Wednesday, July 26, 2006

Waters Corporation (WAT)

Let me initiate my commentary with an apology. I have been terribly busy with a work project and time has been precious. Professional portfolio management is composed of two parts, (#1) Doing whatever it is you do, and (#2) Expaining to the your clients and their consultants (especially these) what it is, you've done. For some of us, there is a third component (#3) Marketing of your services. I have been busy with numbers 1 and 3, I have been preparing for # 2.

Earnings season, despite the complete disdain with which I view most quarterly releases and investors' over-reactions one way or other, is a huge time expense. Conference calls deteriorate into too many hallelujahs and "Nice quarter guys!" Earnings surprises create craters or peaks...long term perspectives are easily lost. As you know, I like the long term perspective. Short term noise and volatility builds commissions, long term perspectives build wealth.

The blog has suffered and I apologize to all of you. Let's get back on track.

Waters (WAT) is one of the leaders in designing and manufacturing scientific analytical instruments, especially in the areas of liquid chromatography,  mass spectrometry, and thermal analysis. These instruments provide enabling technology for environmental studies, for chemistry and for pharmacology. The instruments detect, identify, purify, and measure a full range of compounds. Putting things into a financial  perspective, this is a business that has generated a median return on invested capital of 25.6% in the last five years. Nice!

Waters got clocked yesterday by over 7% following the reporting of its 2nd quarter ended July 1. The market's reaction yesterday was somewhat perverse given the slight improvement in operating margins (50 bp) to 21.8% and an organic growth rate (ex foreign translation) of 9% or 7% with the forex. Operating margin was below some Street expectations and below the TTM 24.1% level.

From a cash flow perspective, the company generated free cash flow of $51 million post capex of $14.7 million. In terms of working capital, accounts receivable turnover showed slight improvement but inventories grew by $15 million which management categorized as $4 million in new Mass spec, $3 million in liquid chromatography, $3 million in forex effects, and $2 million in deferred shipments. The build up in new products in inventory is understandable, the deferral of orders, similarly, is no big deal.

The company also raised its E.P.S. guidance for the year slightly to $2.36 ex-stock options expense, $2.15 with stock options expense. Most companies' earnings would certainly be improved if we eliminated salaries and other compensation, and I regard stock options expense as real and genuine as I do any other compensation. On an apples to apples basis, the management is suggesting 18% EPS growth on a 8% lift in revenues for 2006 over 2005...good operating leverage.

The company did report that there was a double digit sales decline in the first half of the year to its US pharmaceutical clients, but that it anticipated that spending in U.S pharma will improve for the second half.

Some of the underlying trends were particularly interesting. In terms of Asia beyond Japan, namely India and China, sales were up by 36%. U.S. sales declined by 2%. Europe was up 2% and Japan was up 6%...clearly global trends in pharmaceuticals and other high value added sciences are going to be of great benefit to this company. In the conference call, the management also highlighted that sales Stateside to CROs and small pharmaceutical and generic companies was going very well.

The company indicated that free cash flow for the year 2006 should come in around $265 to $275 million.

Compare that with its prior free cash flow history:


The company has been deploying its free cash flow into share repurchases. WAT has a $500 million buyback with $114 million remaining. In the second quarter, the company bought back $80 million of stock, and clearly should complete this program by year end.

The company has introduced a number of exciting (especially to former biophysicists) products which should meet with decent demand. As research labs go, especially around universities and many industries, this tends to be a fourth quarter business. If you have an annual budget, it behooves you to spend it by the fourth quarter lest you lose it.

Liquid chromatography tends to take forever, and WAT has pioneered some very high performance chromatography which operates at nine times the speed of conventional chromatography with improved resolution and sensitivity.

In my view, an interesting way to invest globally in the emerging life sciences markets of Asia with lower risk. A shareholder friendly management that returns capital through effective buybacks and continues to generate significant returns on invested capital.

My valuation is the low $50's.

Disclaimer: I and my family do not have a current position in Waters. However, a number of clients do own a current position in this company.


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