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

Brandon Couillard - Jefferies LLC Patrick Donnelly - Goldman Sachs & Co. LLC Jack Meehan - Barclays Capital, Inc. Dan Leonard - Deutsche Bank Securities, Inc..

Good day, and welcome to the Q3 2018 Bio-Rad Laboratories Conference Call. At this time, all participants are on a listen-only mode. Late, 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, Ron Hutton. You may begin..

Thank you, Twanda. 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 future financial performance, and other matters.

Because our actual results may differ materially from our 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 our risk factors in our business.

The company does not intend to update any forward-looking statements made during the call today. Our remarks today will also include references to non-GAAP net income and non-GAAP diluted income per share, which are financial measures that are not defined under generally accepted accounting principles.

Investors should review the reconciliation of these non-GAAP measures to the comparable GAAP results contained in our earnings release. 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. On the call today are Norman Schwartz, our CEO; Annette Tumolo, President of our Life Science Group; and John Hertia, President of our Clinical Diagnostics Group.

Today we will review our results on a GAAP basis and then provide some commentary and insight to our results on a non-GAAP basis. Net sales for the third quarter of 2018 were $545.1 million and growth of 2.1% versus the same period last year sales of $534.1 million. On a currency neutral basis, sales increased 3.4%.

During the quarter we experienced good demand across many of our key product lines with particular strength noted in the Americas and Asia-Pacific. When comparing to last year, remember that the third quarter of 2017 included an estimated $12 million of revenue that was recovered from the earlier ERP related disruption in Europe.

If we neutralized for those recovered sales as well as for approximately $6 million of sales that were pulled forward into the second quarter of this year, we estimate that currency neutral growth for the third quarter of 2008 was nearly 7%. Let's look at the segment performance a little closer.

Life Science sales in the third quarter were $206.6 million, an increase of 7.1% on a reported basis when compared to last year and growth of 8% on a currency neutral basis.

Much of the growth in the third quarter was driven by continued strong demand for our cell biology, digital PCR, western blot, and food safety products, all of which grew double digits. We also experienced another quarter of increased demand for our process media product line.

Life Science growth in the quarter was offset somewhat by the anticipated decrease in sales of RainDance products by approximately $4 million. On a geographic basis, Life Science experienced strong currency neutral sales growth, most particularly in the U.S. and China.

Sales of Clinical Diagnostics products in the quarter were $334 million compared to $338 million last year, a decline of 1.2% on a reported basis and up slightly on a currency neutral basis. During the quarter, we posted solid growth in the Americas, especially for blood typing and autoimmune testing products, as well as good growth in Asia-Pacific.

This geographic growth was offset by the expected decline in Europe. As many of you know, the third quarter was anticipated to be a very tough compare given the unusual ERP related patterns, I mentioned a moment ago.

Excluding this tough to compare scenario, we estimate that Diagnostics sales growth would have been approximately 5% for the third quarter. The reported gross margin for the third quarter was 52.6%, lower than our annual target and essentially flat with the second quarter gross margin.

The current quarter margin continued to be impacted by the product mix, high service, warranty and reagent rental costs, as well as additional inventory related expense. Amortization related to prior acquisitions recorded in cost of goods sold for the quarter was $4.7 million which compares to $4.9 million in the same period last year.

SG&A expenses for the third quarter were $201.2 million or 36.9% of sales, an improvement when compared to 37.1% last year. When compared to the second quarter of this year, the sequential decrease in spend is the result of lower employee related expenses, as well as a contingent consideration benefit of $4 million.

Total amortization related to acquisitions recorded in SG&A for the quarter was $1.8 million versus $2.4 million in the third quarter of last year. Research and development expense in Q3 was $49.2 million or 9% of sales.

When comparing to the third quarter of last year, remember that the year ago period included $7.6 million of one-time restructuring expense related to our GnuBIO project as well as a $3 million milestone accrual for the acquisition of our new flow cytometer. Going forward, we continue to target our annual R&D investment at 9% of sales.

Looking below the operating line, the change in fair market value of our holdings of equity securities added $318 million of income to our reported results for the quarter and it's substantially related to our holdings of ordinary and preferred shares of Sartorius.

Also during the quarter, interest and other income resulted in net other expense of $4.2 million compared to $8.2 million of expense last year. This improvement primarily reflects higher investment income as well as lower foreign exchange hedging cost versus last year.

The effective tax rate used during the third quarter was 23% and compares to 28% for the same period last year. This lower than expected tax rate was driven by the sizable gain related to our Sartorius investment as well as the benefit of tax reform in the U.S.

Excluding Sartorius and any discrete items that may occur during the year, we expect the full year effective tax rate to be in the 27% to 28% range. Reported net income for the third quarter was $269 million and diluted earnings per share for the quarter were $8.89.

This significant increase in net income and earnings per share versus last year substantially relates to the valuation of our Sartorius holdings.

With this change in accounting regulations for equities securities, coupled with multiple atypical events and charges, it is important to review the results in a manner more reflective of our base operation.

As we look to our results on a non-GAAP basis, we have excluded certain atypical and unique items that impacted both our gross and operating margins, as well as other income. These items are detailed in the reconciliation chart in our press release.

Looking at the non-GAAP results for the third quarter in cost of goods sold, we have excluded amortization of purchased intangibles of $4.7 million as well as restructuring costs of $410,000 related to the closure of our RainDance operation. These adjustments move the gross margin for the third quarter from 52.6% to 53.5%.

This non-GAAP margin compares to a non-GAAP margin in the third quarter of 2017 of 56.9%. In operating expense on a non-GAAP basis, we have excluded amortization of purchased intangibles of $1.8 million, legal related charges of $4.4 million, a net acquisition related benefit of $2.8 million and a small restructuring charge related to a prior action.

In R&D, we have adjusted the reported results to include $496,000 of expense which was reversed as part of the true-up of a prior restructuring accrual. The cumulative sum of these non-GAAP adjustments result in moving the operating margin for the third quarter of 2018 from 6.7% on a GAAP basis to 8.2% on a non-GAAP basis.

Despite a strong topline and relatively good operating expense control, the lower than expected gross margin in the quarter resulted in a non-GAAP operating margin below our expectation.

However, if we look year-to-date, the non-GAAP operating margin is 9.3% compared to 7.1% for the first nine months of 2017, representing good progress year-over-year.

We have also excluded certain items below the operating line which are, the quarterly increase in value of our equity holdings of $318 million as well as $220,000 of loss associated with venture investments that are recorded on the equity method of accounting.

With all of these various items in mind, we adjusted our tax provision for these exclusions resulting in a non-GAAP effective tax rate of 32%. This higher tax rate when compared to the non-GAAP rate of 27% in Q2 primarily reflects a change in our geographic mix of profitability.

And finally, non-GAAP net income and earnings per share for the third quarter of 2018 were $27.6 million and $0.91 per share compared to $30.7 million and $1.02 per share last year. Moving to the balance sheet, as of September 30, total cash and short term investments were $866 million compared to $761 million at the end of 2017.

We continue to make excellent progress on improving our cash flow. For the third quarter of 2018, net cash generated from operations was just over $62 million, which compares to $28 million in the year ago period.

Cash generated from operations in the first nine months of 2018 is $180 million and significantly exceeds the cash flow in all of last year. This positive result reflects improvement in both collections and inventory management as we continue to make progress toward optimizing our global operating model and system.

The adjusted EBITDA for the third quarter was $73 million or 13.4% of sale. Year-to-date adjusted EBITDA, which includes the Sartorius dividend paid during our second quarter, is $253 million, or 15.1% of sales.

This year-to-date adjusted EBITDA margin compares to 13.2% in the first nine months of last year nearly 200 basis points and $50 million of improvement year-over-year. Net capital expenditures for the quarter were $21.9 million.

Given the year-to-date CapEx spend of approximately $72 million, the full year expectation for CapEx will likely be at the low end of our forecasted $100 million to $110 million range. And finally, depreciation and amortization for the quarter was $34.8 million.

Moving to the outlook for the fourth quarter, we are pleased with the continued momentum on the topline. For Life Science, strong research funding around the world coupled with a good lineup of new products and technologies has fueled currency neutral growth of nearly 12% in the first nine months of the year.

In our Diagnostics group, while year-to-day currency neutral growth is around 3%, we have made solid inroads to the U.S. blood typing market and sales of our BioPlex 2200 instruments and assays continue to outpace the market. With all that being said, we are moving into our toughest compare of the year.

Remember that the fourth quarter of 2017 was a substantial record quarter for Bio-Rad with revenue exceeding $620 million. This compare will be especially difficult for our Life Science Group, remembering that the fourth quarter of last year grew at more than 12% fueled in part by the resurgence of growth for process media.

With that in mind, we would not be surprised to see a year-over-year decline in Life Science sales in Q4. While Diagnostics has less of a tough compare, we are still ramping our blood typing business in the U.S. and it takes time for the cumulative impact of reagent sales to move the needle.

And as we've talked about, we continue to face tough competition across many of our product lines. Knowing all these nuances, today, we are reiterating our guidance for full year revenue growth in the 4% to 4.5% range. This annual revenue growth target implies reported sales for the fourth quarter in the $595 million to $610 million range.

When thinking about our guidance for the full year operating margin, we must absorb the lower than expected gross margin recorded in the first nine months of the year.

As I mentioned earlier, this lower margin is the result of changes in product mix, a high level placements of blood typing instruments in the U.S., which incur significant costs in advance of the expected reagent revenue flow and inventory costs incurred as we continue to transition Europe to our new operating model.

While we believe the fourth quarter should show improvement in the margin closer to our historical level around 55%, it will not be enough to overcome the year-to-date results.

As such, and as we cautioned on the second quarter earnings call, we are revising our full year operating margin target to be in 8% to 9% range on a GAAP basis, which is down from our previous target of 10%, but still improved significantly when compared to the 2017 operating margin of 5.5%.

On a non-GAAP basis, we estimate the full year operating margins to be in the 9.5% to 10.5% range compared to the previous estimated margins on a non-GAAP basis of 11% to 11.5%. As has been our practice in prior years, we will share our thinking and outlook for 2019 in February during the fourth quarter earnings call.

And now, we are happy to take your question..

Our first question comes from the line of Brandon Couillard with Jefferies. Your line is open..

Thanks. Good afternoon..

Hi, Brandon..

Christine in terms of the gross margin in the third quarter, could you help us bridge the year-over-year decline in terms of the moving parts between the impact of the instrument placements, currency, the inventory charges? And then to confirm the operating margin guidance for the year, does that include the impact of FX, which I suspect has gotten much worse for you in terms of the full year guide.

Any chance you could quantify the effect of just currency in terms of the updated margin guidance for the year?.

Okay.

Well, in terms of what's impacting the gross margin between the various categories that I talked about, I'd say about half of the impact relates to mix if you will and the other half is really just added costs for either continuing to transition the European operations or cost associated with the upfront investment in these reagent rental placements.

And then as far as FX is concerned in terms of impact, it is true that it is becoming more and more of a negative impact and we do have nine months behind us and so that's part of the headwind that we face. I don't have a specific breakout, Brandon, as to how much is of the change in outlook is related to FX.

But let me see, if I can find it while we continue with the call..

Thanks. I'm just curious, given this is kind of like the third quarter that we've seen the heavy instrumentation placement mix that, I would have I guess suspected that some of the placements that took place in the first half the year would have been at least contributing or are starting to pull through reagent revenues from those.

Can you help us sort of understand sort of the ramp timelines with some of these blood typing instruments as well as the BioPlex 2200s and really as to – if there is something else going on beyond just the instrument mix, whether it might be COGS inflation or factory or ops issues?.

So let me answer a little bit of that and I certainly welcome John Hertia to pipe in. I don't want this to be interpreted that we've placed instruments and they're not generating any revenue.

They do indeed, after – about – it takes about 90 days to complete the installation and get the customer exempted (00:21:33) and then the reagent revenue starts to flow. I think that the difference is that the reagents are at a lower price and cumulatively, you need a lot of those to move the needle of a business as big as our blood typing business.

But nonetheless, certainly the instruments are beginning to produce revenue. The higher costs that we incur when you think about it as we're feeding the U.S. market, we are bearing the additional cost of bringing these instruments which are manufactured in Europe and the reagents as well into the U.S.

and placing them and taking on the initial warranty et cetera. Those – one is a true additional cost which we will continue to offset in other ways. And the other is timing, again, of just what it takes upfront as you initially install these versus the reagent flow later in the product life cycle.

So John Hertia, I don't know if you want to add anything of what you're seeing for the businesses blood typing or the BioPlex 2200 in the U.S.

and around the world?.

I think placements of both have been stronger than expected in the U.S. The ramp up time to reagents in the BioPlex is 60 to 90 days from the time they get the instrument to the time they're running the reagents.

It's a little longer for blood typing in some institutions where it could take three to up to six months to do all of the validation and cross validation of results before they come fully online simply because of the sensitivity of the results and the product line.

And so that ramp up takes a little bit longer but it's definitely beginning to kick in..

That's a good point..

Thanks. That's helpful. And then last one I guess, Christine, anything changed in your view with respect to your 2020 margin targets and your ability to reach those and how would you expect, I guess, the pace of that margin expansion to play out kind of over the next proceeding two years. Thank you..

Yeah. No, I think that's a great question, Brandon. And we're in the process right now of doing a very tight bottoms-up of our 2019 forecast. And we always do the out years as well. I really don't think that there is anything that we're seeing today that changes our target of hitting our 20% goal by the end of 2020.

I think clearly being shy of where we wanted the first year of that progression to be, puts a little more pressure on mining the benefits and the margin expansion in 2019 and 2020. But even with that being said, as John Hertia just pointed out, the pace that we're placing these instruments in the U.S.

is higher than we'd anticipated, but – that means the cost that we're bearing today is higher than we would have anticipated. But at the same time it bodes well for good margin business, higher margin business down the road.

The other factors that are part of our 2020 vision, the specific projects that we're working on and actions that we're taking beyond what's going on with the topline, those are still in place and those are still being worked on and we are starting to see the benefit of many of those and I guess you can see that more in cash flow than you can right now in our operating results.

But that's a long winded way for me to say, I think we're still targeting our 20%. I think we believe strongly in that goal. The trajectory is a little bit different in terms of how it rolls out than we would have originally anticipated, but everything, nonetheless, is still identified..

Thanks. That's very helpful. I'll leave it there and let some of the newbies jump in. Thank you..

And Norman, I don't know if you want to add any commentary to the 2020 outlook or not?.

No, obviously we're still working diligently to meet that plan. And we've got lots of irons in the fire there to make that happen..

Thank you. Our next question comes from the line of Patrick Donnelly with Goldman Sachs. Your line is open..

Great. Thanks for taking the question.

Christine, maybe just on the instrument placements, can you help us think about when gross margins reflect higher on these placements? I guess trying to get out when you currently feel like you're going to see that impact on a corporate level given the increased instrument placements relative to your expectations? Is this going to continue for another couple of quarters in terms of gross margin dilution? Or when do we see those reagent pull throughs really inflect on the gross margins?.

Yeah, Patrick, if I kind of pick up on John Hertia's comments from a moment ago much of the drag is related to feeding the U.S. blood typing market and that's bringing with it additional costs and the labs need to not only go through installation, but they have several validation and crossover studies that they need to complete.

And as John just said that can take 90 days, it can take up to six months. So while we do expect some recovery of the gross margin in Q4, I don't think that's really reflective yet of the cumulative impact of higher reagent revenue.

We're not prepared to talk about 2019 specifically but if we think about spending the full year of 2018 placing instruments in the U.S. and beginning to get those, help their labs with the validation and start that reagent stream, then as we move through 2019, I would expect that we would, on a corporate level, start to see the benefits of that.

So we'll have more specific insight on the fourth quarter call when we give our 2019 outlook..

Okay, that's helpful. And I guess when we think about – Brandon asked about the 2020 targets, you guys sound like you're still confident there.

I guess when we think about the progression, like you said, maybe the progression is going to be a little bit different starting on a little lower level here but are there things that, as the gross margins have kind of come in a little lighter than you expected, you now will pull forward some of these initiatives that you've talked about between procurement, facility consolidations, the ERP systems, costs coming down? Is there opportunity to move some of those costs forward to next year to kind of offset a little bit of this gross margin issue before it inflects higher, or what are your thoughts on that? How nimble can you be?.

So I think there are some things that we can pull forward. Other projects that – as Norman mentioned that we've been working on and identified, they kind of have their own timeline especially when you're dealing with changes in manufacturing in a regulated environment that just takes time, but that was kind of baked into the plan.

It will help that some of the temperament of the gross margin this year has been pretty situational not just with we've been talking about, for example, the U.S.

blood typing market, but situational with working through the optimization of our European operating model after tremendous change in 2017 and some of the charges that we've taken, especially the inventory-related charges, those obviously we don't anticipate to repeat. That's more situational, so that something easier to overcome.

It's not a change in course or practice or acceleration as you were asking about. But it also isn't something that would force us to have a course change. Maybe I've totally confused you.

Hello?.

Mr. Donnelly, your line is open.

Check to see if you are on mute?.

That's all right, Twanda. We can go on to the next question and then Patrick can get back in the queue if he has more – if he needs clarification..

All right. Our next question comes from the line of Jack Meehan of Barclays Capital. Your line is open..

Hi. Thanks. Without going overkill on the margin front, I did have one more on the gross margin. I was curious whether you considered anything one-time within the adjusted gross margins in the quarter. One of the things you talked about was the higher cost for service. I understand kind of the mix dynamic and whatnot.

But just curious whether there was anything else that would roll off as we move into 2019 on the gross margin front..

Yeah. So Jack, the only thing that would – to use your words one-time and maybe and I'll call it more situational, if you will, is we continue to kind of right size and optimize the inventory in Europe.

And there was as such probably another couple million dollars that we took a charge for in the third quarter and we had an even larger charge that we talked about on the Q2 call. It's not something that I'd be willing to non-GAAP out because it is part of running our business but it also though is a pretty specific identifiable event, if you will..

Maybe just from a management perspective, I was curious, Norman, is there any update in terms of the hiring process for a COO?.

Yes, we're actively looking at other candidates at the moment and we've got a fresh slate that's being developed and so we're continuing to work on that..

Great. And then maybe just from a revenue perspective, I thought the Life Science revenues looked pretty good in the quarter, seemed relatively broad based. The one I have to ask about is the process media.

What the level of contribution was there year-over-year and just how that might swing come the fourth quarter?.

So it's a good question. I think process media was up about $8 million year-over-year. As we move into the fourth quarter, I think we expect it to be down year-over-year because that will be their first kind of tough compare.

It was Q4 last year when it came roaring back and that's a little bit of the reason why despite another good quarter of topline growth we're keeping with that 4%, 4.5% outlook. The other thing I'd remind you of though is if we exclude the process media sales I think that Life Science still grew about 6.5%.

And really we shouldn't exclude all $8 million because we did, through the shutdown of our RainDance operation, see a year-over-year decrease of sales of about $4 million and that kind of offset some of that $8 million year-over-year..

Great. Final one if I can squeeze it in is I'd be curious, I'm down here in San Antonio at AMP, what the latest is for droplet digital in terms of getting some of the FDA approvals? I think one you've been working on with BCR-ABL just if there are any updates in terms of the timeline for having clinical test approved? Thank you..

This is Annette. I'll take that. So we have – we're in the submission process, so we are talking to the FDA all the time and I wish I had a crystal ball to know exactly when our clearance would come, but we expect it anytime. So we're continuing our regular dialogue with them on this process..

Thanks, Annette.

The watch continues?.

Yeah..

Our next question comes from the line of Dan Leonard with Deutsche Bank. Your line is open..

Thank you. A couple from me. So you talked at length about the better instrument placements than you had expected.

Can you help us at all put some framing around what that means for the revenue line going forward? And maybe this is a John Hertia question, is this something that lifts the Diagnostics business out of its low-single-digit trajectory into something higher in forward periods?.

So before John jumps in on that, I mean obviously we're not ready to talk about 2019 yet. But even with that, Dan, this is just one part of our business. We have several sizable businesses within Diagnostics, certainly within Life Science. And no single one of them is some big overwhelming needle mover if you will, everything is a contributor.

Certainly in terms of year-over-year growth, I think blood typing in the U.S. should be able to outpace the industry averages and the company averages and help move the needle. But it's just one of many opportunities that we have going forward. So I don't know, Dan, if that answers your question or what – if you're looking for something different..

I was looking for a little bit of framework but if – but I can leave it there. Secondly, Christine, I believe you went live with SAP in Italy, Spain, a couple of Nordic countries in Q3.

Can you comment on how that went?.

Yeah, no, thanks for asking. We did Southern Europe and the Nordics, went live at the beginning of July and it was a much less complicated implementation than the past because it was primarily commercial operations not the more complex manufacturing. I think so far so good.

The team was pretty well prepared not just with the deployment but those that were catching the ball. It is always does take time for people to get used to new processes and screens and systems and charts and you name it.

And so we'll continue to improve those, but I think we're pretty pleased at how well they were able to catch the ball and come right into the SAP world. A lot of lessons learned from the prior European deployments that we took advantage of..

Okay. Great. And then my final question on the buyback.

Did you buy back any stock in the quarter or do you plan to buy back any going forward? Just any update on the authorization that you announced a year ago?.

Sure. So as you probably know almost since the day we announced it we've kind of been in a blackout period. So we didn't buy any during the quarter. Though with that being said, I think we anticipate next week the trading window will open and it's not lost on us.

The movement in the share price and the value that's there, so we're discussing the buyback internally now, vis-à-vis potential execution..

Okay. Thank you..

Thank you. I'm showing no further questions at this time. I would now like to turn the call back over to Christine Tsingos for closing remarks..

Okay. Great. Well, thank you everyone for taking the time to join us today. We appreciate your interest in Bio-Rad, we appreciate your thoughtful questions and we look forward hopefully to seeing you soon. Bye-bye..

Ladies and gentlemen, that concludes today's call. Thank you for participating. You may now disconnect. Everyone have a wonderful day..