Avantor Inc

NYSE:AVTR

Earnings Call Transcript 2020-Q2

[Operator]

Ladies and gentlemen, thank you for standing by and welcome to the Avantor's Second Quarter 2020 Earnings Conference Call. [Operator Instructions]

I would now like to hand the conference over to Mr. Tommy Thomas. Thank you. Go ahead.

[Tommy Thomas, executive]

Thank you, operator, and good afternoon, everyone. Thank you for joining us on today's call. Our speakers today are Michael Stubblefield, President and Chief Executive Officer; and Tom Szlosek, Executive Vice President and Chief Financial Officer.

The press release and presentation accompanying this call are available on our investor website at ir.avantorsciences.com. A replay of this webcast will also be available on our website following this call.

Following our prepared remarks, we will open up the line for questions. I would like to note that we will be making some forward-looking statements within the meaning of the federal securities laws, including statements regarding events or developments that we believe or anticipate may occur in the future. These forward-looking statements are subject to a number of risks and uncertainties, including those set forth in our SEC filings.

Actual results might differ materially from any forward-looking statements that we make today. These forward-looking statements speak only as of the date that they are made, and we do not assume any obligation to update these forward-looking statements, whether as a result of new information, future events and developments or otherwise. This call will include a discussion of non-GAAP measures. A reconciliation of these non-GAAP measures can be found in the appendix of the presentation.

With that, I would now like to turn the call over to Michael. Michael?

[Michael Stubblefield, executive]

Thank you, Tommy, and thanks to all of you for joining us today for our second quarter earnings call. I'm starting on Slide 3 with a brief review of Avantor's revenue profile. You've heard me mention before that our business model is very resilient due to our diversified revenue base, combined with the customized nature of our solutions.

We are well positioned for continued growth in Europe and the Americas, and we are investing to expand our capabilities in emerging markets throughout Asia, the Middle East and Africa. More than 85% of our business is recurring and approximately half of our revenue comes from proprietary branded products and services.

No single customer represents more than 3% of our revenue and approximately 2/3 of our revenue is in attractive life science end markets, such as biopharma and healthcare. Our financial results for the second quarter, which I'll elaborate on in a moment, further substantiate our resiliency.

The second quarter was the first to be fully affected by the global COVID-19 pandemic. Our business was adversely impacted by lab closures across the R&D and academic landscape as well as by declines in elective procedures.

However, we were able to offset most of the headwinds with new COVID-19-related opportunities in diagnostic testing, vaccine and therapy development and clinical trial support.

Moving to Slide 4 and our second quarter business highlights. Despite the challenging environment resulting from the global pandemic, our dedication to our customers has not wavered. Our distribution, research and manufacturing sites have remained fully operational. Our broad customer access and extensive portfolio of products and workflow solutions to support patient testing, research and development, clinical trial services and ultimately, the production of approved treatments and vaccines make Avantor an important partner.

We are actively working with many of the world's leading pharmaceutical and biotech companies as they develop and test potential COVID-19 therapies and vaccines. Our comprehensive bioproduction portfolio is being leveraged in most of the leading COVID-19 vaccine candidates across all major technologies, including recombinant proteins, viral vectors, mRNA and DNA. Our direct involvement in government-sponsored initiatives, such as Operation Warp Speed in the United States, is another proof point of our relevance in the race to combat COVID-19. Of course, the health and safety of our associates who are working at our distribution, research and manufacturing sites remains a top priority.

We continue to comply with local statutes as well as guidelines from credible health agencies around personal protection, workplace density, symptom monitoring and symptom identification and reporting.

Our sales, customer service and support personnel continue to work from home throughout the quarter. We have carefully developed plans to return some of these associates to worksites and will begin to implement those plans in the third quarter as local conditions permit.

Our second quarter results reflect the power of our operating model in even the most challenging conditions. Reported organic revenue declined only 2%, including COVID-19 tailwinds of approximately 500 to 600 basis points.

Despite the organic revenue decline, the resiliency of our model enabled us to expand our adjusted EBITDA margins by 94 basis points, grow adjusted earnings per share of approximately 33% and continue our strong cash generation.

Earlier this month, we refinanced $2 billion of our high interest debt, which will result in cash interest savings of more than $90 million per year. As part of the refinancing, we also extended our liquidity by doubling the size of our revolving credit facility. Our improving balance sheet and favorable outlook resulted in another credit rating upgrade, giving us the opportunity over the next few quarters to further reduce interest costs by lowering the rates on the remaining $3 billion of debt.

Our mission drives our deep sense of purpose to create a better, more sustainable world, and our teams have been actively engaged on improving the transparency of our environmental, social and governance, or ESG reporting. We are pleased to have published our 2020 corporate social responsibility benchmark report and look forward to sharing more information about our ESG priorities in the coming months.

We've also taken a number of recent actions to reinforce our commitments to providing a positive work environment where all associates feel respected and have an equal opportunity to contribute and succeed. There is no place for racism, prejudice or hatred of any kind, and we're actively focused on making the company a role model for diversity, equity and inclusion.

Turning to Slide 5 of the presentation. I'd like to share a few financial highlights from the quarter. Organic revenue declined 2% as COVID-19-related headwinds in our education, healthcare and applied end markets more than offset continued high single-digit growth in our biopharma business, where demand continues to be strong globally, especially in bioproduction, where we realized more than 20% growth in the quarter. Included in our results are approximately 500 to 600 basis points of COVID-19-related tailwinds as we realized incremental revenue associated with higher sales of PPE, qPCR testing kits, qPCR reagents and consumables, serological test kits and proprietary materials being used to support vaccine and therapy development.

Adjusted EBITDA in the quarter was up approximately 3% on a constant currency basis, and adjusted earnings per share increased approximately 33% to $0.19 per share. We continue to generate strong cash flow with first half free cash flow up over $300 million from 2019, enabling continued reduction in our net leverage to 4.3x EBITDA, down from 4.6x at the beginning of the year. We remain committed to continue deleveraging as we approach our target leverage range of 2 to 4x EBITDA.

As I prepare to turn the line over to Tom to discuss the financials in more detail, I want to emphasize that Avantor's mission of setting science in motion to create a better world is more relevant now than ever before. And our second quarter and first half 2020 results are evidence of the mission-critical role we play in supporting our global customers. We are well positioned with a highly recurring revenue base, deep customer access, significant exposure to attractive end markets like biopharma and a strong culture of execution enabled by the Avantor Business System.

With that, let me turn it over to Tom.

[Thomas Szlosek, executive]

Thank you, Michael, and good afternoon. Let's start on Slide 6. Organic revenues declined 2% in the quarter, which, as Michael mentioned, includes the 500 to 600 basis point tailwind from COVID-19 related to PP&E, diagnostic testing, vaccine and therapy development and clinical trial support. These tailwinds were more than offset by the pandemic-driven headwinds, including in our education & government business, reflecting the widespread academic lab closures.

We also experienced impacts from commercial lab closures as well as declines in our healthcare business, reflecting temporary declines in elective surgical procedures and in our industrial businesses.

Looking at growth from a regional perspective. The Americas, which represents approximately 60% of global sales, reported 6.7% organic revenue decline in the quarter. The region sales were impacted by academic and commercial lab closures, fewer elective procedures performed by customers of our health care business and a broad reduction in sales of equipment and instrumentation.

Biopharma production and clinical services were bright spots for the Americas, each growing double digits. Europe, which represents approximately 35% of global sales, reported 3% organic revenue growth, driven by the strong performance in the biopharma and health care end markets, offset by COVID-19-related declines in the health care, education and industrial end markets.

The stronger second quarter growth rate in Europe versus the Americas reflects the lower exposure in Europe to academic labs and elective procedures and a higher participation rate in the COVID-related testing opportunities. EMEA, representing approximately 5% of global sales, reported an 18.2% organic revenue increase. Revenue growth was driven by the biopharma and advanced technology and applied materials end markets.

Slide 7 shows our organic revenue growth by end market and product group for the quarter. What is notable on this slide is the 2 areas where we achieved high single-digit growth in the quarter, the biopharma end market on the left side of the slide and the proprietary product group on the right side. These are our most significant and higher profit categories and their continued strength despite the overall modest sales decline was a big factor in the nearly 100 basis point expansion in adjusted EBITDA margins for the quarter.

Biopharma, representing approximately 50% of our revenue, once again experienced high single-digit organic revenue growth. Strength came from our biopharma production platform, including single-use solutions, production chemicals, personal protective equipment and clinical services.

Health care, which represents approximately 10% of our revenue, declined high single digits, impacted by a reduction in elective procedures and routine clinical diagnostics.

Education and government, representing approximately 15% of our revenue, experienced organic revenue declines of over 20%. This end market was impacted by the full or partial closure of academic and government research labs and K-12 schools for the majority of the quarter.

Advanced technologies & applied materials, representing approximately 25% of our revenue, experienced mid-single-digit organic revenue decline. Economic weakness impacted our industrial segments with modest offsets in our nonindustrial segment, including solid growth in the electronic materials business.

By product group, proprietary materials and consumables experienced high single-digit growth, with strength in the Americas and EMEA. Services and specialty procurement declined mid-single digits, impacted by lower demand for our specialty procurement services. Equipment and instrumentation was down midteens, reflecting CapEx investment declines across our customer base.

In July, the biopharma momentum has continued with strong growth in lab products and biopharma production. We are actively engaged with our supplier partners and customers on offering to support diagnostic testing, vaccine and therapy development and clinical trials. For the other end markets, the COVID-19 impacts we experienced in the second quarter have moderated slightly. Labs in the academic end market have slowly started to reopen. We also expect modest sequential improvement in health care as elective procedures slowly resume.

The industrial portion of the advanced technologies & applied materials end market also continues to see modest improvement. Considering these factors, we expect July's revenues to be approximately flat or grow low single digits versus 2019. However, given the ongoing uncertainties around the intensity and duration of the pandemic, we will continue to refrain from issuing guidance.

Turning to Slide 8. Let me start with our second quarter adjusted EBITDA. Excluding foreign exchange, we achieved 3% growth in adjusted EBITDA and 94 basis points of reported margin expansion. Key drivers of the performance were commercial excellence, favorable mix, including strong growth in biopharma production and proprietary offerings, productivity and continued discretionary cost containment. Free cash flow improved nearly $100 million to $76 million, reflecting stronger adjusted EBITDA, better working capital performance and lower interest and tax payments. First half free cash flow generation of $316 million, or 136% of adjusted net income, was 7x the prior year amount. We are on track to achieve or beat our original full year free cash flow guidance of $450 million to $500 million, recognizing that guidance has since been withdrawn.

Finally, we reported approximately 33% growth in our adjusted earnings per share for the quarter, primarily reflecting strong operating performance, the ongoing reduction in interest expense from our deleveraging and the improvement in our income tax rate.

For the first half of 2020, we grew our adjusted earnings per share 46% to $0.36 per share.

Slide 9 has our segment results. Americas reported 210 basis points of improvement in adjusted EBITDA. Key drivers include commercial excellence, favorable mix, driven by a higher proportion of growth in proprietary materials and consumables, productivity and strong discretionary cost containment. The first half 2020 adjusted EBITDA margin expanded 90 basis points. Europe reported 120 basis points of improvement in adjusted EBITDA. Key drivers include volume growth, commercial excellence, favorable mix, productivity and strong discretionary cost containment. First half 2020 adjusted EBITDA margin expanded 80 basis points. EMEA reported 330 basis points of improvement in adjusted EBITDA. Key drivers include volume growth and favorable mix. First half 2020 adjusted EBITDA margins declined 60 basis points.

Let me move to Slide 10. In this environment, we occasionally receive questions regarding liquidity. Like we did in the first quarter, we are providing a brief summary of our liquidity. You see on the left half of the slide our liquidity as of December 31, 2019 and at June 30, 2020. The June numbers are shown on a pro forma basis to reflect the July refinancing. As part of the refinancing, we more than doubled the size of our revolving credit facility to $515 million. Recall that in the first quarter of 2020, we expanded our receivable securitization line by $50 million.

These facility enhancements and the continued free cash flow generation of the business have enabled a greater than 70% increase in our overall liquidity to $1.037 billion roughly 100% of our adjusted EBITDA, which is in line with our peer group. Both of these facilities remain undrawn. We have no significant debt maturities, and we have a CapEx-light business model.

To summarize, our liquidity and cash flow continue to get even stronger, and we are committed to deleveraging even in these challenging market conditions. Since the beginning of the year, we have reduced leverage from 4.6x EBITDA to 4.3x.

I'm now on Slide 11, which summarizes our July debt refinancing. We recently received approval from our Board to execute a comprehensive strategy to lower the cost of our $5 billion debt portfolio while preserving the existing covenant-light and minimal principal service requirement features. This is a continuation of our move toward an investment-grade capital structure, typical of a large-cap public company. After the first 6 to 8 weeks of the pandemic, the high-yield debt markets began to turn in our favor. Shortly after the July 4 holiday, we launched a $1 billion U.S. debt offering and a EUR 400 million debt offering to replace, in part, the $2 billion 9% unsecured notes that were issued as part of the VWR acquisition in 2017. Each of the tranches offered was significantly oversubscribed, and we're able to upsize the U.S. dollar piece, allowing us to replace the entire $2 billion in unsecured notes, and achieve a composite coupon rate of less than 4.5%. This refinancing will generate close to $90 million of interest savings per year and results in a lowering of the weighted average cost of our entire debt portfolio by approximately 180 basis points.

We incurred approximately $180 million in onetime cash costs, which will be recovered within 2 years under the new financing. In the third quarter, there will be a onetime charge to reflect the costs incurred on the early extinguishment of the 9% unsecured notes.

We continue to monitor the remaining $3 billion of the debt portfolio for refinancing opportunities.

On Page 14 of the appendix, you can see that there are some additional costly pieces of debt remaining in that $3 billion that we are eager to address, depending on the conditions of the pro rata and leverage loan markets.

With that, I will hand it back over to Michael.

[Michael Stubblefield, executive]

Thanks, Tom. I'm on Slide 12. We executed well in a challenging environment, and our top line performance, strong EBITDA growth, outstanding cash generation and continued deleveraging reflect the resiliency of our business model. Our ability to complete a debt refinancing in a challenging time like this highlights the value of our highly recurring revenue base, broad mission-critical product portfolio and exposure to attractive end markets like biopharma. While the uncertainty associated with the current pandemic continues to make forecasting difficult for parts of our business, our long-term growth strategy remains intact. And we are steadfast in our commitment to help our customers combat this coronavirus by supporting ongoing initiatives in testing, vaccine and therapy development and ultimately in the production of approved treatments.

Our mission of setting science in motion to create a better world has never mattered more. I want to sincerely thank you for your interest and investment in Avantor and for your ongoing support. I will now turn it over to the operator to begin the question-and-answer portion of our call.

Operator?

[Operator]

[Operator Instructions] And our first question comes from Tycho with JPMorgan.

[Tycho Peterson, analyst]

Michael, the 500 to 600 basis points COVID tailwind for this quarter. Can you just talk about where that's coming relative to the 50 to 100 basis points last quarter? Is it incremental products? Can you just provide a little bit more color on what's driving the step-up?

[Michael Stubblefield, executive]

Yes. Tycho, thanks for the question. We're getting some tailwinds across a few areas. We continue to see strong demand for PPE, which our supply chain on that particular area is indeed constrained, and we're not able to satisfy all the demand that's coming our way, but you're seeing some contribution from incremental PPE sales. But the bigger tailwinds are actually coming from the work we're doing to support COVID testing as well as vaccine and therapy development. We're pretty deeply engaged in providing a large number of materials across the entire qPCR workflow as well as the lateral flow serological tests. And our proprietary materials portfolio is being broadly used in the process development of the various vaccines across all 4 of the major technologies that are in the front-running the chase for a cure here. So pretty well positioned across that space. And we're giving -- we've got quite a lot of traction in the second quarter in those areas.

[Tycho Peterson, analyst]

And then a follow-up just on EBITDA margins. Obviously, nice improvement despite the top line this quarter. Can you just talk a little bit about the levers? How much of this was VWR synergy versus other factors and sustainability going forward?

[Thomas Szlosek, executive]

Yes. Tycho, it's Tom. I'll take that one. The -- when we look at the 94 basis points, it was a combination of factors. I think the more significant ones continue to be the mix dynamic that we talked about. Of course, in the quarter, we had lower instrumentation, equipment sales and other specialty equipment sales that -- and in replacement, we had better sales in some of our higher-margin offerings. Michael mentioned a few of them, particularly in biopharma production side. So that was a definite tailwind for us. We also continue to do a really good job of managing the price versus COGS inflation dynamic and got a bit of tailwind there.

And I'd say the third thing is just overall productivity, including discretionary cost control. I mean, obviously, nobody is traveling, so that helped us. But there are a number of other discretionary categories that we've been pretty careful with across the landscape. So I'd say those are the biggest drivers.

[Operator]

And our next question comes from Derik with Bank of America.

[Derik De Bruin, analyst]

So I just was wondering, when we looked at your -- compared the first quarter to the second quarter results and Americas was a little bit stronger in the first quarter, a little bit softer in the second quarter. Were there any -- I guess, were there any stocking or pull forwards in that? I'm just sort of thinking about the dynamics between the 2 because this is a question I asked last quarter. I just wondered if you had any further color on it. And this obviously leads into the question of how should we think about the Americas and Europe split as we head into the third quarter?

[Michael Stubblefield, executive]

Yes. Thanks, Derik. When you look at the performance in the Americas in the first quarter compared to the second quarter, you'll know that there was only probably the last 10 days or so of the first quarter where we were really starting to see any impact of the pandemic hit the Americas. It obviously first started in Asia, spread to Europe and was last showing up here. So we had relatively modest impacts, plus or minus in the quarter -- in the first quarter in the Americas, with the most significant impact being felt in the education, the higher ed space.

Moving into the second quarter, obviously, we have the full weight of the pandemic hitting our numbers for the quarter, with April clearly being the low point with significant headwinds, with more than half of the lab work in the university space offline, the slowdown in elective procedures. And just, I would say, routine clinical diagnostics falling off. And then you also had a more modest impact to biopharma R&D capacity in the quarter as well. So I don't think we would look at inventory as a driver of the comparison. I think the bigger issue is just the amount of the first quarter that was exposed to the pandemic relative to kind of the full weight of it hitting in April.

[Derik De Bruin, analyst]

And so a follow-up -- and just a follow-up on that. When you look at your July trends and you talked about a modest improvement in the base, but what about some of the tailwinds that you saw? That 500 to 600 basis points of COVID tail in 2Q, is that something -- a similar level we should expect in the third quarter?

[Michael Stubblefield, executive]

Yes. When you look at the categories we outlined for Tycho around where we're seeing tailwinds, whether it be PPE or testing or vaccine therapy development, we're also doing a fair bit of support through our clinical trial services business in supporting the trials associated with the vaccine development. We've certainly seen each of those categories carry over with some strength into July.

[Derik De Bruin, analyst]

But no comment on whether or not it's too early to know whether or not it's going to be the same magnitude? I'm just thinking about what some of the other companies reported. The organic revenue growth number has been a lot higher for the COVID tail than we would have thought.

[Michael Stubblefield, executive]

Right. Yes. I mean, in July, I think we've seen probably similar magnitude. I mean you obviously see escalation on the number of tests that are being conducted around the country. And as we go forward each day, you see a lot of these vaccines now starting to progress towards late-stage clinical trials, which is driving more demand and more volume. So -- and it appears that certainly, those fundamentals will be with us for the foreseeable future.

[Thomas Szlosek, executive]

Yes. I mean that safety category is we're on allocation with our customers and suppliers. So there continues to be significant demand there. Michael mentioned that as one of the factors. And like you said, on the biopharma production side as well where we saw some good tailwinds, our backlog or open orders is very, very strong.

It's up significantly. So we're continuing to see the demand pulls in those tailwind areas that you mentioned.

[Derik De Bruin, analyst]

Great. And then just one housekeeping. FX hit to the top line for 3Q and the full year?

[Thomas Szlosek, executive]

Yes. Well, I mean, it's kind of tough with the way the FX rates have moved in the last 2 weeks. So we're continuing to look at it just on an organic basis and we try and normalize that. Derik, maybe we can do some follow-up on that. But right now, the situation is a bit volatile. So it's tough for us to predict exactly what the FX impact is going to be for the full quarter when we're not giving guidance on the full quarter.

[Operator]

And our next question comes from Vijay with Evercore ISI.

[Vijay Kumar, analyst]

Congrats on the solid execution here. Mike, maybe a big picture one for you. The July guidance of -- well, maybe not guidance, but I guess, expectation for flat to up rates. Does that include the, I guess, the COVID tailwinds or is that flat to up low singles after the base business? And I'm curious, you made some comments around vaccine. Are we now at a time point where you could perhaps play in the longer-term opportunity within industry [indiscernible] what COVID vaccine could mean?

[Michael Stubblefield, executive]

Yes, Vijay, thanks for joining the call tonight. On your first question regarding the quarter and July specifically. Trying to give you a flavor here of recognizing we haven't quite completed the month of July yet. Just trying to give you some color on how we see things finishing up here as we sit here with a couple of days to go. And we're somewhere in that flat to up low single digits, and that will be inclusive of any of the tailwinds that we're seeing in the business.

On your second question about just where we're at with these vaccines and is it too early to start to frame in potential impact. It certainly is a little bit premature, but it's moving quickly. When you look at the frontrunners and even some of the second runners that are moving forward, you see a lot of promise across recombinant vaccines, viral vector vaccines, DNA vaccines and then the Moderna mRNA vaccine and together with Pfizer. And when you look at our portfolio, within bioproduction, we're going to be relevant across all 4 of these areas, Vijay.

And as I mentioned in the prepared remarks, we're working on all the major programs that are out there. And certainly, being pulled into a lot of the activity and planning by the various governments around the world that are following these things as well. So we're right in the thick of things with -- in doing all we can to support our customers in this.

When you start to look at the impact that one of these vaccines could have, there's obviously a number of factors that play into this, including the number of doses that an individual patient needs to be given in order for it to be effective. How many patients are we looking to the treat? Is it 1 billion? Is it 7 billion? Which technology?

The addressable market, as we look at it, is highly dependent on which one of these therapies ultimately prevails. And on the low end, you could be looking at adding tens of percents to our addressable market for bioproduction. And on the high end, Vijay, you could be looking at doubling our addressable market or -- and then some in bioproduction.

So pretty wide range of potential outcomes here. And I think that will start to clarify here over the next few months as we start to get some feedback from these Phase III clinical trials, and we start to hone in on which one of these vaccines or which ones of these vaccines will make it to market first, but we're definitely going to be relevant here. It will have an impact in a pretty broad range at the moment. But I think we're optimistic about the role that we're playing here.

[Vijay Kumar, analyst]

And then Tom, one last quick question for you. That's a monster number. I'm just curious. Are there any [ one-offs ] in the timing-related elements that's impacting your free cash flow? What's driving it? I mean does the debt refinancing, does that improve, aid the free cash flow here?

[Thomas Szlosek, executive]

Yes. I mean, thanks for the question, Vijay. You're breaking up a little bit. But relative to the first quarter and second, I mean, if you combine the first half, very strong. And as you pointed out, I mean, we're over $300 million -- we're about $320 million of free cash flow through the first half. Our original guidance was $450 million to $500 million. So we're at that 60% point of the high end, as you mentioned. And the performance has been, so far, driven by better performance on working capital, certainly. And as we've gone into the second quarter and look forward to the third and fourth quarter, we've got some other tailwinds that have emerged. I mean certainly, the refinancing is helping us when we've lowered our interest bill significantly on a run rate basis for a full year by $90 million. So we should see somewhere on order of a little less than half of that in the second half alone.

We're doing a lot better than we had expected on tax through a combination of both the CARES Act provisions that have helped the deductibility of our interest costs for both 2020 and 2019. And we've done well on managing risks on some refund applications and those should be coming through as well. So tax will be -- continue to be a really good driver for the second half. So we're really optimistic we can continue the momentum. So if you were kind of looking at the second half and if we were able to maintain a reasonable level of the flat to low single-digit growth that we're talking about in July, I mean, if you could keep that going, you would be looking at doubling the amount of cash for the full year on this basis. Now we have to continue to manage working capital like we have. But if we do that and the other pieces are falling into place nicely, then we should continue the momentum.

[Operator]

And our next question comes from Doug with Cowen.

[Doug Schenkel, analyst]

Just starting as a follow-up to what I think was Vijay's first question on vaccines. It sounds like it's just too early for you guys at this point to quantify in dollar terms what the vaccine opportunity might be, just given all the moving parts, all the unknowns. That said, would you be willing to confirm that you believe vaccine production will drive an either -- even further acceleration of growth within your bioproduction business versus already robust recent trends given the things you're just getting going there? At this point, it seems to us that bioproduction could keep growing more than 20% year-over-year for the next several -- maybe next year or maybe even longer.

I just want to make sure we're thinking about it right.

[Michael Stubblefield, executive]

Yes, Doug. Thanks for the question. Yes, I think, generally, you're thinking about it correctly. When you look at the tailwinds that we've seen in the second quarter within the vaccine area, you got to keep in mind, most of that is or all of that is within just the process development and early phase clinical trial support, which you're talking relatively modest number of doses that we're supporting. And just given the breadth of our coverage here, the number of programs we're going to have exposure to most of the nearly 200 programs that are out there across the main technologies that are coming through here, I think it is reasonable to assume that when one of these hits or whichever one ultimately comes through, that it will have a meaningful impact on the business.

When you look at our open order report, for example, and Tom referenced it, but since the pandemic hit, our open orders, as we sit here today, are up more than 40% and growing. And so we're seeing a tremendous pickup in the business. We drove more than 20% growth in the quarter, and I think we see that certainly continuing through July. And when you look at the strength in the order book, I think we're optimistic about where this is headed.

[Doug Schenkel, analyst]

Okay. That is super helpful. And then moving down the P&L. Gross margin increased 120 basis points year-over-year in the quarter, as you know. How much of the increase was driven by higher proprietary product mix? And then looking to the second half, assuming bioproduction and your other proprietary products continue outperforming and then just layering in the fact that, again, bioproduction is higher margin, is 33% a reasonable floor? Or is that even too low as for the rest of the year?

[Michael Stubblefield, executive]

Yes. A couple of things at work here. Certainly, within the quarter, the strength of the growth of our proprietary materials, high single digits was a significant contributor to the margin expansion we didn't see in the quarter. It was also aided by -- when you look at the headwinds in our business, primarily focused on some of the lower margin components of our portfolio, including our equipment and instrumentation offering as well as our services platform. And so you're getting the kind of the double benefit there of really strong growth in the part of our business that carries the highest margins and that the headwinds were primarily concentrated in the lower margin part of our business.

We expect to continue to see strength in the proprietary offering within the portfolio, which will carry the margins with it. I think one thing to keep in mind, though, is as we see sequential improvement in, say, the education market, in the health care market and some of our applied markets, where you see a more normalized product mix, you will start to bring back in some of the lower margin components of our portfolio, which will somewhat moderate the strength that we're seeing in the proprietary offering.

[Thomas Szlosek, executive]

Yes. And you'll also get, Doug, some -- at some point, we get beyond this, return to some of those discretionary costs that we need to reinvest in here, people will come back and be able to -- want to see customers and incur a little bit of T&E. So that will be a factor we need to consider as we move forward as well.

[Doug Schenkel, analyst]

Okay. And Tom, if I could just sneak in one last one. Congrats on the refinancing your highest cost cut. As you know, you still have a $1.5 billion slug of debt at 6%, well above where you recently refinanced. Why wouldn't you refinance that debt as well over the next 6 months or so? And to be clear along those lines, does 2020 and 2021 interest expense guidance assume any incremental refis?

[Thomas Szlosek, executive]

Right. First question -- or second question first. No incremental refi benefit in what we have laid out in the chart on interest expense going forward. On your first question, really, when we set out to reconsider our capital structure, we -- when we got into COVID, we were really melancholic about the impact that the rates were having. The high-yield rates were, instead of improving, they were approaching 7% or 8% on the debt. And so we just took a pause. But over time, that -- just the high-yield piece of the market seem to improve in our favor. We work with our partners. They did a great job of helping us execute. And yes, that was a good outcome. As for the rest, you're accessing other parts of the debt market, which have not yet returned to pre-COVID levels and are starting to moderate, but it's going to take some time.

It, clearly, is our intention to work with our treasury team and the same set of advisers to get us to a point where we're in a position to do something on those higher cost pieces of debt. The exact time frame remains to be seen. It's really going to be market-driven. I will say that when we looked and we reviewed the entire debt portfolio with our Board and talked about the potential benefits that we saw from refinancing, I would say more than 2/3 of the benefit was in the unsecureds, which we've done.

And so I'm not -- I don't want to hold out that we're going to be able to generate another $90 million of annual savings. It will be meaningful. But I think we got the bulk of it with the first piece here. And we'll continue, to your point, over the next 6 months, maybe sooner to address the other parts of the debt as well.

[Operator]

[Operator Instructions] Our next question comes from Jack with Nephron Research.

[Jack Meehan, analyst]

I was hoping you could comment a little bit more on what you're expecting in terms of the pace of academic and government and lab reopenings in the second half. And I think you're probably one of the companies that calls out K-12 exposure historically. Just maybe help us quantify whether you have a little bit of what that represents and how that might be impacted from COVID-19 specifically?

[Michael Stubblefield, executive]

Yes, Jack, happy to take the question on that. Obviously, the academic market for us has probably been the hardest hit of any of our end markets as the pandemic played out. And as we look at it, it probably hit a low point in April with -- I think you can probably see a lot of the same publicly available information that we follow. But there was probably less than 20% of the scientific capacity at the bench at that time. And we saw incremental improvements as we move through the quarter. And we've seen a steady progression through the month of July as well, not fully back yet, I would say.

And we track a couple of things. We track not only just the number of labs that are open, but we try to take a read on how much of the capacity in the lab is being used. And I think we're encouraged by some of the creativity that our customers are deploying there with implementing shift schedules and such to be able to get more of their scientists back in the labs. We're obviously supporting our customer restarts and talking about how they're going to continue to progress.

I think I would make one point here. It does feel like the return of scientists to the bench will be a separate activity from whether or not students come back to a campus in the fall and I think we're encouraged that our original assumptions that, that would happen do seem to be playing out. So our numbers in Europe, for example, I think are a little bit ahead of where we're at in the U.S., just given the timing of recovery there. And I think we're really encouraged by the momentum we have in Europe. And I think we're certainly not back at full run rates in the Americas, but certainly, things are continuing to improve week by week there.

[Jack Meehan, analyst]

Great. And then, I guess, with the combination of the refinancing which took place, and the outlook seems to be a little brighter today, does it change the way you think about the pace of M&A? And maybe just give us an update on how progress has been building out the strategic development team?

[Michael Stubblefield, executive]

Yes, it's a great question. We've been focused and continue to be focused as a priority of taking our leverage into kind of the target range of 2 to 4x, and we're getting very close knowing that M&A isn't necessarily a linear event. We -- kind of at the end of last year, early in the first quarter, started to rebuild our team, put in place all of our processes and cadence and rhythm with our Board. And we have been active throughout the year in building a pipeline, engaging in a number of discussions, and we continue to be active in that regard.

Certainly, the acceleration of cash flow and the strength of our cash flow generation is encouraging. And when you look at the outlook for cash flow generation, taking into account the improvements that we're making in the business and particularly the financing costs, and we think we are well positioned to start to turn this part of our growth strategy on.

Now having said that, we'll be disciplined about it. And I think we're really focused on bringing in more proprietary technologies. We're very focused on looking at ways of strengthening our bioproduction offering, looking at ways of strengthening our life sciences portfolio within our lab workflows. And yes, we'll continue to be opportunistic about extending our capabilities into Asia. So I think the filter is pretty clear that we're applying. And as we sit here at the end of July, certainly the size of the funnel and sophistication of the funnel is certainly far greater than it was, say, when we spoke 90 days ago. And so it's getting a lot of our attention and we're anxious to put capital to work in that area.

[Thomas Szlosek, executive]

Yes. The one thing I'd mention on that, Jack, I mean going back to the refinancing. I mean that has moved our weighted average cost of capital, which obviously is a factor in our M&A consideration.

I think that will make us more competitive in the way we pursue some of these deals.

[Operator]

And our next question comes from Patrick with Citi.

[Patrick Donnelly, analyst]

Maybe just one on the industrial market trends. Just curious in terms of what you guys are seeing there on the more macro sensitive areas, your confidence in the outlook going forward. It seems like sentiments bottomed a bit in 2Q and then maybe we're on the way back up. But wondering what you guys are hearing from the customer base there and the visibility for the next couple of quarters.

[Michael Stubblefield, executive]

Yes. It's a good question, something that we've been focused on. I think when you look at our applied markets, as we've said before, it's roughly 25% of our business. Half of it is pretty sensitive to the macro environment. And so as you suggest, as we've seen the recession hit, that part of the portfolio has certainly been impacted the most and certainly off double digits.

The other half of that end market is in more kind of defensive growth-oriented applications, probably headlined by our exposure to the semiconductor space, which we play in a relatively unique way, and we continue to see nice growth momentum in that end market. But in things like oil and gas and petchem that were really hardest hit by the pandemic, we do see some modest recovery starting to come back into the business. And I think when you look at platform as a whole, given the depths of the pandemic and the recession to have the platform off mid-single digits in the quarter, I do think it highlights just how diversified that part of our business is and how many levers there are to kind of keep that moving towards a positive direction. So I think we're encouraged by some of the factors we're seeing. Still, I think, net-net, we're probably still experiencing some headwinds in the month of July, but are hopeful that we'll see the trend continue.

[Patrick Donnelly, analyst]

Makes sense. And then maybe one for Tom, just on the margin side. Certainly encouraging the progress so far. Along with the internal initiatives you guys are doing, can you just help us think about the mix shift going forward? Again, things like vaccines have obviously been highlighted quite a bit here tonight. What's the mix look like as you look out a couple of quarters? Is that going to continue to trend higher on the margin side?

[Thomas Szlosek, executive]

Yes. I mean, I guess, if I knew the specifics to that, I would probably give you guidance. Not to be a smug, Patrick. But the dynamics that we've had in this quarter have helped to drive a good portion of that, the EBITDA improvement. And it is a combination of the growth in like the 20% growth in areas like biopharma production. But it's also helped by a moderation on equipment and instrumentation like you're seeing in that landscape across the tools sector. And to the extent that starts to revitalize in the second half, third quarter, fourth quarter, that will moderate the margin expansion that we get from -- that we continue to benefit from in these higher growth areas we've talked about. So it's a tough balance to call right now because it is a significant impact. And we'll continue to watch it and continue to keep you up to date on it.

[Operator]

And our next question comes from Brandon with Jefferies.

[S. Brandon Couillard, analyst]

Mike, back on the bioproduction business. Are you capacity constrained there at all? Or are you seeing any areas where maybe you got competitors that are seeing out of stocks and you've been able to actually capture some share?

[Michael Stubblefield, executive]

Yes, Brandon. Thanks for the question. Within the bioproduction space, we do have a relatively broad and unique offering. And as we sit here today, supporting the clinical trial work, I think we're doing a pretty good job keeping up with really unprecedented demand that we're seeing in the business. I think where we spend our time on this topic, Brandon, is trying to project forward and obviously, it's a pretty complex equation. When you look at the number of programs that are in-flight that we're working on, all different technologies and each leveraging certain portions of our portfolio, But as an industry, we're facing really unprecedented potential demand, if you think about trying to provide a vaccine for the globe.

But at least as we sit here at the moment with what we know, appears that it's not going to be 1 dose per patient, but it looks like it's trending towards multiple doses and probably annually.

So I think capacity is definitely going to be an issue for the industry as things start to move into commercial production across various elements. And I think we're all trying to figure out how you prioritize those bottlenecks and how you can get creative and bringing capacity to the market to support as much production as possible.

So I probably wouldn't look at it so much in terms of near-term market share gain. I think the way we think about it is probably looking ahead at where the bottlenecks inevitably going to be for all of us. Just given the volumes that we're talking about here, it is going to stress the manufacturing capabilities and we're going to have to be pretty creative in how we debottleneck and how quickly we can make the capacity available.

[S. Brandon Couillard, analyst]

A follow-up for Tom. In terms of the COVID tailwinds of 5% to 6% in the second quarter. I'm curious if the exit rate in June was actually higher than that, if that scaled up through the quarter. And any chance you could share with us the impact of those tailwinds by geography between Americas and Europe, quantify those specifically?

[Thomas Szlosek, executive]

Yes. I mean the -- I would just say, overall, our exit rates were positive in June relative to the entire quarter. And that probably was a combination of both further progress on the tailwinds as well as slight moderation on the headwinds. I think as we head into July, that positive momentum on the exit rates continues.

And I think, as Michael said earlier, the mix of the tailwinds right now, I mean, obviously, were not closed, but the mix of that tailwind looks like it should follow a similar pace that we had in the second quarter.

Relative to the mix of the tailwinds amongst the regions, a little bit heavier in Europe, as you saw in the growth rate that we had there. But I wouldn't say it was a material part of the growth differential. I think we were dealing more with the headwinds and the significance of the headwinds in the Americas being more pronounced. With the concentration of -- higher concentration of academic and education in the Americas, which was obviously a headwind as well as higher concentration of our biomaterials business here in the health care space in the Americas.

[Operator]

And our next question comes from Dan with UBS.

[Daniel Brennan, analyst]

I joined a little late, but I kind of got the notes. I'm just wondering, I know there's no guidance for Q3 or the back half. But is it possible to give us a sense? And then you gave a lot of color on July trends and exit rates. But given the repeatability, durability, consumer orientation of your kind of the consumable orientation of your business, I'm wondering if it's possible to even give us some flavor for a range or maybe help a little bit more on thinking through kind of an expectation for Q3.

[Thomas Szlosek, executive]

Yes. Thanks, Dan. The -- as Michael was alluding and as we said in our prepared remarks, the exit rates in June have continued and have accelerated into July. And I think we're being reasonable with saying flat to low single-digit growth, and I really wouldn't want to go beyond that point in terms of forecasting August and September. I mean, you've got a number of variables that work beyond just COVID, including seasonal vacations and shutdowns and things like that. We're not clear entirely how those will play out in this kind of environment.

So I think the variables around the duration and the extent, particularly when you consider some of the things that we're reading about, make it difficult for us to talk about the demand patterns beyond what's right in front of us. We're a low backlog kind of business, putting aside biopharma production business. So most of it turns around in 24 to 48 hours from the time we get an order. And so it's -- we're sort of in a position where we know that we're well positioned with the reordering and as things return, but it's predicting the precise nature of that is difficult from a time frame perspective and from a precision on the absolute range perspective.

[Daniel Brennan, analyst]

Got it. No, Tom, that makes sense. And then I know there's been a bunch of questions on the vaccine. But on the testing side, for COVID, I think Brandon asked about capacity on your kind of biologics part of the business. But on testing, I think expectations are for testing to continue to ramp in the back half, certainly in the U.S., maybe globally. How are you positioned if that does occur from an ability to benefit from that? You didn't quantify within your COVID contribution how much testing was of that, did you?

[Michael Stubblefield, executive]

We did not. But it is significant. And I would say a couple of things about that. One, if you look at the more prevalent testing that's going on right now, the PCR-based testing, and you consider the entire workflow starting with sample collection to RNA extraction, purification and ultimately, through to reaction setup and the actual testing itself, we're going to be relevant at each phase of that workflow with a very broad portfolio. And so as testing has accelerated through the quarter and looking ahead at the expectation that testing is going to -- seems to be going to be an important part of our lives going forward here, I think we are well positioned to continue to build on the position that we've got here and participate in the incremental testing that we've seen playing out.

[Operator]

That is our final question for today.

[Michael Stubblefield, executive]

Yes. Thank you, operator, and thank you all for participating in our call today. As we close, I want to express my gratitude and admiration for all of our associates around the world who continue to live our values and work tirelessly to support our customers as they navigate the COVID-19 pandemic and seek solutions to protect, detect and treat the virus.

Our associates' passion and dedication to our mission of setting science in motion to create a better world really does position us to help bring life-changing therapies that can improve patient outcomes for people across the world. I'm optimistic about what lies ahead for our business and look forward to updating you at the end of the third quarter. Until then, take care and be well, everyone.

[Operator]

And that does conclude today's conference call. Thank you for your participation. You may now disconnect.