Mettler-Toledo International - Earnings Call - Q3 2020

Transcript

Operator (participant)

Good day, ladies and gentlemen, and welcome to the third quarter 2020 Mettler-Toledo International Earnings Conference call. My name is Jemariya, and I will be your audio coordinator for today. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star one on your telephone. 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 (Head of Investor Relations)

Thank you, and good evening, everyone. I'm Mary Finnegan. I'm responsible for investor relations at Mettler-Toledo, and happy that you're joining us. I'm on the call today with Olivier Filliol, our CEO, and Shawn Vadala, our Chief Financial Officer. Let me cover just a couple of financial or administrative matters. This call is being webcast and is available on our website. A copy of the press release and the presentation is also available on our website. Let me summarize the safe harbor language, which is outlined on page two 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, level 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 our recent Form 10-K and other reports filed with the SEC from time to time. All of our 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 operation sections of our filings. 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 the most directly comparable GAAP measure is provided in our Form 8-K.

Let me now turn the call over to Olivier.

Olivier Filliol (CEO)

Thank you, Mary. Good evening, everyone. I hope this continues to find you safe and well. I'm calling in from Switzerland tonight while Shawn and Mary are in Columbus, Ohio. I will start with a summary of the quarter, and then Shawn will provide details on our financials. I will then have some additional comments, and we will open the lines for Q&A. The highlights for the quarter are on page three of the presentation. Local currency sales increased 6% in the third quarter, which was much better than we expected. Demand in our end markets continues to be negatively impacted by COVID-19. However, we had excellent growth in China, and the performance of our lab business was very strong. With our strong product portfolio and innovative sales and marketing strategies, which we have successfully adapted to the challenges of this new environment, we believe we are gaining share.

We have very strong growth in operating margins due to the benefits of some of our temporary cost actions, as well as our ongoing margin and productivity initiatives. Growth in adjusted EPS and cash flow was excellent in the quarter. Overall, we are very pleased with our performance in the quarter, given all the ongoing challenges of COVID. As we look to finish this year and into next year, we remain cautious on the global economy. The impact of COVID on different regions of the world continues to evolve and change quickly, and the ultimate repercussions to the global economy are still to be determined. Our strategy is to remain focused on those items we can control, namely keep our employees safe and continue to serve our customers, the majority of which are in essential end markets of life sciences and food manufacturing.

We have been successful in continuing to launch new products, while at the same time, ensuring our go-to-market approach is most effective given current customer dynamics. Our adjusted go-to-market model and full leverage of Spinnaker have proved to be exceptionally powerful in this environment. This includes incorporating digital tools and techniques to engage with customers in remote settings. Versus our direct competition, we believe this has provided a very strong advantage and has reinforced the leadership positions that we hold in the vast majority of our product lines. Based on market conditions today, we believe we can continue to gain share and deliver solid results in 2020 and 2021. I will have some additional comments on this topic shortly, but let me first turn it to Shawn to cover the financials.

Shawn Vadala (CFO)

Thanks, Olivier, and hello, everyone. Sales were $807.4 million in the quarter, an increase of 6% in local currency. On a U.S. dollar basis, sales increased 7%. Its currency benefited sales growth by 1% in the quarter. On slide number four, we show sales growth by region. Local currency sales increased 3% in the Americas, 4% in Europe, and 10% in Asia rest of world. China local currency sales increased 17% in the quarter. The next slide shows sales growth by region year to date. Local currency sales declined 1% in the Americas, 2% in Europe, and increased 1% in Asia rest of world. China local currency sales increased 5% on a year-to-date basis. On slide number six, we outline local currency sales growth by product area. For the quarter, laboratory sales increased 9%, industrial increased 1%, with core industrial up 8% and product inspection down 9%.

Food retail increased 5% in the quarter. One question I know you have is, how much benefit did we have from COVID tailwinds in the quarter? We estimate our local currency sales growth benefited between 1% and 2% in the third quarter from COVID. The next slide shows sales growth by product area for the nine-month period. Laboratory sales increased 2%, industrial declined 2%, with core industrial up 1% and product inspection down 7%. Food retail declined 7% on a year-to-date basis. Let me now move to the rest of the P&L for the quarter, which is summarized on the next slide. Gross margin in the quarter was 58.2%, a 50 basis point increase over the prior year level of 57.7%. Our margin initiative centered on pricing and Stern Drive contributed to the margin growth.

We also benefited from temporary cost actions offset in part by higher transportation costs and unfavorable mix. R&D amounted to $34.7 million, which represents a 7% decline in local currency. The decline is principally driven by timing of activity as well as some temporary cost savings measures. I would expect R&D as a percentage of sales to be in the historical range of 5% for the full year. SG&A amounted to $205 million, a 1% decrease in local currency over the prior year. Our temporary cost containment measures, as well as ongoing cost savings initiatives, were principal contributors to this decline. Adjusted operating profit amounted to $230 million in the quarter, which is a 17% increase over the prior year amount of $196.2 million. Operating margins increased 250 basis points in the quarter to 28.5%. We are very pleased with this margin growth.

A couple of final comments on the P&L. Amortization amounted to $14.1 million in the quarter. Interest expense was $9.3 million in the quarter. Other income amounted to $3.8 million. Our effective tax rate in the quarter was 20.5% before discrete items and adjusting for the timing of stock option exercises. We expect to maintain this rate in Q4 in 2021. Moving to fully diluted shares, which amounted to 24.2 million in the quarter and is a 3% decline from the prior year. Adjusted EPS for the quarter was $7.02, a 22% increase over the prior year amount of $5.77. On a reported basis in the quarter, EPS was $6.68 as compared to $5.20 in the prior year.

Reported EPS in the quarter includes $0.12 of purchase intangible amortization, $0.15 of restructuring, and a $0.07 difference between our quarterly and annual tax rate due to the timing of stock option exercises. The next slide shows our year-to-date results. Local currency sales were flat for the first nine months, and adjusted operating profit increased 5%. Operating margins increased 140 basis points in the nine-month period. Adjusted EPS amounted to $16.30, an increase of 9% over the prior year amount of $15.02. That is it for the P&L, and let me now cover the cash flow. In the quarter, adjusted free cash flow amounted to $212 million, which is an increase of 44% on a per-share basis as compared to the prior year. We are very happy with our cash flow generation. DSO declined three days in the quarter to 36 days as compared to the prior year.

We are seeing concrete results from our focus on receivable collections and cash flow management during this period. ITO came in at 4.3 times. On a year-to-date basis, adjusted free cash flow was $430 million as compared to the prior year amount of $345.1 million. On a per-share basis, this is a 29% increase. We now expect full-year adjusted free cash flow to be in the $600 million range and to repurchase approximately 775 million shares in 2020, which would put us in our targeted range of approximately a 1.5 times net debt to EBITDA leverage ratio. Let me now turn to guidance. Forecasting continues to be challenging given the significant uncertainty surrounding COVID-19 and the ultimate impact for the global economy. We do not assume any deterioration in the global economy or that our customers are subject to lockdowns again.

Visibility is limited, and market dynamics are fluid, and changes in customer demand can happen quickly. While the economy is outside of our control, we continue to feel confident about the factors within our control, namely executing on our sales and marketing initiatives and continuing to launch new products with clear value-added benefits to our customers. We believe we are well-positioned to continue to gain share and have been successful in identifying and capitalizing on pockets of growth despite the challenges within our end markets. We also expect to continue to generate margin improvement driven by our pricing and Stern Drive initiatives. Now, let me cover the specifics. For the full year 2020, we now expect local currency sales growth will be approximately 1% as compared to the prior year.

We expect full-year adjusted EPS to be in the range of $24.87-$24.97, which is a growth rate of 9-10%. With respect to the fourth quarter, we would expect local currency sales growth to be in the range of 4-5% and expect adjusted EPS to be in a range of $8.60-$8.70, a growth rate of 11-12%. For 2021, we expect local currency sales growth to be in a range of 4-6% and adjusted EPS to be $27.50-$28.30. Using the midpoint of 2020 guidance, this results in a growth rate of 10-14%. Some further comments on 2021 guidance. We expect interest expense to be approximately $41 million in 2021 and total amortization to be $53.5 million.

Other income, which is below operating profit, will only amount to approximately $4 million in 2021 as compared to $13 million this year due to lower expected pension income. As I mentioned earlier, we would expect our effective tax rate in 2021 to remain at 20.5%. In terms of free cash flow for the full year, we expect it to be in the range of $640 million-$650 million. We will continue to repurchase shares and expect to end 2021 in our targeted range of approximately a 1.5 net debt to EBITDA leverage ratio. Some additional details. With respect to the impact of currency on sales growth, we expect currency to increase sales growth by approximately 2% in the fourth quarter, neutral for the full year 2020. In 2021, we expect currency to increase sales growth by approximately 2%.

In terms of EPS, currency is neutral in 2020 and will benefit EPS growth by approximately 1.5% in 2021. That is it from my side, and I'll now turn it back to Olivier.

Olivier Filliol (CEO)

Thank you, Tom. Let me start with some comments on our operating results. Our lab business had outstanding growth in the quarter. Hyper had excellent growth and benefited from COVID-related activity. Process Analytics and Automated Chemistry also had very good growth, driven by the overall strength in biopharma trends. Most other product lines showed modest growth. Self-growth in all regions was strong. We expect the strong biopharma trends to continue to be favorable as we enter 2021 and believe the first half of the year will benefit from vaccine research and testing, as well as bio production scale-up and production. We spent a disproportionate amount of R&D and sales and marketing investments in lab and believe we are well-positioned to capture growth. In terms of our industrial business, Core Industrial was up 8%, driven by strong double-digit growth in China and slight declines in both Europe and the Americas.

China is benefiting from strong demand across most product lines, in part due to pent-up demands. Overall, we are very pleased with the resiliency of our core industrial businesses in 2020, given the challenges of the end market. Our outlook for this business is solid, as we expect to continue to identify pockets of growth. However, we are not immune to the overall economy. Product inspection was down a little more than we expected in the quarter, with declines in all regions. In the near term, market conditions continue to be challenging as large packaged food companies are focused on COVID-related safety in their manufacturing sites and on operational execution. We are more optimistic for Q4 and are well-positioned once packaged food companies return to a more normal operational mode and believe we will benefit from pent-up demand. However, it will take some more time for this to develop.

Food retailing grew mid-single digits in Q3, better than we had anticipated. This business will likely be relatively flat in Q4, and looking to 2021, we expect growth in the low single-digit range. Now, let me make some additional comments by geography. Sales in Europe increased 4% with good growth in lab and food retail. We would expect sales growth in Europe to be relatively flat in Q4 and low to mid-single digit growth in 2021. Americas increased 3% with very strong growth in lab, offset by declines in product inspection and to a lesser degree core industrial. We would expect better growth in Q4 in the Americas and expect mid-single digit growth in 2021. Finally, Asia and rest of the world grew 10% in the quarter, with both lab and industrial doing very well.

As mentioned, China had 17% growth in the quarter, with excellent growth across most product lines. We would expect China to continue to do well for the remainder of this year, although we do not expect the same level of pent-up demand that we saw in Q3. We expect market conditions to be favorable in 2021, although China will face tougher comparisons in the second half of the year. One final comment on the business. Service and consumables were up 6% in the quarter. That concludes my comments on the business. While 2020 has been extraordinary on many different levels, we remain focused on our core growth strategy. We are the market leader in the vast majority of our product lines and have a weighted average share in the 25% range.

We have long spoken to you about our strategy, namely to introduce new products and use leading-edge data-driven sales and marketing initiatives to gain market share each year. Small gains in market share can have a meaningful impact on our growth. We believe we have accelerated market share gains this year by enhancing our digital sales and marketing tools and combining this with advanced data analytics to identify and guide our field force to the best potential opportunities. We could not accomplish this without the investment we have made over many years to structure our front end to allow our direct field reps to spend the majority of their time on non-customers and customers with good cross-selling potential. Let me provide you a little more context to this. The challenges surrounding COVID provided an opportunity to accelerate digital sales and marketing development that were already underway.

On this same call one year ago, well before COVID was a factor, I discussed with you the efforts that were underway surrounding digital sales tools to free up our field resources for more impactful discussions with our customers. These sales tools included a new digital library for storing vast resources, as well as field sales mobility solutions, mobile CRM, and the launch of e-demos for more efficient product demos. With this foundation already in place, we were able to quickly adapt and transform our go-to-market for remote capabilities in March. We further enhanced our digital capabilities this year with developments like simple product demos through e-demo live and co-browsing capabilities with our customers via Microsoft Teams. This has allowed us to maintain engagement with our customers despite the challenges that COVID has brought to remote work environments. Digital sales and marketing tools are one component.

We also use advanced data analytics and machine learning to identify thousands and thousands of customer sites that have potential sales opportunities. During this past year, we also leveraged heat maps of customer segments that helped us navigate COVID resilience and recovery. Internally, these opportunities generate sales alerts that we provide to our front-end organization. The alerts include insightful information such as project descriptions, cross-selling opportunities, contact data, CRM activities, site pictures, and specific value selling guides for associated products and more. We have structured our front end so that back office resources can qualify these sales alerts. They have knowledge of our customers and can determine if the computer-generated alert has the expected potential and, if so, the ideal timing for customer interaction. This helps us guide our direct field sales force to the best opportunities and with all the necessary materials for an effective customer interaction.

We also leverage our front end via telesales reps to sell to smaller or less complicated accounts. The digital sales tools available to our field force are also fully available to our telesales teams, thereby supporting their efforts to articulate the value of our products to customers. With investments we have made in insights and telesales resources over the last several years, our front end is now structured that field reps spend the majority of their time on non-customers or existing customers with strong cross-selling potential. The combination of our strong product portfolio, the innovations we have made to our sales and marketing tools, and the investments we have made over several years to our front-end organization is leading to accelerated market share gains versus our direct competitors.

There are still relatively small gains overall, but they have allowed us to help offset the challenging market conditions of the COVID environment. The COVID challenges have helped us accelerate improvement not only in our sales techniques and approach, but also in our margin and productivity.

Operator.

Operator (participant)

As a reminder, to ask a question, you will need to press star one on your telephone. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. Our first question will come from Vijay Kumar with.

Mary Finnegan (Head of Investor Relations)

Operator, hold on just one second. Olivier, are you still on the line? Operator, I think Olivier was disconnected. Can you connect him?

Operator (participant)

Okay. One moment, please. Hi. Is this Olivier? Hello. Is this Olivier?

Mary Finnegan (Head of Investor Relations)

Operator, we're on here, but should Olivier just dial in again to the same number?

Shawn Vadala (CFO)

He's dialing in now.

Olivier Filliol (CEO)

Sure. Yeah. Where did you need to guide me? I don't know.

Shawn Vadala (CFO)

Olivier has rejoined us.

Olivier Filliol (CEO)

Thank you.

Shawn Vadala (CFO)

Okay.

Olivier Filliol (CEO)

Okay. Here I'm back. Apparently, I was interrupted. Shawn is just signaling me by video where I stopped, so I will continue on. I was just finishing talking about sales and marketing initiatives, and I'm coming to the point that digital sales and marketing tools are one component. We also use advanced data analytics and machine learning to identify thousands and thousands of customer sites that have potential sales opportunities. During this past year, we also leveraged heat maps of customer segments that helped us navigate COVID resilience and recovery. Internally, these opportunities generate sales alerts that we provide to our front-end organization. The alerts include insightful information such as project descriptions, cross-selling opportunities, contact data, CRM activities, site pictures, specific value selling guides for associated products, and more.

We have structured our front end so that back office inside sales resources can qualify these sales alerts. They have knowledge of customers and can determine if the computer-generated alert has the expected potential and, if so, the ideal timing for customer interaction. This helps us guide our direct field sales force to the best opportunity and with all the necessary materials for an effective customer interaction. We also leverage our front end via telesales reps to sell to smaller or less complicated accounts. The digital sales tools available to our field force are also fully available to our telesales teams, thereby supporting their efforts to articulate the value of our products to customers.

With investments we have made in insights and telesales resources over the last several years, our front end is now structured that field reps spend the majority of their time on non-customers or existing customers with strong cross-selling potential. The combination of our strong product portfolio, the innovations we have made to our sales and marketing tools, and the investments we have made over several years to our front-end organization is leading to accelerated market share gains versus our direct competitors. They are still relatively small gains overall, but they have allowed us to help offset the challenging market conditions of the COVID environment. The COVID challenges have helped us accelerate improvement not only in our sales techniques and approach, but also in our margin and productivity initiatives.

Our supply chain teams around the world had to overcome numerous obstacles this year, including obtaining necessary protection supplies, compensating for component shortages, orchestrating global safety stocks, navigating freight capacity, and adapting to changing trade restrictions. We were one of the first manufacturing facilities to reopen in China, and we did not have a single day of shutdown in our western facilities. At the same time, the team continued to make progress on their Stern Drive initiatives, which are focused on productivity improvements in our manufacturing and back office operations. Globally, more than 130 projects have been completed this year, with 350 projects currently underway. That concludes our preparedness comment. The current environment continues to be the most challenging and unique we have ever faced.

We are executing very well, and while much uncertainty still exists in our markets, I remain confident we can continue to gain share regardless of economic conditions and are well positioned for solid results in 2020 and 2021. I want now to ask Vijay Kumar to open the line for questions.

Operator (participant)

As a reminder to ask a question, you will need to press star one on your telephone. To withdraw your question, press the pound key. Please stand by while we compile the Q&A roster. Your first question will come from Vijay Kumar with Evercore ISI. Please proceed with your question.

Vijay Kumar (Senior Managing Director and Equity Research Analyst)

Hey, guys. Thanks for taking my question, and congrats on a really good print here. Olivier, maybe on that China comments, the 17% growth here, could you maybe help clarify what portion of that 17% was perhaps a pent-up demand? I think you guys mentioned one to two points of COVID tailwinds. Is the COVID tailwind the same as a pent-up demand, or is that a separate item?

Olivier Filliol (CEO)

Let me do the second part first because that's an easy one to answer. No, this is not correlated with pent-up. The tailwind for COVID is mainly coming in the tips business that we have with our Rainin and biotech businesses. They serve the testing markets, the COVID testing markets. We call that tailwind, as pent-up is not labeled that way. To isolate the pent-up aspect of the China growth is not so easy to quantify, but I think another way to look at our numbers in China is the year-to-date. As you will recall, in the early part of the year, China had a significant decline, and here we have seen a very good recovery in Q3. In that sense, there is a significant aspect of that is pent-up demand. We see kind of a V-shaped recovery trend.

Beyond that, I certainly feel we have won good market share gains here in China. The team has executed extremely well during the whole COVID crisis. When there was a lockdown, our Chinese team continued to stay in contact with customers. We were very fast in bringing deliveries back and have certainly gained a lot of confidence with the customer base. We had this whole go-to-market change management that I described before in the prepared remarks. We did roll that out globally, but also particularly in China, and that has benefited us also in Q3. Different aspects drove very nice growth, but pent-up demand was certainly one of them.

Vijay Kumar (Senior Managing Director and Equity Research Analyst)

That's helpful. For my follow-up, I guess when you look at the 2021 preliminary outlook, 4-6%, I'm curious, are you assuming any share gains within that 4-6%? Perhaps comment on what's being assumed for the different segments.

Olivier Filliol (CEO)

Yeah. Let me take the first part, and then Shawn can take the second part. In terms of share gain, yes, we do count on share gains, but our whole strategy is not for bold share gains, but actually share gains every year, a few basis points, because that adds up to something significant when we think about organic growth. What we have experienced here, maybe in the last two quarters, was a bigger shift in share gains. I would hope that in next year we can still also have maybe a little bit above average share gains, but not in the same magnitude as we have seen in the last two quarters. Shawn, maybe to the second part of the question.

Shawn Vadala (CFO)

Yeah. Hey, Vijay. Hey, let me start first with the product categories, and then I'll talk about the regions. For 2021, we currently would expect the lab business to be mid to high single-digit growth. In the industrial business, we're currently thinking the product inspection business will be about mid-single-digit growth, with the core industrial business being more like low single-digit growth, and we expect food retailing to be more like low single-digit growth. From a regional perspective, we're currently thinking that Europe will be more low to mid-single-digit growth, while the Americas and China will be more like mid-single-digit growth.

Vijay Kumar (Senior Managing Director and Equity Research Analyst)

Appreciate the comments, guys. Thank you.

Operator (participant)

Your next question will come from Tycho Peterson with JPMorgan. Please proceed with your question.

Tycho Peterson (Managing Director)

Hey, thanks. Actually, Shawn, I want to pick up right where you left off on Europe, being flat in the fourth quarter, a little bit single-digit next year. Obviously, COVID cases going up a lot there. The Horizon 2020 budgets have been cut. What gives you kind of confidence in that market being relatively stable?

Shawn Vadala (CFO)

Yeah. I mean, hey, Tycho, I think our guidance right now is based upon we're assuming market conditions remain the same in terms of where we sit today. As we kind of think about COVID cases, of course, it's a very fluid situation. We're currently not experiencing anything in our business where customers are not allowing us on-site to do installations, or we're not seeing it affect their behavior at this time. Of course, there's certainly risks with COVID, and we certainly acknowledge that. As you can kind of see too, our guidance for the fourth quarter for Europe is flattish. It is modestly a little bit down from where we were in the third quarter. For next year, again, we're thinking more like low to mid-single-digit growth.

Tycho Peterson (Managing Director)

Product inspection, you mentioned that was a little bit worse than expected. You're talking about mid-single-digit growth there next year. Are you getting leading indicators from your consumer packaged goods customers and others that that demand will come back sooner rather than later?

Shawn Vadala (CFO)

Yeah. I mean, it's an interesting one. We certainly have conversations with customers that indicate that there's certainly an interest to do projects, but right now we do see that a lot of customers are distracted with their own operational challenges at the moment. In terms of having the time to really initiate new projects is something that we're still looking forward to. Nonetheless, from a cadence perspective, we do feel like the fourth quarter will be better than Q3, and we certainly are more optimistic going into next year. As you know, we feel very good about this business in terms of our overall competitive advantages and the general dynamics that drive growth in this business around topics like food safety and things like that. We are much more optimistic for the midterm.

It's just a little bit difficult to tell at exactly what time we'll start to see customers returning to more of an investment mode.

Tycho Peterson (Managing Director)

Lastly, for Olivier, there was a lot of talk on the call about market share gains, and that's great to see. I'm wondering if you could talk a little bit more about where those gains have been the greatest, anything you can kind of quantify. With the digital infrastructure now built out, how will they step up share gains going forward? Could they start to accelerate?

Olivier Filliol (CEO)

Yeah. Actually, hey, quantifying it is very difficult. Of course, we do not have particular market data from our direct competitors. We have some data points from our peers that give us a lot of comfort. I think it is more information that we get from our markets around the world. We see it also in terms of many new customers that we can gain. We have some KPIs that we use internally to monitor how much of our business comes from existing customers and how much comes from new customers. That all gives us this indication that we have been winning share. I would be really hard-pressed to come up with a number. Also, what I want to say is we feel this is something we achieve across the world, across businesses.

This is also very much driven by all these programs that I described that we apply really across everything. What we certainly also see the biggest benefit is in our direct business, and our direct business has been also growing faster than, for example, the indirect business. That's probably another indication why these programs work really well.

Tycho Peterson (Managing Director)

Okay. Thank you.

Shawn Vadala (CFO)

Your next question will come from Derek De Bruin with Bank of America. Please proceed with your question.

Michael Ryskin (VP)

Hey, it's Mike Riskinon for Derek. Thanks for taking the question. First, I want to follow up on the guidance comments for 2021, both on the top line and on the adjusted EPS. Just curious, as you obviously posted a strong result in 3Q and you've got a mid-single-digit guide for 4Q, when you go into next year, you're going to be facing significantly easier comps in the first half of the year. And your comp for all of this be your 2020 is going to be a little bit easier. Just wondering, is this more of a not a lot of visibility in the second half of the year? I know we walked through some of the geographies and the business segments, but just curious where you're seeing the puts and takes given which would be a very easy setup for first half 2021.

Shawn Vadala (CFO)

Yeah. Hey, Mike, I'll take this one as Shawn. Hey, as you know, we don't have a lot of backlog in our business, so we're only about one and a half months of backlog at a time. Of course, it's always a little bit challenging to put out our first guidance for next year. As we kind of look towards the year, you're right, we will benefit from easier comparisons in the first half of the year. We look at topics like China and Q3 of next year, and we'll have more difficult comparisons there. Overall, I would say we feel good about the business. We feel good about our execution. We feel good about our momentum. It's always a little bit challenging to kind of guide with some of the uncertainty out there.

If I look at maybe puts and takes, I would say that China is always one that can be an upside or a downside. China, we always like to say things can change rather quickly in China. I think over the last nine months, we've certainly seen things change in both directions very quickly there. If we're looking for upsides and downsides, I'd say I'd point out and highlight China. I think another one that I would also highlight is product inspection. It's also a similar size of our total business. We feel very good about this business, as I mentioned with Tycho's question. That's also a business that can have upside or downside based upon some of the dynamics that I described earlier.

Michael Ryskin (VP)

Great. That's helpful. Then a quick follow-up along the same lines. If we sort of look at the P&L, if my math is right for 2021, it looks like you're guiding to about 40 basis points of margin expansion, give or take, on the OpEx line. Just trying to think through what changed in 2020 relative to your initial expectations. Is this just a lot of the cost that you pulled back on this year coming back, or is this additional incremental investments on top of what would normally happen? Just sort of looking at the 2020 to 2021 moves there.

Shawn Vadala (CFO)

Yeah. I think we'll probably do a little bit better than that, Mike, but you're right. It's going to be a little bit lower than our typical guidance of 70-100 basis point range, which we still feel very good about from a medium-term perspective. We also have to keep in mind that we're coming off of a strong year of operating profit margin growth in 2020 of 120 basis points. In terms of the program supporting our margin, we feel really good about the momentum that we have in terms of the pricing program as well as our Stern Drive program.

You are right, one of the things that will be maybe a little bit of a headwind next year is the temporary nature of some of the cost savings measures that we had in 2020 that we now need to bring back into the cost structure for 2021.

Michael Ryskin (VP)

Okay. Makes sense. Thanks so much.

Shawn Vadala (CFO)

Thanks.

Your next question will come from Brandon Couillard with Jefferies. Please proceed with your question.

Brandon Couillard (SVP)

Hey, good afternoon. Shawn, sticking with the 2021 outlook, free cash flow guidance is a little below 10%. Can you speak to any working capital needs for next year? What are you penciling in for CapEx?

Shawn Vadala (CFO)

Yeah. Just one second, Brandon. Let me pull it up here. Let me start with the second one. For CapEx, we have $103 million in our model for next year. That's going to be up about $10 million from this year. We have some facility investments that we're going to be making in the first half of next year. Otherwise, we feel good about our overall free cash flow growth next year. I think it's going to be kind of in line with our operating profit growth generally. There's always maybe timing topics from one year to another. I think especially if you look at the two years combined, like this year and next year, overall, we're very pleased with the growth. I mean, you saw the cash flow generation that we had here in the third quarter and on a year-to-date basis.

Really, really impressed with the execution in the organization on a lot of different managed-for-cash initiatives. I feel like we'll continue to have that momentum as we kind of go into next year as well.

Brandon Couillard (SVP)

Could you talk about what's embedded in terms of net pricing capture in 2021? As we think about gross margin or margin expansion generally, would that lean more on the gross margin side than OpEx, given some of your comments about some of those cost items coming back into the P&L?

Shawn Vadala (CFO)

Yeah, sure. In terms of our gross margin for next year, right now, for this year, right now, we did just over 2% in terms of price realization for Q3. I think we'll probably be at that kind of a level for 2020. As we look to 2021, we do have good momentum in the program, but at the same time, we're looking at a lower inflationary environment. At this point in time, we're right now thinking that we'd be more like in the 1.5% kind of a range for next year for price realization. If we kind of look at the overall gross margin expansion next year, probably something in the 30 basis point kind of a range. That would exclude maybe a little bit of unfavorable effect of currency.

One of the things that we have as a headwind also to our gross margin next year is going to be some of these temporary cost savings that we talked about that come back. That will also be a little bit of a headwind in terms of our gross margin expansion next year as well.

Brandon Couillard (SVP)

Very good. Thank you.

Shawn Vadala (CFO)

Your next question will come from Patrick Donnelly with Citi. Please proceed with your question.

Thank you. This is Jesse on for Patrick. Just wanted to touch on the 1-2% of COVID-related tailwinds. Wondering if you could break that down a little bit further between the areas you laid out between testing and vaccine research and bioprocessing. Just curious what's implied there for 4Q2020 and into 2021 guidance.

Olivier Filliol (CEO)

As mentioned, it is related to the tips business with pipettes. It's related to testing kits or for testing centers where pipettes and the tips are used. That's the part that we call tailwind because obviously this is tied to the number of tests being conducted and the tips demand associated with that. This can have a very high volatility in demand. We see actually that volatility also following the waves in different regions. The 1-2% was for Q3. For Q4, we would expect more like 1%. When we think about next year, we could still see some tailwind at the beginning of the year. Depending on how COVID evolves, it would start to diminish. Then we would start to have some headwinds from a comparison standpoint.

Okay. Thanks. Just looking back at the earlier days, the pandemic in relation to China saw a pretty strong drop-off in Q1, but strong recovery in Q2 and Q3. As we look ahead, would we expect kind of a similar dynamic if the country was to shut down due to the resurgence of COVID cases? Do you think with this new go-to-market strategy, you can see more resiliency within China, even if we do see quite a big resurgence of COVID this quarter and into 2021?

Yeah. I think what's changed is every country learns to deal with COVID in a more differentiated way. I see that. I experienced that myself being based in Switzerland and Europe. The second wave has a totally different impact on the business world. It is because governments react differently, but of course, also because business and individual people react differently to that. We are so much more knowledgeable about things. We have today face masks that protect us and so on. The B2B world that we are living in is not impacted as much anymore. I see also the reaction of all our customers to be much more controlled, even that we have semi-lockdowns, for example, in Europe right now. We do not see it in the same way in order entry, leads generation, and so on.

The second factor is what you just also mentioned that we have already addressed with our go-to-market approaches. In that sense, I do expect a much smaller impact on our business from any second wave that is taking place right now.

Okay. Great. Thank you.

Operator (participant)

Your next question will come from Jack Meehan with Nephron Research. Please proceed with your question.

Jack Meehan (Equity Research Analyst)

Thanks. Good afternoon. I was hoping you could tease out for us just how much of the sales in the quarter you think might have benefited from some sort of catch-up from earlier in the year. Are there any dynamics looking at each of the three businesses we should just be keeping in mind going into the fourth quarter that the catch-up might impact?

Shawn Vadala (CFO)

Yeah. Hey, Jack. This is Shawn. Hey, of course, it's always difficult to try to know or to quantify that. I think the one region that certainly stood out the most from our perspective was China in terms of catch-up. As we talked about, we definitely see more of a V-shaped recovery in China compared to maybe some of the other regions. In terms of some of the other geographies, it's a little bit more difficult to say. Was there a little bit of catch-up in Europe? Maybe. Very difficult to say. I think I'd maybe just then kind of pivot towards how we're currently seeing the fourth quarter in terms of guidance. Those types of factors would have been considerations for us as we kind of provided our guidance for the fourth quarter.

Jack Meehan (Equity Research Analyst)

Great. I wanted to follow up on R&D investment. Just a clarification. I think I heard 5% of sales, but I was not sure if that was for the full year or for the fourth quarter. Regardless, I think you are calling for a nice step-up going into the fourth quarter. Just maybe talk about where you are finding new projects. Do you think you will continue to invest at these probably more normalized rates in 2021?

Shawn Vadala (CFO)

The 5% is more for the full year. The 5% is actually a good number for also midterm. We always have a little bit of a fluctuation from quarter to quarter. Yeah, when you think about it, when it is independent of product launches or particular events, then the 5% applies. The reason why you saw this summer a bit of a slowdown in spending was, on one hand, the timing of projects, including also product launches, and some of the temporary cost measures that we had, including also quarter-by-quarter furloughs in Europe, had also some impact on the R&D spending. In that sense, yes, Q4 will resume more normal level, maybe even a little bit higher level of R&D spending.

Operator (participant)

Your next question will come from Richard Eastman with Baird. Please proceed with your question.

Richard Eastman (Managing Director and Senior Analyst)

Yes. Thank you. Thank you for the question. Olivier, when you look at the, or Shawn, the core industrial business was up 8% in the quarter. I may have caught that you said Americas and Europe was down modestly. Was that the case? Was the growth of 8% pretty much derived from China?

Olivier Filliol (CEO)

Yes. Yes, it was. Very much so. China was very strong, also related to this pent-up demand effect that we were talking about before. The overall strong momentum that we see in our Chinese business. You might also recall that core industrial in China has a little bit higher percentage of the business mix than the rest of the world. In that sense, a double effect.

Richard Eastman (Managing Director and Senior Analyst)

Yeah. Given there's a cyclical element, obviously, COVID would have impacted the business there as well, just access, I guess, if nothing else. If you think about the cyclical aspect of core industrial in the Americas and Europe, how does it feel if you sift through COVID? Does it feel like that business is maybe bottoming when you think about capital budgets and expenditures on core industrial in the two bigger geographies there?

Olivier Filliol (CEO)

Yeah. If you would have asked me two quarters ago or even one quarter ago, I would have thought that core industrial would be impacted more by COVID and the recession. In that sense, pleasantly surprised. I certainly explain it on the one hand that the global economy recovered faster than we expected. The second one also is we were very successful in shifting our resources to the more resilient industries. The more resilient industries, for example, being biopharma, hold up very nicely. We certainly feel we could gain share there also with our core industrial business. Yeah, I'm happy to see that it's less cyclical than we would have expected and shows that we have also good execution on this.

There are individual segments, like we call it the MPE market, so materials, plastic, and electronics market, that is clearly down and suffering from the economic environment.

Richard Eastman (Managing Director and Senior Analyst)

When you talked about earlier in your presentation, Olivier, when you talked about the digital marketing tools, does that account for some of this more resilient? I mean, is that part of how you shift your resources? Do you deploy those on the core industrial side as well?

Olivier Filliol (CEO)

Oh, yeah. Yes. Absolutely. We really deploy it everywhere. I think there is a multitude of tools that are helping. On the one hand, we do these segment analyses and heat maps that show us which account sites have the most potential. We guide our sales force to go after these opportunities. We use the digital tools, sales tools, virtual sales tools on top of that so that, for example, our salespeople also for industrial businesses would engage customers, not only by physical visits, but more and more by video calls, by online webinars that are dedicated to accounts. We have a digital library and all that. All these topics apply across the business, including core industrial.

Brandon Couillard (SVP)

I see. Okay. Very good. Thank you.

Operator (participant)

Your next question will come from Steve Willoughby with Cleveland Research. Please proceed with your question.

Steve Willoughby (Founding Member, Partner, and Senior Analyst)

Hi. Good evening. Two questions for you. Just wondering if you could break out. You commented that consumables and service was up 6% in the quarter. If I remember correctly, I believe service was down year over year in the second quarter. Just wondering if you could give me a little bit more color between consumables and service. I guess along with that too, where do you stand in terms of being able to meet demand for pipettes these days? Are you building backlog at all given the increased demand in pipettes? Any CapEx you need to do? My second question or topic is, Mary, it looks like you're stepping up the share repurchases in the fourth quarter versus what you were expecting 90 days ago. How much in share repurchase activity is implied within the guidance you gave?

Olivier Filliol (CEO)

Good. Shawn, do you want to take the first one? I take the second one and Mary the third one.

Shawn Vadala (CFO)

Perfect. I got everybody.

Okay. Good. Hey, Steve. On the first one, I want to also clarify in the script, we realized that the 6% should be on a year-to-date basis for service and consumables. In the quarter, service and consumables were actually up by 12%. That included about 4% growth in the core service business with very strong double-digit growth in our consumables business.

Steve Willoughby (Founding Member, Partner, and Senior Analyst)

Gotcha.

Olivier Filliol (CEO)

On the second one, the pipettes themselves are less of a capacity constraint issue. It's more the tips. On the tip side, you have a capacity problem in the whole industry, not just us. We are in a reasonable situation because we have three production facilities. We have one in Mexico, one in California, and one in China. They are all running at full steam. Of course, we leverage the three different facilities for the global supply, not just for local supply. We have been successful in increasing the capacity over the last few months and will continue to further expand capacity. There are different levers that we have. We feel good about it, and we certainly feel that this capacity increase will also allow us to further gain share. The demand is certainly here.

I think we are in a good position to be faster to orders in terms of raising the capacity. This includes also a bigger facility expansion or new facility that will go live next summer. Our whole focus is actually to expand capacity already here in the next couple of weeks and certainly also into the first quarter. Mary, you take number, please.

Mary Finnegan (Head of Investor Relations)

Sure. Hey, so in terms of share repurchase, as Shawn mentioned on the call, hey, we want to keep our net debt to EBITDA in this 1.5 times range. Of course, the actual amount we do next year will depend a little bit on your assumption in terms of EBITDA and cash flow. If I just look at the midpoint of our range, we would be repurchasing somewhere around the $850 million level. Of course, it could be a little higher, a little lower, just depending on how things play out.

Steve Willoughby (Founding Member, Partner, and Senior Analyst)

Okay. Thank you very much.

Operator (participant)

Your next question will come from Dan Arias with Stifel. Please proceed with your question.

Dan Arias (Managing Director)

Good afternoon, guys. Thank you. Olivia, maybe just pecking around the edges and sticking with the market share gain conversation. Obviously, that's easier to do in some places than others. I guess I'm just curious in on the segments or areas of the market where you found it to actually be more difficult to take share. What is it about the competitive offerings that's allowed them to kind of hold serve more than others? Is it customer loyalty, price? What are the factors that are hardest to overcome that you're finding?

Olivier Filliol (CEO)

It's certainly in the area that we have talked about also in the past, and that's retail. In food retail, our spin-up approaches, our sales and marketing approaches have not the same benefit. In retail, we clearly see that we have a highly competitive market because it's more difficult to do value selling to differentiate in front of the customers. The projects are typically also bigger. That's certainly an area where we are not focused on market share gain, but actually on profitability. The second differentiation I could make is direct or indirect channels. Wherever we go, direct channels, these approaches play much better to our benefit. We are introducing spin-up or underplying spin-up approaches also to indirect channels. You can imagine we don't have the same impact, and we can't implement all the tools in the same way. That's probably the way I would mostly differentiate.

From a geographic standpoint, I would not differentiate. For the core business outside of retail, and if it is not a particularly big project or so, all of what we do here is applicable and would help us on the share gain.

Dan Arias (Managing Director)

Yeah. Okay. That's great color. Maybe just operationally, are you guys through the SAP implementation within product inspection? Then on Blue Ocean, when you think about where or how you finished the year there, what percentage of users do you think are fully under the umbrella of Blue Ocean by that point?

Olivier Filliol (CEO)

Indeed, we have the last implementation in product inspection going live in Q3 in Tampa. This was the most demanding and the most complicated facility and operation to go into Blue Ocean go live. You can imagine it was even more difficult to do that under COVID. Very difficult, people being in home offices, international teams not easily traveling. Given all these challenges, we are happy with how things went. It nevertheless had some impact on our Q3 numbers, as Shawn highlighted before. We still have some more work to do in terms of every implementation of Blue Ocean has been a challenge. Also after the go live, there are always challenges in workflows that need to be optimized. It still has material data that needs to be optimized and so on. We are still going through these.

I do expect that in the next couple of weeks, we will have full stabilization and then starting to have the benefits like we have seen in all other units, including the other PI units. I want to recall that a few years ago, we went live with Garvan's Blue Ocean check weighing business that initially was also very difficult. Today, this check weighing business is so much benefiting from the Blue Ocean implementation in terms of material cost savings, operational efficiency. I do expect that these things will also come to Tampa. Right now, we are still kind of streamlining things that we have just implemented. Sean, do you want to talk about the second point?

Shawn Vadala (CFO)

Yeah. Most of the units remaining are, I would say, smaller units in the company. We have a handful of smaller units in Europe still to go, as well as in Asia, rest of the world. The largest unit that we would have would be our French market organization, which will go live in a couple of years. In terms of the overall users, I'd probably estimate it's in the 80% kind of a range that are currently on the system.

Olivier Filliol (CEO)

All major producing organizations are now on Blue Ocean. That was the key part missing with Tampa. That is also one of the reasons why the majority of the benefits that we can get out of Blue Ocean are now in operation.

Yep. Very good, guys. Thank you, Shawn.

Operator (participant)

We do have one final question in queue, and that will come from Dan Leonard with Wells Fargo. Please proceed with your question.

Dan Leonard (Managing Director and Research Analyst)

Thank you. For starters, could you be specific on the growth in China between lab and industrial? If you disclosed that earlier, I missed it.

Shawn Vadala (CFO)

Yeah. We had high single-digit growth in both of those areas, Dan. I mean, I'm sorry.

Olivier Filliol (CEO)

In China?

Shawn Vadala (CFO)

I'm sorry. Double-digit growth. I apologize. We had double-digit growth in both laboratory and industrial in China in the third quarter.

Dan Leonard (Managing Director and Research Analyst)

it safe to assume lab was above 20%?

Shawn Vadala (CFO)

No. Actually, our industrial business was stronger than our laboratory business in the third quarter, which kind of supports our comments on why we felt like there was pent-up demand on the industrial side.

Dan Leonard (Managing Director and Research Analyst)

Got it. My follow-up. Shawn, can you help me think about how you're framing any year-end uncertainty in your fourth-quarter guide? Is it fair to assume that your 4-5% local currency assumption reflects a better result than that during the month of October with more caution around December? Or are you assuming more linearity in your performance?

Shawn Vadala (CFO)

Yeah. I think it's always difficult to try to comment on any particular month. I mean, there's obviously prior year comparisons that can come into play here. I would just say that, hey, we feel very good about our guidance. We feel good about how we enter the quarter. Of course, we had the benefit of seeing the month of October when we provided our guidance. We don't have any—we didn't factor in anything particular from an uncertainty perspective other than that we acknowledge that there is uncertainty in the market. Market, and things can always change quickly.

Dan Leonard (Managing Director and Research Analyst)

Great. Thank you. Have a good night.

Shawn Vadala (CFO)

Thank you.

Operator (participant)

We do have one other question that just came into the queue, and that is from Dan Brennan with UBS. Please proceed with your question.

Dan Brennan (Senior Equity Research Analyst and Managing Director)

Hey, guys. Sorry about that. I guess we were just in queue inappropriately. Thanks for the question.

Congrats on the quarter. Maybe just two questions, Olivier, or Shawn. The guide for 2021, and I do not think this is covered, but the core growth at low single just seems really potentially conservative. I know you are assuming that the world is still kind of—we are not there yet with COVID, but nonetheless, given what you just posted this quarter. Also for China, I know there were some questions earlier, but just maybe give us a little flavor for those two particular guides, kind of what goes behind that. Are you assuming maybe things get a little worse from here and that is what is baked in? Thank you.

Shawn Vadala (CFO)

Yeah. No. Hey, Dan, I'll take the question. This is Shawn. On the core industrial side, as Olivier mentioned before, we're really pleased with the resilience of the industrial division recently and actually for the past couple of years. We feel very good about the execution there. We feel really good about our ability to target the more attractive, faster-growing, more resilient segments of the market. Nonetheless, we're not immune to the economy. When we look historically, we do have that in the back of our minds that this business historically is the more susceptible to the global economy. That's a little bit on our mind with the low single-digit growth. Maybe the second thing is that we just had extremely strong growth in China and industrial, as we just mentioned a few minutes ago.

We are going to have a much more difficult comparison in China when it comes to the industrial business next year. As we mentioned earlier, China is a disproportional percentage of the mix for that business compared to our other businesses. I think the second part of your question was China for next year, was it? Or was it?

Dan Brennan (Senior Equity Research Analyst and Managing Director)

Yeah. I know you covered it several times over, but could you just maybe, in closing, just give us a flavor for kind of what's happening now? I think there was a question earlier about was there any kind of catch-up? I think maybe Jack asked it. Just to be clear, did China benefit from a catch-up this quarter? If not, the 5% next year is really just conservatism or the comp or just any color there? Thanks.

Shawn Vadala (CFO)

Yeah. Just to clarify, in the third quarter, China was up 17%. We had double-digit growth both in the laboratory business and the industrial business with stronger growth in our industrial business. We did feel like there was a pent-up demand in China in the quarter. I mean, if you kind of look at the sequential quarter, starting with Q3 being down 13% in China, it is very much of a V-shaped type recovery. We feel like the team is doing well. We feel like we are executing extremely well. All the digital marketing approaches that Olivier mentioned earlier also benefit in China. We feel like we are gaining a little bit of market share there. We feel very good about our execution.

Of course, we also feel very good about the growth prospects of China kind of going forward, especially from a medium to longer-term perspective, especially with trends in biopharma and things like that. As we think about 2021, I always like to say in China, things can always change very quickly. We saw examples of that going in both directions already in the last nine months. We are always a little bit cautious in that regard when we try to forecast in China. Currently, sitting here today, we feel like mid-single digit. We feel good about that. Could it be higher? Could it be lower? We will see. We tend to think that the laboratory business will be stronger in terms of growth for 2021 compared to 2020 compared to our industrial business.

A lot of that is just coming off this very strong quarter on the industrial side in Q3 and just kind of acknowledging that we're going to have a harder comparison in the second half of next year. I think we're going to start the first half of the year very strong in China. They'll have a much easier comparison in Q1. It's really about the second half of next year.

Dan Brennan (Senior Equity Research Analyst and Managing Director)

Great. Thanks, Shawn.

Shawn Vadala (CFO)

Yep. You're welcome.

Operator (participant)

At this time, we have no further questions in queue. I will now turn it back over to the panel for closing remarks.

Mary Finnegan (Head of Investor Relations)

Thank you. Hey, thanks, everyone, for joining us this evening. As always, if you have any questions, please do not hesitate to reach out. Take care. Bye-bye.

Shawn Vadala (CFO)

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.