SmartMoney Picks from Nov. '06: 10.7% avg. return

So, here is a second installment in the series of posts looking into performance of stock picks made by various business magazines.

This time SmartMoney is on deck, here is how well their stock picks from the November 2006 issue have fared:


* Keep in mind that notes were made based on the article where stocks were mentioned, which means that some things may be outdated at this point.

Stock Analysis: Medtronic (MDT)

Company Description:

Medtronic, Inc., incorporated in 1957, is engaged in medical technology, alleviating pain, restoring health, and extending life for people around the world. The Company functions in eight operating segments that manufacture and sell device-based medical therapies: Cardiac Rhythm Disease Management (CRDM), Spinal and Navigation, Vascular, Neurological, Diabetes, Cardiac Surgery, Ear, Nose and Throat (ENT), and Physio-Control. In June 2007, Medtronic acquired the O-arm Imaging System assets of Breakaway Imaging, LLC, a developer of medical imaging systems for surgery. On December 4, 2006, the Company announced its intention to pursue a spin-off of Physio-Control, its wholly-owned subsidiary, into an independent, publicly traded company. On March 26, 2007, it acquired manufacturing assets, know-how and an license to intellectual property related to the manufacture and distribution of EndoSheath products from VisionûSciences, Inc. (VSI). On July 25, 2006, it acquired substantially all of the assets of Odin Medical Technologies, LTD (Odin).

Click here for a full description of the company’s operations (provided by Reuters).

Annual Report Highlights (latest report is for the period ending 4/27/07):

Overview

Medtronic is the global leader in medical technology, alleviating pain, restoring health, and extending life for millions of people around the world. We are committed to offering market-leading therapies to restore patients to fuller, healthier lives. With beginnings in the treatment of heart disease, we have expanded well beyond our historical core business and today provide a wide range of products and therapies that help solve many challenging, life-limiting medical conditions. We hold market-leading positions in almost all of the major markets in which we operate.

We currently function in eight operating segments that manufacture and sell device-based medical therapies. During the fourth quarter of fiscal year 2007, we revised our operating segment reporting to separate Physio-Control from our Cardiac Rhythm Disease Management operating segment. Our operating segments are:

• Cardiac Rhythm Disease Management (CRDM)
  

• Spinal and Navigation
  

• Vascular
  

• Neurological
  

• Diabetes
  

• Cardiac Surgery
  

• Ear, Nose, and Throat (ENT)
  

• Physio-Control

With innovation and market leadership, we have pioneered advances in medical technology in all of our businesses and enjoyed steady growth. Over the last five years, our net sales have nearly doubled, from $6.411 billion in fiscal year 2002 to $12.299 billion in fiscal year 2007. We attribute this growth to our commitment to develop or acquire new products to treat an expanding array of medical conditions.

Medtronic was founded in 1949, incorporated as a Minnesota corporation in 1957, and today we serve physicians, clinicians and patients in more than 120 countries worldwide. Beginning with the development of the heart pacemaker in the 1950s, we have assembled a broad and diverse portfolio of progressive technology expertise both through internal development of core technologies as well as acquisitions. We remain committed to a mission written by our founder more than 40 years ago that directs us “to contribute to human welfare by application of biomedical engineering in the research, design, manufacture and sale of products that alleviate pain, restore health and extend life.”

With approximately 38,000 dedicated employees worldwide personally invested in supporting our mission, our success in leading global advances in medical technology is the result of several key strengths:

• Broad and deep technological knowledge of microelectronics, implantable devices and techniques, power sources, coatings, materials, programmable devices and related areas, as well as a tradition of technological pioneering and breakthrough products that not only yield better medical outcomes, but more cost-effective therapies.
  

• Strong intellectual property portfolio that underlies our key products.
  

• High product quality standards, backed with stringent systems to help ensure consistent performance that meet or surpass customers’ expectations.
  

• Strong professional collaboration with customers, extensive medical educational programs, and thorough clinical research.
  

• Full commitment to superior patient and customer service.
  

• Extensive experience with the regulatory process and sound working relationships with regulators and reimbursement agencies, including leadership roles in helping shape regulatory policy in the U.S. and abroad.
  

• A proven financial record of sustained revenue and earnings growth and continual introduction of new products.

Our strategic objective is to provide patients and the medical community with comprehensive, life-long solutions for the management of chronic disease. Our key strengths parallel the following basic, but well-implemented, strategies that guide our growth and success:

• Meet unmet medical needs by leveraging our core technologies.
  

• Ensure that people who could benefit from our device therapies increasingly have access to them.
  

• Increase market share in core product lines.
  

• Broaden our global presence in developed and developing markets.
  

• Acquire or invest in breakthrough technologies to treat an increasing number of chronic diseases.

In this decade, we anticipate that technology advancements, the Internet and increasing patient participation in treatment decisions will transform the nature of healthcare services and will result in better care that is more cost effective to the healthcare system and greater quality of life and convenience to the patient.

Our primary customers include hospitals, clinics, third party healthcare providers, and other institutions, including governmental healthcare programs and group purchasing organizations.

Research and Development

During fiscal year 2007, 2006, and 2005, we spent $1.239 billion (10.1 percent of net sales), $1.113 billion (9.9 percent of net sales) and $951 million (9.5 percent of net sales) on research and development, respectively. Our research and development activities include improving existing products and therapies, expanding their indications and applications for use, and developing new products. While we continue to make substantial investments for the expansion of our existing product lines and for the search of new innovative products, we have also focused heavily on carefully planned clinical trials, which lead to market expansion and enable further penetration of our life changing devices.

Acquisitions and Investments

In addition to internally generated growth through our research and development efforts, historically we have relied, and expect to continue to rely, upon acquisitions, investments, and alliances to provide access to new technologies both in areas served by our existing businesses as well as in new areas.

We expect to make future investments or acquisitions where we believe that we can stimulate the development of, or acquire, new technologies and products to further our strategic objectives and strengthen our existing businesses.

On March 26, 2007, we acquired manufacturing assets, know-how, and an exclusive license to intellectual property related to the manufacture and distribution of EndoSheath products from Vision–Sciences, Inc. (VSI), which was accounted for as a purchase of assets. The license acquired from VSI will expand our existing U.S. distribution rights of EndoSheath products to worldwide distribution rights. The EndoSheath is a sterile disposable sheath that fits over a fiberoptic endoscope preventing contamination of the scope during procedures and allowing reuse of the scope without further sterilization.

On September 15, 2006, we acquired and/or licensed selected patents and patent applications owned by Dr. Eckhard Alt (Dr. Alt), or certain of his controlled companies in a series of transactions. In connection therewith, we also resolved all outstanding litigation and disputes between Dr. Alt and certain of his controlled companies. The agreements required the payment of total consideration of $75 million, $74 million of which was capitalized as technology based intangible assets that had an estimated useful life of 11 years at the time of acquisition. The acquired patents or licenses pertain to the cardiac rhythm disease management field and have both current application and potential for future patentable commercial products.

On July 25, 2006, we acquired substantially all of the assets of Odin Medical Technologies, LTD (Odin), a privately held company. Prior to the acquisition, we had an equity investment in Odin, which was accounted for under the cost method of accounting. Odin focused on the manufacture of the PoleStar intraoperative Magnetic Resonance Image (iMRI) Guidance System which was already exclusively distributed by us. This acquisition is expected to help us further drive the acceptance of iMRI guidance in neurosurgery. The consideration for Odin was approximately $21 million, which included $6 million in upfront cash and a $2 million milestone payment made in the three months ended October 27, 2006. The $8 million in net cash paid resulted from the $21 million in consideration less the value of our prior investment in Odin and Odin’s existing cash balance.

Markets and Distribution Methods

We sell most of our medical devices through direct sales representatives in the U.S. and a combination of direct sales representatives and independent distributors in international markets. The main target markets for our medical devices are the U.S., Western Europe, and Japan. Our primary customers include physicians, hospitals, other medical institutions, and group purchasing organizations.

Our marketing and sales strategy is focused on rapid, cost-effective delivery of high-quality products to a diverse group of customers worldwide. To achieve this objective, we organize our marketing and sales teams around physician specialties. This focus enables us to develop highly knowledgeable and dedicated sales representatives who are able to foster strong relationships with physicians and other customers, and enhance our ability to cross-sell complementary products. We believe that we maintain excellent working relationships with physicians and others in the medical industry that enable us to gain a detailed understanding of therapeutic and diagnostic developments, trends and emerging opportunities, and respond quickly to the changing needs of physicians and patients.

In keeping with the increased emphasis on cost-effectiveness in healthcare delivery, the current trend among hospitals and other customers of medical device manufacturers is to consolidate into larger purchasing groups to enhance purchasing power. As a result, transactions with customers have become increasingly significant, more complex, and tend to involve more long-term contracts than in the past. This enhanced purchasing power may also lead to pressure on pricing and increased use of preferred vendors. We are not dependent on any single customer for more than 10 percent of our total net sales.

Competition and Industry

We compete in both the therapeutic and diagnostic medical markets in more than 120 countries throughout the world. These markets are characterized by rapid change resulting from technological advances and scientific discoveries. In the product lines in which we compete, we face a mixture of competitors ranging from large manufacturers with multiple business lines to small manufacturers that offer a limited selection of products. In addition, we face competition from providers of alternative medical therapies such as pharmaceutical companies.

Major shifts in industry market share have occurred in connection with product problems, physician advisories and safety alerts, reflecting the importance of product quality in the medical device industry. In the current environment of managed care, economically motivated buyers, consolidation among healthcare providers, increased competition, and declining reimbursement rates, we have been increasingly required to compete on the basis of price.

In order to continue to compete effectively, we must continue to create or acquire advanced technology, incorporate this technology into proprietary products, obtain regulatory approvals in a timely manner, and manufacture and successfully market these products.

Employees

On April 27, 2007, we employed approximately 38,000 employees. Our employees are vital to our success. We believe we have been successful in attracting and retaining qualified personnel in a highly competitive labor market due to our competitive compensation and benefits, and our rewarding work environment. We believe our employee relations are excellent.

Seasonality

Worldwide sales do not reflect any significant degree of seasonality.

Risk Factors

Investing in Medtronic involves a variety of risks and uncertainties, known and unknown, including, among others, those discussed below.

• The medical device industry is highly competitive and we may be unable to compete effectively.
  

• Reduction or interruption in supply and an inability to develop alternative sources for supply may adversely affect our manufacturing operations and related product sales.
  

• We are subject to many laws and governmental regulations and any adverse regulatory action may materially adversely affect our financial condition and business operations.
  

• Our failure to comply with strictures relating to reimbursement and regulation of healthcare goods and services may subject us to penalties and adversely impact our reputation and business operations.
  

• Quality problems with our processes, goods, and services could harm our reputation for producing high quality products and erode our competitive advantage.
  

• We are substantially dependent on patent and other proprietary rights and failing to be successful in patent or other litigation may result in our payment of significant money damages and/or royalty payments, negatively impact our ability to sell current or future products, or prohibit us from enforcing our patent and proprietary rights against others.
  

• Product liability claims could adversely impact our financial condition and our earnings and impair our reputation.
  

• Our self-insurance program may not be adequate to cover future losses.
  

• If we experience decreasing prices for our goods and services and we are unable to reduce our expenses, our results of operations will suffer.
  

• Our international operations are subject to a variety of risks that could adversely affect those operations and thus our profitability and operating results.
  

• Consolidation in the healthcare industry could have an adverse effect on our revenues and results of operations.
  

• Healthcare policy changes may have a material adverse effect on us.
  

• Our business is indirectly subject to healthcare industry cost containment measures that could result in reduced sales of medical devices containing our components.
  

• Our research and development efforts rely upon investments and alliances, and we cannot guarantee that any previous or future investments or alliances will be successful.
  

• The success of many of our products depends upon strong relationships with physicians.

Properties

Our principal offices are owned by us and located in the Minneapolis, Minnesota metropolitan area. Manufacturing or research facilities are located in Arizona, California, Colorado, Connecticut, Florida, Indiana, Massachusetts, Michigan, Minnesota, Tennessee, Texas, Washington, Puerto Rico, China, France, Ireland, Mexico, The Netherlands, and Switzerland. Our total manufacturing and research space is approximately 3.0 million square feet, of which approximately 75 percent is owned by us and the balance is leased.

We also maintain sales and administrative offices in the U.S. at approximately 90 locations in 40 states or jurisdictions and outside the U.S. at approximately 100 locations in 36 countries. Most of these locations are leased. We are using substantially all of our currently available productive space to develop, manufacture, and market our products. Our facilities are in good operating condition, suitable for their respective uses and adequate for current needs.

Stock Repurchase Program

In October 2005, our Board of Directors authorized the repurchase of up to 40 million shares of our common stock and in April 2006, the Board of Directors made a special authorization for us to repurchase up to 50 million shares in connection with the $4.400 billion Senior Convertible Note offering.

Shares are repurchased from time to time to support our stock-based compensation programs and to take advantage of favorable market conditions. During fiscal years 2007 and 2006, we repurchased approximately 21.7 million shares and 68.9 million shares at an average price of $47.83 and $52.12, respectively. The amounts disclosed as repurchased for fiscal year 2007 include 544,224 shares that we obtained as part of the final settlement of the previously announced and executed accelerated share repurchase program. Excluding the shares obtained in the settlement of the accelerated share repurchase program, for fiscal year 2007 we repurchased 21.2 million shares at an average price of $49.06. As of April 27, 2007, we have approximately 15.1 million shares remaining under current buyback authorizations approved by the Board of Directors.

In June 2007, our Board of Directors authorized the repurchase of an additional 50 million shares of our common stock.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Executive Level Overview

Net earnings for the fiscal year ended April 27, 2007 were $2.802 billion, a $255 million, or 10 percent, increase from net earnings of $2.547 billion for the fiscal year ended April 28, 2006. Diluted earnings per share were $2.41 and $2.09 for the fiscal years ended April 27, 2007 and April 28, 2006, respectively. Fiscal year 2006 net earnings include after-tax special and IPR&D charges and certain tax adjustments that reduced net earnings by $136 million, or $0.11 per diluted share. The fiscal year 2007 increase in net earnings was driven primarily by net sales growth, a reduction in IPR&D charges, and increased interest income.

Net sales in fiscal year 2007 were $12.299 billion, an increase of 9 percent from the prior fiscal year. Foreign currency translation had a favorable impact on net sales of $166 million when compared to fiscal year 2006. The increase in the current year was led by solid worldwide sales growth in the Vascular, Diabetes, Spinal and Navigation, and Neurological businesses and exceptional growth outside the United States (U.S.), where seven of our eight operating segments had growth rates ranging from 16 percent to 32 percent.

While we continue to make substantial investments in the expansion of our existing product lines and the search for new innovative products, we have also focused heavily on carefully planned clinical trials, which lead to market expansion and enable further penetration of our life changing devices. Fiscal year 2007 research and development spending of $1.239 billion increased 11 percent in comparison to the prior fiscal year.

Increased investment in our future is fortified by our continued strong cash flow generated from operations of $2.979 billion during fiscal year 2007 and our $6.082 billion in cash, short-term debt securities, and long-term debt securities as of April 27, 2007. We may use our cash flow from operations to invest in research and development, fund certain strategic acquisitions, and to participate in expanded clinical trials, which support regulatory approval of our products.

We remain committed to our Mission of developing lifesaving and life enhancing therapies to alleviate pain, restore health, and extend life. The diversity and depth of our current product offerings enable us to provide medical therapies to patients worldwide. We will work to improve patient access through well planned studies, which show the cost-effectiveness of our therapies and our alliance with patients, clinicians, regulators, and reimbursement agencies. Our investments in research and development, strategic acquisitions, expanded clinical trials, and infrastructure provide the foundation for our growth. We are confident in our ability to drive long-term shareholder value using the principles of our Mission, our strong product pipelines, and continued commitment to research and development.

Other Matters

On December 4, 2006, we announced our intention to pursue a spin-off of Physio-Control into an independent, publicly traded company. Physio-Control is our wholly-owned subsidiary that offers external defibrillators, emergency response systems, data management solutions, and support services used by hospitals and emergency response personnel. On January 15, 2007, we announced our voluntary suspension of U.S. shipments of Physio-Control products manufactured at our facility in Redmond, Washington in order to address quality system issues.

We are currently in discussions with the U.S. Food and Drug Administration (FDA) regarding the corrective actions that need to be taken before shipping in the U.S. can resume. We have a dedicated team from across the Company working on the corrective actions necessary to address the quality system issues.

The suspension of U.S. shipments in fiscal year 2007 did not have a material impact on our overall results. We expect the suspension of U.S. shipments to continue into the second half of fiscal year 2008. Following the resolution of these matters, we intend to continue to pursue the spin-off of Physio-Control.

Financial Highlights:

Revenue Growth (1-yr): 8.9%
Revenue Growth (9-yr average): 19.6%

Net Income Growth (1-yr): 10.1%
Net Income Growth (9-yr average): 28.3%

Earnings-Per-Share Growth (1-yr): 15.3%
Earnings-Per-Share (9-yr average): 25.7%

Free Cash Flow Growth (1-yr): 33.7%
Free Cash Flow Growth (9-yr average): 37.1%

Net Profit Margin (current): 22.8%
Net Profit Margin (10-yr average): 19.1%

Return On Equity (current): 27.5%
Return On Equity (10-yr average): 24.3%

Debt Ratio (current): 0.44
Current Ratio (current): 3.09

Financial analysis:

• Although the company is more leveraged than it was ten years ago (debt ratio of 0.26 in 1998), current debt ratio is still only 0.44.
  

• ROA has been fairly consistent throughout the past ten years. Currently it stands at 13.8% and 10-yr average is 15.9%.
  

• ROE has been relatively consistent as well. Currently it’s at 27.5% and 10-yr average is 24.3%.
  

• All margins (gross margin, operating margin, and net profit margin) have stayed relatively consistent throughout the past ten years. Profit margin is currently at 22.8% and company posted a 19.1% 10-yr average.
  

• Revenue growth has slowed down lately: growth in the 2007 fiscal year was a mere 8.9% while 9-yr average is 19.6%.
  

• Net income has been varying wildly: posting three-digit growth in 2000 and then slipping into negative territory in 2001, 2002, and 2005. Most recently, net income grew 10.1% and 10-yr average is 28.3%.
  

• Free Cash Flow has been fairly consistent and currently stands at an impressive 19.6%. FCF growth has been very rocky: a loss of 48% in 1999 followed by gains of 206% in 2000 and 99% in 2001 followed by losses of 14%, 2%, and 24% in 2002, 2005, and 2006, respectively. In the 2007 fiscal year, company showed FCF growth of 33.7% and 10-yr average is 37.1%. Those numbers are very impressive, but “consistency” and “stability” are definitely not the words to associate with such performance.
  

• Medtronic’s Current Ratio is rather impressive at 3.09. This shows that company is currently holding a lot of cash on hand, enough to pay for the current expenses three times over. Such high Current Ratio may suggest that company has transferred some of its assets into a more liquid form to be able to act fast on potential acquisition targets.
  

• Inventory Turnover has been consistent throughout the past ten years and currently stands at 2.65.

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 14% per year for the next 10 years and at 3% (trailing GDP growth) perpetually after that. Company’s free cash flow grew at an average rate of 37% during the past nine years, which makes my conservative estimate very plausible.

I used a discount rate of 10% because Medtronic is a mature company with an established market leader position in many market segments and therefore can command a below-average discount rate.

Using the assumptions listed above, my intrinsic value of the stock came out to $69.06. My intrinsic value of Medtronic is somewhat higher than what Morningstar has as a “fair value” for this company. I believe our difference in opinion lies in the fact that Morningstar underestimates this company’s growth potential.

Pros:

• Medtronic is a wide-moat company with a diversified product portfolio that is further diversifying to treat more chronic diseases..

• Medtronic is an innovator and is often a market leader in its product segments.

• Company has a strong balance sheet and impressive growth rates throughout the past decade.

• Company is consistently buying back its common stock and plans to continue doing so in the future.

Cons:

• In the recent years, Medtronic has issued several volunteer product recalls, which has hurt its sales growth and possibly doctors’ confidence in its products.

• Medical device market is inherently risky as it’s driven by innovation, government regulations, and insurance reimbursement rates.

• Company has had a bumpy top- and bottom-line growth in the short-term, although it did provide investors with impressive returns over the long-term.

Final Decision:

Medtronic is an innovator in a great financial health that still has, in my opinion, significant potential for growth. Currently, MDT’s stock trades at $47 vs. $.69 that I have for intrinsic value of the company. Given my safety margin of 30-50%, it is within my buying price range $35-$48. At this point, Medtronic is most certainly “pre-approved” for a slot in my portfolio, but I will not make any final decisions on the portfolio picks until I have more solid candidates such as Medtronic and Johnson & Johnson.

Morningstar Stock Rating Performance Revisited

Morningstar has recently released its regular update on how well their stock rating system has been performing. If you were to buy their 5-star stocks and sell them at Fair Value, you would have trailed S&P 500 for the past year (11.2% vs 18.4%), but if you had followed this strategy since the inception of their stock rating system in 2001 you would have outperformed S&P 500 by 2.3% (7.9% vs. 5.6%).

They compare different strategies of using their rating system in comparison to S&P 500 performance in the full article: Stock Star Rating Performance Update.

Even though I wouldn't call these results mind-boggling, they did outperform the overall market in the long-term comparison. I also believe that this proves that Morningstar ratings are a great starting point for finding great stocks: if you can outperform the market by simply basing your buy/sell decisions on their star ratings, think how well you can do if you also apply your own analytical skills.

Microsoft Rallies, I Cry

As Microsoft has posted one of the largest gains (as far as short-term spikes are concerned) within the last five years, I'm starting to kick myself in the butt. I analyzed MSFT just 3 days after it started its rally on Oct. 19th, but since I'm still in the process of analyzing a bunch more stocks, I have not made my final portfolio picks yet.

I'm sure there are still plenty of great opportunities in the market, but it's definitely a bummer when you miss out on a 15% gain (within a week!) from a company like Microsoft.

The only stock that is currently in the "buy" zone for me, is Johnson & Johnson (JNJ). It's currently trading at a 34% discount to my intrinsic value of the company.

Additional resources:

• Morningstar: U.S. stocks rally on Microsoft's strong profit, Fed hopes

Forbes Picks from 12/11/06: CYT, TRMB, PAYX, PEP, OMI

I decided to create a new topic/category/column, whatever you'd like to call it, focusing on stock picks made by various business magazines that I read. It will be a relatively short-term comparison, dating back 6-12 months. But then again, most of the picks they make are not exactly intended to be long-term investments anyway, so it's fair.

Here is a first set of stock picks, they're from the 12/11/06 issue of Forbes 2007 Investment Guide:


* Keep in mind that notes were made based on the article where stocks were mentioned, which means that some thing may be outdated at this point.

I welcome any feedback in regard to the format of this spreadsheet. If you have any suggestions on how to make it more useful or simply more user-friendly, please feel free to share.

Stock Analysis: Waters Corporation (WAT)

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.

Click here for a full description of the company’s operations (provided by Reuters).

Annual Report Highlights (latest report is for the period ending 12/31/06):

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 December 31, 2006, compared to approximately 2,400 field representatives in 87 sales offices as of December 31, 2005. The Company’s sales representatives have direct responsibility for account relationships, while service representatives work in the field to install instruments and minimize instrument downtime for customers. Technical support representatives work directly with customers, helping them to develop applications and procedures. The Company provides customers with comprehensive product literature and also makes consumable products available through a dedicated catalog.

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 Milford, Massachusetts, where it performs machining, assembly and testing.

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 Singapore. The Company expects to continue to pursue other outsourcing opportunities in the future. During 2006, the Company added four manufacturing locations in connection with the ERA, VICAM and Thermometrics acquisitions.

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 Milford, Massachusetts, with input and feedback from the Company’s extensive field organizations.

The majority of the MS products have been developed at facilities in England and nearly all of the current thermal analysis products have been developed at the Company’s research and development center in New Castle, Delaware.

At December 31, 2006, there were approximately 571 employees involved in the Company’s research and development efforts, compared to 555 employees in 2005. The Company has increased research and development expenses relating to acquisitions and the Company’s continued commitment to invest significantly in new product development and existing product enhancements.

Employees

The Company employed approximately 4,700 employees, with 45% located in the United States, and approximately 4,500 employees, with 47% located in the United States, at December 31, 2006 and 2005, respectively. The increase of 4% over 2005 is primarily due to increases in manufacturing operations, research and development and from acquisitions.

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.

Risk Factors

• 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

Properties

Waters operates 21 United States facilities and 71 international facilities, including field offices. The Company believes its facilities are suitable and adequate for its current production level and for reasonable growth over the next several years. The Company also operates and maintains 12 field offices in the United States and 59 field offices abroad.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Business and Financial Overview

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 Asia. The 2006 and 2005 sales growth benefited from the introduction of the ACQUITY UPLC ^® and the Quattro Premier ^tm XE based systems and an increase in chemistry consumable sales. In addition, the 2006 sales growth also benefited from the introduction of the new SQD, TQD and Synapt ^tm HDMS mass spectrometry systems which were introduced in the second-half of 2006.

U.S. sales increased 4% and 2%; European sales grew 12% and 3%; and Asian sales (including Japan) grew 19% and 10% during 2006 and 2005, respectively. Asian sales growth was strongest in India and China.

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 Asia by expanding an existing partnership to manufacture instrumentation in Singapore. The Company transitioned the manufacturing of the Alliance ^® instrument system and, while the Company expects to achieve cost savings efficiencies in the future, the overall impact during the ramp-up in 2006 was slightly negative on gross profit margin percentages in 2006 compared to 2005.

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.

Acquisitions

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 February 2006, the Company acquired the net assets of the food safety business of VICAM Limited Partnership (VICAM) for approximately $13.8 million. VICAM products added approximately $8.0 million to sales and were about neutral to earnings for the year ended December 31, 2006 after debt service costs. VICAM product sales in 2007 are expected to be approximately $10.0 million.

In August 2006, the Company acquired all of the outstanding capital stock of Thermometric AB, a manufacturer of high performance microcalorimeters, for a total of $2.5 million in cash and the assumption of $1.2 million of debt. Thermometrics’ products added approximately $1.5 million to sales and were neutral to earnings for the year ended December 31, 2006. Thermometrics sales are expected to be approximately $4.0 million in 2007.

Year Ended December 31, 2006 Compared to Year Ended December 31, 2005

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 U.S., Europe and Asia (including Japan) strengthened approximately 4%, 12% and 19%, respectively, in 2006. The effects of foreign currency translation increased sales growth by 2% in Europe and decreased sales growth in Asia by 3% in 2006. The growth in Europe was broad-based across most major countries, particularly in Eastern Europe, while Asia’s growth was primarily driven by increased sales in India and China. U.S. sales growth in 2006 was primarily due to higher demand from the Company’s pharmaceutical and industrial customers.

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 Europe and Asia.

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 Singapore and product introduction costs on new MS instruments.

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 U.S. and Europe that resulted in the employment of 74 employees being terminated, all of which had left the Company as of December 31, 2006. In addition, the Company closed a sales and demonstration office in the Netherlands in the second quarter of 2006. The Company implemented this cost reduction plan primarily to realign its operating costs with business opportunities around the world.

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 Netherlands.

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 U.S. to fund the stock repurchase programs.

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 India.

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:

There is huge disparity between my intrinsic value of the company, $40/share, and the market price, $75/share. It may be due, to a large extent, my lack of understanding of their business operations, but also I think market is too optimistic about this company’s prospects. Given my 30%-50% margin of safety requirements, my buying range for Waters Corporation would be $20-28. Since that is not likely to happen, as can be seen from the current market valuation, there is a very good chance that this company will never be a part of my portfolio.

Stock Analysis: Procter & Gamble (PG)

Company Description:

The Procter & Gamble Company (P&G), incorporated in 1905, is focused on providing branded consumer goods products. The Company markets its products in more than 180 countries. During the fiscal year ended June 30, 2007 (fiscal 2007), the Company was organized into three global business units: Beauty and Health, Household Care and Gillette GBU. P&G had seven segments under United States Generally Accepted Accounting Principles: Beauty; Health Care; Fabric Care and Home Care; Snacks, Coffee and Pet Care; Baby Care and Family Care; Blades and Razors, and Duracell and Braun. In September 2006, the Company's Sure brand (an antiperspirant and deodorant brand) was acquired by Innovative Brands, LLC. In January 2007, P&G acquired HDS Cosmetics Lab Inc., which manufactures and markets Doctor's Dermatologic Formula (DDF) skin care.

Click here for a full description of the company’s operations (provided by Reuters).

Annual Report Highlights (latest report is for the period ending 6/29/07):

Description of Business

Business Model. Our business model relies on the continued growth and success of existing brands and products, as well as the creation of new products. The markets and industry segments in which we offer our products are highly competitive. Our products are sold in over 180 countries around the world primarily through mass merchandisers, grocery stores, membership club stores and drug stores. We have also expanded our presence in “high-frequency stores,” the neighborhood stores which serve many consumers in developing markets. We work collaboratively with our customers to improve the in-store presence of our products and win the “first moment of truth” — when a consumer is shopping in the store. We must also win the “second moment of truth” — when a consumer uses the product, evaluates how well it met his or her expectations and whether it was a good value. We believe we must continue to provide new, innovative products and branding to the consumer in order to grow our business. Research and product development activities, designed to enable sustained organic growth, continued to carry a high priority during the past fiscal year. While many of the benefits from these efforts will not be realized until future years, we believe these activities demonstrate our commitment to future growth.

Key Product Categories. In 2007, one product category accounted for 10% or more of consolidated net sales. The laundry category constituted approximately 16% of net sales for fiscal years 2007 and 2006 and 17% of net sales in fiscal year 2005. In fiscal year 2005, we had three product categories, including the laundry category described above, that accounted for 10% or more of consolidated net sales. The diaper category represented approximately 11% of net sales in fiscal year 2005. The retail hair care category accounted for approximately 10% of net sales in fiscal year 2005. Fiscal year 2006 net sales percentages for the above categories decreased due to the addition of The Gillette Company on October 1, 2005.

Key Customers. Our customers include mass merchandisers, grocery stores, membership club stores, drug stores and high-frequency stores. Sales to Wal-Mart Stores, Inc. and its affiliates represent approximately 15% of our total revenue in both 2007 and 2006 and 16% of total revenue in 2005. No other customer represents more than 10% of our net sales. Our top ten customers account for approximately 30% of total unit volume in 2007, compared to 31% in 2006 and 32% in 2005. The nature of our business results in no material backlog orders or contracts with the government. We believe our practices related to working capital items for customers and suppliers are consistent with the industry segments in which we compete.