Waters Corp. Stock: Built-in Expectations High in Current Conditions (NYSE:WAT)

Investment update

Following my last publication on Waters Corporation (NYSE: WAT) the stock is +24% and now trading close to our initial price target of $340/share. I revised my outlook on WAT in the last report for a number of reasons, not least related to the fact that it sold for about 22 times forward earnings at the time, around what I thought was fair value (my opinion was that the business was worth ~$19.5 billion – it sells for $19.8 billion as I write). ). Thus, I am not deterred by the “lost opportunity” given my analysis of the company’s economics.

In addition to the above, several of my findings in the previous report remain statistically relevant today after WAT’s Q2 FY’24 numbers, including:

• Widening of days sales backlog ~196 days (+30 days from FY’21), which continues to be a problem from Q2 onwards. Instrument replacement times are slowing down in the industry – CAGR of 1% is projected for FY’24 tool growth vs. 5% LT average. Management says these trends will normalize, creating a “recovery” tailwind as inventories are replenished. We will see.
• Sales guidance was revised lower, with management now projecting a decline of -0.5% to -2% at the top end this year, noting that while “customer activity shows signs of recovery“, he is cautious. I am wary of this contrasting language. We know that the consumer – especially at the low end – is feeling it right now, and there’s no telling that it won’t be the same in these end markets.
• WAT earns extraordinarily high returns on all capital that has been put to work in the business – typically >20%. This is highly constructive as it is a capital intensive business. The risk is that ROICs fade to industry averages with a high decay rate. Additionally, if management is correct in the comments above, then my view is that it could earn substantially higher cash flows from its existing and incremental investments. This would require 1) lower NOPAT reinvestment percentages to achieve a stated level of growth, 2) allow for a larger capital base to work from (in theory), and 3) guarantee higher EV/IC multiples.
• Built-in expectations remain high and the economic contributions required to justify any combination with intrinsic business value are extraordinarily high, so my view is that the margin of safety in owning the stock is relatively low. I see investors paying higher market prices for the company in the coming years, though not over more selective opportunities. It was the same in the final analysis.

I remain on WAT based on the factors mentioned today, but in summary due to 1) potential ROIC contractions, implying less cash available to support its competitive position + growth, 2) growth rates are not enough to offset this (both). in asset + sales growth) and 3) valuations imply only marginal upside from current levels. The upside risk is if WAT’s ROICs expand from here, justifying higher multiples.

Q2 FY’24 Revenue Information

As expected, Q2 sales were -400 bps y-o-y but +500 bps sequentially, with China continuing to be a drag on top performance. I see this a lot in medtech + life sciences this earnings season, with Chinese demand lagging well behind the previous decade. Management is taking steps to reduce the downside, but it continues to be a hindrance in my view.

Management has revised FY’24 sales down, as mentioned earlier, but sees earnings of ~$11.65/share at the high end of the range, which is flat from last year. Consensus eyes ~9-10% revenue growth each year in FY26, though unfortunately being off a “low base” this isn’t as exciting. It produced $143mm in FCF in Q2 ($377mm this year, 28% of sales), equal to ~128% adjustment. earnings.

In terms of divisional breakdown, critical packages include the following:

• Although I talked a little about this above, I want to delve a little further – China fell into the low-teens, YoY, with downside across all exposures (AT, electronics, chemicals, materials, academic + government). However, management noted successive gains in its pharmaceutical and industrial markets. Also mentioned was the government stimulus there, which produced “improved quote and funnel trends”, meaning more demand. These are expected to be converted into orders in FY’25.

• Total sales in Asia (including China) were -300 bps y-o-y, while the Americas and Europe saw steeper declines of -700 bps each.

• Meanwhile, the tools business was down 17% from last year, reflecting reduced customer CapEx (which ties into my consumer points earlier) and potential delays in large equipment purchases. Again, management expects these trends to normalize (especially in China), but I’d have to see evidence of that happening first before speculating. Its Chemicals and Services segments were +5% YoY.

My take on the quarter was that it was largely in line with expectations. It was no surprise to see a drop in topline growth given the subdued performance. China has been in the last 4-5 quarters. The sticking point in the investment debate is what these types of headwinds — including reduced customer capital spending and the inventory holding trends mentioned so far — mean for estimates of future value creation.

I was initially very attracted to WAT at the end of 2022 given that it had exceptional excess ROIC spread above our 12% hurdle rate and showed persistence in these numbers (low fade). As operating profits have compressed, invested capital has not, leading to a large compression of returns on invested capital. However, they are still extraordinarily high at ~25% over the last 12 months.

The issues are 1) whether there is further compression, 2) whether management lacks the opportunities to redeploy funds into the business to maintain its competitive position or grow, and 3) what both mean for implied valuations. My estimate is that WAT’s competitive advantage period (“CAP”) – the length of time it can return above the identified hurdle rate – has shrunk to 15 years (still attractive), but the ROIC loss rate has doubled to 6.3 % (Figure 2).

Figure 2.

Positive reviews related to high bar multiples

While I’m well aware that the company trades +25% from my neutral rating, the pullback over more contextual periods supports the view. Management has recycled approximately $950mm of capital back into the business in a phased manner since FY21, however, this is valued at -$2 to the market for every $1 that has been reinvested.

In my view, the reason is that the company’s falling ROIC explains a lot – investors were paying >10x equity in FY’21 when the business was producing >35% ROIC, probably expecting this to continue (estimated >21.5B USD in economic profit from the company going forward, or 10 times the value of equity) – but this changed rapidly as the yield on equity contracted by ~10 basis points per year in FY’22-’23 (Figure 3).

Figure 3.

Evaluation perspectives

• It now trades at ~6.5x EV/IC, which is likely to contract further. These high multiples are now becoming increasingly difficult to justify, with increasing ROICs shrinking from industry averages + historical averages. The business is not producing an excess return as in FY’21–’22, and the market value added (multiple of invested capital) suggests that every dollar that management puts to work upfront is worth $6.50 in the market. I’m not sure my models agree either (see: Appendix 1) – bake

Figure 4.

• There is a problem in that, given the diminishing ROICs, investors will have to value incrementally higher earnings.r – at ~28x NOPAT vs. 27x now to trade at ~6.5x equity in FY’26E. Also, EV/IC multiple down to 6x takes us to $360/share by FY’26E, on the contrary, it rises to >$400/share with more upside.

Figure 5.

Investment risks

The key risk to the thesis is if management raises its return on equity back to the ranges seen in 2021 and 2022. That would cause it to reinvest more and grow earnings at faster rates than we’ve modeled here. I give this a probability weighting of 40%, based on 1) historical trends and 2) the outlook for business recovery in China. Additionally, entering a cycle of lower rates earlier than expected could be an optimistic tailwind from my view.

On the downside, the risk is if new investments don’t pull their economic weight and further compress returns. That would make the stock trade fairly at current levels, in my opinion.

Investors should fully realize these risks before proceeding.

In short

In my opinion, WAT remains a hold at this point in the cycle. This is a fundamentally sound business that produces exceptional returns on operating capital, no doubt about it. However, the built-in expectations are extraordinarily high and require the company to produce ongoing stellar numbers above par + above statistical norms. While it did so 2-3 years ago, the trend has not remained in place and ultimately there are valuation multiples at risk that may contract further if these high expectations are not met. In other words, my view is that the margin of safety is relatively low right now, and I continue to see the business being valued at around $340 per share, potentially reaching $360 per year by FY’25E. Net-net, hold again.

Appendix 1.