2023-09-27 18:00:59 ET
Summary
- Waters Corporation has seen a significant hit to its share price as momentum has left the life sciences tools space and as spending from the key biopharma end-market has corrected.
- Biopharma spending likely won't return to the torrid pace of the boom years, but ongoing investments into discovery tools, production equipment, and QA/QC equipment should drive healthy growth.
- The company's presence in industrial markets, such as food and water quality testing, provides a steady source of profitability and growth potential in areas like battery testing and sustainable polymers.
- If Waters can generate mid-single-digit long-term revenue growth and some incremental margin leverage, the shares look to be worth serious consideration.
For much of the last decade, life sciences tools has been a “yeah, but” sector. Meaning, yeah, the revenue growth rates have been good, business relationships tend to be sticky, margins (and return metrics like ROIC) are typically very good, and opportunities like bioprocessing / bioproduction provide an attractive runway for growth. The “but” comes in with valuations, as industry multiples climbed from the low double-digits (forward EV/EBITDA) to 20x, with individual stocks well above that. That made it hard to recommend names like Waters ( WAT ) even while acknowledging otherwise superior investment characteristics.
Since my last update on this leading liquid chromatography, mass spec, and thermal analysis company, the shares have lost about a third of their value, underperforming the likes of Bruker (BRKR), Danaher (DHR), and Mettler-Toledo (MTD), and barely outperforming Agilent (A), though at least outperforming more bioproduction-driven names like Repligen ( RGEN ) and Sartorius Stedim .
A relatively sudden and unexpectedly large decline in biopharma spending has driven a lot of this reset, with particularly sharp declines in China, though there have been some signs of weakness in select non-academic and biopharma markets. I believe the biopharma market will recover, though, and I like the progress Waters has made to reposition its business toward better long-term growth opportunities. Given the reset in expectations and valuation, I think this could be a time to consider this name.
A Big Biopharma Reset
Biopharma customers (pharmaceutical companies, pre-commercial biotechs, and contract manufacturers) have driven impressive growth for life sciences tools as companies have reinvested profits (and/or VC funds) into tools meant to facilitate drug development and the production of new pharmaceutical products, particularly large molecule biological products like antibodies. But what was once treated like an endless pool of capital to drive instrument and consumable revenue growth for companies like Waters has since found definite boundaries in recent quarters.
Over the past four quarters, Waters has seen revenue from its biopharma customers transition from 9% year-over-year growth (in Q3’22) to a 4% contraction in Q1’23 and another 4% contraction in Q2’23. China has been a major contributor to recent weakness (Agilent and Mettler-Toledo have the most exposure to China, Danaher and Thermo Fisher ( TMO ) the least, with Waters on the middle-to-high side of the scale at 19%), but spending from larger pharma companies has fallen off as companies have prioritized free cash flow generation and “digesting” the investments made over the last few years. With biotechs the issue has been more related to funding, as VC funding had fallen off, partnerships were harder to come by, and the entire market froze for a time with the failure of Silicon Valley Bank.
I don’t expect biopharma to go back to investing in research and production tools at the same pace as we saw before 2023, but I also don’t believe the weak recent trends are any sort of new normal. Pipelines are full of new biologics and this is going to remain an attractive market for years to come. What’s more, life sciences companies continue to innovate and find new technologies (or repurposing of older technologies) that drive new insights into drug targets and drug manufacturing.
Not only do I expect industry spending to recover, but I also see Waters benefiting from a multiyear repositioning toward more growth opportunities in the space. The company has long had a strong core presence in areas like quality assurance and quality control (QA/QC), as well as drug development, but the company has more recently started to leverage its strengths in areas like liquid chromatography and mass spec, as well as the light scattering technology it acquired with Wyatt Technology earlier this year, to target growth opportunities in bioseparation, bioanalytical characterization, and diagnostics.
With that, the company is setting itself up to be a partner not only to drug companies (the company recently won business for LC columns used in GLP-1 workflow), but also bioprocessing companies that don’t have strong in-house LC/mass spec capabilities. In doing this, and focusing on areas like bioseparation, characterization, purification, and QA/QC, I think Waters can successfully leverage the underlying growth in bioproduction without having to go head to head with companies like Danaher or Thermo, or at least not as directly head to head.
Industrial Markets Could Be Underappreciated
Not all “industrial markets” (which in this context usually means “anything that isn’t biopharma or academic/government") are the same. While I mentioned in a recent article on Agilent that that company’s exposure to cyclicality/reduced capex in some markets (like chemicals) could be a near-term risk, I see less risk with the business mix at Waters.
Industrial markets are about 30% of the mix at Waters, and the company enjoys a strong legacy position in areas like food and water quality testing. Given ongoing concerns about foodborne pathogens and allergens as well as water contaminants (lead, PFAS, et al), I don’t see any real issues with these markets – they won’t grow like biopharma, but they’re a good steady source of profitability. Moreover, I’m not suggesting they won’t grow – I expect food quality/safety testing to continue to expand from here and likewise with water quality testing, as officials and the public become more aware of the prevalence of contaminants (like microplastics) and their potential role in health problems.
I also see emerging growth opportunities here. Driven in large part by the company’s leading thermal analysis capabilities, battery testing should be a strong growth market as vehicle electrification and battery production expand. I likewise agree with management that there are attractive opportunities in areas like sustainable polymers as companies try to transition away from traditional petrochemical-based products without compromising product quality and performance.
The Outlook
While Waters’ results in FY’21 and FY’22 were very close to my model expectations (within 1% on revenue and 3% on EBITDA, as the company outperformed a bit with its profitability improvement efforts), FY’23 has been tougher than I expected and my revenue target for the year is about 6% lower than at the time of my last update. I’ve also reduced my forward growth assumptions given what I think will be a more restrained approach to biopharma capex (particularly in the 2024 election year); I’m still looking for a healthy long-term revenue growth rate of 6%, but I have reined in my expectations a bit.
Turning to margins, Waters has out-executed my expectations, and I’ve actually boosted my EBITDA and operating margin assumptions despite the weaker revenue outlook. While EBITDA margins have been in the neighborhood of 35% for a while, I do a see path toward 36% and 37.5% over the next three to five years, and I still believe mid-to-high 20%’s is possible for free cash flow margins, supporting a low double-digit FCF growth rate over the next decade.
Discounted back, those assumptions get me to a fair value a little over $310. I also like to use a margin/returns-driven EV/EBITDA approach, and Waters’ credentials support a 19x forward multiple that drives a $323.50 fair value.
The Bottom Line
Lackluster revenue growth and guidance reductions from management have certainly impacted sentiment, not only driving lower estimates on the sell-side, but a few downgrades as well. At this point, sentiment isn’t particularly robust even though management thinks the worst may already be over in its U.S. and EU biopharma businesses. While I wouldn’t call Waters dirt cheap today, the valuation looks considerably more reasonable, provided that 6% revenue growth and positive FCF leverage are attainable targets, and I think this is a name to consider.
For further details see:
Waters Has Made Progress In Repositioning The Business, And The Valuation Is Much More Accommodating Now