Thermo Fisher Scientific Inc

NYSE:TMO

Earnings Call Transcript 2018-Q1

[Operator]

Good morning, ladies and gentlemen, and welcome to the Thermo Fisher Scientific 2018 First Quarter Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you.

I would like to introduce our moderator for the call today, Mr. Kenneth Apicerno, Vice President, Investor Relations. Mr. Apicerno, you may begin the call.

[Kenneth J. Apicerno, Thermo Fisher Scientific, Inc.]

Good morning, and thank you for joining us. On the call with me today is Marc Casper, our President and Chief Executive Officer; and Stephen Williamson, Senior Vice President and Chief Financial Officer.

Please note this call is being webcast live and will be archived on the Investors section of our website, thermofisher.com, under the heading Webcasts and Presentations, until May 11, 2018. A copy of the press release of our first quarter 2018 earnings and future expectations is available on the Investors section of our website under the heading Financial Results.

So before we begin, let me briefly cover our Safe Harbor statement. Various remarks that we may make about the company's future expectations, plans and prospects constitute forward-looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors including those discussed in the company's annual report on Form 10-K for the year ended December 31, 2017, under the caption Risk Factors which is on file with the Securities and Exchange Commission and is also available in the Investors section of our website under the heading SEC Filings.

While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so even if our estimates change. Therefore, you should not rely on these forward-looking statements as representing our views as of any date subsequent to today.

Also during this call, we'll be referring to certain financial measures not prepared in accordance with generally accepted accounting principles or GAAP. A reconciliation of these non-GAAP financial measures to the most directly comparable GAAP measures is available in the press release of our first quarter 2018 earnings and future expectations and also in the Investors section of our website under the heading Financial Information.

So with that, I'll now turn the call over to Marc.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Thank you, Ken, and good morning, everyone. Thank you for joining us today for our Q1 call. As you saw in our press release, we had a very strong start to the year. We achieved excellent growth in revenue and earnings. Our team executed well to capitalize on the good market conditions, and we continued to successfully execute our growth strategy by building on our innovation leadership, leveraging our global scale and strengthening our customer value proposition. Our great performance in Q1 sets us up to deliver another outstanding year.

Let me begin with our financial performance for the quarter. Starting with our primary metric of success, adjusted EPS, we delivered very strong results again in Q1, growing earnings by 20% to $2.50 per share. Our revenue in the quarter was also very strong, increasing 23% year-over-year to $5.85 billion.

Adjusted operating income increased 20% to $1.29 billion, and our adjusted operating margin in Q1 was 22%. When I think about the quarter at a high level, the overriding message is that our team executed well and took advantage of the opportunities in our markets to deliver an excellent quarter.

Now let me give you some color on our performance by end market, starting with pharma and biotech. We delivered just over 10% growth in the quarter, with continued strength across all of our businesses serving this end market. The underlying dynamics here are robust, and we continue to gain share with these customers by delivering our unique value proposition.

In academic and government, we grew in the mid-single-digits during the quarter. And in diagnostics and health care, we had low-single-digits growth in Q1. Conditions here were in line with what we've been seeing for some time.

Last, in industrial and applied, we delivered high-single-digit growth in the quarter, driven by continued strength in this end market. It was great to see strong performance in Q1 across all of our Analytical Instruments businesses serving this customer base.

So to summarize the performance, the good conditions we saw in our end markets at the end of last year continued in Q1, and our team did an excellent job of identifying the opportunities and delivering results.

Now I'd like to review some of the highlights from the quarter. And as usual, I'll cover them in the context of our growth strategy. I'm pleased to report that we continued to make great progress in advancing our strategy to meet the needs of our customers and ensure a bright future for our company.

As you know, our growth strategy consists of three pillars. The first being our commitment to develop high-impact, innovative new products. We continued to see great traction from new products we've recently released. For example, you recall that one of the significant new products from 2017 was the Thermo Scientific Orbitrap Q Exactive HFX mass spectrometer. I'm pleased to say that it's already a strong contributor to growth less than a year after launch. This example points to the success of our innovation strategy and our ability to continuously develop the best-in-class products that our customers expect from Thermo Fisher.

In 2018, we'll spend close to $1 billion in R&D, and we started the year strong with a number of product launches in Q1. In Analytical Instruments, we introduced several new Thermo Scientific products that leverage our leading instrument platforms and digital capabilities to help our customers simplify their workflows and better manage data.

One of the highlights was our new line of Vanquish Duo UHPLC systems. The Vanquish Duo platform help scientists in biopharma labs maximize sample throughput while ensuring the quality of their results. And we continue to build on our gold standard Chromatography Data System by introducing the Chromeleon XTR, which allows customers to capture and manage their data across the entire laboratory.

In Q1, we also launched new products in electron microscopy portfolio, including the Thermo Scientific Verios G4 extreme high-resolution scanning electron microscope for advanced semiconductor production. The electron microscopy business continues to perform very well, and we had another great quarter in Q1. Just after quarter-end, we were very pleased to learn that our Krios G3i Cryo-EM system for structural biology applications received the 2018 Gold Edison Award, which recognizes the world's best innovations.

Finally, in our next-gen sequencing business, we introduced the Ion GeneStudio S5 Series of instruments, which features a flexible chip format that allows multiple experiments to be run on a single platform. The GeneStudio is easily integrated with our Ion AmpliSeq, Ion Chef and Ion Torrent bioinformatics to create a seamless workflow that provides greater sequencing flexibility and speed. And when combined with our expanding Oncomine portfolio of liquid biopsy and immuno-oncology assays, this new platform offers a complete solution that help researchers bring new cancer diagnostics to the clinic.

The second pillar of our growth strategy is our ability to leverage our scale in emerging and high-growth markets, and we continued to see strength across these geographies in Q1. Another quarter of outstanding performance in China, India and South Korea led to double-digit growth across the Asia Pacific region. I'll cover a couple of the highlights from the quarter.

First, in South Korea, our Analytical Instruments were used by the Korean (sic) [Korea] Institute of Science and Technology's Doping Control Center to identify banned substances in athletes during the major world sports event that took place there this winter. We also provided on-site technical and application support to our Unity Lab Services capability.

Another major event for us in the region during Q1 was the first China-U.S. Precision Medicine Summit, which was held in Beijing in late March. Thermo Fisher played the leading role in creating the summit in partnership with the CEO Roundtable on Cancer, the China Academy of Medical Sciences and Peking Union Medical College. Our collective goal was to bring together thought leaders from government, academia and industry to accelerate precision medicine advancements and continue to increase the impact on patient care.

You may recall that Thermo Fisher established a Precision Medicine Science Center in Guangzhou last year. We remain focused on leveraging our industry leadership to advance this key initiative, not only in China, but for our customers and their patients around the world.

Now, I'll turn to the last element of our growth strategy, our unique customer value proposition. Probably the best example of the power it brings is in the pharma and biotech end market, where our customers are focused on both increasing productivity and accelerating their pace of innovation to keep their pipelines full.

As you know, we've continued to strengthen our offering for these customers and our acquisition of Patheon last year was the most significant recent example. I'm pleased to let you know that the Patheon integration continues to go very well and the team has done a great job right out of the gate.

Our PPI Business System is already widely utilized. We're achieving our cost-synergy target and the team is making great progress in driving the revenue synergy opportunities as a result of our combined capabilities.

But even more important is the feedback we're hearing from our customers, both large and small pharma and biotech companies see the value we can provide. For example, large customers are taking advantage of our ability to help them optimize their manufacturing networks, drive productivity and simplify their supply chains. And small and emerging customers are looking for us for the technical expertise and know-how to develop and produce complex drugs.

Thermo Fisher is in a unique position to address these and other challenges with the most comprehensive solution in the industry. I've recently met with the manufacturing leaders of a number of our pharma and biotech customers. They clearly see the benefits we can bring by leveraging our capabilities across the company to support their goals from research through commercial production.

And we continue to make our value proposition even stronger for these customers. We've recently announced that we're investing in a new best-in-class supply chain facility in Europe near Baden, Germany and we're expanding our U.S. biologics manufacturing center in St. Louis.

Before I cover our revised guidance, I'll make a quick update on our capital deployment. In the quarter, we acquired IntegenX, a small acquisition that nicely complements our technologies used for human identification by adding a rapid DNA platform. It's a great addition to our genetic sciences offering.

Turning to our guidance. As you saw in our press release, we're raising both our revenue and adjusted EPS guidance for the year. The increase is based primarily on our strong operational performance in Q1, both organically and from the Patheon acquisition. It also factors in the more favorable foreign exchange environment that we saw in Q1.

So the headlines are: that we're raising our revenue guidance to a new range of $23.62 billion to $23.86 billion in 2018. This would result in 13% to 14% growth over 2017. In terms of our adjusted EPS guidance, we now expect to deliver between $10.80 and $10.96 per share. This would lead to 14% to 15% growth over the strong adjusted EPS performance we delivered this past year.

So to summarize our key takeaways from Q1, we're pleased to start the year strong, and our teams did a great job of capitalizing on the good market conditions. We're also making terrific progress with our growth initiatives and clearly gaining market share. Our excellent results in Q1 really sets us up to achieve another successful year ahead.

With that, I'll now hand the call over to our Chief Financial Officer, Stephen Williamson. Stephen?

[Stephen Williamson, Thermo Fisher Scientific, Inc.]

Thanks, Marc, and good morning, everybody. I'll take you through an overview of our first quarter results for the total company. And then, I'll provide some color on our four business segments and wrap up with our updated 2018 guidance.

Before I get into the details, let me start with a high-level view of how the first quarter played out versus our expectations at the time of our last earnings call. As you saw in our press release, we delivered a very strong quarter with 7% organic growth, which is about 2 points ahead of our expectations. This is driven by strong operational execution taking advantage of good market conditions.

We were also able to deliver $0.10 more adjusted earnings per share in Q1 than we'd assumed in the midpoint of our previous guidance. $0.07 from operational performance, driven by the incremental organic growth as well as strong contributions from our pharma services business, the former Patheon, and $0.03 from more favorable FX versus our initial guidance. So we're off to a great start to the year.

Now let me give you more color on the quarter. Starting with our total company financial performance for Q1. As you saw in our press release, we grew adjusted EPS by 20% to $2.50. GAAP EPS was $1.43, up 2% from Q1 last year.

On the top line, our reported revenue grew 23% year-over-year. The components of our Q1 reported revenue included 7% organic growth, 12% growth from acquisitions and a 4% benefit from foreign exchange.

Looking at growth by geography in Q1. North America grew low single-digits, while Europe grew in the mid-single digits. And Asia Pacific grew in the mid-teens, including another quarter of high-teens growth in China. And rest of the world grew in the mid-single digits.

Turning to our operational performance. Q1 adjusted operating income increased 20% and adjusted operating margin was 22%, down 50 basis points from Q1 of last year. As a reminder, Patheon is a scale acquisition with gross margins and operating income margins lower than the company average. The effect was approximately 110 basis points dilutive to total adjusted operating margins in the quarter.

The addition of Patheon will continue to be dilutive to our adjusted operating margins over the first 12 months of ownership through late August. Foreign exchange did not have a material impact on operating margins during the quarter. So our underlying operational performance was strong in the quarter at 60 basis points of expansion, driven by productivity, volume leverage, partially offset by strategic investments and unfavorable business mix.

Moving on to the details of the P&L. Total company adjusted gross margin came in at 46.3% in Q1, down 300 basis points from the prior year. Strong productivity was more than offset by the expected significant dilutive impact of acquisitions and to a lesser extent, unfavorable business mix.

Adjusted SG&A in the quarter was 20.4% of revenue, which is down 190 basis points versus Q1 2017, and total R&D expense came in at 4% of revenue, down 50 basis points versus Q1 last year. Both were primarily due to acquisitions. And R&D as a percent of our manufacturing revenue in Q1 was 6.7%.

Looking at our results below the line, net interest expense was $143 million, up $26 million from Q1 last year, mainly as a result of the incremental debt related to our capital deployment activities in 2017. Adjusted other income and expense was a net expense in the quarter of $1 million.

As a reminder, as of January 1, 2018, we adopted the new pension accounting standard and have restated prior years. The impact versus our prior guidance is an increase in operating costs of approximately $3 million per quarter and an offsetting increase in other income. There is no net impact to adjusted EPS.

Our adjusted tax rate in the quarter was 11.4%, down 260 basis points versus last year due to the impact of U.S. tax reform, the addition of Patheon as well as the timing of discrete tax planning items. This was in line with our guidance, and we still expect the full year tax rate to be 12%. Q1 average diluted shares were 406 million, up 12 million year-over-year.

Turning to cash flow and the balance sheet. Cash flow from continuing operations through Q1 was $80 million, and free cash flow was negative $40 million after deducting net capital expenditures of $120 million, and this is in line with our full year guidance. We ended the quarter with $950 million in cash and investments.

As for capital deployment activities in Q1, as Marc mentioned, we closed the acquisition of IntegenX, and we also returned $60 million to shareholders through dividends in the quarter.

Our total debt at the end of Q1 was $20.9 billion, down $75 million sequentially from Q4, and our leverage ratio at the end of the quarter was 3.8 times total debt-to-adjusted-EBITDA. And wrapping up my comments on our total company performance, adjusted ROIC was 10.1%, up 10 basis points from last quarter and in line with our expectations.

So now I'll provide you some color on the performance of our four business segments. Starting with Life Sciences Solutions Segment. Reported revenue increased 10% in Q1 and organic revenue grew 5%. In the quarter, we saw strong growth in our bioproduction, next-generation sequencing and biosciences businesses.

Q1 adjusted operating income in Life Sciences Solutions increased 19%, and adjusted operating margin was 34.5%, up 270 basis points year-over-year.

In the quarter, we drove very strong productivity, had good volume pull-through and saw favorable FX. This was partially offset by unfavorable business mix and strategic investments.

In the Analytical Instruments Segment, reported revenue increased 19% in Q1 and organic revenue growth was 13%. In the quarter, we benefited from strong growth contributions across all of our businesses in this segment: electron microscopy, chroma/mass spec and chemical analysis.

Q1 adjusted operating income in Analytical Instruments grew 28% and adjusted operating margin was 19.6%, up 140 basis points year-over-year. In the quarter, we saw very strong volume leverage and productivity partially offset by strategic investments and the expected dilutive impact of FX.

Turning to the Specialty Diagnostics Segment, in Q1 total revenue grew 9% and organic revenue growth was 5%. We saw particularly strong growth in our health care market channel.

Adjusted operating income increased 4% in Q1 and adjusted operating margin was 25.6%, down 130 basis points from Q1 of the prior year. In the quarter, we drove strong productivity, but this is more than offset by product mix and strategic investments.

And finally, in the Laboratory Products and Services Segment, which includes the Patheon acquisition, Q1 reported revenue increased 42%. Organic revenue growth was 6%.

In the quarter, we saw a strong growth in both our clinical trials logistics business and in our research channel. Adjusted operating income in the segment increased 30% and adjusted operating margin was 11.6%, down 110 basis points from the prior year.

In the quarter, we saw very strong volume leverage and productivity, but this was more than offset by product mix and strategic investments. So I'll now move on to our updated full year 2018 guidance.

As you saw in our press release, we're raising both our revenue and adjusted earnings per share guidance. And let me walk you through the details. First, revenue. Given the strong start to the year we're raising the midpoint of our guidance by $170 million and tightening the range by $60 million.

The $170 million increase to the midpoint consists of three elements: first, a $50 million increase in our organic growth outlook for the year, so we now expect full year 2018 organic growth of about 5%. Second, a $60 million increase from acquisitions, primarily reflecting the strong start to the year by Patheon, but it also includes the impact of adding IntegenX. And third, a $60 million increase in revenue to reflect a more significant benefit from FX in Q1 versus our initial guidance.

Turning to adjusted earnings per share, we're increasing the midpoint of our adjusted EPS guidance by $0.10. This comprises $0.05 from strong Q1 operational performance, $0.07 from both favorable FX environment and $0.02 of dilution for the acquisition of IntegenX. To sum this up, the increased 2018 revenue guidance is now a range of $23.62 billion to $23.86 billion and this will represent 13% to 14% growth versus 2017.

We expect acquisitions to contribute just over 7% to our reported revenue growth in 2018, and FX is expected to be a benefit of just under 2%. And our updated adjusted earnings per share guidance for 2018 is now a range of $10.80 to $10.96, with a midpoint of $10.88. This represents growth of 14% to 15% versus 2017.

A few other details behind the revised 2018 guidance. We're now assuming that foreign exchange is a $360 million revenue tailwind for the year or just under 2%. The FX tailwind on adjusted EPS is now assumed to be $0.20 or just over 2%. Given the ongoing volatility in FX rates, we've continued to take a conservative approach to FX guidance versus current spot rates.

In terms of adjusted operating margins, we continue to expect to deliver 20 to 30 basis points of expansion for the year. Excluding the impact of acquisitions, this represents 70 to 80 basis points of expansion. We continue to expect net interest expense to be in the range of $550 million to $555 million, and we're now assuming other income and expense to be a net income of just under $10 million versus our previous forecast of an immaterial net expense.

As I mentioned earlier, this is largely driven by the adoption of the new pension accounting rules. From an EPS standpoint, there's no net impact versus our prior guidance, it's just a switch in P&L categories.

We continue to expect an adjusted income tax rate of 12% for the year. Due to the timing of discrete planning items, the rate was slightly lower than this in Q1 and will be slightly higher for the remaining quarters of the year. But for the year as a whole, we still expect the tax rate to be 12%.

In terms of capital deployments, my model continues to assume $500 million of share buybacks in the second half of 2018. We also continue to assume we'll return approximately $275 million of capital to shareholders through dividends. Our guidance does not include any future acquisitions or divestitures.

We're assuming net capital expenditures will be approximately $700 million to $730 million. No change from previous guidance. And for free cash flow, we're expecting about $3.8 billion for the full year, consistent with previous guidance. We continue to expect full year average diluted shares to be in the range of 405 million to 407 million.

And finally, a couple of comments on phasing for the rest of the year. We expect organic growth in Q2 and Q3 to be about the company full year level. And as a reminder, we have very strong comps in Q4. But in terms of adjusted EPS phasing, we continue to expect the same phasing as 2017 when you look at each quarter of the year as a percentage of the full year. In summary, we started the year with an excellent Q1, and we're in a great position to achieve our goals for the year.

With that, I'll turn the call back over to Ken.

[Kenneth J. Apicerno, Thermo Fisher Scientific, Inc.]

Thank you, Stephen. Operator, we're ready to open it up for questions.

[Operator]

Your first question comes from the line of Ross Muken with Evercore ISI. Your line is open.

[Ross Muken, Evercore Group LLC]

Good morning, guys, and congrats.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Thank you, Ross. Good morning.

[Ross Muken, Evercore Group LLC]

So maybe, could we start on sort of China? The outperformance there continues, I mean it's quite remarkable given the size and scope of the enterprise to be up high teens. Can you give us a little color kind of underlying what the mix is there in terms of semi versus industrial versus pharma? Because it seems like you're getting pretty broad strength in that market, and the pharma market in particular seems to be kind of notable standout, at least versus where maybe some of us were thinking comparative to the cyclical parts.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Ross, thanks for the question. So China is an area that we have had a very good track record for a long period of time, and we've been delivering high teens growth, 2016, 2017 and into the first quarter of 2018. The outlook continues to be very strong. In terms of where it's coming from, the health care, pharma, biotech has been quite robust. Academic spend has been good, and industrial spend certainly has improved as we've seen out geographically as well, improvements in industrial and applied.

So it's really broad-based, not driven by any one particular area. It was really exciting that we orchestrated the first ever China-U.S. Precision Medicine Conference. We had 400 participants there, and co-hosted that with the Chinese Academy of Medical Sciences and the CEO Roundtable on Cancer, so really, very strong. The outlook looks good.

One of the questions that I've been asked in other venues is, how is the headlines in the papers affecting China customer sentiment? And no effect. Very robust outlook. Mark Stevenson, our COO, was there a couple of weeks ago. I'm heading off to China on Sunday. And the team is really excited. It's very, very positive market for us.

[Ross Muken, Evercore Group LLC]

Thanks, Marc. And just maybe sticking on pharma for a second, it seems like Patheon notably kind of exceeded what most of us were looking for and that business has kind of improved last couple of quarters after having a fairly mixed go of it prior to the acquisition. Can you give us a little underlying color of what you're seeing in some of those key segments for Patheon? How those conversations are going at the pharma level in terms of incremental business development, and then talk about the recent facility expansion you highlighted?

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Sure. So, in terms of our pharma services business, it's off to a good start. The Patheon acquisition integration is going very well. When I think about the performance, as Stephen noted, we're ahead of where we thought we were going to be in Q1, and part of our revenue and earnings increase for the guidance for the balance of the year or for the full year is based on Patheon's strong performance. So that's very encouraging.

I've had the chance to meet with quite a number of customers in the first four months of the year and bringing colleagues from the former Patheon business with me to meet some of the colleagues and open up new doors. Really, it's a very, very encouraging feedback.

As you know, it's a long-cycle business. It takes a while to go through decision, tech transfer, but the pipeline of activity has been fantastic, right? So not only is the business doing well short-term, but the outlook, we continue to be very, very bullish on. So, great start, lots of work to do, and we're looking forward to it.

We had two expansions that we announced in the quarter, one in our clinical trials business, which we actually made the facility a bit larger to also incorporate some of Patheon's capabilities. And that's a world-class supply chain set of capabilities for clinical materials in Europe and really allows us to serve the growing business there.

And secondly, we announced earlier this week the expansion of our St. Louis biologics facility, part of our 4-factory network for biologics production. This is something that Patheon had been evaluating and presented to us during the diligence process. So it was something that was very well thought through. We wanted to just understand it in more detail post ownership and feel great about it.

So that's an expansion that will meaningfully increase our single-use technology capabilities in St. Louis for our biotech and pharmaceutical customers.

[Ross Muken, Evercore Group LLC]

Great. Thank you so much, Marc.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Thanks, Ross.

[Operator]

Your next question comes from the line of Derik de Bruin with Bank of America Merrill Lynch. Your line is open.

[Derik de Bruin, Bank of America Merrill Lynch]

Hey. Good morning.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Good morning, Derik.

[Derik de Bruin, Bank of America Merrill Lynch]

Hey, a couple of questions. We've been getting a bunch of incomings from people asking a little bit more color on FEI. I think there's some concern about some of the – the numbers coming out of some of the semiconductor customers and people are just sort of worrying about sort of the trends in the business.

If I remember correctly, when you guys acquired FEI, about 35% of the business was semi capped at the time. Sorry. Could you refresh me? And sort of like reflection was sort of like the growth rates have been in that business and sort of like your outlook for it?

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Yes. So, Derik, thanks for the question. Our electron microscopy business continues the trend of very strong performance. We saw that strong performance in materials science applications. That's both semiconductor and all other applications, things like batteries for automotive, things like advanced materials research, as well as strong growth and momentum in our life sciences or structural biology applications.

The business grew well above the company average as did all of our Analytical Instruments businesses. So when you look at the Analytical Instruments Segment, it wasn't really electron microscopy-driven, but actually it was strength across chroma/mass spec, chemical analysis and electron microscopy.

When you look at the performance of FEI, synergies are on track. Integration is pretty much done. And when I think about the outlook there, bookings continue to be strong. So, we feel very good about it.

And in terms of kind of the materiality, FEI, if we didn't have FEI as part of our numbers, we would have grown 6% in the quarter. So the company had a great quarter. Electron microscopy had a great quarter from a top line. So, hopefully, that kind of answers the various perspectives on electron microscopy.

[Derik de Bruin, Bank of America Merrill Lynch]

Yes, that's a lot more color than I expected. So thanks, appreciate that. And then just I'm going to squeeze in two, because I've just been getting these and they're sort of related to each other. I've got a bunch of questions on just the sort of like as we see sort of changes in interest rates, sort of how your current balance sheet is set up? And if there's any issues in terms of needing to re-financing and sort of fixed and floating rates and, I guess, sort of how this is – how sort of like the changing environments impacts your capital deployment strategy in terms of – does it change up with your M&A targets or metrics?

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

So in terms of the M&A portion, we've used the same weighted average cost of capital since I joined the company, as is Stephen in 2001, which is a hurdle rate of 8.5%. So, in terms of the interest rate movements or potential movements, we've been using the cost of capital assumption that's been greater than what our true cost of capital is. So there's no effect there. And obviously, when we're deploying capital, we're looking for double-digit returns. In terms of what we've assumed in our model, we've assumed the Fed to increase rates 25 basis points each of the quarters. So that's assumed in the interest cost. I don't know Stephen, if you want to make...

[Stephen Williamson, Thermo Fisher Scientific, Inc.]

Yes, I'd add some additional color. Derik, when we think about the long-term model that I talked about at the last analyst meeting, basically that assumes an increase in rates going forward. So I don't see that unless rates spike very fast, but I think we're basically modeling that out in terms of the company's performance going forward. We've got just over $5 billion of debt that's variable rate right now. In terms of the maturities, we're making sure we've got a good ladder in terms of maturities so we can manage the debt appropriately. And about half of that variable rate debt actually is outside of the U.S. in euros. So I think we're managing it appropriately.

[Derik de Bruin, Bank of America Merrill Lynch]

Great. Thank you very much.

[Operator]

Your next question comes from the line of Tycho Peterson with JPMorgan. Your line is open.

[Tycho W. Peterson, JPMorgan Securities LLC]

Hey, thanks. Marc, I want to follow up on your comment a minute ago about Analytical Instruments because you're showing accelerating growth here against comps that have gotten a little bit more difficult. And obviously, FEI has been a big part of that. But as you mentioned, the overall Analytical portfolio is doing better. How much do you think is just the market doing a little bit better versus maybe share gains versus maybe you being exposed to some faster growth segments?

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Yes. So, Tycho, you've covered the company a long time, and to see all three of our instrument lines do well, the chemical analysis piece is really driven by market, right? So that's encouraging in terms of the acceleration. The chroma/mass spec, clearly, is share gain. The business is doing very well and very strong growth. So that one is straightforward. The market is good, actually. When I look at it geographically, the chroma/mass spec business, it was good in China, it was good in India, it was good in the U.S. So that business is performing very well.

But market, chemical analysis, probably good market in chroma/mass spec with strong share gain as well. And as I mentioned earlier, electron microscopy, we have a good position there, and our business is performing well across the three applications of the two materials science ones and life sciences.

[Tycho W. Peterson, JPMorgan Securities LLC]

Okay. And then a follow-up on Patheon. We had a couple of people asking with the news this week, the additional capacity expansion. Are you able to say how much of that is committed at this point? Or how do we think about utilization ramping as that comes online?

And then at the time of the Patheon deal, you had also talked about the opportunity set being pretty wide for bolt-ons around that. So I'm just curious as to how actively you're looking at complementing what you had there with M&A?

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Yes. So, Tycho, thanks for the question. Because it's single-use technology expansion, what we're doing is really expanding the shell of the building, but you add the physical capacity of the reactors as you get customer commitments, so that you don't wind up. It's not a big stainless steel facility where you start with very low utilization after ramp. It's rather you kind of add as you go. So we feel good about what the revenue outlook is and it kind of lines up with the expansion of capacity during 2019 and beyond.

In terms of the pipeline, we have a very active M&A pipeline across our various businesses, including our pharma services business. And we'll continue to evaluate the various transactions. And if they're good fits with good returns, then we'll do that. But, as you know, we continue to be a very disciplined acquirer.

[Tycho W. Peterson, JPMorgan Securities LLC]

Okay. And then just one quick clarification. Was there any flu contribution in Specialty Diagnostics? I had a few people asking about that.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Yes. So in terms of flu, we saw stronger growth in our health care market channel, which benefited from the stronger flu season in the U.S. At the company level, flu was negligible in terms of the impact. When you look at the Specialty Diagnostics business, there was a little bit of an offset to the strong flu which was the first quarter was a particularly weak seasonal allergy season. So you got benefit of flu which is lower margin and a little bit of softness in seasonal allergy which is higher margin. So that probably – as you kind of work your way through numbers, that helps reconcile things.

[Tycho W. Peterson, JPMorgan Securities LLC]

Okay. Thank you.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

You're welcome.

[Operator]

Your next question comes from the line of Jack Meehan with Barclays. Your line is open.

[Jack Meehan, Barclays Capital, Inc.]

Thanks. Good morning. So thanks for all the Patheon updates. At the clinical trial logistics business, so strong growth in the quarter. How are booking trends there and what new outsourcing opportunities are you seeing with the integrated offering?

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

So the clinical trials business had a nice start to the year and a good outlook for the full year. So that business has returned to robust growth which is in line with what we thought it would do. So that's good to see. The feedback from the customer base in terms of the combined offering of both formulation and the packaging logistics and manufacturing capabilities we have has really been very positive. That's actually been the area where we've gotten our first revenue synergies already in the book. And the reason you would do that or get that faster is at shorter decision-making time, right. You're dealing with clinical materials versus commercial products. So we're starting to see the synergies there, and we're making the offering as integrated and as seamless as possible for the customer base which will be very positive over time.

[Jack Meehan, Barclays Capital, Inc.]

Great. And then geographically could you give a little bit more color on the U.S. market? I think I heard low single digits. Just how the various businesses are performing domestically? Thanks.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Yes. So, Jack, North America very similar to what we've been seeing, low single-digit growth in the quarter. And nothing really jumped out as a particularly different trend than what we've seen in the last year. So we've been able to deliver the very strong organic growth for the quarter with that low to mid-single-digit-type growth that we've been seeing in North America, and that's what our expectation is.

[Jack Meehan, Barclays Capital, Inc.]

Thank you, Marc.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

You're welcome.

[Operator]

Your next question comes from the line of Doug Schenkel with Cowen. Your line is open.

[Doug Schenkel, Cowen & Co. LLC]

Hi. Good morning. I just want to go back to free cash flow. It was negative in the quarter. This seems largely attributable to the increase in working capital in the quarter. It was a figure that was light of our forecast.

And while you indicated that free cash flow was in line with your expectation, you would need to ramp Q2 through Q4 free cash flow at a steeper rate than we've typically seen you generate and that's to get to your reiterated full year free cash flow target of $3.8 billion for the year. So with that in mind, just a few questions. One, why was Q1 free cash flow negative? Is this just typical Q1 timing?

Second, how is Patheon impacting free cash flow? And what's the long-term target there? Third, what gives you confidence in your ability to ramp the way your guidance implies over the balance of the year? And fourth, you materially beat revenue and EPS expectations for the quarter. You increased guidance for the year, but you didn't change your free cash flow outlook. I'm wondering why. Thank you.

[Stephen Williamson, Thermo Fisher Scientific, Inc.]

Okay. So thanks for the four-part question. So when you think about the negative cash flow in Q1, as you can see from the cash flow statement, it's really driven by working capital. A piece of this is in Q4. We had a very strong contribution from working capital, and that was slightly higher than we had anticipated in – as we were entering Q4. So we've seen a little bit of that unwind as we've gone into Q1. And that's really then offset by the strength and the outlook in terms of overall for the earnings for the year.

So that's why we still feel very confident about the $3.8 billion for the full year. And when you look on the history of our cash flows, they're very much – they're favoring towards the end of the year, Q2 and Q3, in particular. So, yes, there's nothing really to read into this. It's really just around the change in the working capital, little bit on cash taxes and cash interest.

[Doug Schenkel, Cowen & Co. LLC]

And the Patheon impact?

[Stephen Williamson, Thermo Fisher Scientific, Inc.]

Yes, the Patheon is basically as we'd expected. So we previously – before Patheon expecting to deliver about 90% of adjusted net income into free cash flow. Patheon has slightly had very capital intensity of a business and the overall of that brings the company average to 88%. And that's kind of what we guided to for the year.

[Doug Schenkel, Cowen & Co. LLC]

Okay. And real quick, just to sneak in one more. On NIH, how is activity and demand from U.S. academic, government, research customers trended subsequent to the new fiscal 2018 NIH budget release? And does the NIH budget change impact your growth expectations for the end market as you've incorporated assumptions into guidance? Thank you.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Doug, thanks. In terms of NIH, if you go back to our guidance at the end of January, our assumption in the guidance was that we would get a budget at some point in the early part of the year and that that budget would increase. So the $3 billion increase that we saw in March was in line with what we're expecting to happen.

Obviously, it happened late in the quarter, so it really had no effect on what we saw in the North America spend in the market. And generally, when you look at academic and government, the North America was modest growth in the quarter and good strength in Europe and good strength in China.

[Operator]

Your next question comes from the line of Steve Beuchaw with Morgan Stanley. Your line is open.

[Steve Beuchaw, Morgan Stanley & Co. LLC]

Thanks for the time here. Just a couple of clarifications on channel dynamics. I guess, first, I'd start with diagnostics. If I take the results in Specialty Diagnostics, certainly a good number, actually a little ahead of us, little bit of help from flu. But then if I look at the results on the diagnostics and health care channel, maybe a little lighter than we expected. I wonder – I appreciate that you called out that it was in line with internal plan. Can you just help us parse through the deltas there on the trends so we can maybe piece the model together a little bit more finely?

[Stephen Williamson, Thermo Fisher Scientific, Inc.]

Yes. So, Steve, I'll take that one. So when you think about Specialty Diagnostics growing 5% and diagnostics and health care are growing low-single digits. In terms of like gap, in terms of the diagnostics products we have good traction with some applied end markets particularly around food safety and that shows up in industrial and applied.

And then outside the Specialty Diagnostics, you see the impact of timing of some large orders in some businesses there. And the combination of those two things create that dynamic, slightly different growth rates. When you look at the actual, we give low single-digit ranges and specific numbers for the segments. It's not that materially different between the two.

[Steve Beuchaw, Morgan Stanley & Co. LLC]

Okay. Got it. And then one for Marc on bioprocess. It's been a long time since I've seen such a big spread between revenue growth in bioprocess and order growth in bioprocess. And to be fair, of course, there is comment on what we're seeing outside of Thermo as we don't see your numbers. But if we roll the numbers up, it looks like strong order growth against revenue growth that's still maybe mid-single digits. Is that a reasonable way to think about the market? It still hasn't really popped back in a strong way, but really strong lead indicators. We just love to hear any observations you have on how things are evolving there. Thanks.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Yes. I mean if I think about the quarter for pharma and biotech, first starting at the one level above your question, which is, it's a great quarter, right, 10% growth. And when you look at it, we saw strength across our entire business and we saw really strong performance in bioproduction, chroma/mass spec and in our channel business. And then, when you look at the bioproduction piece, it was a great quarter, right, with very strong growth. So I'm not sure about this bookings mid-single-digits, it's not reflective at all of our performance in the market.

[Steve Beuchaw, Morgan Stanley & Co. LLC]

Well, love to see the share gains. Thanks, Marc.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

You're welcome.

[Operator]

Your next question comes from the line of Steve Willoughby with Cleveland Research. Your line is open.

[Steve Barr Willoughby, Cleveland Research Co. LLC]

Good morning. A couple of quick questions for you guys. First, if you could just remind us on your exposure to India and generics? And any comments related to that end market? And then I had one follow-up.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Well, what's the follow-up? What's the second one?

[Steve Barr Willoughby, Cleveland Research Co. LLC]

The second one is just it sounds like the guidance increase for organic growth here for the full year seems to be largely due to the outperformance here in the first quarter. I'm just wondering why you don't think or at least not factoring in here kind of that stronger trends continuing or being sustainable over the remainder of the year?

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Sure. Good question. So India is less than 2% of our revenue, double-digit growth, been on that trend for a long period of time. So it's really – there's not much more in India other than the business is doing well.

[Steve Barr Willoughby, Cleveland Research Co. LLC]

And not a concentration in generic manufacturing customers. So...

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

No, we cover the full market, including that customer base. From an organic perspective, obviously, very strong start to the year. We were pleased to raise our guidance from 4% to 5% to about 5%. And we raised the guidance by $50 million organically. We obviously also raised it for the strong – on top of that for the Patheon performance as well, which doesn't show up in the organic calculations.

When we think about the balance of the year and why we did that level, I felt like the right thing to – from a prudent standpoint to do, but with one quarter behind us, that perspective. If the market conditions continue to play out like we saw in Q1, this is going to be a very, very strong year. So we're going to maximize our share gain and capitalize on all the opportunities and play it out that way.

Just as a reminder, we have a challenging comparison in the fourth quarter with the 8% growth last year in the fourth quarter. So the strong start to the year gives us a little bit of buffer for a range of outcomes on the fourth quarter, but everything we see right now is quite positive.

[Steve Barr Willoughby, Cleveland Research Co. LLC]

Okay. Thanks very much.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Thanks, Steve.

[Operator]

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

[Patrick Donnelly, Goldman Sachs & Co. LLC]

Great, thanks. Marc, maybe just on the industrial/applied markets, can you talk through the core industrial growth rates in various geographies? Wondering specifically on how the U.S. and China trended in that market.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Yes. Patrick, thanks for the question. So industrial and applied markets is very strong with high single-digit growth. Really, saw it strongly in our instrument business. The chroma/mass spec, chemical analysis, which is a lot of your spectroscopy-type instruments, electron microscopy for the materials science applications. Asia was really the stand-out. It was not at all limited to China, but China was strong. Japan actually had a good quarter. We saw it in Korea. So, Taiwan was good. So, really, broad-based across Asia Pacific and reasonable market conditions in Europe and in North America. But really, the strength was driven by broad-based strength in Asia Pacific.

[Patrick Donnelly, Goldman Sachs & Co. LLC]

Okay. And then maybe now some of the hurricane disruptions are farther on the rearview here, can you update us just on Patheon cost synergies? How utilization is trending in some of the facilities? I know that's where the synergies are going to come from. So I'm curious on how that's trending.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Yes. So in terms of the cost synergies, we're running right on track from the cost synergies and the funnel on the revenue synergies looks very encouraging, which should really be very helpful to the 2019 numbers as we build that. But those are running on track from that perspective.

From the hurricane impact, I did go down and visit our sites in Puerto Rico in March. And really, the team there has done a remarkable job. We got back up into production in January, so no impact financially in terms of this year. But actually, the team across our sites there actually took the adversity of a tough situation and actually made the business stronger. Really, I was very impressed, and came away inspired by what the teams are doing. So we're off to a good start in Patheon, not only in Puerto Rico but across the board.

[Stephen Williamson, Thermo Fisher Scientific, Inc.]

Patrick, just some additional color. So we're rolling out the PPI Business System across the Patheon sites. That's essentially being completed in terms of the first seven key sites and rolling out to the rest. And it's been really well embraced by the team. And it's going to be a big driver long-term of the cost synergies and the capacity utilization.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

And we said we were running slightly ahead of the $0.30 accretion that we expected for the first full year. So, things are going well there, Patrick.

[Patrick Donnelly, Goldman Sachs & Co. LLC]

Appreciate it. Thanks guys.

[Operator]

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

[Dan Leonard, Deutsche Bank Securities, Inc.]

Thank you. So, on the LPS segment, I was hoping you can give some more color on the margin declines. Stephen, I think you mentioned mix and some strategic investments, but anymore color you could offer would be helpful.

[Stephen Williamson, Thermo Fisher Scientific, Inc.]

Yes. So in terms of LPS, in terms of the mix dynamic, it was primarily due to the channel business, which is lower-margin than the rest of the businesses in that segment growing faster than the Lab Products business, which is a higher-margin business in that segment. So that was really the mix dynamic. And then investment-wise, we continue to invest in the capabilities here, serving key end markets. And we continue to invest in the service and e-business capabilities, e-commerce capabilities within the channel business.

[Dan Leonard, Deutsche Bank Securities, Inc.]

Appreciate that. Thank you.

[Operator]

Your next question comes from the line of Dan Arias with Citigroup. Your line is open.

[Daniel Arias, Citigroup Global Markets, Inc.]

Good morning, guys. Thanks. Marc, just another one on industrial. Obviously, the things there have come back nicely. So, I guess, when you talk to customers, does it feel like there's a potential for sort of a natural pause once you get past this initial wave of pent-up spending? Or do you think, for the most part, order trends are pretty smoothly upward for a while? Just trying to get a sense for the second or third inning of what the rebound might look like.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

That's a hard one to know. In bookings, we're good, right? So which gives you some revenue visibility going forward and obviously the teams have a very active funnel of potential new orders. But that's going to be driven by ultimately if they converge it's just going to be a function of macroeconomic outlook, geopolitical, things of that sort. But right now, very encouraging in terms of what we're seeing.

[Daniel Arias, Citigroup Global Markets, Inc.]

Got it. Okay. Thanks. And then, Stephen, to your point in the prepared remarks, LSS margins have been kind of creeping up pretty steadily here. Is mid-30s the right way to model that segment these days before just thinking about mid-single-digit organic?

[Stephen Williamson, Thermo Fisher Scientific, Inc.]

Yes. I think we get very good volume leverage off that business. So we got good margin expansion potential for that going forward.

[Daniel Arias, Citigroup Global Markets, Inc.]

Okay, got it. Thank you.

[Stephen Williamson, Thermo Fisher Scientific, Inc.]

Thanks, Dan.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Operator, we have time for just one more.

[Operator]

Your final question comes from the line of Paul Knight with Janney Montgomery. Your line is open.

[Paul Richard Knight, Janney Montgomery Scott LLC]

Hey, guys. Congratulations on the quarter.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Thanks, Paul.

[Paul Richard Knight, Janney Montgomery Scott LLC]

As you look at the past cycles on PMI, what are you think Marc where we are? You think first three months of this or a year or what's your thoughts?

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Yes. In terms of the discussion with the industrial customer base, it's been very positive. We went through a long period of very difficult conditions in the industrial base. So you're benefiting from two different factors: a) older fleet out there, so customers are wanting to get the benefit of a new fleet of instruments as well as capacity expansion. And we actually – we got our first big new expansion in the mining portion of our business. It's a very small portion of our business, but that's very encouraging, right? Because those are multiyear projects and based on the forecast of the economic growth, it's going to be good. So, at least right now we feel like the outlook continues to be very positive in the industrial end markets. Thank you for the question, Paul.

[Paul Richard Knight, Janney Montgomery Scott LLC]

Marc, with the media business, isn't that going to help op margins at Thermo with media integrated with Catalent. Could you talk to that?

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Yes. So in terms of our media capabilities, it should be – one of the things I've been super excited about is the collaboration between our bioproduction team which would be media and our biologics team, which would be Patheon and the knowledge sharing and the learning that we're getting. So, over time, that clearly is going to improve the margins for our contract manufacturing activities as well as raise our expectations and performance for bioproduction. So feel very good about it.

[Marc N. Casper, Thermo Fisher Scientific, Inc.]

Let me wrap-up the call. Obviously, we're pleased to deliver another very strong quarter. We feel we're in a very strong position to deliver on our growth goals for the year. As always, thank you for your ongoing support of Thermo Fisher Scientific. And we're looking forward to seeing you at our Investor Day in New York City on May 23, which you know I always consider as my favorite day of the year. Look forward to seeing all of you. Thanks.

[Operator]

This concludes today's conference call. All participants may now disconnect.