Ronald W. Hutton - Bio-Rad Laboratories, Inc. Christine A. Tsingos - Bio-Rad Laboratories, Inc. Norman D. Schwartz - Bio-Rad Laboratories, Inc..

Brandon Couillard - Jefferies LLC Mike Sarcone - Deutsche Bank Securities, Inc. Sara Silverman - Wells Fargo Securities LLC Shannon Hall - Bio-Rad Laboratories, Inc. Dan Leonard - Deutsche Bank Securities, Inc..

Good day, ladies and gentlemen, and welcome to the Bio-Rad Laboratories Q2 2017 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. I would now like to introduce your host for today's conference, Vice President and Treasurer, Mr.

Ron Hutton. Mr. Hutton, you may begin..

Thank you, Sherry. Before we begin the call, I would like to caution everyone that we will be making forward-looking statements about management's goals, plans and expectations, our financial – our future financial performance and other matters.

Because our actual results may differ materially from these plans and expectations, you should not place undue reliance on these forward-looking statements, and I encourage you to review our filings with the SEC, where we discuss in detail the risk factors in our business.

The company does not intend to update any forward-looking statements made during the call today. With that, I'd like to turn the call over to Christine Tsingos, Executive Vice President and Chief Financial Officer..

Thanks, Ron. Good afternoon, everyone, and thank you for joining us. Also on the call today are Norman Schwartz; John Goetz; Shannon Hall, President of our Life Science Group; and John Hertia, President of our Diagnostics Group.

Net sales for the second quarter were $504.7 million, a decrease of 2.3% on a reported basis versus the same period last year's sales of $516.8 million. On a currency-neutral basis, year-over-year sales declined 1.6%.

On our first quarter earnings call in May, we shared our caution and expectation that with the transition of Western Europe to our global ERP system, productivity would likely slow down as people adapted to the new system and processes and that this, in turn, could lead to lower sales.

During the second quarter, we indeed experienced a substantial slowdown in our supply chain operations. You may remember that when we went live with our global ERP in the U.S. during the summer of 2015, we experienced a similar impact with sales disruption at the time to be estimated at $10 million.

This current European deployment is substantially larger, both in terms of number of manufacturing sites and selling locations and, as such, the level of disruption and negative impact on sales is also larger.

For the second quarter, we are estimating the slowing of productivity and manufacturing and distribution resulted in a negative impact to sales of $15 million to $17 million.

This amount, coupled with approximately $9 million of sales that were pulled forward into the first quarter in anticipation of the European go-live, led to the significant headwind when compared to last year.

In addition to ERP transition challenges, we also experienced another lumpy quarter for our process media business, as current Biopharma ordering patterns make for a tough comparison with last year.

Having said all that, it is important to note that we did experience bright spots with good sales growth across several of our key markets during the quarter. Most notably, sales of our Droplet Digital PCR, western blotting, diabetes monitoring, autoimmune, and quality controls product lines all posted solid growth in the second quarter.

On a geographic basis, quarterly top line growth was highlighted by strong sales in the Asia-Pacific region, including solid double-digit growth for both China and India. And finally, sales from the recently acquired RainDance business contributed $5.4 million to the top line during the second quarter.

The reported gross margin for the second quarter was essentially flat with last quarter as well as the year-ago period at 54.2%. For the quarter, the total noncash purchase accounting expense recorded in cost of goods sold related to acquisitions was $7.1 million, which compares to $7.2 million in the second quarter of last year.

SG&A expense for the quarter was $213 million, or 42.2% of sales, compared to $195 million in the first quarter and $205.5 million or 39.8% of sales in the year-ago period. The sequential increase in SG&A primarily reflects increased expense associated with our ERP project and operating model changes in Europe.

We estimate that ERP project-related expense increased $6 million from the first quarter. Also, when comparing SG&A spend on a sequential basis, remember that the first quarter of this year included a one-time contingent consideration benefit of $10 million.

And when comparing to the year-ago period, remember that the second quarter of 2016 included approximately $10 million of expense for the European restructuring. Also included in SG&A this quarter is $1.8 million for amortization of intangibles related to acquisitions.

Research and development expense in Q2 was higher than expected at 12.4% of sales or $62.6 million compared to $49.8 million last year.

The year-over-year increase in R&D spend is primarily a reflection of acquisition-related expense, including $7.5 million for the purchase of a promising, early-stage diagnostic device, plus $4 million for development milestones of our new flow cytometer for the cell biology market.

The inclusion of RainDance also contributed to the year-over-year increase. Going forward, we are targeting base R&D to return to the 9% to 10% of sales range.

However, it is important for me to note that in addition to this base level of investment, we are anticipating up to $9 million of additional milestone expense for the new flow cytometer technology in the second half of this year.

As you can see, the second quarter operating results are below expectations and certainly disappointing in the short term.

The top line headwinds, principally related to the ERP disruption and the lumpiness of our process-media business, combined with additional ERP and acquisition-related expense and the inclusion of RainDance, all resulted in the reporting of a loss at the operating line for the second quarter.

During the quarter, interest and other income resulted in a net income position of $3.5 million compared to a net $4.3 million position in Q2 of last year. This decline in income versus last year is largely related to higher foreign exchange losses, partially offset by an increase in dividend income typically associated with our second quarter.

The effective tax rate used during the second quarter is actually a benefit and somewhat meaningless.

This quarterly rate was driven by the combination of the low profit before tax coupled with discrete tax benefits related to the transfer of intangible assets within Europe as we set up our new operating model and a benefit related to share-based compensation.

Given the year-to-date effective rate of 18% and excluding any discrete items that may occur, we now anticipate the full year tax rate to be in the 31% to 32% range. Reported net income for the second quarter was $5 million, and diluted earnings per share for the quarter were $0.17.

This compares to net income of $18 million and $0.61 per share in Q2 of last year.

Excluding the acquisition-related expense of $7.5 million associated with new technology for the diagnostic market, plus the flow cytometer milestone expense of $4 million and the inclusion of RainDance and its quarterly operating loss of $2.5 million, we estimate that net income would have been approximately $15 million for the second quarter and earnings per share would have been approximately $0.51.

And now for certain segment information. Life Science sales for the second quarter were $179.4 million, a slight decrease on a reported basis compared to last year's sales of $180 million. On a currency-neutral basis, sales grew 0.3%.

These quarterly results reflect strong growth of our Digital PCR products, both instruments and consumables, sales of western blotting products and the inclusion of the acquired RainDance sales I mentioned earlier.

This growth was substantially offset by a sizable decline in our process media business, reflecting a difference in the quarterly ordering patterns of our Biopharma customers when compared to last year.

Additionally, we estimate that disruption related to the ERP go-live in Europe negatively impacted Life Science sales by approximately $3 million to $4 million during the second quarter. On a geographic basis, sales to the U.S., China and Asia-Pacific markets posted good increases for Life Science during the quarter.

Our Clinical Diagnostics segment posted quarterly sales of $322 million compared to $333.7 million last year, a decrease of 3.5%. On a currency-neutral basis, year-over-year sales for the Diagnostics Group declined 2.7%.

This decline is largely attributable to the supply chain challenges of the ERP implementation, as many of our diagnostic instruments and consumables are manufactured in Europe. We estimate that ERP-related disruption to the Diagnostic sales in the second quarter was $12 million to $13 million.

The most notable year-over-year decline was seen in our blood typing product family, which also felt the impact of the absence of sales that were pulled forward into the first quarter. Setting this aside, it is important to highlight that sales of diabetes monitoring and BioPlex 2200 products posted double-digit growth in the second quarter.

On a geographic basis, currency-neutral sales to the Asia-Pacific market, most notably, China and India, were especially strong for Diagnostics during the quarter. Moving to the balance sheet as of June 30, total cash and short-term investments were $717.4 million.

Net cash generated from operations during the quarter was $62.4 million compared to a negative $56.2 million last quarter and $77.2 million in Q2 of last year.

This significant increase in cash flow versus the first quarter is substantially related to the higher vendor payments that we processed in the first quarter in advance of our go-live as well as higher investment income from the annual Sartorius dividend in the second quarter. EBITDA for the quarter was $44 million or just under 9% of sales.

For the first half of 2017, EBITDA is $104 million, or just over 10% of sales. Net capital expenditures for the quarter declined to $25.6 million from $39.3 million in the first quarter, reflecting the transition from deployment stage to support stage of our ERP project.

Our full-year expectation for CapEx remains in the $125 million to $135 million range. And finally, depreciation and amortization for the quarter was $37 million, up on a sequential basis, primarily related to increased depreciation associated with our ERP project.

Moving to the outlook for 2017, the second quarter has certainly been a bump in the road on our journey to greater efficiency and profitability. With that being said, we continue to anticipate currency-neutral organic sales growth of approximately 4% for the full year.

This growth rate does assume that a substantial portion of the estimated $15 million to $17 million of ERP-related sales disruption that we experienced during the second quarter is made up by the end of this year.

And while we are making progress with improving our productivity levels, we are also facing sizable increased demand for our blood typing and diabetes monitoring products that are manufactured in Europe. Obviously, increased demand is a good problem to have, but will also likely extend the time it takes for us to return to a more normalized state.

And finally, on top of the anticipated 4% organic sales growth, the inclusion of RainDance could add up to another 1% of sales growth for the full year.

Moving to the outlook for operating profit and margin for the remainder of the year and considering the sizable top line headwinds and acquisition-related expense in the first half of the year, it will be difficult for us to achieve our original goal of 7% operating margin on a reported basis for the full year 2017.

We are currently estimating the full year operating margin to be in the 6% to 6.5% sales range. Given the year-to-date margin of 2.3%, this revised target clearly anticipates a strong recovery of profitability in the second half of the year, albeit likely back-end loaded.

While the third quarter may continue to feel some growing pains during our transition to a new operating model, we anticipate that by the fourth quarter we will be able to greatly improve our productivity and shed much of the added expense we have been carrying in the first half of the year. And now, I will turn the call over to Norman Schwartz..

Thank you, Christine. So I just wanted to say, while the results for the quarter were obviously somewhat disappointing, I would emphasize that given the massive amount of change that we initiated in the second quarter, I think we have not done too badly.

We not only turned on our new global ERP system across major parts of Europe, we reorganized our legal entity structure in Europe, our European product distribution opened up a brand new distribution center here and moved to a shared service model. I think all allowing us to consolidate significant resources throughout the region.

As anticipated, we did experience some slowdown in fulfilling customer orders. However, from day one, we have been able to make product, take orders and ship to customers. And I do feel the team has done a remarkable job, and I'm confident that we will work through the challenges of this transition over the next few quarters.

I guess I would also say with this final major deployment behind us, we have almost 100% of our manufacturing and more than 65% of our sales on a single system. And as the dust settles, I think we certainly can begin to look to the benefits of the changes that we've made. So, Sherry, now I think we're happy to open it up for questions..

Thank you. Our first question comes from Brandon Couillard with Jefferies..

Thanks. Good afternoon..

Hey, Brandon..

I guess to kick off on ERP, could you give us a little more detail on, I guess, the dynamics in the quarter, whether this was a function of supply chain issues, your ability to source raw materials? Or whether it was really more delays in shipments to customers? I'm curious as to whether this dynamic perhaps it begins to normalize say exiting the quarter with most of the drag absorbed earlier in the period?.

Sure. So, gosh, Brandon. It's probably a little bit of everything. When you transition – this is an SAP system that helps you manage the business in a full end-to-end process. I think, for us, transitioning to a new system in production just naturally slows things down, and then the same in the warehouse itself in terms of fulfilling orders.

I don't think we hit any glitches in terms of how the system operates. But from the person on the phone taking the order to the person on the manufacturing plant floor making the product to then our new warehouses picking and packing and shipping, all in the face of pretty strong demand, just was a lot to get through in the quarter..

Yeah. Just to amplify that a little bit. I mean, you can imagine when you turn on a new program for the first time, or go through some kind of an upgrade personally, it takes time to learn the system. And if you've got thousands of transactions you're trying to accomplish every day, it just – things go slower.

And it's a bit like the old show in I Love Lucy where she's on the candy line and the candy keeps coming down the line. You have a little bit of that going on all around the organization. You've got a lot of new people in place with these shared service centers not only learning the system but learning the customers, learning the products.

And so it just takes a little time to work through it..

Fair enough.

Christine, in terms of the drag from the ERP productivity in the second quarter, any sense of when you would expect to recuperate those revenues between the third and fourth quarters?.

Yeah. It's a good question. Because we can see that we've already made progress in catching up on some of the backorders or the shipping. But at the same time there's a lot of new things coming out on the demand side and the new order side.

So that's why I don't think we're going to be able to make it all up in one quarter the way we did when we went live in North America. You may remember that the backorder we made up the following quarter after go-live. I think for us this is really going to take us through the fourth quarter.

Our goal is to get to that normalized state so that we can enter 2018 kind of firing on all cylinders..

Gotcha. One more for Christine. In the second quarter could you quantify the dollar impact from the process media business? The decline..

In terms of the decline year-over-year?.

Yeah..

I think it's about $8 million..

Okay.

And as far as the full year outlook goes, number one, could you give us a sense of what's embedded in guidance for the total costs that you're absorbing both from the ERP project as well as the other duplicative costs, number one? And then number two, in terms of the operating margin guidance, I believe your prior outlook for about 7% excluded RainDance, which I think is about a 50 basis point drag nut now it includes.

I just want to make sure that's the case..

That is the case. So in terms of what we're carrying this year, you just mentioned about $10 million of operating loss in RainDance and we did on top of that $10 million there was some charge in Q1.

But to the first part of your question in terms of the ERP spend or what we call ERP-related, meaning the folks working on the project as well as some of the backfill that we have throughout the organization so that our folks can focus on the project, for the full year of 2017 that's probably running in the $35 million to $40 million of expense for us.

And as we move into 2018, we expect that to go down.

Same is true for – I think when you asked about duplicate costs and that in the year, I think you're referring to some of this duplicate head count that we have because we were spinning up shared services, we're spinning up a new warehouse, but we're not able to, at least in the first half of the year, shut down that.

For 2017, that's probably $6 million of expense. A lot of that is front-end loaded, but again, hoping to shed that as we move into 2018..

Very good. Thank you..

Thank you. Our next question comes from Dan Leonard with Deutsche Bank..

Hey guys. This is Mike Sarcone on for Dan Leonard. Thanks for taking the questions. The first one, as it relates to that 4% organic growth, I know you said it assumes you recover a substantial portion of the revenues that were delayed from the ERP implementation.

Can you just comment on what type of visibility you have in terms of recouping those revenues?.

In terms of visibility, I mean, and this is a testament to the SAP system, we're able to see line-by-line what's going on in the business, both in terms of the impact as well as where we are in terms of the catch-up. So I think that we'll continue to monitor that and, as I said, we're making progress every day.

And demand in the market seems to be hanging in there around the world too. So all of that kind of contributes to our reiterating our original top line outlook of 4% organic growth rate..

Got it. That's helpful. And I know you said the European implementation was way larger than North America.

Did you guys have an internal forecast maybe or an expectation for what type of disruption you could see quantitatively? And if so, can you comment on what you actually did see in Q2 stacked up to that?.

So the answer to the first part of your question is, no, I don't think we had a financial outlook for the magnitude of the disruption. We certainly knew there would be disruption and we talked about it on the Q1 call in May. Because this is now our third major deployment, so we've experienced this before.

I think that the magnitude of the disruption is larger than we may have anticipated. But, as Norman said, we've been operating the business from day one and it really is just about keeping up pace of where we were before we went live and getting back to that level..

Okay. Thank you..

Thank you. Our next question comes from Tim Evans with Wells Fargo..

Hi. This is Sara Silverman on for Tim. I wanted to....

Hi, Sara..

Hi. I wanted to see – can you just talk about what you're seeing in the process chromatography media business given the slowdown this quarter? Kind of just curious about your commentary around what's going on there and what the trajectory is and when you kind of expect to see a recovery..

Well, this is a business that is very traditionally lumpy. This is a supply chain provision into the drug development market, and customers are very often buying for their own purposes as they decide to shore up safety stocks or run down stocks. So it's very hard for us to know exactly where things are going to land.

But this is really par for the course. We have a pretty long history with this business, and we're not terribly surprised by the ups and downs. We are sometimes surprised by the magnitudes..

Okay..

So I'm not saying that it forecasts a negative outlook for the business going forward, either. Perhaps that's worth saying too..

Yeah. And I think last year we saw customers stocking up, for lack of a better word, in terms of process media and the Biopharma production to market, and that makes for a really tough compare in the first half of the year. But certainly, the long-term outlook of the business, for us, remains very positive..

Okay. Thanks. That's helpful.

And then, kind of stepping back, bigger picture, can you help us a little bit on the bridge from kind of operating margin at the end of this year to kind of your stated goal of around 15%? Just if you're able to give us some sort of sense of how much of the improvement is kind of less investment in ERP versus cost savings improvements versus kind of sales growth on some of your less profitable assets, so far?.

Sure. So, Sara, I think you have the – you're identifying some of the correct budgets – or buckets of spend as we move forward. In terms of where does improvement come from, it is related to spend on the project.

It is related to some of these technology investments that we've been making for cell biology, for Droplet Digital PCR, et cetera, that those get up-righted as time goes on. And it's about the sales top line increasing and contributing to the bottom line. And it's about really extracting benefits of a more efficient model.

So with all of that as my setup, we are all very much looking forward to our Investor Day, which we will hold in New York the morning of November 28. And part of our goal at that meeting is to help give more color and detail around our bridge to our 2020 financial goal..

Okay. Great. Well, I guess I'll wait for that then. Thanks for taking my questions..

Absolutely..

Thank you. Speakers, I'm showing no further questions at this time. I'll turn the call back over to you for any additional remarks..

Can you poll one more time?.

We do have a question from Mike Sarcone with Deutsche Bank..

Hello. Dan Leonard here this time. We're hopping around with a few things.

So hoping to better understand, if you could educate me; how do you mitigate any competitive disruption or competitive impact with the customers? It sounds like you conditioned your customers to expect things like elongated delivery times in Q2, but things came in a bit worse than you planned.

So presumably, you have competitors that use that to their advantage. And what can you do to offset? Because you must think you're offsetting it if you're not changing the organic revenue growth guide and outlook..

Yeah. Well, in most of the business, especially in Europe, these are diagnostic customers with these technologies embedded in their labs. I mean, we did try to work with them closely. As you remember, we had a fair amount of pull-forward of orders and we've, obviously, we just try to stay very close to those customers.

You can never say that you're going to retain all of those customers. You've probably got the odd customer who gets fed up and the salesman walks in from a competitor, and you lose that business. And certainly, the same is true when other companies have disruptions or problems, and we try to be Johnny-on-the-spot, as well. So it goes back and forth.

But we have tried to stay very close to the customers and hold their hands throughout this entire process. And I was at the AACC the last few days and talking with some customers who – especially one large customer who had some issues, and we worked through that with them and they're certainly very happy now. So we can only try..

I think the other thing, Dan, to remember is most of the disruption was on the Diagnostics side of the business and related to large instruments that are already placed. These tend to be closed instruments. And while Norman says we are hand-holding, making sure all of our customers are happy, they're sticky customers..

Okay. Thank you for that color..

Thank you. I'm showing we do have a follow-up from Brandon Couillard with Jefferies..

Thanks. Christine, could you break out the year-over-year impact on, I guess, on the SG&A line from ERP expenses? You said it was up $6 million sequentially, but curious if you have the year-over-year number..

Probably up a little more than that on a year-over-year basis. Probably $7 million, $7.5 million, something like that..

Super.

And then I guess just to confirm, is it safe to say that despite the lower base profitability outcome for this year that your 2020 margin targets are still unchanged?.

Still unchanged..

Roger that. Thank you..

Thank you. I'm showing no further questions in the queue..

Okay. Thank you, everyone, for your interest and your participation today. And hopefully, we will see you in New York on November 28 for our Investor Day. Bye-bye..

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect, and have a wonderful day..