarter, where we were a little bit more challenged. The other buckets of our cost savings had to do with nondiscretionary travel because things were locked down. So I would say, in general, that we would expect these were temporary and that we would see these come back next year and normalize. Obviously, during this time, we've learned how to be more efficient and effective using digital and video and that type of thing. But I'd say, largely we'd expect these to come back next year.

Jack Meehan, Analyst

Yes. Thank you. Good morning. Chris and Sherry, I was hoping you could provide a little bit more color, just around the expectations for capital equipment in the second half of the year. I know it's tricky, given the progress of lab closures. But maybe some color around how order trends were in the second quarter and just what you're seeing across academic and industrial customers would be helpful.

Chris O'Connell, CEO

Sure, Jack. Happy to take that. So, capital equipment, as we look at the quarter, we've modeled certain demand for instruments. We actually came in a little bit better than our model in the second quarter. And so conditions were slightly more favorable in the quarter relative to capital purchasing than we expected and we expect that to continue. And so, while we still see some year-over-year declines in capital spending in the back half of the year, it should be on a much-improved trajectory. And as I mentioned before here, the largest uncertainty on that as we look out into the rest of the year is really around what year-end kind of budget activity looks like that typically we see in this industry. That's led by pharma. As I mentioned, pharma instruments were better than the rest. But if you look at the industrial and academic side those have been held back in part because of the industrial labs, particularly in the food and environmental area, there's been less activity. Some of that’s government activity which has been a little slower government and academic. And then generally the government and academic sector, while actually turning out better than we expected in the quarter, is still curtailed by delays in university reopenings and restrictions to government funding particularly tender programs. So I think we're just stepping through this. We do expect modest improvement in that environment over the quarter with the caveat on the end of the year and we'll see how it plays out. In summary, though sales in our second quarter continued to be impacted by the COVID-19 pandemic, our revenue result reflected modestly better market conditions than we had anticipated, an increasing impact from our new products as well as strong execution by our global sales, service, and operations teams. We also took decisive actions to manage our costs to ensure the largest portion of our 2020 savings plan in the second quarter, which as expected was a more challenging environment than the first quarter. This combination of better-than-expected top line performance, with the benefits of our cost-containment efforts enabled us to exceed our margin and EPS expectations. Although risks remain with the uncertain trajectory of the global COVID-19 pandemic, we expect market conditions to improve modestly in the second half versus the first half of the year, and therefore have accelerated our growth investments to take advantage of opportunities as demand recovers. With that, I'd like to pass the call over to Sherry Buck for a deeper review of our second quarter financials. Sherry?