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Executive Summary:

We believe that Waters Corp (WAT) is a high quality company with a Business Quality Score of 7 based on a scale of 1 to 10 (10 is best). Also, shares of Waters Corp appear to be undervalued based on a discounted cash flow analysis. Waters Corp stock would need to rise about 20% to reach fair valve based on the closing price of $92.21/share for Water Corp shares on 02-06-2013.

Business Description:

Waters Corp is in the analytical instrument business. Due to the complicated nature of their operations I thought it best to refer to the company's 10-K annual report in order to best describe their business.

(Source: 10-K)

Waters Corporation ("Waters ® " or the "Company") is an analytical instrument manufacturer that primarily designs, manufactures, sells and services, through its Waters Division, high performance liquid chromatography ("HPLC"), ultra performance liquid chromatography ("UPLC ® " and together with HPLC, referred to as "LC") and mass spectrometry ("MS") technology systems and support products, including chromatography columns, other consumable products and comprehensive post-warranty service plans. These systems are complementary products that are frequently employed together ("LC-MS") and sold as integrated instrument systems using a common software platform and are used along with other analytical instruments. Through its TA Division ("TA ® "), the Company primarily designs, manufactures, sells and services thermal analysis, rheometry and calorimetry instruments. The Company is also a developer and supplier of software-based products that interface with the Company's instruments as well as other manufacturers' instruments.

Business Quality Analysis:

We assign a Business Quality Score to each company undergoing analysis. The score is based on a scale of 1 to 10 with a value of 10 indicating the best possible Business Quality Score. Our Capital Business Quality Score is a proprietary metric which takes into account the 10 year historical performance of the company. Performance is measured considering the absolute performance (and trends) in revenues, earnings, profit margins, and returns on assets/equity.

Low Business Quality Scores indicate companies that are in a cyclical or commodity business. These businesses have erratic revenues and earnings with associated low profit margins and poor returns on capital. Low quality companies operate in highly competitive/cyclical businesses where consistent profits are nearly impossible to achieve.

High Business Quality Scores indicate companies that are in high quality businesses with some type of durable competitive advantages that keep competitors at bay. These businesses typically have steadily rising revenues and earnings with associated high profit margins and good returns on capital.

Revenue:

Waters Corp's revenues have preformed well over the last 10 years. Revenues have risen steadily with the exception of 2009 and 2012. Revenues dropped about 5% in 2009 which is not bad considering the horrible economic conditions at the time. In 2012, revenues where essentially flat at $1.84 billion in 2012 versus $1.85 billion in 2011. We believe this underperformance to be essentially random noise and not a future revenue growth trend.

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Earnings per share:

Waters Corp has steadily grown earnings over the past 10 years at an average growth rate of 14.5%. This is excellent performance which should continue in the future, albeit at a lower average growth rate of about 10%.

A company's earnings per share is a measure of profitability for a company. The earnings per share is calculated by dividing the net income attributable to the common stock by the average number of common shares outstanding. One drawback in using earnings as a profitably measure is that it does not consider the amount of assets needed to generate the earnings. Earning the same profit using fewer assets is more profitable but this is not considered in the calculation of earnings per share.

High quality companies will have steadily rising earnings that do not vary greatly through a full business cycle (expansion-recession-expansion). Investing in high quality companies is fairly easy assuming an investor has realistic profit expectations and has the patience to wait for a reasonable stock price relative to the company's value.

Lower quality (cyclical) companies will have earnings that vary greatly over a business cycle. Often these cyclical companies will experience a drastic reduction in earnings during economic recessions. Investment profits can be had with investments in cyclical companies but the timing of the buying and selling of the investment must be in sync with the ebb and flow of the stock market. Typically, the stock market will start to recover about 6 months before the economy comes out of recession. However, this point in time is not obvious in the moment and is only known latter with the benefit of hindsight. Furthermore, timing when to sell a cyclical stock is even more difficult. Timing the stock market is a matter of luck so it is best to stick with the higher quality stocks where market timing is not as critical to investing success.

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Operating Profit Margin:

Waters Corp has had consistently high operating profit margins in the range of 26.4% -32.5% over the last 10 years. This is excellent performance; however, it would be better if there was an upward trend in the operating margin instead of a random distribution in the previously described range.

The operating profit margin is earnings before interest and taxes are paid divided by net revenues. As a rule of thumb, consistent operating profit margins in the range of 15% - 20% or higher is an indicator of a good company with some type of durable competitive advantage. One exception to this rule of thumb is the retailing sector where operating margins in the 5% - 10 range are the norm even for great companies. One thing to look for is the trend in the operating profit margin. Ideally, the operating profit margin should be steady and rising over the past 10 years.

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Net Profit Margin:

Waters Corp has had consistently high net profit margins in the range of 17.4% to 25.0% over the last 10 years. This is excellent performance as the trend has been rising steadily since 2006.

The net profit margin is net income divided by net revenues. For non retailing companies, a consistent net profit margin of 7% or higher is an indicator of a good company with some type of durable competitive advantage. In the retailing sector a net profit margin in the range of 3% to 6% is the norm even for the best companies. Ideally, the net profit margin should be steady and rising over the past 10 years.

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Return on Assets:

Waters Corp has had a consistently high return on assets in the range of 11.2% to 18.4% over the last 10 years. This is good performance but it would be better if the return on assets showed an upward trend instead of bouncing around erratically within the described range.

Return on assets is a measure of how much profit is generated from a company's assets independent of how much debt is used to finance the acquisition of those assets. The return on assets is sometimes a better measure of profitability than return on equity because the return on equity can be significantly increased by adding more debt to a company's balance sheet. Adding more debt to a company can inflate profits but comes at the price of a greater risk of bankruptcy. Measuring profitability using the return on assets does not have this problem because to calculate the return on assets the net income plus the interest expense net of income tax savings is divided by the average total assets of the company. Thus, by dividing the net income (adjusted for the affects of debt financing) by the total assets (debt + equity) of the company it cancels out the positive effects of debt. The return on assets is great for comparing the profitability of companies with different levels of debt in their capital structures. Generally speaking, a consistent return on assets of about 7% or more is a good indication of a good business with some type of durable competitive advantage. One exception to this rule of thumb is the banking sector where a return on assets of just 2% is considered exceptional.

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Return on Equity:

Waters Corp has had consistently high return on equity in the range of 27.2% to 68.8% over the last 10 years. This performance is good but the fact that the trend has been steadily downward since 2006 is an item of concern. However, the most recent return on equity of 34.4% is still a very good return on equity. Hopefully, this trend will flatten out or reverse in the coming years.

Return on equity measures a company's performance in financing and using assets to generate earnings. In contrast to the return on assets, the return on equity considers the affect of financing in generating profits. To calculate the return on equity the net income (minus dividends paid on preferred stock) is divided by the average common shareholder's equity. As a rule of thumb, a consistent return on equity of 15% or more (assuming a reasonable level of debt financing) is an indicator of a good company with some type of durable competitive advantage.

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Valuation:

A discounted cash flow analysis reveals a fair value for Waters Corp of $110.27/share.

We use the percent of revenue method in its discounted cash flow analysis. The model assumes an average weighted cost of capital (WACC) of 7.5%. Our WACC is calculated using a unique proprietary formula. An average revenue growth rate of 10% is projected over the next 10 years. An average revenue growth rate of 6% is assumed for every year thereafter.

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Conclusion:

Waters Corp appears to be a high quality company with an undervalued stock price. Based on a fair value of $110.27/share and Waters Corp's closing stock price of $92.21/share (on 02-06-2013) the stock must rise 19.6% to reach fair value.

Disclaimer: Ulfberht Capital is not an investment advisor. This article is not a recommendation to buy or sell securities. Always consult your investment advisor before making any investment decision.

Source: Waters Corp: 20% Upside To Reach Fair Value