Company Description:
Waters Corporation (Waters) is an analytical instrument manufacturer. The Company operates in two business segments: Waters Division and TA Division (TA). 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. These systems are complementary products that can be integrated together and used along with other analytical instruments. Through TA, Waters designs, manufactures, sells and services thermal analysis and rheometry instruments, which are used in predicting the suitability of polymers and viscous liquids for various industrial, consumer goods and healthcare products. The Company is also a developer and supplier of software-based products that interface with the Company's, as well as other instrument manufacturers' instruments.
Annual Report Highlights (latest report is for the period ending
General
The Company’s products are used by pharmaceutical, life science, biochemical, industrial, academic and government customers working in research and development, quality assurance and other laboratory applications. The Company’s LC and MS instruments are utilized in this broad range of industries to detect, identify, monitor and measure the chemical, physical and biological composition of materials as well as to purify a full range of compounds. These instruments are used in drug discovery and development, including clinical trial testing, the analysis of proteins in disease processes (known as “proteomics”), food safety analyses and environmental testing. The Company’s thermal analysis and rheometry instruments are used in predicting the suitability of fine chemicals and polymers for uses in various industrial, consumer goods and health care products.
The Company typically experiences a seasonal increase in sales in its fourth quarter, as a result of purchasing habits for capital goods by customers who tend to exhaust their spending budgets by calendar year-end.
Waters is a holding company that owns all of the outstanding common stock of Waters Technologies Corporation, its operating subsidiary. Waters became a publicly traded company with its initial public offering in November 1995. Since the IPO, the Company has added two significant and complementary technologies to its range of products with the acquisitions of TA Instruments in May 1996 and Micromass Limited in September 1997.
Customers
The Company has a broad and diversified customer base that includes pharmaceutical accounts, other industrial accounts, universities and government agencies. The pharmaceutical segment represents the Company’s largest sector and includes multi-national pharmaceutical companies, generic drug manufacturers and biotechnology companies. The Company’s other industrial customers include chemical manufacturers, polymer manufacturers, food and beverage companies and environmental testing laboratories. The Company also sells to various universities and government agencies worldwide. The Company’s technical support staff works closely with its customers in developing and implementing applications that meet their full range of analytical requirements.
The Company does not rely on any single customer or one group of customers for a material portion of its sales. During fiscal years 2006 and 2005, no single customer accounted for more than 3% of the Company’s net sales.
Sales and Service
The Company has one of the largest sales and service organizations in the industry focused exclusively on its LC, MS and thermal analysis installed base. Across these product technologies, using respective specialized sales and service forces, the Company serves its customer base with approximately 2,400 field representatives in 82 sales offices throughout the world as of
Manufacturing
The Company provides high quality LC products by controlling each stage of production of its instruments, columns and chemical reagents. The Company currently assembles a substantial portion of its LC instruments at its facility in
The Company outsources manufacturing of certain electronic components such as computers, monitors and circuit boards to outside vendors that can meet the Company’s quality requirements. In 2006, the Company transitioned the manufacturing of the Alliance HPLC instrument system to a company in
Research and Development
The Company maintains an active research and development program focused on the development and commercialization of products that both complement and update the existing product offering. The Company’s research and development expenditures for 2006, 2005 and 2004 were $77.3 million, $66.9 million and $65.2 million, respectively.
Nearly all of the current LC products of the Company have been developed at the Company’s main research and development center located in
The majority of the MS products have been developed at facilities in
At
Employees
The Company employed approximately 4,700 employees, with 45% located in the
Competition
The analytical instrument and systems market is competitive. The Company encounters competition from several worldwide instrument manufacturers in both domestic and foreign markets for each of its three technologies. The Company competes in its markets primarily on the basis of instrument performance, reliability and service and, to a lesser extent, price. Some competitors’ businesses are generally more diversified and less focused on the Company’s primary instrument markets. Some competitors have greater financial and other resources than the Company.
In the markets served by LC, MS and LC-MS, the Company’s principal competitors include: Applied BioSystems, Inc., Agilent Technologies, Inc., Thermo Fisher Scientific Inc., Varian, Inc., Shimadzu Corporation and Bruker BioSciences Corporation. In the markets served by TA, the Company’s principal competitors include: PerkinElmer Inc., Mettler-Toledo International Inc., NETZSCH-Geraetebau GmbH, Thermo Fisher Scientific Inc., Malvern Instruments Ltd. and Anton-Paar. The Company is not currently aware of a competitor that it believes offers an instrument system comparable to its ACQUITY UPLC.
The market for consumable HPLC products, including separation columns, is highly competitive and more fragmented than the analytical instruments market. The Company encounters competition in the consumable columns market from chemical companies that produce column chemicals and small, specialized companies that pack and distribute columns. The Company believes that it is one of the few suppliers that process silica, packs columns, and distributes its own product. The Company competes in this market on the basis of reproducibility, reputation and performance and, to a lesser extent, price. The Company’s principal competitors for consumable products include: Phenomenex, Supelco Inc., Agilent Technologies, Inc., Alltech International Holdings, Inc., Thermo Fisher Scientific Inc. and Merck and Co., Inc.
The ACQUITY UPLC instrument is designed to offer a predictable level of performance when used with ACQUITY UPLC columns to effect the chemical separation. UPLC columns are both fluidically and electronically connected to the ACQUITY UPLC instrument to allow users to simultaneously employ and track the performance status of the UPLC column. The Company believes that the expansion of ACQUITY UPLC technology will enhance its chromatographic column business because of the high level of synergy between ACQUITY UPLC columns and the ACQUITY UPLC instrument.
- Competition and the Analytical Instrument Market
- Risk of Disruption
- Foreign Operations and Exchange Rates
- Reliance on Key Management
- Protection of Intellectual Property
- Reliance on Customer Demand
- Reliance on Suppliers
- Reliance on Outside Manufacturers
Waters operates 21
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The Company’s sales were $1,280.2 million, $1,158.2 million and $1,104.5 million in 2006, 2005 and 2004, respectively. Sales grew 11% in 2006 over 2005 and 5% in 2005 over 2004. Overall, the sales growth achieved in these years can be primarily attributed to the Company’s introduction of new products and sustained growth in
In 2006, global sales to pharmaceutical customers rebounded from 2005 levels and industry-wide sales grew 8%, as these customers increased their capital spending on the Company’s new products. Global sales to pharmaceutical customers were weak in 2005 as the Company’s large pharmaceutical customers decreased capital spending as these customers dealt with various new drug pipeline, merger and acquisition and litigation issues. Global sales to industrial and food safety customers continued its positive trend as sales grew 13% in 2006 over 2005. The TA Division sales, a business with a heavy industrial focus, grew 9% and 8% for 2006 and 2005, respectively, and the sales growth can be attributed to new product introductions and expansion of its Asian businesses.
The Waters Division sales grew by 11% in 2006 and 4% in 2005. The Waters Division’s products and services consist of LC & MS instrument systems which include high performance liquid chromatography (“HPLC”), ultra performance liquid chromatography (“UPLC” and together with HPLC, herein referred to as “LC”), mass spectrometry (“MS”) products, chemistry consumable products, and LC and MS services. The sales growth is strongly influenced by ACQUITY UPLC sales and sales growth in the chemistry consumables business.
In 2006, the Company continued to enhance its operations in
Operating income was $295.2 million, $283.2 million and $284.9 million in 2006, 2005 and 2004, respectively. Operating income was primarily impacted by the following:
- The $12.0 million net increase in 2006 operating income from 2005 is primarily a result of the increased sales volume being partially offset by the $28.0 million of the additional stock-based compensation costs incurred as a result of the adoption of Statement of Financial Accounting Standard (“SFAS”) No. 123(R) “Share-Based Payment” and $8.5 million of restructuring costs incurred relating to the February 2006 cost reduction initiative. The Company does not expect to incur any significant additional restructuring costs for this initiative in the future.
- The $1.7 million net decrease in operating income in 2005 from 2004 is primarily attributable to a litigation provision of $3.1 million related to a patent litigation settlement with Hewlett-Packard Company in February 2006 that was recorded in the fourth quarter of 2005. The remaining increase in 2005 operating income was primarily a result of sales growth. The 2004 operating income included the benefit of a litigation judgment in the amount of $17.1 million from Perkin-Elmer Corporation partially offset by litigation provisions of $7.8 million and a technology license asset impairment of $4.0 million.
The Company continues to evaluate the acquisition of businesses, product lines and technologies to augment the Waters and TA operating divisions. On December 15, 2006, the Company acquired all of the outstanding capital stock of Environmental Resources Associates, Inc., (ERA), a provider of environmental testing products for quality control, proficiency testing and specialty calibration chemicals used by environmental laboratories, for approximately $62.5 million in cash and the assumption of $3.8 million of debt. The Company expects that ERA will add approximately $17.0 million of product sales and be about neutral to earnings in 2007 after debt service costs.
In August 2006, the Company acquired all of the outstanding capital stock of
Year Ended
Net Sales:
Net sales for 2006 and 2005 were $1,280.2 million and $1,158.2 million, respectively, an increase of 11%. Foreign currency translation benefited the 2006 sales growth rate by less than 1%. Product sales were $922.5 million and $834.7 million for 2006 and 2005, respectively, an increase of 11% over 2005. The increase in product sales was primarily due to the overall positive growth in LC, MS and TA instrument systems sales, an increase in chemistry consumables sales and the effect of acquisitions. Service sales were $357.7 million and $323.6 million in the 2006 and 2005, respectively, an increase of 11%. The increase was primarily attributable to growth in the Company’s installed base of instruments and higher sales of service contracts.
The following commentary discusses the Company’s sales performance by product line.
Waters Division Net Sales:
The Waters Division sales grew approximately 11% in 2006. The effect of foreign currency translation benefited the 2006 Waters Division sales growth by less than 1%. Chemistry consumables sales grew approximately 18% in 2006. This growth was driven by increased column sales of ACQUITY UPLC proprietary column technology, new XBridge tm columns, Oasis ® sample preparation products and the sales associated with the acquired VICAM product line. LC and MS service sales grew 9% in 2006 due to increased sales of service plans to the higher installed base of customers. LC and MS instrument systems sales grew 9% in 2006. The increase in LC and MS instrument sales during 2006 is primarily attributable to higher sales of ACQUITY UPLC systems and higher MS triple quadrupole system sales, offset by a decline in lower-end MS systems sales. Waters Division sales by product mix was substantially unchanged in 2006 and 2005 with instruments, chemistry and service representing approximately 57%, 16% and 27% respectively. Geographically, Waters Division sales in the
TA Division Net Sales:
TA Division’s sales grew 9% in 2006 as a result of TA’s new product introductions and expansion of its Asian businesses. Foreign currency translation had no impact to this overall sales growth rate. Instrument sales grew 4% as TA introduced four new differential scanning calorimeters during 2006 and, in late August 2006, the Company entered the field of microcalorimetry through the acquisition of Thermometrics. Instrument system sales represented approximately 70% and 73% of sales in 2006 and 2005, respectively. TA service sales grew 22% in 2006 and can be attributed to the increased sales of service plans to the higher installed base of customers. Geographically, sales growth for 2006 was predominantly in
Gross Profit:
Gross profit for 2006 was $744.0 million compared to $679.9 million for 2005, an increase of $64.1 million or 9% and is generally consistent with the increase in net sales. Gross profit as a percentage of sales decreased to 58.1% in 2006 from 58.7% in 2005. The 2006 gross profit was negatively impacted by $4.3 million of stock-based compensation costs relating to the adoption of SFAS No. 123(R). The remaining slight decrease in gross profit percentage in 2006 as compared to 2005 is primarily due to product transition costs to
Selling and Administrative Expenses:
Selling and administrative expenses for 2006 and 2005 were $357.7 million and $321.7 million, respectively. As a percentage of net sales, selling and administrative expenses were 27.9% for 2006 compared to 27.8% for 2005. The $36.0 million or 11% increase in total selling and administrative expenses for 2006 is primarily due to additional stock-based compensation costs of $18.6 million, annual merit increases across most divisions, other headcount additions and related fringe benefits and indirect costs of $11.6 million. Other increases in selling and administration expenses were offset by decreases related to the February 2006 cost saving initiative. The Company has made investments in Asia, largely in the second half of 2006, in support of growing business opportunities and management expects expenses to continue to grow at a modest rate in the future as compared to 2006.
Research and Development Expenses:
Research and development expenses were $77.3 million for 2006 and $66.9 million for 2005, an increase of $10.4 million or 16% primarily due to stock-based compensation costs of $5.1 million relating to the adoption of SFAS No. 123(R)and the merit increases across most divisions, other headcount additions and related fringe benefits and indirect costs. The remaining increases in research and development expenses in 2006 as compared to 2005 reflects the costs of introducing multiple new MS instruments in the second half of 2006.
2006 Restructuring:
In February 2006, the Company implemented a cost reduction plan primarily affecting operations in the
The Company does not expect to incur any additional charges connection with the February 2006 restructuring initiative. The Company achieved approximately $4.4 million of cost savings in 2006 from this initiative, mostly in the second half of 2006, and expects to achieve approximately $7.4 million in cost savings annually as a result of this restructuring. Other charges include approximately $0.7 million of leasehold improvement assets, net of accumulated amortization, written-off as a result of the closure of the facility in the
Litigation Provisions:
Litigation provisions in 2005 were $3.1 million relating to patent litigation with Agilent Corporation and Hewlett-Packard Company (“Hewlett-Packard”). This patent litigation was settled in February 2006 and recorded in the 2005 statement of operations. No additional provisions were made in 2006.
Interest Expense:
Interest expense was $51.7 million and $24.7 million for 2006 and 2005, respectively. The increase in 2006 interest expense is primarily attributable to increases in interest rates on the Company’s outstanding debt and an increase in average borrowings in the
Interest Income:
Interest income for 2006 and 2005 was $25.3 million and $19.3 million, respectively. The increase in interest income is primarily due to higher interest rate yields.
Stock Repurchase Program
During 2006, management continued to apply the Company’s net cash flow to repurchase shares of Company stock through the $500.0 million program authorized by the Company’s Board of Directors in October 2005. During 2006, the Company purchased 5.8 million shares of its common stock at a cost of $249.2 million. The Company has repurchased an aggregate of 11.3 million shares of its common stock under this program at a cost of $465.3 million, leaving $34.7 million authorized for future repurchases.
The Company also believes that it has the financial flexibility to fund these share repurchases given current cash and debt levels, and invest in research, technology and business acquisitions to further grow the Company’s sales and profits.
Financial Highlights:
Revenue Growth (1-yr): 12.1%
Revenue Growth (9-yr average): 8.6%
Net Income Growth (1-yr): 19.1%
Net Income Growth (9-yr average): 13.3%
Earnings-Per-Share Growth (1-yr): 15.2%
Earnings-Per-Share (9-yr average): 11.5%
Free Cash Flow Growth (1-yr): 20.5%
Free Cash Flow Growth (9-yr average): 24.9%
Net Profit Margin (current): 13.5%
Net Profit Margin (10-yr average): 11.1%
Return On Equity (current): 15.9%
Return On Equity (10-yr average): 33.3%
Debt Ratio (current): 0.52
Current Ratio (current): 0.78
Financial analysis:
- Waters Corp. has a pretty high debt ratio of 0.78, which is likely to be a burden on the cash flow and doesn’t’ do much for stability of the company.
- ROA has been fairly consistent throughout the past ten years. Currently it stands at 16.0% and 10-yr average is 15.7%
- After slipping into negative territory in 1997, company’s ROE has been very impressive and ranged between 22.1% and 70.8%. It has posted ROE of 68.7% for the 2006 fiscal year and 10-yr average is 36.2%.
- Profit margins have stayed consistently in the mid-teens throughout the past ten years. Most recently, company’s profit margin was 17.3% and 10-yr average is 15.1%.
- Revenue growth has not been very consistent, but it stay positive throughout the past nine years. Revenue growth in the most recent fiscal year (2006) was 10.5% and 9-yr average is 12.2%.
- Net income growth has been even less consistent than revenue growth with growth rates slipping into negative territory twice, in 2001 and 2005 fiscal years. Most recent annual income growth was 9.9% and 8-yr average is 17.6%.
- Free Cash Flow margin has consistently stayed in mid-teens, most recently at 16.6%. FCF growth has been rocky, decreasing in 2003 and 2006, but did manage to pull off a 9-yr average of 15.1% in annual growth. Most recent FCF growth is -13.8 for the 2006 fiscal year.
- On the efficiency side, company’s accounts receivable have been growing at a much faster pace than the overall revenue meaning that it is not getting payments from customers nearly as fast as it used to. If this trend persists, it may put a significant pressure on the operating cash flow (which it already does). A/R Turnover Ratio has decreased from 8.4 in 1997 to 4.8 in 2006; Avg. Collection Period has increased from 43 days in 1997 to 75 days in 2006.
- Inventory Turnover has increased from 2.98 in 1998 to 3.57 in 2006. This means that every year inventory sits in the warehouse 20 days less (102 days instead of 122 in 1998).
Discounted Cash Flow (DCF) Analysis:
I used discounted cash flow analysis to arrive at the intrinsic value of the company. I estimated that free cash flow would grow at an average rate of 10% per year for the next 10 years and at 3% (trailing GDP growth) perpetually after that.
I used a discount rate of 12% because this company represents a relatively low risk due to its established portfolio of products and significant market share in many market segments.
Using the assumptions listed above, my intrinsic value of the stock came out to $39.67. My intrinsic value of Waters Corp. is about 30% lower than what Morningstar has listed as a “fair value” for this company. While I agree with Morningstar analysts that this company will average 10% annual growth for the next ten years, disagreement comes in the form of company risk. They believe this company’s risk is below average, while in my opinion it is above average due to its high exposure to pharmaceutical capital spending which is not the most reliable source of revenue I could think of. Then there is mixed records of revenue and net income growth, which coupled with the fact that I have hard time understanding their business, makes it a risky investment for me.
Pros:
- Company has shown remarkable Return on Equity figures during the past ten years.
- It expects a rebound in capital spending from Big Pharma clients, which would boost its revenues.
- Company conducts most of the business overseas and expects increased growth in the Asian markets such as Chine and
Cons:
- Lack of consistency in revenue and net income growth make it somewhat unpredictable.
- It’s a very specialized company that I have trouble understanding and may not appreciate its value and/or risk appropriately.
- It has aggressively repurchased shares in the past two years, this trend is unlikely to continue.
Final Decision:
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