Mettler-Toledo International Inc

NYSE:MTD

Earnings Call Transcript 2018-Q3

[Operator]

Good day, ladies and gentlemen, and welcome to our Third Quarter 2018 Mettler-Toledo International Earnings Conference Call. My name is Holly, and I'll be your audio coordinator for today. [Operator Instructions]

I would now like to turn our presentation over to your hostess for today's call, Ms. Mary Finnegan. Please proceed, ma'am.

[Mary Finnegan, executive]

Thanks, Holly, and good evening, everyone. I'm Mary Finnegan. I am the Treasurer, and I'm responsible for Investor Relations, and glad that you're joining us today. I'm joined here today by -- with Olivier Filliol, our CEO; Bill Donnelly, our Executive Vice President; and Shawn Vadala, our Chief Financial Officer. I want to cover just a couple of financial administrative matters. This call is being webcast and is available for replay on our website. A copy of the press release and the presentation we refer to is also on our website.

Let me summarize the Safe Harbor language, which is outlined on Page 2 of the presentation. Statements in this presentation, which are not historical facts, constitute forward-looking statements within the meaning of the U.S. Securities Act of 1933 and the U.S. Securities Exchange Act of 1934. These statements involve risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by any forward-looking statements. For a discussion of these risks and uncertainties, please see the discussion in our recent Form 10-K. All of the forward-looking statements are qualified in their entirety by reference to the factors discussed under the captions, factors affecting our future operating results, and in the business and management discussion and analysis of financial condition and results of operations in our Form 10-K.

Just one other item. On today's call, we may use non-GAAP financial measures. More detailed information with respect to the use of, and the differences between, non-GAAP financial measures and most directly comparable GAAP measures is provided in our Form 8-K. I will now turn the call over to Olivier.

[Olivier Filliol, executive]

Thank you, Mary, and welcome to everyone on the call. I will start with a summary of the quarter, Bill will provide details on our third quarter results, and Shawn will be discuss our guidance for the rest of this year and for 2019. I will then have some additional comments, and we will open the lines for Q&A.

The highlights for the quarter are on Page 3 of the presentation. We are pleased with our sales growth, which was 7% in local currency in the quarter. Our laboratory products had very good broad-based growth. In addition, China had strong growth despite excellent sales growth in the prior year. Our sales growth, combined with results from our margin and productivity measures, drove a 17% increase in adjusted EPS.

Let me comment briefly on how we observe current market conditions and how we are deploying our strategies given the environment. First, demand in our markets remains good. Sales, orders, even leads look solid. But there are many reasons to be cautious about the global economy, including higher interest rates, a strong dollar and uncertainty and costs arising from tariff disputes. I would characterize it as a sunny weather but clouds on the horizon. These clouds provide a different outlook than it was 1 year ago when we gave guidance for 2018.

So what do these clouds mean for us in terms of strategy deployment? We clearly remain focused on growth. We are investing for growth but somewhat more cautiously than we were at this time last year. We want to remain agile and react to, even to a certain extent, and anticipate a slowdown. We are confident that we can continue to deliver share gains, irrelevant of underlying market growth. And with our strong focus on margin enhancement and cost management, this should translate to reasonable earnings growth under almost any circumstance. Shawn will cover this further in his comments on guidance.

I now want to turn it over to Bill, but before I do, I want to acknowledge that this is Bill's last earnings call with us. Bill has made tremendous contribution to Mettler-Toledo over more than 20 years. I have worked closely with Bill and want to personally thank him for his support, dedication and leadership with the organization. Bill's personality, in particular his sense of humor and his down-to-earth approach to our challenges, will be missed. I think one of Bill's greatest contribution to Mettler-Toledo was his nurturing and development of his successors. He leaves the global supply chain and IT organizations in good hands with Oliver Wittorf, who many of you will hear from on Monday at our investor meeting. And, as I think many of you have seen over the last year or so, he leaves the finance organization in the skilled hands of Shawn, who has worked with Bill for many of this -- of his 20 years here. Bill, an official thank you for all of your contribution to Mettler-Toledo and you know I personally wish you all the best for the future.

[William Donnelly, executive]

Thanks, Olivier, for the warm remarks. I acknowledge we're on a transcript and a call, so I'm not going to take too long but the thanks go back in return. It's -- Mettler is a great company, I'm proud of what we've accomplished and it's been an honor to work here. And maybe to the shareholders on the call and to the investors on the call, I have great respect for the job you guys do. I hope you feel that respect from all of us in return. And maybe, one of the things I've loved about our shareholder base is they've been with us for a really long journey and maybe, a special thanks to them for all they've done for us. And maybe also to them, I want to acknowledge that -- what Olivier said, I think we left things in -- I feel like I'm leaving things in great hands with Shawn and Oliver but maybe to you in particular, Olivier, you and the rest of the team around the globe, I feel like the company is as strong as it has ever been, and thank you for the opportunity.

All right. So enough of that stuff. I'll try to cover the numbers now. Sales were $735 million in the quarter. That's an increase of 7% in local currency. The Biotix acquisition contributed about 1% to local currency growth. On a dollar basis, our sales increased by 5% because currencies reduced sales by 2% in the quarter.

On Slide #4, you'll see our growth by region. So local currency sales grew by 5% in the Americas, 3% in Europe and 11% in Asia, Rest of World. Our sales growth in China increased by 12% in the quarter and that growth was broad based. In China, growth was particularly impressive when you consider that we had 28% sales growth in the prior year. Biotix benefited our growth by about 1% in the Americas.

Now I'd like to turn to Slide #5 and that's our 9-month numbers. So you see there, local currency sales have increased by 5% in the Americas, 3% in Europe and 10% in Asia/Rest of the World. Biotix benefited the Americas growth year-to-date by approximately 2%.

Onto Slide #6. We outlined in local currency sales growth by product line. In the quarter, lab grew by 11% while industrial increased 1% and retail grew 14%. Biotix helped out the lab group by about 2%. Within our industrial group, our core industrial business grew by 2.5%, offset against very strong growth in the prior year, offsetting this to a degree was approximately a 1.5% decline in product inspection and we'll elaborate on that later.

Turning to the next slide. We have year-to-date sales growth by product line. So lab is up year-to-date 10%, while industrial is up 1% and retail is up 6%. And Biotix helped the lab sales by about 2% and of course, all those numbers were in local currency.

All right, let's go to now Slide #8, which gives you the P&L for the quarter. Our gross margins were 57.1%, that compares to 57.4% in the prior year. On a constant currency basis and adjusted for acquisitions, gross margins were down 10 bps in the quarter. Pricing continues to be a strong contributor to gross margins but we had headwinds from tariffs as well as poor mix in retail and some initial costs associated with our product inspection U.S. facility comp consolidation as well as a little bit on product launches.

R&D in the quarter was $34.8 million and that's a 10% increase in local currency, and our SG&A of $202.5 million was a 1% decrease in local currency versus the prior year. That number included increased investments in our field force, which were offset by cost savings initiatives as well as lower variable compensation. That resulted in an adjusted operating income of $182 million in the quarter, and that's a 13% increase over the prior year amount of $161.7 million. We estimate that currencies reduced operating income by about $1 million, a little worse as compared to what we told you last time.

Our adjusted operating margin was 24.8%, and we're pleased with that 170 basis points improvement over the prior year. A couple of comments on the P&L. Our amortization amounted to $11.9 million, while interest expense was $9 million even. Other income was $1.5 million, which primarily is pension income.

Now let's cover taxes. We reduced our effective annual rate slightly from 22% to 21.5%. This reduction reflects the impacts of changes in our income sources and some benefits in China. The effective tax rate for the quarter was 20.7%, which reflects the cumulative catch up to get our year-to-date rate to 21.5%. We expect our Q4 effective rate to also be 21.5%. As Shawn will cover in a moment, we expect our rate to be further reduced to 21% in 2019.

All right, now moving to fully diluted shares, which were 25.7 million in the quarter, and that's a 2% decline from the prior year, reflecting the impact of our share repurchase program. Adjusted earnings per share was $5.12, and that's a 17% increase over the prior year amount of $4.36 per share. On a reported basis, EPS was $4.93, that compares to $3.99 in the prior year. Reported EPS includes $0.07 of restructuring, $0.10 of purchased intangibles and $0.02 related to a discrete tax item surrounding our stock option program.

The next slide provides year-to-date results. Local currency sales increased by 6%, operating profit increased 13% and adjusted EPS was up 16%. Of course, we're very pleased with those results. Okay, that's it for the P&L, and now we'll cover cash flow. In the quarter, adjusted free cash flow was $121.3 million, and that compared to $111.9 million in the prior year. Our working capital statistics remained solid, with DSO at 39 days while ITO is at 4.5x. And that's it from my side, and then I want to turn it over to Shawn to give some info on our guidance.

[Shawn Vadala, executive]

Okay, thanks, Bill, and hello, everyone. Let me start with a couple upfront comments on guidance before covering the specifics. First, our growth and productivity initiatives. These are well within our control, and we feel confident in their effectiveness and our ability to execute them. These initiatives are well ingrained within the company and have proven to be a success, and we feel very good about our ability for them to drive sales and earnings growth.

Second, the economy. As Olivier mentioned earlier, demand in our markets is solid. This is evident with our third quarter results. Similar to how we have done this in the past, our guidance for Q4 in 2019 assumes market conditions remain largely unchanged. We do acknowledge, however, there is some more uncertainty in the global economy, in particular, what could be the potential longer-term impact on the Chinese and global economy due to the trade/tariff situation, but we're not seeing any impact to date. Third, tariffs and currency. On our last call, we outlined the impact of tariffs from the first wave that went into effect in early July. As a reminder, we estimated this would reduce operating profit by approximately $10 million on a full year annualized basis. We had built the net impact of the tariffs and response initiatives into our previous 2018 guidance. The second wave went into effect at the end of September, and we estimate the full year annualized impact, once the full rate is implemented, will be approximately $15 million. For clarity, these incremental tariffs are initially at a 10% rate and step up to a 25% rate in January. The $15 million is the full 25% impact on the second wave. Therefore, the total impact of tariffs, both the first and second wave on an annualized basis, is $25 million reduction to our operating profit.

Our guidance for Q4 and 2019 reflect the impact of this new wave of tariffs and our responses. In addition to tariffs, currencies also continued to move against us. In particular, the Chinese renminbi versus the dollar and the Swiss franc versus the euro. One final comment on taxes. As you heard Bill mention, we reduced our tax rate in Q3 to 21.5% for the full year 2018. Due to some additional impact of income sourcing, we expect a further reduction in our tax rate to 21.0% in 2019. I realize this is a lot of numbers and data but thought it was important as it will help put our guidance into perspective. With respect to the fourth quarter of 2018, we expect local currency sales growth of approximately 6%. This is organic, and we have owned Biotix for more than a year now. We expect this sales growth will generate adjusted EPS in the range of $6.72 to $6.77, a growth of 13%. We estimate currency and the impact of tariffs are a headwind to Q4 adjusted EPS growth of approximately 5%.

For the full year, we expect local currency sales growth to also be 6%, with an adjusted EPS in the range of $20.20 to $20.25, a growth rate of 15%.

For 2019, we expect local currency sales growth of approximately 5% and adjusted EPS growth in the range of $22.40 to $22.60, a growth rate of 11% to 12%. We estimate the headwind to earnings growth in 2019 due to adverse currency and tariffs will also be approximately 5%, similar to what we are facing in the fourth quarter.

Let me also comment on cash flow for 2019. We expect cash flow of approximately $510 million. This represents a growth of 12% per share, adjusting for facilities CapEx. In terms of share repurchases, you saw in the press release that the board has increased the authorization as we would have exhausted our current authorization by the end of the year. We would expect share repurchases in 2019 to include our free cash flow estimate, plus option proceeds, totaling approximately $545 million. In terms of quarterly guidance for 2019, as usual, we will provide that on our upcoming call. However, I know you will update your models and want to point out that while our adjusted EPS growth is 11% to 12% for the full year, I would expect a lower growth in the first half, in particular, the first quarter, due to currency and timing of tariffs and implementation of our response actions. On a preliminary basis, we would expect adjusted EPS percentage growth in the first quarter of 2019 to be in the mid-single digit range. In terms of currency on sales, we expect currency to decrease sales growth by approximately 3% in the fourth quarter. For the full year 2018, we expect currency to benefit sales growth by approximately 1.5%. In 2019, we expect currency to reduce sales growth by approximately 3%, with more decline in the first half of the year as compared to the second half. That is it from my side, and I now want to turn it to Olivier.

[Olivier Filliol, executive]

Thanks, Shawn. Let me start by providing some additional comments on our operating results. Our lab business continues to perform very well, as shown by the 9% organic growth in the quarter. I point out -- this out, as this was in addition to solid growth in the prior year. Sales growth was broad based, with most product lines showing good growth. We are executing well in this business, as we benefit from a very strong product portfolio, our continued investment in field resources and our Spinnaker sales and marketing initiatives. I would expect good growth in lab for the remainder of 2018 and into 2019.

Turning now to industrial. Let me cover this in 2 parts: Core industrial had approximately 2.5% growth, which was impacted by the very strong 9% growth in core industrial in the prior year. We would expect to see a better growth in core industrial in the fourth quarter and in 2019. As you heard from Bill, product inspection was down slightly in the quarter. We had expected it to be flat to a little weaker as compared to last time we spoke. I want to remind you, this business is impacted by prior year's comparisons, not one in 2017 but strong growth we saw in the second half of 2016. We expect to see growth in the fourth quarter and in 2019.

For those of you joining us on Monday, you will hear more about this business and have a chance to see its new facility. The final piece of our company is the retail business, which was up 14% in the quarter, better than we expected, given some project activity in the United States. As you know, this business is lumpy, and we would expect a modest decline in the fourth quarter and minimal, if any growth, in 2019.

Now let me make some additional comments by geography. Europe came in pretty much how we expected. We had good growth in lab and retail, while industrial was down slightly. In the Americas, lab had very good growth and that is on an organic basis. Industrial was down, in both core industrial and product inspection. Retail in the Americas was strong due to project activity just mentioned.

Finally, Asia/Rest of the World had strong growth, with excellent growth in lab and very good growth in Industrial. Retail was up nicely as well. China had very strong growth across most product lines. As we look to next year, we would expect Americas and Europe to have growth at, or little bit below, the mid-single-digit range and Asia/Rest of World, including China, to have growth a little more than mid-single digits.

Longer term, we would guide for Asia and China, in particular, to have growth in the mid-to-high single digit range. But they will be impacted in 2019 by very strong growth over the last 2 years. That concludes my comments on the different pieces of the business.

Let me now comment on our overall guidance for 2019 and what gives us confidence in our ability to generate the sales and earnings growth we have outlined today. I will start with our Spinnaker sales and marketing strategy, which we believe are a unique competitive advantage and important source of growth. We have core initiatives surrounding lead generation and investments in our field force through our Field Turbo program. These initiatives remain well on track, and we are also focused on sales force activities. Specifically, we have tools and programs to help ensure our front end sales reps maximize their productivity by targeting those customers with the greatest potential. How do we go about it? First, we identify what are the most attractive pockets of growth. This means specific market segments, where products provide the most value and the specific customer accounts where we have the best access and highest cross-selling potential. Second, we utilize sophisticated go-to-market strategies, which ensure we utilize the most cost-effective sales channel given the sales and profit potential of the different accounts. This increasingly means that sales reps are spending more of the time with high potential noncustomers and we use telesales resources for accounts with lower sales potential. It is worthwhile to highlight that over the last 4 years, we have more than doubled our telesales resources and currently have almost 300. We have developed a substantial amount of materials and tools to support our sales reps and telesales resources in demonstrating how our solutions help specific needs of the customers. Finally, we leverage our unique data analytics to formulate tailored marketing and sales campaigns. We process millions of internal and external data to guide our sales reps to the most promising opportunities. These sales force activities will increase the sales force time with the most strategic accounts and it will ensure we are redirecting resources to our most attractive businesses.

This is core to maximizing our sales force productivity. We believe these sales force activities in combination with our other Spinnaker sales and marketing initiatives will continue to allow us to gain share. New product launches are another important contributor to growth. As we have spoken to you about in the past, we are constantly coming to market with new products. No single launch will make a material impact to our results in any quarter but all of them combined are essential for our strategy to trigger replacement, gain share and support our pricing program.

Let me give you a recent example from our laboratory offering and the launch of our new line of analytical balances. We have the most comprehensive portfolio of these balances and have reduced the minimum weight by 50%, thereby allowing customers to use smaller sample sizes and reduce waste. A patented cooling system and intelligent features that include ensuring the balance is level and free from static actively monitor weighing conditions to ensure outstanding accuracy and reproducible results. A large user interface and process and settings that can be saved for different tasks also help improve the efficiency of our lab customers. We are excited about this launch, which is receiving very favorable customer reactions. We also launched the newest generation of LabX, our lab data management system. From central control of instruments and tasks to eliminate manual errors, LabX helps ensure security, efficiency and data integrity of the lab. As mentioned, this is just one example of our many new product launches.

With our Spinnaker sales and marketing programs and new products focused on growth and capturing share, our pricing and productivity initiatives are driving operating profit growth. I'm very pleased with our extensive pricing programs, trainings and tools we have developed over the last several years. On the productivity side, Stern Drive is continuously driving productivity and cost leadership of our operations and supply chain. Stern Drive is the platform for improvements in how we manage our procurement as well as how we improve our labor productivity in both the shop floor as well as back office operations.

Using data analytics and benchmarking, we identify high-impact and fast-return projects in these areas. So far, we have completed more than 500 projects and have managed to establish a continuous pipeline of projects that allow us to deliver against our target of $20 million year-over-year savings.

In summary, we feel very good about the factors we can control, namely the execution of our growth and margin and productivity initiatives. Demand remains solid, and we will monitor the global economy and be ready to react if conditions change. We face headwinds next year in terms of currency and tariffs but believe can still deliver strong earnings growth. That concludes our prepared remarks, and I want to ask the operator to open the line for questions.

[Operator]

[Operator Instructions] Our first question will come from the line of Dan Arias, Citi.

[Daniel Arias, analyst]

Bill, I'm sure I won't be the only guy to say it's been a pleasure and good luck. You've been one of the best around for a long time, so thanks.

[William Donnelly, executive]

Thank you.

[Daniel Arias, analyst]

I just wanted to maybe start on pricing, if I could. That's been a really good tool for you guys. What are you baking in for 2019? How much of that do you expect is related to areas where maybe historically you've pushed hard versus those areas where maybe you've been a little bit less aggressive?

[Shawn Vadala, executive]

Dan, this is Shawn. Thanks for the question. For 2019, we normally would guide to about 150 basis points. But the way we're thinking about 2019 is something in the 2%, maybe a little bit better than that kind of a range. We put in place some additional pricing actions, as you know, during the second half of this year, and we're thinking similarly as we, kind of, enter next year, given the higher inflationary environment, and we would expect to do a little bit better than what I said on an annualized basis in the first half of the year, given the timing of some of these measures versus the second half of the year.

[Daniel Arias, analyst]

Okay. I believe it was Olivier that made the comment, but you talked about just how you entered the year versus the way that things are now. So I guess, the question is if you ignore comps, and you just think about the outlook for demand, can you, kind of, crystallize the way that you see things headed into 2019 and how that differs from the way that you were looking at spending and demand heading into the year this year. I'm just curious about the relative confidence that you have when we think about the customer segments and the macro environment?

[Olivier Filliol, executive]

Yes, the things that we really see in our numbers, in terms of leads generation and quote requests, but also all the feedback that I get from the organizations around the world, they all remain very positive. And in that sense, we have -- we don't see any negatives yet of the clouds that I was referring to in the prepared remarks. But of course, we are more alert, and we are a bit more cautious because there are things out there that could impact us. And that's just ask for us to, kind of, hedge our risks here. But when you think about investments and activities, we are very much still in this growth mode. Very comparable to what it was last year. I'm still funding Field Turbo programs, very committed to that, and we certainly also, when we interact with our market organizations around the world, we go for the growth mode really, in every single market. That includes also all the emerging markets, even that they might be impacted a little bit by the dollar topic or China that of course, is also impacted by the tariffs. But we don't see it and that, in our markets directly until we feel we need to go for the top line.

[Daniel Arias, analyst]

Okay. And if I could sneak one more in on the tariffs, obviously that's a headwind on costs. But I'm just curious whether you're finding that -- are the tariffs and the trade war concerns diminishing or washing out any of the smaller local competitors over there, as the mom and pop type places try to make it all work?

[Olivier Filliol, executive]

No. I don't really think it changed much to the competitive landscape. So when we talk about our many Chinese competitors, I also referred to, we have hundreds, sometimes even thousands of weighing scale companies there, they serve the domestic market. Hardly any of them are engaged in significant export. The one thing that could happen -- from today's perspective, these tariffs mostly impact the discrete industry metal plastic, and I would say, this is a market segment that is maybe more served by the local competitors, as we have refocused our business already for now a couple of years, more to the value add businesses like Pharma, chemical industry and so on. And I would think that these businesses will be less impacted by tariffs. But again, our Chinese competitors that we have are not really directly involved in export business.

[Operator]

Our next question comes from the line of Ross Muken with Evercore ISI.

[Ross Muken, analyst]

So, Bill, I'll second the comment. Obviously, it's been a long time we've known each other. Great pleasure and best of luck. In terms of the business, so maybe on China, I'll, sort of, stick on that as a theme. There's a lot of cross currents, right? So the macro data in some parts has kind of deteriorated, at a country level, you've got a number of the consumer-oriented companies are, kind of, warning on demand. And yet, every company in the space, including yourselves had good results, not really seeing any shift in demand. It seems like your commentary and orders are still consistent. So help us, kind of, make sense of how these budgets are protected. How it's so broad in that, sort of, stability of demand and, kind of, what you're looking at in terms of the customer base in some of the more volatile or cyclical parts of your Chinese business that's kind of, giving you comfort that some of these other warning signs won't sort of, manifest themselves over the balance of '19.

[Olivier Filliol, executive]

First, I want to say, we don't see it today, and we don't know if there will not be future side effects from certain market segments that will decline and then spill over to others. But at this stage, what we see, the markets that we serve predominantly are less impacted because, as I described before, they are less export oriented. And the -- for the domestic consumption, there is still this desire for better quality, safety and productivity. And so, we see our Chinese customers to continuously invest and look to our instruments. I certainly also would expect that the Chinese government will continue to drive the growth in these value-added industries, for example, life science industry. And that's the piece that we are more and more focused on and probably, also not a coincidence I was talking about the strong results that we have from the lab business in China. We have the 10th quarter of mid-teens growth in this business. And I see that really, also the last quarter being very strong and that gives us confidence also going forward. But there might be spillover effect, from these other segments that are negatively impacted and it's just too early to really see it. And that's why we remain agile or also a little bit cautious. You certainly have seen us guiding for China next year a little bit more modest, and this is, on the one hand, because comparisons but secondly, also that we realize that the overall economy will not be that strong.

[Ross Muken, analyst]

Right. No, that's helpful. And maybe, it's really a tremendous job, the whole team did around sort of mitigating some of these tariff and FX related headwinds. One, can you just give us kind of an example outside of obviously, price of maybe anecdotally, something you came up with or decided to do to kind of help with margin management for next year. And then, help us think through in sort of the various scenarios. You reacted so quickly this year to some of the headwinds that came up, like, how much flex do you have into next year, should the 25% tariff go into place or other counter -- other measures or we see even more volatility in the dollar, et cetera? How much, kind of, juice is left to be reactive because you've already obviously, done a lot.

[William Donnelly, executive]

Maybe I give you an example, Ross, it's Bill. I think an easy one to understand is, if you take a look like at how we bring product into the United States from China, if we can bring down the transfer price, that of course, has $1.04 -- or $0.25 on a dollar kind of impact. And so that might require that we also adjust where some activities happen in the supply chain. So moving some value-add from some -- one place the other. Now if -- back to your point what we can do in the future, well, we certainly, as you know, we sell a lot of SKUs. So we don't try to do too many things to touch the supply chain because we don't have that many products we can get a lot of activity behind it. But if we were to think it might be more permanent, we could probably do more on the supply-chain side and have more on the transfer pricing side to, kind of, offset that. But I think one of the bigger points would be is those are only mitigations. We're not eliminating the tariff in those cases, and frankly speaking, we would prefer if things were reversed, that the tariffs went away, we'd frankly rather move those activities back to China. Let China enjoy a little bit larger transfer price and -- but our overall cost structure would be much more efficient if we didn't have that work around.

[Operator]

Our next question will come from the line of Dan Leonard, Deutsche Bank.

[Daniel Leonard, analyst]

So I wanted to talk about the result in industrial. Appreciate the issue around comps but how much of the performance do you think is a reflection of more challenging comps versus anything structural, like CapEx pressures and some of the big food companies?

[Olivier Filliol, executive]

So I think we need to talk -- when we talk about industrial, we should really differentiate between core industrial and product inspection. I think here, you refer more to product inspection. And in product inspection, we had 3 key effects: One is, this comparison topic and this is very much related also to some key account activities. Very strong key account orders that we had in previous years. And these key account activities are more lumpy. And partially, also related to what you said, the very big packaged food companies did manage their capital spending in a more forceful way this year than we have maybe seen in previous years. But I -- the early signals that we have is, this is something that will come back. And so, that's one of the reasons why I'm not worried. The second one -- impact that we had was that we made some important changes to our manufacturing blueprint, particularly here in the U.S. This was a major undertaking. This will make the franchise so much stronger and the -- the ones of you that join us next Monday I'm sure, you will immediately recognize what this means. Consolidating 3 plants but also 3 technologies at one place. It's going to bring huge synergies going forward, not just in terms of production capability but very much, this brings benefits to customer interactions because we can demo and all the technologies at the same time. And that in sense, this was a pre-investment. A pre-investment that did cost some margins initially but also brought some distraction for us to serve the markets as we normally would do. And that's something that I see us recovering really fast and is a part of why I say Q4 will also look better. When I say Q4, I imply with that, also next year. I expect good growth from product inspection.

[Daniel Leonard, analyst]

And, Olivier, is it possible -- can you give us just kind of a rough flavor of how much you expect the industrial segment to accelerate in Q4? What roughly would be in your plan?

[William Donnelly, executive]

We should grow high single-digit in the fourth quarter and maybe, one of the interesting things, Dan, is if you look at, like, multi-year growth rates, I think it will be our best 3-year growth rate of the year, which speaks to, I think, the foundation, as Olivier mentioned, of the franchise.

[Operator]

Our next question will come from the line of Patrick Donnelly, Goldman Sachs.

[Patrick Donnelly, analyst]

Definitely want to echo the prior sentiments that you'll be missed, Bill. It was great working with over the years. And maybe since it's your last earnings call I'll throw one your way. Always appreciate your macro perspective. So I just want to expand on, I think it was Dan's earlier question. Relative to this time last year when you provided guidance for '18, sitting here today, looking ahead to 2019, can you just walk through the geographies and then talk through which you feel more cautious or constructive on.

[William Donnelly, executive]

So sure, I'm happy to do that. So, I mean, on a broad statement, I think emotionally, even as you look out a year ago, we had a very positive currency environment looking forward. We had no -- the tariff situation wasn't where it is today. And so, it's just the combination of those two things. I think when Olivier refers to clouds, I think that's the type of the thing he has in mind. If I go through the world geographically as compared to a year ago, I think we knew we had -- I start with the Americas. We knew we had a tough comp coming in the Americas when it came to product inspection, and we probably underestimated a little bit some of the challenges with the plant consolidation. So those two should both be a little bit better. In terms of the core industrial business, I think we probably feel like we're getting later in the cycle now, so do we feel materially different? Not really. And then the lab business looks to be again on solid footings. If I go to Europe, I think we do see that maybe GDP forecasts are a little bit less for '19 than they were a year ago for '18. But if I look out, kind of, what we've done recently as well as what we do in the fourth quarter, it's pretty solid, and we haven't built in overly high expectations as part of our guidance for Europe. I think one of the bigger changes is China, and the change there just relates to -- we were coming off a year ago very strong comparisons in China, and now, we see that that's kind of behind us, but we still keep a pretty solid base. But I thought Olivier answered the question around, kind of, outlook and confidence for China very well. I think the 5-year plan calls for them to invest in life sciences. So the life science, we see no reason why even these tariff topics should have much of an impact there. The industrial business is probably a little bit more exposed but certainly, much less exposed than the industrial business we would have had 3 years ago for these moves that Olivier mentioned. So I think that would be my key comments.

[Patrick Donnelly, analyst]

That's very helpful. And just for '19 on the guidance side, could you guys just let us know what the growth rates you're guiding for, for lab, industrial and food are? Just to -- want to make sure we have that.

[Shawn Vadala, executive]

This is Shawn. So on the lab side, we would be doing, kind of, a mid-to-high single-digit. On industrial, kind of, more in line with the total group number. And then, on food retailing, we're currently looking at flattish, just given the pipeline of project activity looking towards next year.

[Operator]

Our next question will come from the line of Jack Meehan with Barclays.

[Jack Meehan, analyst]

Bill, it was a short time but I echo, good working with you. I was hoping you could elaborate a little, either you or Shawn, as we look into 2019 on the gross margin line with some of the moving parts, whether it's the different currencies or tariffs and pricing and just, underlying productivity. If you could, kind of, walk us through some of those factors and what the build for gross margin looks like.

[Shawn Vadala, executive]

Sure. Hey, I'll take that one. So in terms of 2019, we'd probably be looking at currency -- sorry, not currency -- gross margin benefit of probably like, say, 50 to 60 basis points on a currency-neutral basis. I'd start with the price increase. I mentioned earlier, we'd be looking at a price increase in the 2%-plus range. That would probably have about a 90 basis point improvement on the margin. Offsetting that would be the cost of the tariffs. The tariffs would be about 60 basis points. And then, on the differential, we've have some of the benefits of some of the productivity and other actions we've been taking place this year and maybe some of the upside of some of the benefits from our facility consolidations that Bill and Olivier talked about earlier in the call.

[Jack Meehan, analyst]

Great. And then, maybe just continuing on that. Excited to see all the work in Tampa next week. Could you -- sorry if I missed it, but what was the CapEx forecast for '19? And could you just give us an update on the what the right pacing looks like as you wrap up some of these projects?

[Shawn Vadala, executive]

Yes, so the total CapEx number would be about $120 million. And that still includes some facility CapEx because we have one more facility to go in the U.K. in our -- one of our product inspection facilities there, which requires additional capacity to keep up with the volume growth.

[Operator]

Our next question will come from the line of Tycho Peterson, JPMorgan.

[Ruizhi Qin, analyst]

This is Julia on for Tycho today. First off, congrats, Bill. And on behalf of Tycho, thank you for being so great to work with and best of luck. So maybe to follow up on China. I know you guys mentioned midteens growth in the quarter. Could you maybe break that out by end market?

[Shawn Vadala, executive]

Sure, Julia. This is Shawn. I'm just going to -- I'll just run down the different business lines. So on the lab side, we did just under 20% in the quarter. And then, on the industrial business, we did a high single-digit.

[Ruizhi Qin, analyst]

Okay. And then, how much of your China exposure is from the Pharma industry and to what extent did you benefit from the generic quality regulation in the past year?

[Olivier Filliol, executive]

So we don't break out the details by -- for a country. But -- I would phrase it that way, the whole life science piece is one that has been steadily growing, and that's true actually for the laboratory business as well as pieces of the industrial business. And regarding your last point, it didn't have any particular impact for us. It's -- also -- remember, we are very strong in general labs, QC labs as well as R&D., and it's not particular in the bioresearch area or even medical area also. It's very, very broad based when we talk about life sciences industry. It would also include academics that is connected to life sciences.

[Ruizhi Qin, analyst]

Got you. And then finally, on the services, how much was services as a percentage of revenue in the quarter? And how high do you think you can increase the mix to? And to the extent possible, can you comment on just the current service penetration rates within the biopharma and food markets particularly? And the runway you had?

[Olivier Filliol, executive]

I've got to hand over afterwards to Shawn to give you the specific share for the quarter. When it comes to growth -- so the way we look at service is, we, over a midterm, we clearly see that service will outgrow product. I say the midterm because it doesn't necessarily happen in every quarter. If we have a very strong product quarter, that doesn't mean that service can top of it. But I expect that service is outgrowing product because we really have a great opportunities there. We have very strong value propositions and we, as we often refer to, we have strong programs like the iBase and marketing campaigns that is really addressing our installed base. We're also using Big Data analytics for that. And then, we try to do more and more service under contracts. In that context, we talk about the attachment rate. And this is something that you build up over a years -- over years because it's really hard work but one that has great payoff. We have very different service attachment rates by different countries and businesses. And so, just using a year-on-year universal number, would not be that insightful. But you will see on next Monday, we have actually a separate session that talks about service, and we're going to drill down in more details and to illustrate to you that what the value proposition is and how we do these iBase campaigns and contract attachment rates for the product inspection business specifically. What's -- maybe one insight also that I already want to share with you today and I will talk to again also on Monday is that the service contract business is actually outgrowing the average service growth that we have also because the break/fix part of the businesses is not growing as fast. And that's a consequence that our quality of our products actually are continuously improving. And so, there is these extra efforts going in, in the service contract business. And in the meantime, I'm sure Shawn has the number. And so, I'll hand over to you.

[Shawn Vadala, executive]

Thanks, Olivier. So, Julia, the service as a percentage of our total revenue is 22%. And if we include consumables, that number would be 31%.

[Operator]

Our next question will come from the line of Derik De Bruin, Bank of America.

[Derik De Bruin, analyst]

Bill, it's been an interesting 15 years. It's been a pleasure. I'll miss you and I look forward to seeing your one-man show on Broadway the next time you're in town because I assume that's what you're going to do, I can already envision it, Hamilton. So on that note, let's talk about net interest expense and sort of what you're thinking about for interest rates next year and how should we think about the interest expense and then interest expense for 2019 and this sort of leads on to a conversation about, you just annualized the Biotix deal. How are you looking at capital deployment beyond share buybacks, M&A? Do you feel comfortable in this environment levering up a bit if you need to -- just find something interesting.

[William Donnelly, executive]

Hey, it's a timely question, I think, in terms of our capital structure. One of the things we've reviewed with the board in recent days is we think it's appropriate to start to gradually move our leverage up. We have tended to think that a medium-term number in 1.5 range, just for you guys that aren't tracking it, we're probably at about 1.1 right now, would be appropriate. I think we would look to be doing that over with a combination of M&A and share repurchases, if I just look back on past probabilities, for lack of a better expression. But I do think it would be appropriate to lever up a little bit more and I think we're going to that over maybe 2 years.

[Derik De Bruin, analyst]

Great. And thinking about the last time, a couple of years ago, when China was topical and started to hit. I'm just curious, any signs of credit problems like we saw in the past? And then just on a broader note, I mean the currencies have moved so much. Is there any sense of hesitation that people don't have enough purchasing power right now, to go out and buy things, any sort of hesitation that FX, rather than the tariff issues, are causing some slowdowns in spending, or potentially?

[William Donnelly, executive]

I -- just, maybe for the benefit of everybody, Derik, your memory is good. One of the things we've commented about in the past in China is there's not a free flow of credit like there is in the Western world. And so, a couple of comments in response. And then, because of that in times -- at times in the past, things have moved quickly or markets have deteriorated relatively quickly when the boys in Beijing dialed back credit a little. Now if I look at how we've moved our mix of business, kind of, again going back to this combination, to the point that Olivier made, that our industrial business today is a different industrial mix than it was 3 to 5 years ago. And secondly, the percentage of our sales going into lab and product inspection is a lot bigger than it was 5 years ago. The two of those facts would make us, let's say, less susceptible to such items. But I think everyone that does business in China would acknowledge that a tightening of credit would flow through the market and -- but sitting here today, we don't see signs of that, and we certainly would say that, given all the other uncertainties and what's going on in their stock market and how their government has typically worked to keep the economy going, I just -- I would not anticipate that and frankly, would be quite surprised if that happened. And we see no details in our credit-type stuff that would indicate that, that's the case with our customers nor in how they -- in how the government's dealt with us in terms of bringing cash out of the country and that type of thing.

[Derik De Bruin, analyst]

Great. And one final question. Just talking a little bit about supply chain moving around, east-west supply chain is like -- is there -- how -- can you -- just a little bit broader plans on what you're doing to sort of mitigate some of the impact that you're seeing now?

[William Donnelly, executive]

So I gave one specific example so I want to avoid repeating that. So for us, it's largely focused on our U.S. -- the impact is really on our U.S. industrial business, our U.S. retail business and our U.S. Ohaus business. And it's an impact on products we manufacture in China and sell into the U.S. market as well as some components that we bring into the country. So we haven't been impacted, we see no signs on the -- we're not impacted by the Chinese tariffs that they've put on some U.S. products, I mean, it's de minimus, and we also haven't seen any, let's call it, prejudice against our products in China, which frankly speaking most of what we sell in China is coming from Switzerland and everybody loves Switzerland. And so, the -- in terms of what we're doing now, we're doing as much as we can to mitigate as Shawn and Olivier talked about with regard to pricing, so where we think we can. But of course, Olivier would point out, pricing isn't without some volume consequences. And we're doing the little things that we can in supply chain like the example I gave in response to Ross's question, and we don't really want to do more permanent things because we hope that this would end but there would be additional steps we could take if this thing were to continue on for multiple years. But frankly, none of them -- none of the mitigating steps would be as good as what we have now with our manufacturing capabilities in China.

[Operator]

Our next question will come from the line of Daniel Brennan, UBS.

[Daniel Brennan, analyst]

Bill, obviously it's been tremendous working with you and certainly hope to see around. So first question would just be on, what was the price realization in this quarter?

[Shawn Vadala, executive]

Dan, this is Shawn. Price realization was about 2.7%.

[Daniel Brennan, analyst]

Great, thank you, Shawn. And then, Olivier, not to belabor China, just had one follow-up on your comments that you've already made, just so I understand it. So to the extent your demand was to be negatively impacted, is what you were basically portraying earlier in the conversation that basically would be just from slower economic growth in China that just kind of seeped into your customers or I know you talked about a spillover effect, but I'm just trying to think through, you talked about the clouds and you're not seeing it today but effectively, is that essentially what it is? Just kind of general slowdown in China, that would, kind of, be felt across your businesses?

[Olivier Filliol, executive]

Yes, I think there are market segments that are today already impacted. Of course, there are exports related to discrete manufacturing segments that are impacted by the tariffs and when they export to the U.S. I think we will see more of that going forward. But these are typically markets that we don't sell to directly. However, if these market segments are slowing down, I would not exclude that they might also have an impact on other markets that partially supply the exporting segments. And so, I would not exclude that, for example, chemical segments will be impacted because the discrete manufacturing segments are buying less. That's one of the spillover effects that I was meaning. And overall, the economy in China might be impacted also just by the sentiments around these topics. But that's more a macroeconomic view than something that I see today already or the team tells me.

[Daniel Brennan, analyst]

Great. And then, maybe as just one follow-up, I know Bill has already talked about it earlier in the quarter. But in terms of the core industrial business, which I know you've deemphasized some of the more cyclical areas within that business in China specifically, to kind of temper, I guess, the impact. But you just remind us today like how big that business is in China and give us some perspective on what that business did this quarter? And I know Shawn already mentioned 8% total industrial growth but more with the breakdown of core industrial and as you look out towards 2019, kind of, what are you baking in for that core industrial business in China?

[Shawn Vadala, executive]

Yes, so the core industrial business in China is about 42% of the total business. That business was up high single-digit in the quarter. And as we, kind of, like, look to next year, hey, we'd probably be mid-single-digit and wouldn't be surprised if it's even a little bit lighter than that next year, just given the tough comparison that we have.

[Operator]

Our next question comes from the line of Steve Willoughby, Cleveland Research.

[Joshua Waldman, analyst]

It's Josh on for Steve. Just a quick one on the earnings guide for '19. You guided for 11% to 12% earnings growth. If I understand you, that's including the 5% headwind from FX and tariffs. So effectively guiding to 16% to 17% earnings growth in your initial guide. Just looking back over the last decade, the strongest earnings growth you guided to right out of the gate was 13%, last year was 13%. So given you're already absorbing this 5% headwind from FX and tariffs, how much cushion are you factoring in, in your initial guide compared to maybe years past?

[William Donnelly, executive]

I think we do our -- as the guide guy for a long time, I think the guide process was similar to how it was in the past. I struggled a little bit to understand, I think if I -- I thought I heard you say that 13% has been our highest earnings per share number, and that -- I'm not sure where that number came from.

[Joshua Waldman, analyst]

That was -- the 13% year-over-year growth in your guide just out of the gate for the following year.

[William Donnelly, executive]

Okay. Our guide for -- yes. I think one thing certainly is that we have put some measures in place. I think that the comments with regard to foreign exchange are factual, the comments with regard to tariffs are factual now. If these tariffs were to go away because maybe, if I give you the example around that we talked about earlier on transfer pricing. If the tariffs went away tomorrow it's not that we would add 5% back on because it would probably be 3.5% maybe 4% back on because the tariff piece, the mitigating factors, it isn't 100% reversal. So I think that one of the reasons that the earnings power is so good next year is that you have full benefits coming from some facility consolidation we did in Switzerland. We have full benefits of facility consolidation that we did in Tampa. We have the Stern Drive program now is maturing significantly. Shawn mentioned quite a bit of pricing power and that combination of things meant that our incremental margins, particular incremental margins excluding the impact of tariffs and foreign exchange, are excellent. So I – process-wise, I think we went about it the same way. But yes.

[Olivier Filliol, executive]

I'll add also that because of the tariffs, we have a little bit of higher inflationary environment particularly in the U.S, which allows us to do more on pricing. And that's, of course, we build in, and we did not have that in the recent years. Actually, the inflationary environment, we didn't have, and that's the reason why Shawn was sharing with you that we expect more than we normally would expect. And that alone has quite an impact on our EPS guidance.

[Shawn Vadala, executive]

And hey, maybe one final comment is that we do get a little bit of benefit from reducing tax rate by another 50 basis points next year. So that's maybe 70 bps on the growth rate, which would round to 1%.

[Operator]

I'll now turn today's conference back to Mary Finnegan for closing comments.

[Mary Finnegan, executive]

Thanks, Holly, and thanks, everyone, for joining us tonight. For those of you that are attending our investor meeting on Monday, safe travels, and we look forward to seeing you. Take care, everybody. Bye-bye.

[Operator]

Once again, we'd like to thank you for participating on today's conference call. You may now disconnect.