Waters Corporation (WAT) is an analytical instrument manufacturer. Through its Waters Division, Waters designs, manufactures, sells and services high-performance liquid chromatography (HPLC), ultra performance liquid chromatography (UPLC), referred to as liquid chromatography (LC), and mass spectrometry (MS) instrument systems and support products, including chromatography columns and other consumable products, and post-warranty service plans. Through its TA Division (TA), the Company primarily designs, manufactures, sells and services thermal analysis, rheometry and calorimetry instruments. The Company is also a developer and supplier of software-based products that interface with the Company’s instruments, as well as other manufacturers’ instruments. Waters operates in two segments: Waters Division and TA Division. In February 2009, the Company acquired Thar Instruments Inc.
Waters Corporation is not the most basic company to evaluate. Given the highly technical nature of its product line, it will be very difficult to model out growth and profit margins into the future. However, the firm has done a remarkably consistent job with growing profits and sales over the past decade. Furthermore, WAT has sustained very high returns on capital, demonstrating a very successful defense of their niche. All of this success has come with the price of premium valuation. They will need to sustain their economic performance in order to justify such a price.
The Waters division (approximately 90% of revenue) designs, manufactures and sells mass spectrometry (MS) and liquid chromatography (LC) instrumentation and related consumables. The company also provides support services for these products. These are basically high tech instruments serving the healthcare sector and other specialty industries. There is an increasing need for a combined LC-MS platform, making it more difficult to distinguish the two markets and causing the company to aggregate LC and MS into one division. It is estimated that approximately 35-40% of Waters’ Instruments are integrated LC-MS instruments, and that proportion will increase in the future. The remaining instrument sales are primarily LC platforms, half of which are used for regulated quality control testing for pharmaceutical companies.
Waters is pursuing a large niche strategy, giving the company a market-leading position in its two core technologies. There is currently a product refresh and replacement cycle underway which should drive growth. The competitive climate is becoming increasingly intense, as companies want a piece of this profitable category. This is a real risk for the company as the category is very large and the pace of technological change is rapid.
Waters has a balanced mix of recurring (45%) and nonrecurring revenue (55%). Instrument sales account for the nonrecurring portion, while consumables and service account for the recurring portion. Recurring revenue is more economically stable and has higher operating margin, but nonrecurring instrument sales tend to be higher growth, though more economically sensitive. Approximately 30% of Waters’ revenue comes from service contracts which are a significant portion of the overall mix. Waters believes it has one of the largest sales and service organizations in the industry. More than half of the employees are specialized sales and service field representatives. The high percentage of service revenue is the result of the complex nature of the instrument systems, and the service plans are provided for primarily commercial customers only. The commercial/academic end user mix is highly weighted to commercial providing more stability than competitors. Service contracts tend to have gross margin in the mid-50s and operating margin in the mid-30s; thus, services tend to dilute the consolidated gross margin, but are accretive to the consolidated operating margin. The current mix of business among instruments, consumables, and service is 55%, 16% and 29%, respectively. Longer term, the company targets a mix of 60% nonrecurring and 40% recurring; thus the proportion of instrument sales should increase over the coming years. Within the instruments business, roughly half of sales are replacement products, with the other half being new placements.
The company has large exposure to the biotech industry. Therefore, issues within pharma such as patent expiration or lack of new funding are a potential risk. Large pharmaceutical firms have begun to resume spending on instruments after a prolonged slump. This was evidenced by increased spending for contract research accounts in the most recent quarter. This was the first quarter-over-quarter growth in over a year for large pharma—but the company’s outlook for spending remains cautious. Recent shifts in tech spending may benefit the company. For example, the growing presence of biologics in the drug development pipeline should benefit Waters.
Due to its increased size and industrial exposure, economic recovery will have a major impact. New areas of development include areas such as food safety testing, which had strong growth in the recent quarter. Although food safety accounts for only 6% of the company’s revenue, it is an important growth driver for the future. Waters also has exposure to government spending. The risk of government budget cuts will have an impact on revenue. Overall, the company has a nice diversity of revenue streams—no single customer accounted for more than 3% of revenue in any of the past three years. The company has made great efforts to reduce its customer concentration over time. Management notes that the top 15 accounts were nearly 25% of revenue five years ago, but now account for about 12% of revenue.
Waters derives approximately 70% of its revenue from outside the United States. International sales have become an important factor in the company’s growth strategy. China and India are major end markets. Many of the company’s primary facilities are located outside the United States. The company has taken advantage of off shoring over the past five years and this trend is expected to continue. Recently, Waters announced plans to build a new mass spec facility near Manchester, England to expand and consolidate the company’s U.K. footprint. The new facility is expected to be completed in 2013 and is to house R&D, manufacturing and customer support functions currently spread across multiple buildings in Manchester.
Ratios – P/E (ttm) 21.4X
Discounted Cash Flow Analysis:
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- Economically sensitive business—receives a significant amount of revenue from capital budgets.
- Pricing pressure.
- Healthcare spending pressure. Significant exposure to the healthcare industry.
- Exposure to government spending – both domestic and international.
- Currency risk. Approximately 70% of Waters’ revenue is derived outside of the U.S.
- Competes in a rapidly changing industry.
The company has demonstrated the ability to dominate a large and profitable niche. Shareholders have benefitted as a result. However, the risk/reward payoff may be unattractive for most value investors due to its rich valuation.
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