Waters Corporation: Q2 2017 Form 10-Q
Business context and period. Waters designs, sells and services analytical instruments, consumables and software, principally for life, materials and food sciences. The unaudited quarter ended July 1, 2017; comparisons are with the quarter ended July 2, 2016. The company reports one aggregated segment.
Financial performance
| Metric | Q2 2017 | Q2 2016 | First half 2017 | First half 2016 |
|---|---|---|---|---|
| Net sales | $558.3m | $536.6m | $1,056.2m | $1,011.8m |
| Operating income | $153.8m | $151.6m | $272.7m | $264.3m |
| Operating margin | 27.5% | 28.3% | 25.8% | 26.1% |
| Net income | $131.8m | $128.2m | $237.4m | $222.3m |
| Diluted EPS | $1.63 | $1.57 | $2.94 | $2.72 |
- Revenue rose 4% year over year in both periods. In Q2, product sales increased 4% and service sales 5%; first-half increases were 4% for each.
- Gross margin was approximately 58.9% in Q2 and 58.3% in the first half, broadly unchanged from the comparable 2016 periods.
- First-half operating cash flow was $351.3m, versus $320.4m. Investing cash outflow was $293.9m and financing cash outflow $22.3m. Cash and equivalents increased $61.6m to $567.3m.
- At July 1, cash, cash equivalents and investments totaled $3.126bn; current assets were $3.947bn and current liabilities $653.3m. Total debt was $1.912bn, including $225.2m current and $1.687bn long-term debt. Available borrowing capacity under the credit agreement was $383m; the company reported compliance with debt covenants.
Material changes and management commentary
- Sales growth was led by Asia, up 13% in Q2 and 14% year to date, including China growth of 18% and 19%, respectively. U.S. sales fell 2% in Q2 and 4% year to date; management cited weaker pharmaceutical and industrial demand and macroeconomic and policy uncertainty. Europe increased 2% in both periods.
- Operating income growth was limited partly by a $10m German patent litigation provision. First-half results also included $11m of severance and early-retirement costs and a $5m acquired in-process R&D charge. The licensing arrangement may require up to $7m in additional milestone payments and royalties on future sales.
- The effective tax rate was 11.0% in Q2 and 9.2% year to date, down from 11.9% and 11.8%. Adoption of share-based compensation accounting guidance reduced tax expense by $4m in Q2 and $12m year to date, adding $0.05 and $0.14 to diluted EPS, respectively. A 0% Singapore contractual tax rate on qualifying activities is expected to continue through March 2021, subject to milestones.
- The board authorized a new $1bn share-repurchase program over three years. The company repurchased $159m of shares in the first half and had $964m remaining under the new authorization at July 1. No dividends had been paid, and none were planned at that time.
Outlook, risks and contingencies
- The filing gives no specific numerical sales or earnings guidance. Management said current resources, expected cash flows and committed borrowing capacity should support operations, debt service, capital spending, authorized repurchases and potential acquisitions for at least the next 12 months.
- Management cautioned that foreign exchange could increase reported sales while weighing on gross profit for the remainder of 2017, partly because of U.K. manufacturing costs. Foreign currency translation reduced sales growth by 1 percentage point in Q2 and about 2 points year to date.
- Most cash and investments—$3.081bn of $3.126bn—were held by foreign subsidiaries and may have material tax effects if distributed to U.S. entities. A hypothetical 10% strengthening of the U.S. dollar would reduce the value of foreign-currency cash and investments by about $32m.
- In June 2017, a German court ruled against the company in patent litigation; Waters recorded a $10m provision. Accrued patent litigation expense was $16m at July 1. The company said other ordinary-course litigation was not expected to materially affect its financial position, results or cash flows.
- Other stated risks include currency movements, economic and political uncertainty, customer spending and funding, competition and product acceptance, regulatory requirements, intellectual-property disputes, tax audits and changes in tax laws. Management reported no material changes to previously disclosed risk factors.
Investor verification points
- Assess whether growth in Asia can offset continued weakness in U.S. pharmaceutical and industrial demand, and check subsequent regional and end-market sales.
- Track operating-margin trends and the effects of litigation, restructuring, product mix, foreign exchange and investment in new technologies.
- Review the German patent case, the recorded accrual and any further payments or appeals disclosed in later filings.
- Monitor foreign cash accessibility and potential repatriation taxes, debt maturities and borrowing capacity, and the pace of share repurchases.
- Evaluate the sustainability of the low effective tax rate, including stock-compensation tax benefits and Singapore tax incentives.