A High-End R&D Machine

06/15/2009 12:53 pm EST


Paul Larson

Editor, Morningstar StockInvestor

 Paul Larson, editor of Morningstar StockInvestor, and analyst Alex Morozov say Waters makes instruments for top research companies and is holding up well in the downturn.

Waters (NYSE: WAT) makes instruments for pharmaceutical, biochemical, and industrial firms. Its applications range from laboratory research and drug manufacturing to nutritional labeling and quality control.

The company is known for its liquid chromatography (LC) instruments, which separate compounds for purification, quality control, and other research-and-development activities.  Waters is also a top-three manufacturer of mass spectrometers, which are used to identify molecular composition and structure.

Waters’ bread and butter is chromatography, where the company enjoys a strong 20%–25% market share. The key to the firm’s dominance in this segment is its ability to innovate, as illustrated by the 2004 introduction of its ACQUITY Ultra Performance system. The platform revolutionized the LC industry, as it provides a level of technical performance that remains unsurpassed after more than four years on the market. A rapidly growing installed base is also propelling sales of high-margin chromatography columns used with the platform.

While Waters’ recent offerings appear to be well received, a difficult spending environment has thwarted recent selling efforts. Waters’ platforms carry a hefty price tag, and tighter belts across various sectors, particularly among industrial clients, are disrupting Waters’ instrument sales.

While the weak spending will likely remain a concern for most of 2009, the company’s recurring revenue comprises nearly half of its total sales and is generally not affected by capital-spending trends. We also believe that the rising complexity of research requires increasingly sophisticated platforms, and the pent-up demand for scientific tools caused by near-term economic head winds should result in strong sales growth once normalcy returns.

The company, even with sales declining for the first time in its history, should still surpass the industry’s negative growth, indicating market share gains. Waters’ superior technology, while starting to lose its sizable advantage over competition in performance and efficiency, has provided the firm a much stronger moat component—a rapidly increasing installed base and corresponding switching costs.

Waters’ positioning in high-end instrumentation is very defensible as a result. [Its] enviable technological prowess and leading share in many markets it serves will likely continue yielding returns on capital well above those of its peers, validating the company’s wide economic moat.

While we remain optimistic about this firm’s long-term prospects, the weak spending environment and foreign-exchange head winds should result in a revenue decline in 2009 for the first time since the company’s initial public offering in 1995.We think that high-single-digit revenue growth should return in 2010, driven by pent-up demand. We also think Asian markets, particularly China, will grow rapidly, driven by the expansion in food and environmental testing. The long-term operating margin will likely settle around 25% to 26% as the outsourcing of manufacturing overseas will be offset by increasing price competition.

Our fair value estimate is $67, and we’d consider buying below the mid-$40s. (It closed above $48 Friday—Editor.)

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