Company Highlight Series – Waters Corporation (WAT) by Allen Bond, CFA, Portfolio Manager – Jensen Investment
Waters Corporation (WAT) – Narrow Focus Belies Large Company Fundamentals
Founded in 1958, Waters Corporation (NYSE: WAT) is a global leader in the development of analytical instruments used in pharmaceutical research. Specifically, the company focuses on the design and manufacture of equipment used in the related scientific disciplines of Liquid Chromatography (LC) and Mass Spectrometry (MS). Liquid Chromatography is a process in which a substance is exposed to a high pressure solvent in order to reveal its underlying chemical components. Mass Spectrometry identifies those components based on mass.
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Jensen’s Investment Thesis
Competitive advantages for Waters are a function of technology leadership and high customer switching costs. We estimate that Waters has a 20% to 25% global market share of the LC/MS market. This market position has proven resilient due to a steep product learning curve and the tendency for these instruments to become embedded in workflow. From a technology standpoint, Waters has continually enhanced its product offerings via improved software interfaces, faster and more accurate throughput, and more integrated functionality between LC and MS equipment.
Our research indicates that new LC and MS instruments cost upwards of $100,000, ostensibly exposing Waters to the whims of customers’ capital spending cycles. Accordingly, we have witnessed some quarter-to-quarter revenue lumpiness since our initial purchase of Waters’ shares. However, when viewed from a longer-term perspective, Waters’ revenue growth has been notably more consistent. We approximate average annual organic revenue of 6.1% and 6.0% over the past five and ten years, respectively.
As mentioned, Waters sells expensive capital equipment, but nearly half the company’s revenue is generated from consumable products and service contracts that tend to be somewhat recurring in nature. Revenue consistency also benefits from the company’s broad geographic range. Roughly speaking, 40% of sales are derived from the Americas, 35% from Asia, and 25% from Europe. Finally, Waters may be best known for its research equipment, but a meaningful portion of its products are used in regulated quality control processes for pharmaceuticals (both patented and generic) already on the market. These ‘workhorse’ tools have lifespans of five to seven years, creating a natural replacement cycle.
A Case Study for Value Creation
At Jensen, we often talk about the long-term link between business- and shareholder-value creation, and we believe Waters is an excellent case study. In the eight-year period from 2008 to 2015 (a rough approximation of our ownership period through the most recent year-end), we estimate Waters produced annualized net income and EPS growth of 7.1% and 10.0%, respectively, on a pro-forma basis. During this same period, Return on Equity (expressed as a percentage) averaged nearly 36%, well above our estimate of Cost of Equity and strong evidence of business value creation, in our opinion.
We first purchased shares of Waters’ in October 2007 at a price of $68.54. And, in full candor, our purchase timing was unfortunate in the short-term as the price declined shortly thereafter due to a weaker-than-expected quarterly earnings report. However, our confidence in the underlying business did not waver, and we used the pullback as an opportunity to add to our position. Thus far, our conviction has been rewarded. From that initial purchase through June 30th of this year, Waters’ stock has produced a total annualized return of 12%, besting that of the S&P 500 Index by 800 basis points.
With annual revenue slightly north of $2 billion and market capitalization of approximately $13 billion, Waters is the smallest company held in the Jensen Quality Growth Fund. However, we believe it benefits from characteristics normally seen in much larger companies including geographic diversity, deep competitive advantages, and consistent free cash flow production. Importantly, we continue to believe Waters has a bright future. We expect long-term growth and value creation driven by continued scientific advancement in the LC and MS disciplines, a renaissance in drug research, and ultimately new drug production.