In June 2021, I published my last article about Waters Corporation (NYSE:WAT) and back then I rated the business as a "Hold" and the stock is once again trading at the same price as back then (in the meantime, the stock climbed as high as $430 but declined again over the last few months). And although the stock price is basically the same as when my last article was published does not mean the investment decision also has to be the same. The business could have improved over the last nine months, but it is rather unlikely that a business is improving so drastically over nine months to make a previously overvalued stock undervalued now (without the stock price moving).
But we should take a closer look nevertheless and in the following article, we start by looking at the last annual results and try to identify what aspects could contribute to growth in the years to come. And we are looking especially at the role of share buybacks in the last ten years. Finally, we calculate an intrinsic value to determine if Waters Corporation is a good investment right now.
In fiscal 2021, many companies could report strong growth rates as fiscal 2020 was a rather bad year with declining revenue and earnings per share. One of the companies that could report high double-digit growth rates was Waters Corporation and the company reported only moderate declines in fiscal 2020 (revenue declined 1.7% and EPS declined 3.8%). In fiscal 2021, the company could generate $2,786 million in sales and compared to $2,365 million in fiscal 2020, this is resulting in 17.8% year-over-year growth. Operating income also increased from $645 million in fiscal 2020 to $822 million in fiscal 2021 - 27.4% YoY growth. And diluted earnings per share increased 33.6% YoY from $8.36 in fiscal 2020 to $11.17 in fiscal 2021.
When looking at the different segments and different regions, all of them contributed to growth in fiscal 2021. When looking at the geographic regions, Asia was responsible for 39% of total revenue, America was responsible for 33% of total revenue and Europe was responsible for 28% of total revenue. Out of the three different end markets, Academic & Government is only responsible for 10% of total revenue and could only report 5% YoY growth. Industrial is responsible for 30% of revenue and could report 15% YoY growth and Pharma is responsible for 60% of total revenue and could also report the highest growth rates (19% YoY).
Waters Corporation is also expecting growth to continue in fiscal 2022. Management is expecting constant currency sales growth to be in the range between 5% and 7% compared to fiscal 2021 revenue and non-GAAP EPS is expected to be between $11.75 and $12.00 resulting in 5% to 7% growth for adjusted earnings per share.
But for us, it is not just important what growth rates Waters Corporation can report in fiscal 2022, but to determine if Waters Corporation could be a good long-term investment, we must look at larger timeframes. Management is not really providing mid-term or long-term targets for the business and is not telling us what revenue or EPS growth rates it is expecting for the years to come. At least, Waters Corporation is offering some expectations for the markets it is operating in.
And while "Academic & Government" is expected to grow only in the low-to-mid single digits, this is not such a huge problem as the segment is responsible for only 10% of total revenue. The other two end markets - "Pharma" as well as "Industrial & Applied" - are expecting higher growth rates. Industrial & Applied is expecting mid-single digit growth and the most important segment - Pharma - should grow in the mid-to-high single digits. And we can also make the argument that Waters Corporation can outperform the market and revenue growth rates around 7% seem realistic.
But Waters Corporation cannot just grow its top line but might also be able to improve its margins in the years to come. At least when looking at the last decades, Waters Corporation could improve its operating margin and net income margin over time.
And we can assume that Waters will be able to improve its margins further in the years to come and improving margins might also contribute about 1% or 2% to bottom line growth.
When looking at the last two decades, we see Waters Corporation increasing earnings per share with a solid pace. Aside from the outlier 2017 (with an extremely low EPS), we can see earnings per share increasing almost every year and since 2000, Waters Corporation could increase EPS with a CAGR of 11.48%. Of course, we can also see that growth rates seem to slow down over the last two decades, but in the last few years, it seems like Waters Corporation could at least stop that trend and maybe even reverse it (as growth rates seem to be increasing again).
But analysts are not so optimistic for the years to come and until fiscal 2026, they are "only" expecting earnings per share to grow with a CAGR of 8.76%.
And revenue growth as well as margin improvements are probably not enough to generate double-digit growth for the bottom line. However, there is one final aspect that could also contribute to bottom line growth in the last two decades, which hasn't been mentioned so far - share buybacks.
While revenue growth and margin improvements contributed to bottom line growth in the past, share buybacks were also a major driver of bottom-line growth. In the last two decades, the number of outstanding shares declined from 137.93 million to 61.38 million right now, which is resulting in a CAGR of 3.78% in the last 21 years. However, at current stock prices it doesn't seem possible for Waters Corporation to repurchase a similar amount of outstanding shares as the free cash flow is not high enough. To repurchase 3.8% of outstanding shares right now, Waters Corporation would have to spend about $760 million on share repurchases, but free cash flow in fiscal 2021 was only $579 million.
And we probably should take a closer look at Waters' share repurchases in the last few years. As the company is not paying a dividend, it could spend a large part of its free cash flow on share buybacks. But when looking at the last decade, the amount spent on share buybacks is clearly exceeding the free cash flow generated in the last ten years. Between fiscal 2012 and fiscal 2021, Waters Corporation spent $6,558 million on share buybacks but generated only $4,898 million in free cash flow.
And when a company is spending more on share buybacks than it is generating in free cash flow over a long timeframe, we should take a closer look where the money is coming from. First, we can see that long-term debt increased over the last ten years. Back then, long-term debt was about $1 billion and increased to about $2 billion at the beginning of 2018 and is now about $1.5 billion - about $500 million higher. And it seems like Waters Corporation used debt to finance share buybacks, but as the company spent $1.7 billion more on share buybacks than generated free cash flow, debt can't be the only explanation.
The answer can be found by looking at the liquid assets on the balance sheet. While cash and cash equivalents remained rather stable over the last ten years, short-term investments were about $1 billion ten years ago, increased to $2.75 billion in early 2018 and then declined to basically zero in 2019. And as we can see above, 2018 and 2019 are also the two years in which Waters Corporation spent high amounts on share buybacks and the number of outstanding shares declined pretty steep.
I honestly don't know if it was a good move by management to repurchase shares so aggressive in fiscal 2018 and fiscal 2019. And it is certainly fine to use short-term investments for share buybacks. But it also seems like Waters Corporation financed a small part of the share buybacks by taking on debt, which is not a good idea. And the company certainly won't be able to repurchase shares with a similar pace in the years to come. With rather low liquid assets, Waters Corporation can't spend more than free cash flow on share buybacks - unless it would take on additional debt, which would be a terrible idea. Therefore, I would expect share buybacks to contribute not more than 2% to bottom line growth.
We can start by looking at the simple valuation metrics of Waters Corporation and when looking at the price-earnings ratio or the price-free-cash-flow ratio, the stock doesn't appear cheap. Right now, Waters Corporation is trading for 30 times earnings and for 36 times free cash flow. And especially the P/FCF ratio is close to the highest number it has been in the last ten years. And the stock is also trading clearly above the 10-year average of 26.45.
Aside from the simple valuation metrics, we also can use a discount cash flow calculation to determine an intrinsic value for the stock. As basis, we can use the free cash flow of the last four quarters, which was $579 million. For perpetuity, we can assume 6% growth (as always when dealing with wide moat companies). Additionally, we calculate with 61.4 million outstanding shares and a 10% discount rate. When using these assumptions, Waters Corporation must grow 11% in the next ten years to be fairly valued right now.
However, 11% growth is rather optimistic and not a growth rate I would use. Not only are analysts expecting lower growth rates, we also must keep in mind that Waters Corporation could grow about 11.5% on average during the last 20 years but only with the help of massive share buybacks. And as I have argued above, Waters Corporation won't be able to buy back shares with a similar pace as in the past. I would not use higher growth rates than 9% for the next few years, which would result in an intrinsic value around $290.
Waters Corporation can line up in a group of high-quality businesses that are still a bit too expensive and therefore not a good investment right now. And although the stock declined about $100 from its previous all-time highs, it is still not trading for a price that I consider as acceptable. It might be annoying, but in an overvalued market it is rather difficult to identify high-quality companies that are not trading for a premium.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.