Waters: Analyze This (NYSE:WAT) (2023)

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Please skip the following introduction if you have read my previous articles.

Introduction

“It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

“Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down."

- Warren Buffett

What is a wonderful company, and what is 'quality merchandise' from an investing standpoint? The most constructive definition to address this question is Buffett's concept of ‘economic moat’, a long-lasting competitive advantage that allows a given company to harvest above-average returns on its capital, even when faced with economic downturns or powerful competitors.

A quality investing strategy should, therefore, capture the fundamental nature of Buffett's philosophy. Here, the aim is to identify high-quality stocks - or ‘compounders’ - trading at reasonable prices by calculating a simple Quality Score based on fundamental factors related to the actual business and its intrinsic economic characteristics. These are (possibly) the qualitative and quantitative factors that best capture the elusive 'quality dimension' of a specific company, at least according to Buffett and other investors in such best-of-breed companies like Charlie Munger, Chuck Akre, and Joel Greenblatt. The intention is not to discuss fleeting quarterly results (far from it) but rather to analyze and find superior companies and business models capable of compounding value for many years into the future. To calculate the Quality Score, the following questions will be addressed:

1) Presence of strong and enduring competitive advantages; 2) Favorable market dynamics and relative positioning; 3) Presence of multiple and complementary sources of revenue; 4) Presence of market leadership; 5) Presence of pricing power; 6) Presence of high and persistent Returns on Invested Capital; 7) Strong cash-generation ability; 8) Presence of superior gross profitability; 9) Presence of superior revenue growth; 10) Absence of systemic and company-specific risk factors with the potential to compromise the firm's future; 11) Presence of a solid financial position, with little debt.

To calculate the Quality Score, one (1) point is awarded when the answer is fundamentally positive ("Yes"); minus one (-1) point is subtracted when the answer is essentially negative ("No"); no points are added or subtracted (0) when there is too much uncertainty or when negative and positive factors are essentially in equilibrium. 'High-quality companies' are the ones with a Quality Score of "6" or above. Let us then calculate the Quality Score for Waters Corporation (NYSE:WAT).

1. Does Waters have strong and durable competitive advantages over competitors? Yes: 1 Point

“We certainly taught chemists how to use liquid chromatography better than anyone else.”

- James Logan Waters, founder of Waters Corp.

Founded by Jim Waters, an entrepreneur with a propensity for the hard sciences, the company now known as Waters Corporation has been pioneering innovative scientific instruments since 1958. With perfect foresight, Jim affirmed in 1965 that he believed that “liquid chromatography can become a mass-market which will extend far beyond the research laboratory into production, quality control, and clinical testing”. Indeed, up until the mid-sixties, the analytical technique of gas chromatography (GC) was the preferred means to separate, identify, and characterize chemical compounds; this technique, however, had severe limitations because only a small percentage of all organic compounds is volatile and therefore amenable to be analyzed through gas chromatography. In contrast, liquid chromatography (LC) had no such limitation, as both volatile and non-volatile compounds can be analyzed with this (at the time, relatively novel) technique.

The potential market for LC was hence enormous, but chemists and other scientists had neither the knowledge nor the specialized instruments to carry it out. By creating the first, ‘user-friendly’ mass-market LC instruments, Waters was the company that capitalized on this promising opportunity. Throughout the years, and as Waters’ diversified its offerings, the company’s installed base of analytical equipment grew at a very fast clip to become one of the larger within its industry. As a consequence, the company’s offerings are now deeply entrenched in the daily workflows of tens of thousands of scientists and other personnel working in the academic, industrial, biochemical, governmental, environmental, pharmaceutical, and nutritional safety markets.

Such an entrenched position is a function of the strong customer switching barriers created by the company's razor-and-blades business model: once a given customer acquires the company’s instruments (the ‘razors’), this customer will only be able to use compatible consumables provided by Waters (the ‘blades'). As expected, instruments and their respective consumables are designed to operate as a single system. As a result, roughly half of Waters’ revenue is now generated by consumables and by service contracts.

These high barriers are further solidified by the fact that the company's instruments are mostly used in sensitive, demanding, and heavily regulated industries. Regarding the development and manufacture of pharmaceuticals, for instance - and in order to ensure the quality and homogeneity of the final product - regulators demand the implementation of very precise, well-defined, and consistently reproducible testing and production methods. Such demands, however, can only be fulfilled if the same exact methods, techniques, scientific instruments, and trained workers are employed throughout a drug’s lifecycle. This happens because different systems from different companies will, in general, provide distinct results even when identical methods are implemented.

Besides, after using Waters’ solutions for many years, pharmaceutical and other life sciences companies are naturally unwilling to retrain their specialized workforce to use instruments from other companies. Being so, stringent regulatory, repeatability, and quality assurance demands, as well as training requirements, all contribute to creating almost impregnable switching barriers for the benefit of Waters. And, finally, Waters also benefits from the patents, trademarks, know-how, and experience amassed through the decades as a knowledge-based company operating in highly specialized arenas.

2. Is Waters a diversified company, with multiple and complementary sources of revenue? Yes: 1 Point

Waters has two operating segments (Waters and TA) which possess similar offerings, economic characteristics, types of customers, and regulatory environments. Given such overlap, Waters has decided to combine the segments into a single reporting segment for financial statement purposes.

The TA (‘Thermal Analysis’) business designs, manufactures, sells, and services rheometry, calorimetry, and thermal analysis instruments. Widely applied in various cyclical and non-cyclical industries - such as plastics, chemicals, electronics, and pharmaceuticals - these technologies are utilized to predict the suitability and stability of materials such as polymers, pharmaceuticals, fine chemicals, and viscous liquids. In essence, thermal analysis measures the physical/thermodynamic properties of materials as they change with varying temperatures. Rheometry, on the other hand, is the technique used to determine certain properties of materials under different stresses and strains; the rheological properties of materials provide critical insights into their behavior during processing, packaging, transport, storage, and usage. By representing more than 25% of sales, the servicing and support of these instruments is a key source of recurrent revenue for the TA segment. This business, which generates 12% of the company’s total revenues, faces competition mainly from PerkinElmer (PKI), Mettler-Toledo (MTD), and Thermo Fisher (TMO).

On its part, the Waters segment designs, manufactures, sells, and services high-performance liquid chromatography (HPLC), ultra-performance liquid chromatography (UPLC), and mass spectroscopy (MS) systems, as well as other offerings that include consumables, post-warranty service plans, and software-based solutions. The company’s systems can be integrated and used along with other analytical instruments.

Liquid chromatography is a ubiquitous technique used to purify a full range of compounds and to detect, identify, monitor, and measure the physical, chemical, and biological composition of all sorts of materials. LC instruments are widely employed in numerous industries for quality control, process engineering applications, and research and development purposes.

Crucially for Waters, the most significant end-use markets for its LC offerings are formed by the pharma and life science industries. Due to their heavily regulated environment, exacting standards, and intrinsic profitability, these markets tend to be both very lucrative for Waters and very dependent on the company’s differentiated offerings. Here, the company’s systems are extensively utilized, for example, to find new molecules, to understand pathological processes, to confirm the safety of biologics and biosimilars, to implement manufacturing methods, and to guarantee the purity and potency of active compounds. Among many other distinct purposes, the company’s LC solutions are also used to analyze nutritional, chemical, and consumer products, and to test air and water purity.

Mass spectrometry, on the other hand, is a technology used to identify unknown compounds through their molecular weight, to determine the structure and chemical properties of molecules, and to characterize and quantify known compounds within a given sample. Often used in conjunction with gas or liquid chromatography, MS is vital in the analysis of proteins, in environmental testing, in drug discovery and development, and in nutritional safety analysis. Waters, as a global leader in MS, supplies a multitude of biomedical, pharmaceutical, nutritional, and environmental end markets. A growing percentage of these customers are simultaneously acquiring MS and LC hybrid components, a fact that will undoubtedly increase their switching costs.

By representing over 35% of sales, the servicing and support of LC and MS systems is a sizable and growing source of recurring revenue for the Waters segment (overall, about 50% of the company’s total revenues have a recurring nature). Support plans normally involve scheduled instrument maintenance and agreements to repair non-functioning instruments. Waters also provides other services that enable customers, among other functions, to maximize productivity, improve budget controls, and support compliance activities. In the markets served by the Waters segment, the company’s main competitors include Agilent (A), Danaher (DHR), and Thermo Fisher.

Considering the widespread applicability of its solutions, Waters counts as customers not only private enterprises but also universities, research institutions, and government agencies that include the FDA, the EPA, and their respective foreign counterparts. As a result, Waters is not overly dependent on any single customer for a material portion of its sales. Last year, 13% of the company’s net sales were to academic institutions and governmental bodies, 30% to a diverse array of industrial accounts, and 57% to pharmaceutical accounts. Waters also benefits from its large geographic footprint, as only 28-29% of its revenues are generated by the domestic market.

3. Has Waters been able to consistently increase sales over the past 10 years? No: -1 Point

As seen in the question above, Waters is in fact a diversified company with multiple and complementary sources of revenue. But the company’s geographic diversity is a double-edged sword. Indeed, due to Waters' heavy reliance on overseas markets, negative foreign currency translations can have a sizable effect on the company’s sales. In addition, Waters' expensive products – its analytical instruments can cost upwards of USD 100.000 - and relative dependence on universities, governmental agencies, and industrial customers also subject the company to the whims and vagaries of the prevailing political and economic contexts. About 50% of Waters’ sales are generated by instrument placements, and these tend to suffer from deferrals or cancellations when public funding becomes scarcer (impacting many academic and governmental organizations) or when the economy slumps (impacting industrial customers).

Recently, for instance, the company has suffered from weak demand caused by the uncertainties surrounding Brexit and by sweeping government policy changes in China (in late 2018, Chinese authorities launched a new procurement scheme that lowered generic drug prices and encouraged the consolidation of its fragmented system for procuring drugs); in 2020, results were also affected by lower demand across all major geographies due to the COVID-19 crisis.

Source: Author

4. Is Waters present in attractive markets offering clear growth runways? Yes: 1 Point

The conclusion of the Human Genome Project in 2013 opened numerous new opportunities to analyze and understand human health, but it also led to the somewhat disquieting realization that the genetic material is only one of many distinct elements that orchestrate life. In fact, on top of the genome, there are several other layers of functional complexity determined by the full complement of proteins, carbohydrates, and other entities within organisms. The need to comprehend these biological constructs resulted in the creation of entirely new fields of research like proteomics (which studies proteins within living beings), metabolomics (which studies metabolites), and glycomics (which studies carbohydrates). Notably, the glycome - that is, the entire repertoire of carbohydrates inside a cell or organism - is widely considered as one of the most complicated entities in the natural world.

These fast-expanding fields are crucial to understanding all major chronic diseases, but their extreme complexity and analytical challenges require continued investments in highly specialized scientific instrumentation, as well as in related products such as dedicated informatics (because they are being overwhelmed by the sheer volume and intricacy of data, researchers are becoming increasingly dependent on life sciences software to convert facts and figures into tangible knowledge).

Given its position as a market and technology leader, as well as its solid foothold in the biopharmaceutical arena, Waters seems poised to benefit from the unrelenting demand for better analytical techniques: in fact, without sustained investments in cutting-edge solutions, CROs*, biotechnology, and pharmaceutical companies will struggle to remain competitive in their quest to provide more effective and personalized care.

Driven by the mounting incidence of conditions like cancer, diabetes, and autoimmune diseases, the glycomics market alone is projected to expand at a CAGR of 14-15% over the next half-decade, whereas the global proteomics market is estimated to grow at a CAGR of 11-12% during the same period. Growth should be particularly strong in Asia-Pacific due to the fact that Big Pharma players are progressively outsourcing their drug discovery and development to nations in this dynamic geography.

Waters is also likely to capitalize on the widespread adoption of advanced mass spectrometry and high-/ultra-performance liquid chromatography systems, as their unrivaled accuracy and sensitivity (to the presence of pollutants, for instance) make these technologies fundamental in areas with ever-tightening standards such as mining, food safety, wastewater treatment, petrochemical production, and environmental monitoring.

Dominated by only about 20 different companies worldwide, the market for mass spectrometry is large, intrinsically profitable, and moderately fragmented. According to the National Institutes of Health, the upsurge in demand for biosimilars, phytopharmaceuticals, and regenerative medicine, as well as the technique’s wide applicability across chemistry, biology, and medicine domains, is expected to sustain a CAGR of 6-7% over the next 5 years. Last but not the least, the company’s TA business segment should equally profit from the anticipated broad-based demand for high-performance, low-impact materials.

* Contract Research Organizations: companies that provide outsourced research services on a contract basis for the life sciences industry.

5. Is Waters well protected against systemic and company-specific risks with the potential to severely compromise its future? Neutral: 0 Points

The analytical instrument market is highly competitive and subject to rapid changes in technology. Of course, over time, other market participants will certainly try to introduce superior or less expensive offerings than the ones provided by Waters. With its deep know-how, industry relationships, and vast asset base, a large rival like Thermo Fisher, for example, has many of the requisites to gradually capture market share over the long term; Thermo Fisher already possesses one of the more advanced and comprehensive instrument businesses within the industry, a fact that mitigates its cash flow volatility and enables the company to offer integrated, wide-ranging solutions at attractive prices.

Waters, on the other hand, has a much more focused position in the lucrative biopharmaceutical arena; furthermore, and in contrast to several acquisitive competitors, Waters’ corporate strategy is based on maintaining its leading position through organic means. Such a strategy, though, requires a substantial amount of persistent spending before significant sales are realized. Despite their respective advantages, Waters’ focused approach and reliance on organic sources of growth can hurt the company if new, internally-developed offerings fail to gain traction in the all-important life sciences market.

Finally, as a leading provider of prized and valuable technologies for many key economic sectors, Waters can be subjected to industrial espionage or to patent infringements by private or state-sponsored entities. Often conflated with cybercrime, these offenses are more severe and more common than most people realize: state-sponsored industrial spying, for instance, is responsible for the theft of billions of dollars of intellectual property every year. This, in turn, can lead to the introduction of copycats and to the subsequent weakening of Waters’ competitiveness over the long-term. For all of these motives, and in addition to the company’s susceptibility to the prevailing political and economic contexts, technological disruption is one of the most serious risks facing Waters.

6. Is Waters a superior cash-generative business? Neutral: 0 Points

Free Cash Flow Generation & FCF per Share: Waters has always been free cash flow-positive over the past decade, a period through which cash flow generation increased by only 35.7%. However, on a per-share basis, FCF has expanded by a more satisfactory 75.2%, as Waters was able to reduce its share count by nearly a third over the past 10 years. Recently, though, the company has taken debt to fund repurchases at more unattractive prices.

Free Cash Flow Margin (5-year average): Generating abundant and growing FCF is always desirable but its amount should be deflated by revenue to demonstrate what percentage of the top line gets converted into cash. Waters current FCF/Sales (TTM) ratio is 23.4%, an exceptional percentage that translates a healthy conversion of sales into FCF; on average, this parameter has been around the 23.0% mark during the last 5 years of activity. No direct rival comes close to Waters in this instance.

Source: Author

CapEx/Sales (5-year average): This ratio gauges investment intensity by showing how many dollars of CapEx a firm spends per each dollar of Sales. According to this parameter, Waters has been the most capital-intensive company within its peer group over the last half-decade. Naturally, lower intra-industry average ratios are in general better than higher ratios; however, its long-term trend needs to be monitored because a falling or chronically low ratio can also signal sluggish demand, heightened competition, or absence of reinvestment opportunities. And indeed, this ratio’s progression throughout the last decade seems to indicate that Waters is ramping up its CapEx in order to capture future growth opportunities (said differently, Waters seems to be increasing its ‘growth’ CapEx and not its ‘maintenance’ CapEx). This hypothesis is reinforced by the fact that Depreciation & Amortization only grew by 28.9% over the last 5 years, whereas Net Capital Expenditures grew much faster (by 88.6%) during this period. If that is the case, then Waters should not be penalized (as no company can expand its business without committing capital to growth initiatives).

Source: Author

Cash Conversion Rate (5-year average): As measured by Free Cash Flow/Net Income, Waters CCR averaged 94.4% between 2015 and 2020 (the company’s CCR in 2017 was an outlier, a fact that excluded that year from the calculation; this reflected a one-time impact due to the consequences of the US Tax Reform, which caused earnings to drop sharply). Obviously, companies that do not achieve a high conversion of accounting earnings into free cash flow are more inhibited in their ability to reinvest in the business or return money to shareholders. Among its peer group, WAT is one of the least effective companies at making this conversion. Due to its relationship with the accrual ratio, the CCR also affords an important means to identify firms with high earnings quality*. According to a vast body of research, because they are less profitable on a pure cash basis, companies with high accruals today tend to earn lower future returns.

Source: Author

* The accrual ratio can be calculated as (Net Income - FCF)/ Total Assets; this way, when FCF is larger than Net Income (that is, when the CCR > 1 in any given year), accruals are negative. This means that cash earnings - or 'real' earnings - are higher than accrual earnings and that earnings quality is high. By representing adjustments made to cash flows to create a profit measure mostly unaffected by the payments of cash and timing of receipts, accruals are simply the non-cash component of earnings.

7. Is Waters a highly productive and economically profitable company? Yes: 1 Point

As shown below, Waters’ strategy of allocating capital mainly to organic growth initiatives has enabled it to achieve a level of economic profitability well above most of its direct rivals (and well above its estimated weighted average cost of capital of 8-9%); historically, the company’s ROIC has also benefited from effective cost controls and from its focus on the intrinsically profitable biopharmaceutical market. Given that it possesses solid competitive advantages, and given that Waters is present in growing arenas, the company will likely have ample future opportunities to continue to reinvest capital at high rates of return (provided execution remains on track, of course).

Source: Author

As demonstrated by its high levels of gross profitability, Waters is also one of the most productive companies within its peer group. In essence, gross profitability - which is also known as the ‘quality ratio’ - is a parameter that determines how efficiently companies use their total assets to generate profits. It is calculated as (Sales -COGS) / Total Assets. Here, the calculation uses gross profits (instead of earnings, for instance) because they are frequently considered as “the cleanest accounting measure of true economic profitability.” Indeed, both operating and net income can be noisy, as they are often manipulated to such a degree that they fail to accurately characterize the economic position of a business.

On the other hand, gross profits are not affected by bottom-line distortions caused by classifying costs as capital or operating expenses. In very broad terms, and regardless of the sector or industry, the most productive companies usually exhibit year-over-year gross profitability ratios above 33%. Although Mettler-Toledo has been the most productive company along this dimension, Waters is not far behind.

Source: Author

8. Does the company have a high degree of pricing power? Yes: 1 Point

The capacity to raise prices above the inflation rate without alienating customers is one of the hallmarks of a great company. Mentioned by Warren Buffett as the “single most important decision in evaluating a business,” pricing power is classically assessed by the magnitude and stability of a company’s gross margins when compared against the margins of competitors within the same industry. However, because they may contain information on R&D effectiveness (via R&D investments) and on customer acquisition costs (via SG&A expenses), operating margins should equally be included in the assessment of pricing power: having lower customer acquisition costs, for instance, can be an indication that customers do not need much convincing to make repeated purchases.

Source: Author

Likewise, the preservation or improvement of market share and the preservation of high returns on invested capital, are also indirect but strong signs of pricing power: after all, a stable market share means that a firm is not losing customers, and the generation of persistently high ROICs means that rivals are not eating away a company’s economic profits. In fact, provided ill-advised capital allocation decisions are absent, a falling ROIC is often one of the first symptoms that a company is losing its power to raise prices (and indeed, this is the main reason why most firms see their ROIC fade toward the cost of capital over time). Faced with new entrants or fiercer competition, only a small minority of companies within a given industry succeeds in creating pricing power, harnessing it, and supporting it in today’s era of volatility and anemic GDP growth. Is Waters one of these few companies within its industry? It certainly seems so: in addition to boasting high returns on capital, high gross margins, and high operating margins, Waters believes that it has the leading liquid chromatography market share in Asia, Europe, and the United States.

Source: Author

Besides, unlike some larger competitors, the company has been perfectly able to maintain this dominant position without ever engaging in serial, large-scale M&A initiatives: why buy external sources of sales growth to remain competitive, if the internal innovation engine continues to produce winning solutions? Waters competes primarily on the basis of product performance, reliability, and service; by the company’s own admission, lowering prices is the least important lever to drive sales performance. All things considered, there are many reasons to believe that Waters exhibits a high degree of pricing power.

9. Is Waters financially strong? Neutral: 0 Points

Waters’ Altman Z-Score of 8.6 places the company well inside the so-called 'safe zone' and nowhere near insolvency. Waters also displays an adequate if unspectacular Piotroski F-Score of 6 (out of 9) that is being penalized by higher year-over-year gearing (long-term debt divided by average total assets), a lower year-over-year current ratio, and an increase in stock issuance. Long-term debt and other long-term liabilities account for roughly three-quarters (74.6%) of the company's total liabilities. Waters’ total debt to capital ratio now stands at 1.03, whereas its cash to debt ratio stands merely at 0.24 (as cash & short-term investments only make up 14.8% of the company's total assets). Still, with an interest coverage of 11.9x, the firm should be able to cover comfortably its interest expense. Standing at 1.79 and 1.23, respectively, Waters’ working capital and quick ratios are also quite solid. The company’s financial position is not overly fragile.

Valuation (Discounted Cash Flow Analysis) | Main Assumptions and Fair Value

Revenues: Waters derives roughly half of its revenues from the dynamic biopharmaceutical arena. Innovation in the life sciences industry is accelerating, and with it, the monitoring requirements for biotherapeutics are also growing. Thanks in part to the recently launched BioAccord system (a fit-for-purpose LC-MS biopharmaceutical solution), such emphasis on this sector should help the company expand sales by 3-4% per annum over the next 5 years. Besides delivering rich mass spectrometry data for improved productivity and effective decision-making, the BioAccord system has features specifically designed to accurately identify, scrutinize and characterize crucial components of both the glycome and the proteome (which are, respectively, the biological entities studied by the expanding fields of glycomics and proteomics); furthermore, and despite its recent missteps in the country, Waters’ strong presence in China is expected to have a positive impact on revenues going forward. The company’s sales grew at a CAGR of 3.9% over the last decade of operations; now, with (apparently) safe and effective vaccines ready to start immunizing vast segments of the world’s population, Waters should see a gradual return to its historical growth rates.

Gross and Operating Margins: Gross margins should see a slight improvement from their current levels with the eventual normalization of the economic background (to 57.5-58.0%, up from 57.1%, currently). A new CEO at the helm with the explicit mandate to solve pressing issues (such as anemic sales) should, however, cause an uptick in R&D investments and SG&A expenses; as a consequence, the DCF model expects operating margins within the 26.0-26.5% interval during the next few years.

Operating Cash Investments: The model assumes that the sum of capital expenditures investments with the changes in working capital will reach a level equivalent to 5.5-7.5% of revenues, on average, per year; it also estimates that invested capital will reach an amount equivalent to 30-35% of sales, on average, per year.

Cost of Capital, Terminal Growth Rate, and Fair Value Estimate: The model assumes a WACC within the 8.0% + [± 1.5%] range; it also assumes a terminal growth rate between 1% and 2%. After a sensitivity analysis, the valuation model delivers a present-day fair value estimate range between USD 160 and USD 185 per share, implying that Waters is slightly overvalued.

Waters| Conclusion

The Quality Score for Waters is 4 out of 9 possible points. Waters is a special company that only needs to revive its sales and become a bit more cash-generative to qualify as an investment of the highest grade. Also, by exhibiting a free cash yield of 4.9%, a PEG ratio of 3.1, and an earnings yield of 3.40%, Waters looks somewhat overvalued at the moment. Still, this competitively-advantaged company has a lot going for it, as it will surely play a decisive role in the development of treatments that are expected to revolutionize the future of medicine. Indeed, the astounding complexity of the glycome and the proteome has resulted in many challenges that can only be overcome by new advances in analytical technologies like mass spectrometry. Because their components perform critical functions in almost all biological processes and pathways, the promise of a truly comprehensive knowledge of these subjects is immense. These processes include, for instance, aging, immunity, pathogen invasion, cell development, cancer metastasis, and protein folding. Scientists around the globe are now testing if reversing some changes in our glycome and proteome can help prevent serious diseases or even slow down aging - a tantalizing possibility. What is certain is that the company’s groundbreaking methods have the potential to drive the development of new fields for many decades to come… just like Jim Waters predicted more than 55 years ago.

From Portugal, educated in Portugal and in the UK. Investor for a relatively long time - 26 years. Higher education: Radiation Physics; Radiology; Medical Imaging; Radiation Protection; Radiobiology.