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Waters Corporation: Picks And Shovels Don't Always Sell Cheap

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Life science tools companies like Waters Corporation (NYSE: WAT  ) , Thermo Fisher Scientific (NYSE: TMO  ) , Agilent (NYSE: A  ) , and Danaher (NYSE: DHR  ) are often described as "picks and shovels" plays on pharmaceuticals, biotech, and specialty chemicals, as these companies sell to a wide range of companies in those industries and have far less of the development risk or regulatory burden. True as that may be, these companies don't often trade cheaply and Waters is no exception.

Even though the Street has grown concerned about Waters' organic growth, these shares continue to trade at a double-digit EV/EBITDA multiple, a 50% premium to the company's expected growth over the next few years. Waters should see improving demand from the pharmaceutical space as clients work through R&D restructuring programs and Waters is well-positioned in emerging markets. There is also the possibility that a change in management (the company is searching for a new CEO) could bring with it a new approach to acquisitions. Even with that, though, it would seem that investors are not likely to see double-digit appreciation from today's price level.

A Leader In Two Key Tools Markets

Relative to Thermo Fisher, Agilent, and Danaher, Waters is quite focused. The company is among the leaders in liquid chromatography (LC), mass spec (MS), thermal analysis, and it stays true to those markets.

Waters is a top player in the over $3 billion LC market, trailing only Agilent with its mid-teens overall market share. Waters does not attempt to compete in all parts of the LC market, though, and actually is a share leader in those areas where it competes. Nearly one-third of the company's sales go to quality control in the pharmaceutical space, while the newer Acquity UPLC platform has thus far seen more adoption in the high-end drug discovery and regulated testing market.

Mass spec is a slightly smaller market than LC, but still worth more than $3 billion in addressable revenue. Waters has a broadly similar market share in MS (low to mid teens), but comes in fourth behind Danaher, Agilent, and Thermo in terms of market position. Danaher and Agilent are strongest in the quadrupole segment, which makes up about one-third of the market, while Waters and Danaher are stronger in the TOF-LC/MS segment, a smaller market, but faster-growing. Waters does not have as full of a product line in MS as Danaher, Agilent, or Thermo, but that isn't to say Waters isn't a serious player. Waters has recently introduced the Acquity QDa, the first detector that brings MS data to chroma separations.

More Focused On Industry Than Academia

Like Agilent and Danaher, but unlike Illumina, Bruker, and post-merger Thermo/Life Technologies, Waters generates relatively little (less than 15%) revenue from the academic research/NIH markets. Instead, more than half of the company's revenue is drawn from biotech and pharmaceuticals and another third from industrial customers (chemical companies especially) and customers in the food and environmental sector.

As I said above, Waters' tools are used by pharmaceutical companies to develop new drugs and maintain quality control in drug manufacturing. The former is likely a significant part of the growth pressure that Waters has been seeing recently. Large customers like Merck and Teva have been restructuring their R&D operations, delaying capital purchases as they do so. Waters can offset this somewhat with a solid position in emerging markets like India and China, and I do believe the branded and generic drug sectors are closer to the end of restructuring than beginning.

Is It Time For More Drastic Action?

Waters has generally been a conservatively run business. The company has not avoided M&A, but the deals have tended to be smaller tuck-in deals rather than large transformative moves. Perhaps now is the time to consider something more significant. Waters has no presence in molecular or atomic spectroscopy, nor lab automation, and any of these markets could be logical extensions of the business. The acquisition of either Bruker or PerkinElmer would likely be too far outside of the company's comfort zone, but there are other worthwhile deals in those spaces for the company to contemplate.

It's also worth asking if a restructuring could be in the company's future. Waters is very well-run, with operating margins consistently in the high 20%'s and returns on invested capital in the high teens to low 20%'s. I find it a little difficult to imagine that there are sizable inefficiencies in the business, but the company hasn't really done a restructuring in about 15 years, so it may yet prove worthwhile.

Last and not least, I wouldn't entirely rule out the possibility of Waters as a target of M&A. Agilent, Danaher, and Thermo Fisher would all likely encounter antitrust obstacles, but General Electric, Sigma Aldrich, and/or Merck KGaA could all come into play as potential acquirers.

The Bottom Line

I am optimistic that ongoing demand in pharmaceutical and biotechnology markets will allow Waters to maintain mid single-digit revenue growth over the long term. I likewise see the potential for added scale to support free cash flow growth in the mid-to-high single digits. Unfortunately, a discounted cash flow analysis suggests that that sort of growth is worth about $90 a share today.

I don't want to give the impression that I think Waters is a bad pick. Rather, I think that at today's price investors are trading risk for reward, with Waters shares likely to appreciate at a single-digit rate. That's not good enough for me to buy today, but I wouldn't be in a great rush to sell Waters if I already owned shares.

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