It’s Time for Value and Quality

03/03/2008 12:00 am EST

Focus: STOCKS

James Stack

President, Stack Financial Management

James Stack, editor of InvesTech Research, says there’s less downside risk in the market and he recommends a quality stock he thinks is attractively valued.

The steep market retreat and an overly accommodative Federal Reserve policy have removed a fair amount of the downside risk in this market and improved the near-term outlook.

At this point, we are watching our indicators carefully and may make further additions if the market continues to improve. In doing so, however, we intend to focus on top-quality value stocks that are now selling at a discount to fair value.

In a market overreaction to a weaker-than-expected fourth quarter, an opportunity has been created to invest in Waters (NYSE: WAT), a high-quality company at an attractive valuation level.

Waters is a medium-sized company based in Massachusetts which designs, manufactures, and services high performance liquid chromatography (HPLC) and mass spectrometry (MS) instrument systems.  Its products help test air and water quality, analyze nutritional content of foods, and develop drugs. Within the pharmaceutical and life science industries, its most significant end-use market, HPLC, is used to identify, manufacture, and assure the potency and purity of new drugs.

Approximately 68% of Waters’ sales come from international markets. The Asian markets, particularly China and India, continue to produce strong results for the company, with revenue growing over 30% annually in these regions. Asian operations are benefiting from increasing market presence of generic drug makers and a significant increase in food safety and environmental testing by the Chinese government.

The company’s commanding market share and technological leadership have helped produce a strong record of earnings growth and an enviable level of profitability. Waters’ equipment [provides] important information in a world demanding more detailed information, [with] increasing government regulation and [growing environmental concerns]. The company is also a clear beneficiary of the expected per capita increase in health care spending and the dramatic development of the Asian economies.

The key to the firm’s dominance is its drive for innovation and unsurpassed technical performance. A high proportion of recurring revenue streams from consumables and service contracts generates strong free cash flow. Waters’ free cash flow is currently 17% of sales, compared with 7% for the Standard & Poor’s 500 Index.

The stock dropped 20% when the company reported earnings that were eight cents shy of Wall Street’s $1.06 estimate. The shortfall was primarily a result of a higher-than-expected tax rate for 2007 and weaker sales in Japan, [reflecting] a change in government regulations for water testing. Our concern over this event is limited given that Japan accounts for less than 10% of the Waters’ sales and is not a key growth market for the firm.

We conservatively forecast sustainable earnings per share growth in the 14% to 16% range. It is important to note that the company’s 2007 earnings that disappointed Wall Street were up 18% for the year. (The stock closed below $60 on Friday, more than 20% off its 52-week high—Editor.)

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