Earnings Call Transcript - WAT Q2 2022

Operator, Operator

Good morning. Welcome to the Waters Corporation Second Quarter 2022 Financial Results Conference Call. All participants will be in a listen-only mode until the question-and-answer session of today’s call. This conference call is being recorded. If anyone has objections, please disconnect at this time. It is now my pleasure to turn the call over to Mr. Caspar Tudor, Director of Investor Relations. Please go ahead, sir.

Caspar Tudor, Director 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 guidance regarding possible future results of the company and commentary on potential market and business conditions that may impact Waters Corporation over the third quarter of 2022 and full year 2022. We caution you that any and all such statements are only our present expectations and that actual events or results may differ materially from those indicated in the forward-looking statements. For a detailed discussion of some of the risks and contingencies that could cause our actual performance to differ significantly from our present expectations, see the risk factors included in our annual report on Form 10-K for the fiscal year ended December 31, 2021, in Part 1 under the caption Risk Factors and in our most recent quarterly report on Form 10-Q for the quarter ended April 02, 2022 in Part 1A 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. 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. 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 in the appendix of our presentation which are 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 and in the appendix of our presentation. Unless stated otherwise, references to quarterly results increasing or decreasing are in comparison to the second quarter of fiscal year 2021. 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. Udit Batra, Water's President and CEO. Udit?

Udit Batra, President and CEO

Thank you, Caspar and good morning, everyone. Along with Caspar, joining me on this morning's call is Amol Chaubal, Waters' Senior Vice President and Chief Financial Officer. In the second quarter, we continued to deliver excellent results, led by instrument growth of 12% with continued broad-based strength across our end markets and geographies. I would like to take a moment to, again, acknowledge the unwavering efforts of our teams who have persistently worked through the challenging environment to deliver for our customers. We saw this with our China team whose dedication and agility through the lockdowns in Shanghai drove exceptional results against this quarter, which came ahead of our expectations. But importantly, we've seen this commitment across all our teams and regions, and it truly reflects the indomitable spirit we have here at Waters. Turning now to Slide 3, we have three messages; how strong commercial momentum is driving great results in markets that remain healthy. This is reflected in the broad sustained growth we are delivering across our products, geographies and end markets. Customer demand remains robust with orders that again outpacing sales as our strong momentum continued with double-digit sales growth again in the second quarter. Innovation is contributing meaningfully to our growth. Our refreshed product portfolio is highly competitive and providing key benefits to our customers, which is again driving stronger uptake of these new products, as well as market share gains. Over time, we expect that the strong instrument placements and resulting expansion in our install base will drive growth in recurring revenue tied to these instruments. And thirdly, we have a robust business model serving an attractive and resilient base. Waters serves end markets with sustainable growth drivers that are linked to key demographic areas, such as population growth and increasing regulatory requirements around testing. With our strong business model, we have growth levers that exist throughout the market cycle, across instruments, service, chemistry and informatics. Growth in one of these areas usually results in follow-through performance across our business model, and you can see this today with our strong pull through of instrument sales into higher attachment rates, which is again driving recurring revenue growth. Now moving on to Slide 4; in the second quarter, revenue grew 5% as reported and 10% on a constant currency basis with broad strength across our end markets and geographies, as well as in both instruments and recurring revenues. Orders in the quarter exceeded sales of $714 million as we continued to see very strong demand from our customers. Our Q2 non-GAAP adjusted earnings per share was $2.75, up 6% year-over-year, despite FX headwinds. The impact of FX headwind lowered our non-GAAP earnings per share growth by 11% versus the prior quarter. Amol will cover the impact of FX in more detail later in the call. Now looking more closely at our top line results for the quarter on Slide 5 in constant currency. First by operating segment, Waters division grew 10% while DA grew 12%. By end market, our largest market category pharma grew 10%, industrial grew 8% and academic and government grew 16%. In pharma, we saw continued broad-based strength across segments, geographies and applications with growth in large molecule and small applications. Growth was led by the U.S., which grew mid-teens with large molecule applications growing twice the rate of small molecule applications. China, which grew in mid-teens and India, which grew 12%. In industrial, growth was driven by the U.S. up mid-teens; Europe, up high single digits and India, which grew over 50%. Our food and environmental business is performing well with testing also positively impacting growth. In academic and government, after seeing a slower recovery than our other end markets last year, customer spending continued to be more active during the quarter with mid-teens growth for the quarter, led by strength in China, India and the Americas. Now by geography, sales in Asia grew 9%, the Americas grew 15% and Europe grew 7%. In Asia, growth was led by China, where sales grew 9% despite the presence of COVID-related lockdowns for much of the quarter. Customer demand in China remained strong and we're observing great activity levels which rapidly picked up in June relative to April and May when the lockdowns were in effect. Meanwhile, sales in India grew 24%. The Americas was again our fastest-growing region, with the U.S. growing 14%, which was led by strong instrument sales, which grew 20% along with recurring revenues, which grew 11%. In Europe, the growth was led by pharma and industrial, which both grew high single digits. By products and services, instruments grew 12%, with our LC mass spec and TA portfolios each growing double digits. Recurring revenues grew 8% with chemistry, up 9%, and service, up 8%. New products again contributed meaningfully to growth in the quarter with unit sales of Arc HPLC and ACQUITY Premier more than doubling versus the second quarter of last year. Unit sales of MaxPeak Premier columns also more than doubled and have continued to add strength and incremental growth to our chemistry business, driven by large molecule applications. In mass spec, we saw strength across our portfolio, including for our Xevo TQ-XS and cyclic IMS instruments as well as strong traction for our newly launched Xevo TQ Absolute, which sold out at launch and has already developed a backlog. Customers are seeing the value that TQ Absolute provides in application areas such as food safety and pharma development in small and large molecule applications given its dramatic leap in performance and efficiency compared with other instruments in its class. Here in New England, one state public health laboratory was the first to purchase and install TQ Absolute for the express purpose of PFAS testing in water and environmental samples. That customer told us that TQ Absolute is giving them a 100 to 400-fold increase in sensitivity versus their prior instrument while being far easier to use in terms of sample prep and in quickly giving them highly accurate results. Meanwhile, at the high end, we're seeing good demand for our cyclic IM mobility technology. One example is researchers at MD Anderson Cancer Center at the University of Texas who are using it for precision molecular profiling within OMEX research. We're getting feedback that it is enabling significant progress in discovering and validating novel blood and plasma biomarkers for early disease detection in oncology. Finally, TA had another great quarter with sales up 12%, led by strong growth in thermal analysis, microcalorimetry and rheology. Demand for TA products continues to be strong across all regions, led by electronics and batteries. Now moving to Slide 6. I would like to reflect on the excellent strength and momentum we have sustained in the first half of the year driven by our commercial execution, product innovation and pricing offsetting inflation, leading to these great results. So far this year, instruments have grown almost 20%, with recurring revenue up just under 10% against strong stacked comps last year. In the U.S., instruments have grown over 35% year-to-date. All our regions have seen growth, led by Americas, which has grown 20% year-to-date. Meanwhile, China has grown low teens despite the COVID-related lockdowns, which we were able to successfully navigate through in both the first and second quarters of 2022. Each of our end markets have seen double-digit growth, which speaks to our broad execution across regions and segments. Meanwhile, we continue to observe strong demand from our customers and are seeing ongoing positive impacts from our market growth initiatives. Now turning to Slide 7; like each of these initiatives continue to progress, the 3 areas I would like to highlight this quarter are service attachment, e-commerce adoption and launch excellence. First, with service attachment, we're seeing strong pull-through of our instrument sales into service plan coverage which has driven our attachment rates over 100 basis points higher so far this year, which is ahead of our expectations and builds on excellent results last year. The progress we're making with service underscores the opportunity ahead to grow our recurring revenues which layers on top of our instrument growth. Second, also part of our recurring revenues, e-commerce adoption of chemistry has continued to move higher which is having a positive effect on sales by making it easier for our customers to do business with us and driving incremental growth opportunities. 31% of our chemistry is now sold through digital channels, which is a 10-point increase compared to 2019 when the initiative began, and we see further runway to over 50% in the long term. Since we started the initiative in 2019, revenue from digital sales has more than doubled. And in the first half of this year, it grew over 30% versus the first half of 2021. Third, our revitalized portfolio is contributing to growth as demand has scaled up for Arc HPLC, for ACQUITY Premier and MaxPeak Premier columns. Our product vitality index has grown 300 basis points versus the second quarter of last year to 15% as sales of these products have quickly ramped, with launch excellence and the impact of innovation driving strong market uptake. As I've shared before, ACQUITY Premier and MaxPeak Premier were specifically designed to solve challenges that are particularly relevant for large molecules. This technology is capturing growth opportunities as pharma customers seek to expand their capacity and build capabilities for biologics and novel modalities, such as oligonucleotides, mRNA and peptides. Meanwhile, small molecule growth remains solid with customers continuing to refresh and expand their capital equipment with Arc HPLC. Now on Slide 8. In June, at the ASMS, we announced our new Xevo G3 high-resolution mass spec. The G3 is our latest generation benchtop Q-tof and it provides increased sensitivity and range for large molecule analysis over its predecessor, the G2, which is one of our best-selling high-res mass spec products. This instrument is described by our customers as an analytical workhorse given that it offers the power and range needed to characterize complex biotherapeutics while also providing the reliability, robustness and reproducibility needed in late-stage development. As biologics and novel modalities increasingly move into later stages, this instrument supports the associated workflows by allowing more detailed characterization of these molecules in product and process development. This occurs before they move downstream into higher volume manufacturing QA/QC where routine analysis will then be performed on instruments such as BioAccord. A further key piece of innovation is the software we've developed on waters_connect which allows the compliant workflows developed on the G3 to seamlessly transition to BioAccord with just a few mouse clicks. This ease of transfer had been unheard of before now and it allows our customers to transfer data between instruments and global locations within their enterprise network, all while remaining in an industry compliance setting. On waters_connect, our latest apps are enabling exciting new analytical areas for the G3 and BioAccord, including cell culture media analysis and peptide analysis with in-depth protein and glycan profiling. Most recently, we've added the ability to characterize oligonucleotides and conduct impurity analysis as well as perform lipid nanoparticle compositional analysis and stability testing which is highly relevant for mRNA molecules. These are all new analytical areas in large molecule characterization where there is a lot of long-term potential as the market looks for more advanced characterization capabilities for biologics and novel modalities. As we continue to innovate and expand our offering, we are increasingly well positioned to support biologics and novel modalities as they move downstream into routine analysis. Now I'd like to pass the call over to Amol to continue covering our second quarter financial performance and provide our guidance for the remainder of 2022. Amol?

Amol Chaubal, CFO

Thank you, Udit, and good morning, everyone. Udit already covered the breakdown of our sales growth for the quarter, so I will now cover the remaining elements of our non-GAAP financial performance versus the prior year. Gross margin for the quarter was 57% and compared to 58.9% in the second quarter of 2021, driven primarily by foreign exchange headwinds from the strong U.S. dollar as well as a higher instrument mix. Pricing for the quarter was over 300 basis points, successfully offsetting the impact of material and freight inflation. Operating margin for the quarter was 28.4% compared to 29.2% in the second quarter of 2021. This represents 70 basis points of margin expansion in constant currency before 150 basis points of foreign exchange headwind. For the first half of the year, operating margins have expanded 120 basis points before 80 basis points of foreign exchange headwind. Our effective operating tax rate for the quarter was 14.1%. Average share count came in at 60.5 million shares, which is about 1.6 million less than the second quarter of last year. Our non-GAAP earnings per fully diluted share for the second quarter increased 6% to $2.75 in comparison to $2.60 last year. The foreign exchange headwind lowered our EPS growth by 11%. On a GAAP basis, our earnings per fully diluted share was $2.72 compared to $2.69 last year. A reconciliation of our GAAP to non-GAAP earnings is attached to the press release issued this morning and in the appendix of our earnings call presentation. Turning to free cash flow, capital deployment and our balance sheet. We define free cash flow as cash from operations, less capital expenditures, and excludes special items. In the second quarter of 2022, free cash flow was $67 million after funding $39 million of capital expenditures. Excluded from free cash flow was $11 million related to the investment in our Taunton precision chemistry operations and a $38 million tax reform payment. Our free cash flow in the quarter was impacted by our proactive measures to secure supply and rebuild safety stock, resulting in a $40 million increase in inventory before exchange rates. Additionally, timing of shipments and installations, particularly in China, resulted in an 8-day increase of DSO to 81 days and an increase in accounts receivable of approximately $60 million before FX. We expect these dynamics to correct in the second half of the year as we have already observed an increase in collections in July. For the full year, we anticipate being close to our historical free cash flow conversion levels. We maintain a strong balance sheet, access to liquidity and a well-structured debt maturity profile. This strength allows us the ability to prioritize investing in growth, including M&A and returning capital to shareholders. We continue to evaluate M&A opportunities that will meaningfully accelerate value creation in well-thought-out, attractive, high-growth, adjacent markets. In Q2, we repurchased approximately 479,000 shares of our common stock for $152 million. At the end of the quarter, our net debt position was approximately $1.1 billion with a net debt-to-EBITDA ratio of about 1.1. Now as we look ahead for the remainder of the year, I would like to provide some updated context on our thoughts for 2022 which is on Slide 10. We've seen continued strong performance this year, driven by robust end market demand and strong commercial execution across all our geographies. As we look ahead, we expect our solid momentum to continue and that our near-term growth initiatives and innovation will provide a lasting contribution to our performance. We also expect to continue to successfully address supply chain constraints and inflationary pressures, assuming these challenges do not worsen over the remainder of the year. These dynamics support increasing the full year 2022 guidance to 9.5% to 10.5% constant currency sales growth, up from our prior guide of 7.5% to 9%. At current rates, a negative currency translation is expected to subtract approximately 5 percentage points, resulting in full year reported sales growth guidance of 4.5% to 5.5%. Gross margin for the full year is expected to be about 58% and operating margin is expected to be approximately 30.5% as our resilient business momentum is able to mitigate the impact from exchange rates. We expect our full year net interest expense to be approximately $35 million and full year tax rate to be approximately 15.5%. Average diluted 2022 share count is expected to be approximately 60.4 million. Our share repurchase program will continue into the year and we'll provide quarterly updates as appropriate. Now rolling all this together and on a non-GAAP basis, full year 2022 earnings per fully diluted share are now projected in the range of $11.95 to $12.05, which includes a negative currency impact of approximately 9 percentage points. Currency impact is $0.56 incrementally worse than our previous guide. However, our stronger-than-expected results for Q2 and our increased full year growth outlook are expected to offset the currency headwind. Looking to the third quarter of 2022, we expect constant currency sales growth to be 8% to 10%. At today's rates, currency translation is expected to subtract approximately 6 percentage points, resulting in third quarter reported sales growth guidance of 2% to 4%. Third quarter non-GAAP earnings per fully diluted share are estimated to be in the range of $2.50 to $2.60. This includes a negative currency impact of approximately 10 percentage points. Now I would like to turn it back to Udit for some summary comments.

Udit Batra, President and CEO

Thank you, Amol. So in summary, we are pleased with our sustained broad strength for the quarter which was driven by our strong commercial execution and the impact of innovation in our highly competitive refreshed product portfolio. Demand has remained strong across our end markets as we've continued to capture growth opportunities in both large and small molecule applications, food and environmental testing and battery material analysis, each of which has long-term durable growth opportunities that we're well positioned for. To reflect our strength, we're raising our full year constant currency sales growth guidance from 7.5% to 9% to 9.5% to 10.5%. Meanwhile, we have delivered great operating results despite the challenging macroeconomic environment. And for EPS, our strong results for Q2 and our increased full year growth outlook are expected to offset the impact of foreign exchange headwinds. With that, we will now begin the Q&A session.

Operator, Operator

The first question comes from Vijay Kumar with Evercore. Your line is open.

Vijay Kumar, Analyst

Congrats on the quarter. Udit, maybe my first one for you. You did mention orders were about of revenues in the quarter. Can you give a little bit of color on where the order strength is coming from? Which customer segment, which product class? And any comment on order growth rates, if you will. I think in the past call, there's been some debate on instrument pull forward, so color on orders would be helpful.

Udit Batra, President and CEO

Sure. So firstly, thank you, Vijay. Really, it's been another fantastic quarter. And the growth has again been driven by instruments really leading the charge. Orders came in ahead of sales again, which increases our backlog. From a demand perspective, it's really very much broad-based. I mean, pharma grew 10%, industrial 8% and you also saw academia grow 16%. And for the first half of the year, all three of our end market segments are now in the double-digit range, right? So pharma is 14%, industrial and applied is at 12% and academic and government at 10%. So we see really broad-based demand across our end markets. And from a geographic perspective, again, nice momentum across the board. The U.S. and India sort of leading the chart. The U.S. at 14%, India at 24%. And very nice to see China really in the high single digits at 9%. And again, first half of the year, Americas at plus 20%; China, mid-teens; India, again, in the 20s. So really broad-based strength across customers and geography. And we see really no sign of any sort of slowdown.

Vijay Kumar, Analyst

That's helpful, Udit. And maybe one for Amol. I think FX, Amol, you said incremental $0.50 plus. So what is the total impact now? I think it's close to $1. And I think your guide implies back half gross margin step-up. Why would gross margin step up if you have this FX dynamic? And I think you're also assuming tax rate steps up in the back half. First half has been sub-15%. So any color will be helpful.

Amol Chaubal, CFO

Yes. Let me address those three points one at a time. Regarding the exchange rate, our full year guidance was previously about $0.45. Now it's 9% worse, which translates to $1.01. This indicates an additional $0.56 decline. This situation will be evident across our Q2, Q3, and Q4. We are offsetting the $0.55 decline with improved business performance, with $0.31 already achieved in Q2. During Q2, the exchange rates were about $0.18 less favorable compared to our previous guidance, but we performed $0.15 better than our forecast midpoint, totaling $0.31. For Q3, our earlier guidance included an assumption of $0.08 for foreign exchange, but it is now at $0.26. This results in an additional $0.18 challenge in Q3, which is reflected in our guidance for that quarter. Moving on to gross margin, typically, during the second half of the year, we experience higher sales, which reduces volume leverage in terms of operations and absorption. In the first half of this year, two key factors influenced our results: increased activity related to spot buys affected our profit and loss statements, and while supply chain conditions are gradually improving, we are not fully out of the challenges yet. The swift changes in exchange rates also caused transactional gains and losses that impacted our cost of goods, which is visible in our gross margin. Overall, we anticipate a more favorable impact on gross margin in the second half. Lastly, concerning taxes, the tax rate for the first half of the year is below 15.5%, but this is due to one-off items that are not expected to recur in the second half. Additionally, there will be a catch-up effect related to how profits are distributed throughout the year. At this point, we consider a 15.5% tax rate as a sensible approach.

Udit Batra, President and CEO

So maybe just one sort of summary comment on really the very precise and nice description that Amol has given. I mean our top line continues to do extremely well, right? And we've just guided to double-digit growth for the full year after printing a 16% growth for last year and then 16% in Q1, first half of the year in the teens. So top line momentum continues. This flows very nicely through the P&L. And the EPS on an organic basis is in the high teens, right, even for the full year in the guide, right? On an organic basis, it's in the high teens, which basically sets us up really well as we go into next year, right? And in our trends, in our sort of results, there is no benefit of COVID or M&A embedded, right? So it's a very clean number that you can build off for the next year and shows the strength of our business provided we continue to deliver on the top line. And with resilient end markets with great innovation and such a good team executing, we feel very good about where we stand.

Amol Chaubal, CFO

Exactly. And just to build on that. The $0.55 sticks with us in the baseline and the $0.55 adverse effects, once the currencies recorrect, it will come back.

Operator, Operator

Our next question comes from Luke Sergott with Barclays. Your line is open.

Luke Sergott, Analyst

I want to follow up on what you mentioned, Udit, regarding your current performance in the high teens from an instrument perspective. How should we view the potential for that to continue moving forward? You provided some insights on the backlog, and it seems you're beginning to focus on high-end mass spec and a new upgrade cycle. Could you share your thoughts on how you expect this progress to unfold for the remainder of the year and into early 2023, especially considering a potential recession?

Udit Batra, President and CEO

Thank you for the question, Luke. We're very pleased with our performance. I'll address the latter part of your question regarding instruments as I go along. In terms of our competitive environment, we are performing exceptionally well. Instruments have played a significant role in our story, as they grew close to 20% in the first half while our overall growth was around 13%, and we again saw orders exceed sales. We are aware of the macro challenges, but considering our execution over the last two years since my arrival, we've secured our leading position even during the pandemic. Innovation is now making a meaningful impact on our growth, and I have strong confidence in our team. While we do not foresee a downturn based on our market visibility, we are well-positioned in all end markets. Historically, back in 2009, Waters was one of the few companies to demonstrate positive EPS growth, and we are in an even better position today. Our portfolio has evolved; we had 40% recurring revenues then, and now it's over 55%. We're witnessing outstanding strength in end markets, particularly in pharmaceuticals, where over 60% of our focus is on late-stage pharma, which is very resilient. In the applied industrial sector, more than 50% is in food and environmental, and in the TA segment, we are increasingly focused on faster-growing areas like batteries. Therefore, I feel very positive about our standing in the end markets. Despite significant headwinds from foreign exchange, we are able to meet the EPS commitments we made earlier. Now, regarding instruments, historically, Waters has seen growth rates of 3% to 4%, and currently, we are at 19%. While it is unrealistic to expect sustained growth at that rate, we have initiatives from earlier this year that still hold promise. The replacement cycle is ongoing, which we anticipate will continue for the next 2 to 3 years, resulting in improved attachment rates. We have also expanded into new segments with CDMOs and CXOs. I am optimistic about the implementation of our initiatives, which should support our instrument growth rate moving forward. In summary, while we don't expect to maintain 19% growth indefinitely, we do expect our initiatives to enable us to exceed the historical growth rates of 3% to 4%. I hope this provides additional insight.

Luke Sergott, Analyst

Can you discuss China? You are guiding for 200 to 300 basis points this quarter, but it actually came in at 9%. How did that compare to your expectations? Also, your guidance of low to mid-teens appears to have already been achieved in the first half. What should we expect for China in the second half?

Udit Batra, President and CEO

Yes. Firstly, I'm incredibly proud of the team. If you had asked me in April and May where we were going to end up, it was difficult due to the headwinds we discussed. However, in June, the team's performance was remarkable in shipping our products to customers. I'm very pleased with what we accomplished. For the second half of the year, we expect to see mid-teens growth for China without any significant slowdown, showing strength across all end markets. Our TA business is also strong, particularly with our instrument replacement cycle and the success of Arc HPLC. Additionally, the biopharmaceutical applications for our ACQUITY Premier technology are performing well. Overall, demand in China looks very positive, and we still anticipate mid-teens growth for the full year, provided there are no major shutdowns in that region.

Amol Chaubal, CFO

Yes. Just one thing to add. Last year, we had a shipment issue in Q3. And so close to $12 million of sales moved from Q3 to Q4. So the baseline for Q3 is somewhat lower. And so you will see a more pronounced growth in China in Q3 with a more subdued growth in Q4 because of last year's shipment dynamics.

Udit Batra, President and CEO

I mean it's a lumpy sort of environment, as you can see, quarter-to-quarter. But I mean, overall, look, 16% growth last year, mid-teens already at the middle point of this year, and we feel very good where we sit today.

Operator, Operator

Our next question comes from Daniel Brenna with Cowen. Your line is open.

Daniel Brenna, Analyst

Congratulations on the quarter. For my first question, I'd like to revisit the macroeconomic perspective you just shared. You seem very confident, which is encouraging. Historically, in '08, your growth was at 4.5%, and in '09, there was a contraction of about the same amount, reflecting a 9-point swing. As you noted, the business landscape has changed significantly, along with the various commercial initiatives you are implementing. While we don't anticipate another recession similar to that period, it's worth considering that if the economy maintains its current level, your operations might still be affected. Could you provide more insight into the sensitivity, or lack thereof, across your different business units? Additionally, what would be a reasonable benchmark for how you might respond if the economy were to decline in '23?

Udit Batra, President and CEO

Thank you for the question, Dan. It's similar to what I just mentioned. Let’s break down each of the end markets and their composition. In the pharmaceutical sector, we likely have the highest exposure to late-stage quality assurance and quality control, which is closely linked to pill count. Regardless of economic conditions, people continue to take medicines and pharmaceutical companies do not halt their production. If there is a slowdown, it is more likely to occur in research and development funding. Our focus on quality assurance and quality control in pharmaceuticals is beneficial for both small and large molecules. Looking at our industrial and applied segment, over half of it now comprises food and environmental sectors. Food safety, particularly with our updated portfolio in food testing, is a significant growth driver in both food and environmental testing. Additionally, our testing activities for batteries are expanding, showing a shift in the testing segment. The growth we are experiencing is widespread, and our business is geographically diverse. We have a substantial presence outside the U.S., and while a strengthening dollar presents challenges with foreign exchange impact, our geographic diversity helps us manage these fluctuations more effectively. I feel very optimistic about our exposure to various end markets. This industry is responsive to innovation, and we've seen that in our results. When I joined almost two years ago, some believed we were too focused on the small molecule quality assurance and control sector, which was becoming commoditized. However, we have proven otherwise with the introduction of our Arc HPLC, which offers better performance without necessitating re-filing or re-validation of customer processes, leading to growth in that segment. We are currently in a strong position from an innovation perspective. Importantly, we have a dedicated team that has successfully navigated the challenges posed by the pandemic and macroeconomic factors, with most of us being new in our roles. I am very confident that we can effectively handle whatever economic conditions we might face, and we are better positioned than during the downturn in 2008 and 2009, a period in which Waters managed quite well. I hope this provides more clarity.

Operator, Operator

And our next question comes from Matt Sykes with Goldman Sachs. Your line is open.

Matthew Sykes, Analyst

Congrats on the quarter. Maybe the first question, Udit, I know you've talked in the past about the academic government market and that was an area of focus for you going forward. Clearly, some of the initiatives that you did there have paid off with the growth that you saw this quarter. Can you just maybe talk about what was the inflection for that end market this quarter? Was it Waters-specific initiatives? Or is there something going on in that particular end market that results in that growth? And how sustainable is that in your mind?

Udit Batra, President and CEO

Matt, thank you for your question. We're pleased with our progress in the academic and government sectors. In the first half of the year, we experienced double-digit growth, with around 16% growth in this quarter. It's important to note that this market can be unpredictable, and we started from a low point last year. Over a three-year period, we are looking at approximately 40% inorganic growth in this segment, which is heavily influenced by our instruments that performed exceptionally well in the last two quarters. However, the segment remains somewhat volatile due to our focus on instruments. We have begun to implement our strategies for improvement in this area, but there's still a lot to accomplish, particularly in enhancing our e-commerce and e-procurement efforts. While we are making progress, we are not finished yet. Commercially, we are reestablishing our KOL contracts to support our high-resolution mass spec portfolio. Even with the renewed portfolio, we recognize that there is still work to be done in the commercial arena. Therefore, while we are satisfied with our results, we are not declaring victory at this stage.

Operator, Operator

The next question comes from Josh Waldman with Cleveland Research. Your line is open.

Josh Waldman, Analyst

Just one for Udit and one for Amol. Udit, orders again outpaced sales. Can you provide more context on the backlog at this point? I guess the magnitude of the backlog and the level of visibility you think that provides into the second half and maybe even into '23. You had previously commented you didn't think orders are benefiting from pull forward. Is that still your sense?

Udit Batra, President and CEO

Yes, Josh, thank you for your question. There is no pull forward; orders continue to exceed sales. All of our end markets are performing well, so we are optimistic about our demand outlook. However, it is still too early to discuss 2023. We need to navigate the rest of this year carefully in a challenging environment. That being said, the drivers of demand remain strong. Our innovation efforts are succeeding, and our commercial presence and execution are enabling us to seize opportunities more effectively than our competitors. Thank you for the question, but there is no pull forward, and we feel very positive about our demand situation.

Amol Chaubal, CFO

Look, our Q3 guide is 8% to 10%. Adjusted for the shipment issue, it's like 6% to 8%. The implied Q4 guide is sort of 5% to 7%. Adjusted for the shipment is 6% to 8%. So again, I mean, at this stage, we have visibility in our pipeline for Q3 and Q4. We feel good about it. But at this stage, it's good to be prudent, especially for Q4. So we feel good about where the guide is at this stage. And our teams continue to execute flawlessly and continue to beat our expectations.

Udit Batra, President and CEO

The backlog is at healthy levels. Waters didn't have a healthy backlog for a while, but now we feel a bit better having a reasonable backlog. It's not extremely substantial, but it allows us to navigate through any turbulence. We have a lot of visibility into Q3 and we feel optimistic about how we will end the year.

Operator, Operator

Our next question comes from Rachel Vatnsdal with JPMorgan. Your line is open.

Rachel Vatnsdal, Analyst

So first up on pharma, drug pricing reform continues to be a headline topic. So can you just walk us through how you see that impacting Waters' portfolio especially given your unique exposure in small versus large molecule in QA/QC. And then have you started to have any conversations with your pharma customers regarding that drug pricing reform and do you expect that it could have any impact on your pricing power?

Udit Batra, President and CEO

Thank you for your question, Rachel. We haven't noticed any impact so far. There haven't been any discussions from customers about their expectations. I want to emphasize that we're primarily focused on the late-stage part of the pharmaceutical value chain, specifically quality assurance and quality control. Our costs represent a very small fraction of the pharmaceutical overall, so it's typically not an area they scrutinize for cost reductions. Historically, we haven't experienced any effects during pricing discussions, and we don't anticipate anything changing in the future considering our focus on QA/QC and the minimal portion of costs we represent. While early-stage research might be affected, our primary alignment is with QA/QC.

Operator, Operator

Our next question comes from Derik De Bruin with Bank of America. Your line is open.

Derik De Bruin, Analyst

So I'm just curious, really good growth in India, 24%. But I do recall that a few years ago when the dollar appreciated strongly against the rupee that some of your customers in India didn't have enough money budgeted, so they didn't have the purchasing power as for go out and do it and it sort of delayed orders. The combination of FX and price increases, are you worried at all about some emerging economies, particularly India, to be slowing in demand because of a bit on the budgets?

Udit Batra, President and CEO

I'll start off, Derik, and I'll let Amol comment a little bit on the FX piece as well. Really, India has been doing extremely well given the demand for small molecule production, again reviving, and some of this has to do with the government initiatives in India that were initiated last year and us being so heavily focused on that part of pharma, QA/QC for genetics, QA/QC for small molecules in India, we've seen an outsized benefit and that's continued well into this year. So it's a fundamental demand driver that we can explain based on government policy and again driven heavily by instrument growth. Consumables are doing well but driven heavily by instrument growth. Amol, do you want to comment on the FX piece?

Amol Chaubal, CFO

Yes. No. And just to build on what Udit said, right? I mean we have a fantastic team in India. And if you go back to the second quarter of last year when India was going through a very tough COVID environment, the team executed flawlessly and had a great growth in second quarter of last year. So the baseline was already high. And then again, this year, you see 24% growth in the second quarter. So a lot of confidence in that team. And then when you couple that with how we've sort of handled pricing through inflation, we've provided detailed transparency to our customers on what's happening on the semiconductor side, on the freight side. And that's allowed us to have the customers share the burden of pricing. And I think the same processes that we build, the same systems that we build are going to start playing a role in explaining the impact of exchange rate and U.S. dollar and where our cost base lies. And I think not just India, but there are other markets that are impacted by this and our commercial teams are doing a great job of providing this transparency to the customer so that we can work this through hand in hand.

Operator, Operator

Our next question comes from Puneet Souda with SVB Securities. Your line is open.

Puneet Souda, Analyst

So first one for Udit, just wondering if there are any changes in the M&A approach that you talked about at the Investor Day, Udit. Just wanted to get any updated thoughts given the valuations you're seeing in the market here.

Udit Batra, President and CEO

Thanks for the question, Puneet. Our capital allocation priorities remain unchanged, with a strong focus on growth. We prioritize organic growth when allocating capital, and that is going very well. We are funding internal innovation and our high-growth adjacencies, which are showing promising results. I attended AACC last week with our team on LC, MS for diagnostics, and it's clear that as customers find new biomarkers, mass spec plays a significant role. We had our R&D and commercial teams there, conducting various workshops with different customers, and we feel confident about our organic initiatives. We plan to invest in adjacent areas like bioseparations and analytical bioprocessing, as well as batteries and LC, MS, and diagnostics. Regarding M&A, we are keenly watching for opportunities that align with our strategic priorities, but there is no urgency. We've announced a few collaborations that are progressing well, particularly the one with Sartorius in the bioanalytical characterization area, especially upstream. While discussions are ongoing, we remain financially disciplined and nothing has changed since our last update. We know some people are still holding on to memories of their peak valuations, but our organic business is performing excellently, and we continue to focus on partnerships and have a solid pipeline of M&A targets that we are actively evaluating.

Operator, Operator

Our next question comes from Brandon Couillard with Jefferies. Your line is open.

Brandon Couillard, Analyst

Udit, you launched the new QTof at ASMS. It's been a long time since you refreshed that product line. Could you just talk about the importance of that introduction, whether you think it's a needle mover for the mass spec franchise overall relatively near term?

Udit Batra, President and CEO

No, absolutely, Brandon, thanks for following up on that. Look, it's a workhorse instrument in that segment. And now along with the instrument being upgraded, you also have the waters_connect software, which is a compliance software, that allows us to introduce new applications, but allows us to transition methods from upstream more powerful tops to BioAccord directly downstream, right? So that's a significant benefit. And that product has done very well, right? It's already doing extremely well with our customers. I mean the orders are again outpacing the sales. I mean, within the first few days, significant backlog developed, right? So we feel very good about what we've done there. And as I said, it's not just the instrument being more powerful in those segments, but it's also the launch of the waters_connect software, the informatics software that allows for an easier transition into the BioAccord in late stages. So again, really consistent with our long-term strategy of doing analysis upstream and making it seamless for the customers to transfer that analytical method downstream, especially as you look at larger and larger molecules.

Operator, Operator

And our next question comes from Patrick Donnelly with Citi. Your line is open.

Patrick Donnelly, Analyst

Maybe just a follow-up on the M&A one earlier, a different angle. Udit, you talked about the large molecule growth kind of outpacing small molecule, even double the rate. Can you just talk about, I guess, balancing inorganic versus organic investments in that piece? Again, obviously, a big growth area you guys are kind of pouring into. So can you talk about, again, the internal strategy and then also kind of the inorganic opportunities on that front.

Udit Batra, President and CEO

Thank you for the question, Patrick. To start, it all begins with the organic aspect. Focusing on bioseparations and bioanalytical characterization, which are high-growth areas, we initiated our collaboration with Sartorius and worked with the University of Delaware, gaining a deep understanding of both upstream and downstream bioprocessing. Our team has effectively mastered this area, and I want to emphasize that before we make significant moves, we need to develop this business organically. I'm very pleased with what we've accomplished over the past year, learning a lot from Sartorius and the University of Delaware. We've allocated substantial resources to this effort, sparing no expense as this business expands. We've already created four workflows for the BioAccord targeting upstream characterization, including an outstanding one for cell culture media analysis in bioreactors. Several other workflows have also been successfully implemented. The organic segment of the business is performing well. When it comes to M&A, this opens up numerous ideas, such as opportunities for sampling, data analytics, and other analytical characterization methods in both upstream and downstream bioprocessing, which we will discuss further as time goes on. Regarding bioseparations, we possess leading capabilities in separating small molecules. We've developed some valuable applications with the MaxPeak Premier technology and our columns to enhance the separation of oligonucleotides and larger molecules. We see significant potential for organic growth in this area, and our team is being substantially strengthened. It also creates opportunities for inorganic growth as we gain insights into this segment. We'd like to collaborate with organizations that have strong expertise in reagents for larger molecules, which is something we are carefully considering. The organic component comes first, helping us understand the possibilities while opening up multiple avenues. As I mentioned earlier, we remain quite engaged in this area with several ideas at different stages of development.

Operator, Operator

Thank you. And now back to you, Caspar.

Udit Batra, President and CEO

Thank you very much, and thank you for all your questions. You'll agree with me that we've again had a tremendous quarter. The team continues to execute in a turbulent environment. And thank you for your participation. And on behalf of our entire management team, I'd like to thank you for your continued support and interest in Waters. Thank you, and have a wonderful day.

Operator, Operator

Thank you. And that concludes today's conference. You may all disconnect at this time.