Waters Corporation (WAT) is a fantastic company that will increase earnings tremendously over the long term, however management is exposing the firm to a variety of unnecessary social risks. A strong economic moat and the winds of a massive secular trend make the investment attractive, but outsourcing US jobs, avoiding US tax payments, and a lack of social and environmental disclosures are creating risks and preventing Waters Corporation from achieving an even greater potential. Regardless, this stock will outpace the overall market significantly in the years ahead.
What Does Waters Do?
Waters makes analytical instruments. Specifically, the Waters division makes chromatography instruments (separates liquids/substances), and the TA Division makes thermal analysis (rheometry and calorimetry) instruments. The instruments are used by pharmaceutical, life science, biochemical, industrial, food, environmental, academic and government customers working in research and development, quality assurance and other laboratory applications.
Why is Waters One of the Good Guys?
Waters is one of the good guys because they are in an industry that makes positive contributions to society. Food safety, environmental management, health care delivery and worldwide water quality are all good things. This may sound like meaningless fluff to some people, but as a counter example, consider Wall Street. There seem to be no greater villains in the corporate world than big Wall Street banks who are accused of caring only about profits and have been blamed for the recent global financial crisis. Society's disapproval of big Wall Street banks has resulted in very expensive regulation (think Dodd-Frank) and harsh propaganda by some government officials (for example some people argue that Obama Hates Wall Street). The point is that focusing only on short-term profits is not enough, companies must also be keenly aware of their long-term responsibility to the greater good of society, and in this regard Waters Corporation is one of the good guys because of the industry in which they operate. I don't soon see society and/or government launching a witch hunt against anyone trying to improve food safety, environmental management, health care delivery and worldwide water quality.
What is Waters' Economic Moat?
Waters' economic moat is the trust they've built with customers. The scientists that use Waters' products are concerned primarily with the reliability and consistency of the products, not necessarily the price. For example, according to the Financial Management Association, the company "maintains a strong competitive advantage from a wide moat around its life science tool product line in Liquid Chromatography and Mass Spec systems used in the chemical analysis of drugs and other consumer products." Any shortcomings in product quality introduce another variable into scientific studies that may disqualify results. It is this economic moat that allows Waters to maintain its very attractive operating margins.
Waters' annual report specifically states, "The Company competes in its markets primarily on the basis of product performance, reliability, service and, to a lesser extent, price (annual report, p7). In order to defend this economic moat, Waters Corporation must continue to differentiate itself by defending its high quality reputation.
What is the Secular Trend that is Benefiting Waters?
Congruency between Waters' business and the secular aspirations of society at large creates a huge tailwind at Waters' back that will help the company grow at a pace faster than the overall economy. I agree with page one of Waters' Annual Report which notes the world population continues to grow, and societies are increasingly dependent on laboratory science to improve our health, our food and our environment. A growing world population and the continued development of emerging markets puts Waters right in the middle of a growing secular trend, and the company will continue to profit from it in the future. Especially considering Waters is one of the "good guys" that society will work with instead of fight against.
What is Waters Worth?
Free Cash Flow (FCF): Free Cash Flow is an important metric in measuring the value of a company because unlike accrual based earnings, cash flow is much harder to manipulate. Free cash flow is cash available for distribution among all the securities holders of an organization, including equity holders, debt holders, preferred stock holders, and convertible security holders. According to the company's 2011 Shareholders Letter, Waters generates around $0.25 of free cash flow for every sales dollar. The company calculates free cash flow as Cash from Operations on a GAAP basis after funding Capital Expenditures and adding back stock compensation tax benefits (for Waters, it also excludes $11 million of business acquisitions and $16 million of Capital Expenditures associated with the funding of a land purchase during 2011 for a new facility near Manchester, United Kingdom). On 2011 sales of $1.85 billion, FCF was around $463 million. 2012 sales of $1.84 billion generates around $460 million in FCF. Waters' strong FCF is an indicator of the company's ability to create wealth.
Discounted Cash Flow (DCF) Model: A DCF model is one way to gauge the value of a company. The basic formula is: [Free Cash Flow / (WACC - growth rate)] / shares outstanding. For Waters, the weighted average cost of capital (WACC) can be calculated Cost of Equity x Weight of Equity + Cost of Debt x Weight of Debt. The Capital Asset Pricing Model (CAPM) can be used to calculate the cost of equity: risk free rate + Beta x (Return on Market - risk free rate):
- Risk free rate = 10 year Treasury = 2%
- Beta = 1.06 (per Yahoo!Finance)
- Return on Market = Long-term assumption = 7.5%
- Cost of Equity = CAPM = 2% + 1.06 x (7.5% - 2%) = 7.83%
- Cost of Debt = 2.33% (annual report, p56)
- Weight of Equity = total equity / total assets = $1,467.36 million / $3,168.15 million = 46.3%
- Weight of Debt = total debt / total assets = $1,700.79 million / $3,168.15 million = 53.7%
- WACC = 7.83% x 46.3% + 2.33% x 53.7% = 4.9%
- Shares outstanding = 86,950,000 shares
Therefore a zero-growth DCF model says Waters shares are worth:
[460,000,000 / (4.9% - 0%)] / 86,950,000 = $107.97 per share
This valuation assumes zero future growth, and it assumes Waters will continue to generate $460 million of FCF per year in the future. I believe Waters will be able to maintain at least this level of FCF for a variety of reasons, but a couple of the more interesting ones are efficiency and the fact that customers are averse to switching over to the competition. First, Waters operates very efficiently; for example, its operation in Singapore serves its customers in the Far East where the company enjoys a zero corporate tax rate while its European customers are addressed from an operation in Ireland where corporate taxes are just 9%. The company's operation in Massachusetts is mostly involved in the manufacture and testing of custom products (while these are examples of efficiency, they're also sources of social risk, as will be discussed later). Secondly, Waters benefits from an economic moat that exists because customers prefer NOT to switch to the competition. Waters competes in its markets primarily on the basis of product performance, reliability, and service. Price is NOT the main competitive threat (Annual Report, p7). Scientists have incentive to NOT switch to the competition because changing products/tools introduces another variable into their work and can screw up their results. According to the Financial Management Association, the company "maintains a strong competitive advantage from a wide moat around its life science tool product line in Liquid Chromatography and Mass Spec systems used in the chemical analysis of drugs and other consumer products." These are two of the reasons I believe Waters can maintain its current level of free cash flow, and the company is worth at least $107.97 per share, and it's actually worth more because free cash flow will grow.
Can Waters Grow?
As stated previously, the world population continues to grow, and societies are increasingly dependent on laboratory science to improve our health, our food and our environment (annual report, p1). Waters is sitting right in the middle of this growing secular trend, and the company will continue to profit from it in the future.
Waters has multiple internal growth goals. For example, for the last sixteen years management has been incentivized to achieve a non-GAAP earnings per share growth target of 15% (annual report, p29). Interestingly, since becoming a public company in 1995, Waters has also reduced its share count by a third, supporting earnings per share growth targets (2011 Shareholder Letter). Waters does an excellent job managing earnings, and utilizes share buybacks to help provide a competitive rate of return. Another internal goal is a non-GAAP operating income target of 7% annual growth. This goal gets closer to the true growth power of the company because it is not distorted by share repurchases like EPS growth is distorted.
Ben Graham Model to Account for Growth:
To bake growth into a company's valuation, I like to use a model first published by Warren Buffett's mentor, Benjamin Graham, in the 1940's. According to the formula, a stock's value = EPS x (8.5 + (2 x growth)). If we conservatively estimate Waters will grow at 2% (which is well below the company's internal EPS growth target), then Waters is worth: $5.20 x 8.5 + (2 x 2) = $127.40 per share. And if we use the average earnings growth estimate of the 20 analysts following Waters according to Yahoo!Finance (9.78%) then Waters is worth: $5.20 x 8.5 + (2 x 9.78) = $145.91 per share. And if we use the company's internal EPS growth target of 15%, then, according to Graham's model, Waters is worth: $5.20 x 8.5 + (2 x 15) = $200.20 per share.
What is the Social Rift Waters Corporation is Creating?
There is an increasing belief that US companies have a responsibility to make positive contributions to society rather than simply making dollars and cents. Waters Corp is succeeding in the "dollars and cents" category, however the firm is fueling a growing rift with society at large by moving operations overseas, reducing tax payments to the US Government, and not disclosing enough with regards to social and environmental considerations. At best, these actions may prevent the firm from achieving an even greater level of profitability, and at worst they will lead to the company's demise if not addressed.
1) Moving Operations Overseas: Waters Corporation has painted a large target on its own back by moving manufacturing jobs overseas. In our current politically charged economic environment, any business that appears to NOT be acting in the best interest of the United States can quickly become a bad guy in the popular media. Considering Waters' economic moat is based on its reputation, the firm needs to guard its reputation like its life depends on it, because it does. Waters was founded in the US in 1958, but today the majority of the firm's manufacturing is overseas. "The company's operation in Massachusetts is mostly involved in the manufacture and testing of custom products," while Singapore and Ireland account for large portions of the company's manufacturing. Waters annual report makes clear "the company continues to pursue outsourcing opportunities as they may arise" (annual report, p6). When the US economy is struggling and the unemployment rate is high, Waters Corporation is exposing itself to a significant social risk by continuing to outsource US jobs overseas.
2) Reducing Tax Payments to the US Government: In addition to taking jobs away from US citizens by moving overseas, Waters is also reducing their tax payments to the US government. Specifically, Waters' Singapore operation enjoys a zero percent corporate tax rate, and the tax rate for the large operation in Ireland is only around 9%. While these lower tax rates have helped recent earnings-per-share, they create a headline risk and open the firm to the wrath of popular media. And for a company that relies on image and trust to survive, this is a significant risk.
3) Lack of Social and Environmental Disclosures: There is significant room for improvement with regard to Waters Corporation's social and environmental disclosures. This is a significant risk to the company because it operates in an industry that is focused on contributing to society. The company depends on its reputation to succeed (pricing is not the primary competitive differentiator) and lack of disclosure creates a significant headline risk. If the media and regulators decide to take issue with Waters' lack of disclosures it will have a significant negative impact on the company's success. The company is named after its founder, but the name Waters also has fantastically pure and good connotations (water is pure, good and really important to people), and the company is missing out on an obvious opportunity to capitalize and be a leader with regard to social and environmental disclosures, especially considering they operate in an industry where social and environmental considerations are so fundamentally important. Several examples of the company's sub-par social and environmental disclosures are listed below.
- Waters published a Sustainability Report in 2009 and 2012, but the reports seem to pick and choose only disclosures and languages that spin the firm in a positive light. According to Trillium Asset Management "Waters has a publicly disclosed environmental health and safety policy, although the company could significantly improve their sustainability reporting and transparency."
- Bloomberg's ESG disclosure score recently awarded the firm only 16.53 points out of 100. This is not good. It's also below Boston area peers such as PerkinElmer and Thermo Fisher. This score will likely increase in the next iteration which should account for the firm's most recent Sustainability Report (the previous one was published in 2009), but not significantly (Waters only scored 20.25 in 2009 when the last Sustainability Report was published).
- Goldman Sachs rates Waters below average in "Management Quality" with regard to ESG (Environment, Social, Governance), and rates the company below average for its industry.
- CSR Hub gives Waters Corporation a Corporate Social Responsible Rating of only 52 out of 100. For a company in Waters' industry this is not good enough.
- Good Guide gives Waters a Social Performance Rating of only 5.3 out of 10. Again, not good enough for a company in Waters' industry.
- Waters Corporation received a Carbon Disclosure score of 63, barely putting them in the B band (Integration of climate change recognized as priority for strategy, not all initiatives fully established).
A Note to Chairman & CEO, Doug Berthiaume, on Social Responsibility:
Doug: You need to do better. You're in an industry where contributing positively to society and the environment truly matters. Your firm scores low. Your firm also scores low relative to your Boston-area peers such as Marc Casper at Thermo Fisher and Rob Friel at PerkinElmer. And with an $8 billion market cap you're big enough to start doing better. A lot better. Increase your social and environmental disclosures. Make your public image a priority. Considering the industry you're in, Waters is an amazingly marketable name (as described previously), yet 93% of your shares are owned by institutions. If you'd do a better job addressing your firm's responsibilities to society, you could build incredible brand recognition, increase your retail investor base, and increase your stock price. You wouldn't need to buy back so many shares to create value for investors (your 2011 annual report acknowledges on page 20 that share buy backs increased net income per diluted share by $0.06 in 2010), and you could save that EPS management lever for a rainy day. Most importantly, you owe it to society to do better.
The stock price of Waters Corporation will likely increase tremendously over the long-term. Positive contributors to the stock price will be the firm's pricing power (price is not the primary competitive differentiator) as well as increasing demand from an industry that is growing in global importance. The firm has additional opportunities for improvement by addressing serious social risks. Personally, I do not own shares simply because I believe there are even better investment opportunities given the company's current stock price (and because the overall market seems a little frothy to me right now). However, I continue to monitor the company, and I may purchase shares if the stock price pulls back enough to provide a margin of safety that makes me comfortable.