Agilent Master File – January 2011
Included below – several rounds of work that span October 2010 to January 2011 and that includes the work of a few different analysts (hence, some repetition). We have questions about just how rapidly Agilent can grow trend-line … and questions about how much EBIT margin expansion is possible … but in Agilent we see a company who has made itself better over the last decade, and we think that there is a good chance they can surprise us on either the EBIT margin line or revenue line over the next several years.
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Agilent Pre-determined Game Plan January 2011
** Thesis: Agilent, a provider of measurement instruments to the communications, life sciences and chemical analysis industries, will benefit from a restructuring that has dramatically shifted its exposure from highly cyclical end markets to secularly growing ones. To address this opportunity, the company will leverage a string of smart acquisitions and divestitures along with – importantly – a long-standing presence in China.
** Burning Questions (Jan 2011)
#1) NODE #3: Does product breadth and a diverse portfolio really provide an advantage in a sales process? If so, why?
#2) MODULAR: Will modular components grow as a percent of this NODE #2 market? What advantage do measurement tools dedicated to specific applications (i.e. non-modular ones) have over modular ones? (MODULAR: What is special about the NON-modular approach that modular can’t match?)
#3) GROWTH: Where will growth come from, specifically? Additional customers – whether new regions, share gains, verticals or channels; deeper penetration into existing customers; or higher prices?
#4) GROWTH: Is there any way to gain insight into the trend line growth potential of the life sciences, food, petro-chemical markets beyond Agilent’s “GDP + a few % points”?
#5) USER CRISIS: What is the end user crisis? Who makes the purchase decision? Is that person’s budget rising or falling? Is Agilent more tied to Do More With Less, Enablement, or neither?
#6) USER TRIGGER: What is the trigger that would make that person decide to pick up the phone and call Agilent? How does this differ between Life Sciences, Chemicals and Electronics? When would … say … Nokia have to buy more test equipment? After X # of handsets are sold? Or when new handsets are launched (with new specs)?
#7) CHINA: How specifically does their long presence in China translate into a sustainable competitive advantage?
** Where the Thesis Will Be Wrong (Jan 2011)
#1) MODULAR: Virtual instrumentation and modular components steal share from Agilent or hurt pricing.
#2) CYCLE: Electronics is still 50% of revenues at Agilent and has a high degree of cyclicality to it.
#3) NODE #4 LEVERAGE: Despite the significant change at Agilent, if there is not significant upside to Agilent’s high teens EBIT margin, we are left with a high single digit grower with flat margins. Interesting, but not monumental.
#4) While Agilent’s end markets are now more secular growers than cyclical, they exist in a Do More With Less context (e.g. the pharmaceutical industry and not-for-profit academia) which will curb growth.
#5) CHINA: The stimulus provided a one-time boost in China and sets Agilent up with tougher comps.
***** NODE #1 THROUGH NODE #4 CONSIDERATIONS
** NODE #1: SOCIETAL SHIFT
Positive. Agilent benefits from:
- Naked Without Data with its deep focus on measurement.
- Globalization with its presence in China.
- Human Population Change in that some of its growth in the life sciences area is being driven by an increased focus on the human condition … the aging of population … the focus by the gov’t on providing better healthcare in both developed and emerging countries.
** NODE #2: MARKET OPPORTUNITY
Positive… but with questions.
The key point here is that Agilent’s transformation has dramatically re-shaped the end markets it sells into. The positives: the company has more exposure to secularly growing end markets like life sciences and chemicals. The question: while these markets are less cyclical than the areas Agilent has focused on in the past (e.g. semi equipment), just how fast are they growing? Agilent provides CAGR estimates for context, but is there a way to gain conviction in what the actual growth will be? For their part, when asked, Agilent justifies their projections by simply saying the markets will grow “GDP + a few % points” because of the secular drivers.
Our take: we can imagine how these markets will grow in a secular fashion, but is there a way to determine whether growth will be 10-12% as opposed to 6-8%? More thinking to do.
SEGMENT MIX:
Some useful information to set the NODE #2 context:
- Life Sciences: 27% of revenues. Organic growth expected to be 11-12% in 2011.
- Chemical Analysis: 22% of revenues. Organic growth exp to be ~6% in 2011.
- Electronic Measurement: 51% of revenues. Organic growth exp to be high single digits in 2011.
By region, Asia is 40% of revenues, Americas are 39%, and Europe is 21%.
NODE #2 DRIVERS:
What are some of the underlying drivers of the NODE #2 secular growth in the life sciences and chemical end markets?
** Life Sciences: Growth driven by changes in therapeutic research and drug discovery and development. The growth of generic drugs in developing countries is something that Agilent is benefiting from too, as the # of participants is growing. So, even though large pharma is struggling, there are more companies getting into the game.
Academia is also contributing to growth in Life Sciences as there is an increased focus – in both develop an emerging countries – by governments and universities on the human condition … the aging of population … and the need to provide better healthcare.
** Chemical Analysis: Drivers include:
- PetroChemical: The drivers: simply … the consumption of oil and the build-out of refineries. The increased use of fine chemicals. Alternative energy research.
- Forensics / Environment: Driven by environment – clean air, Asia, LatAm. The users here are both private enterprises that have to ensure quality air & water and gov’t entities that are testing air and water for their community.
- Food: relatively faster grower, driven by food safety regulation. As the world population grows and as more food is distributed around different countries, food safety is a growing concern. The customers: private enterprises to ensure food is up to the standard. Also exporters of food to other countries to world. India testing spices they send to rest of world so there are no added dyes or anything like that.
** NODE #3: COMPETITIVE ADVANTAGE
Modestly Positive. More work to do.
More in our master file, but Agilent competes against different companies depending on the end market it serves. For their part, they claim that their competitive advantage is two-fold:
1) The breadth of its portfolio.
2) Its scale, which allows it to invest more in R&D.
Our thought: #2 makes sense to us. #1 leaves us with questions.
Among the competition: Danaher, Thermo Fisher Scientific, Waters, Perkin Elmer, Shimatsu, National Instruments.
One question we’ll burrow into involves modular components in measurement, as offered by folks like National Instruments, for example. While such products are a small niche in the broader measurement market today, we’ll want to track it and learn why more measurement won’t be done with these types of products.
At any rate, many of our burning questions as we go forward involve the NODE #3 competitive landscape.
** NODE #4: FINANCIAL LEVERAGE
Modestly Positive. Our biggest consideration here: while Agilent has successfully, and impressively, transformed itself, are we simply left with a high-single digit grower that has already reached near-peak EBIT margins? If so, kudos to Agilent but it may not fit our portfolio that seeks monumental change in NODE #4.
The company’s headline estimates: FY 2007 thru FY 2013E
- Revenue growth: 9%, 7%, (22%), 22%, 15%, 6%, 6%
- EBIT margin: 16%, 16%, 9%, 17%, 18%, 18%, 19%
- EPS: $1.81, $2.05, $0.80, $2.00, $2.48, $2.81, $3.10
- Valuation: 17x CY 2011 EPS
** DECISION ENGINE
We ran two scenarios here and both get Agilent into the 4th and 5th (least expensive) quintiles.
#1: 10% mid-term growth and 20% EBIT margins (as a reminder, they’re presently at 18%): “Upside” = 50%, which would put it in the least expensive quintile.
#2: 7% mid-term growth and 16% EBIT margins: “Upside” = 8%, which would put it in the lower end of the 4th quintile.
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Agilent Extended Look 10/15/2010 — AARON
**I’m using a quasi relook template here since we havent looked at the company in over a year, but this is an extended look.
** CONTEXT: Helen did an extended look on Agilent in July 2009. At the time, her conclusion was that we didnt have the relevant background and expertise to really assess their competitive positioning in the life sciences and chemical markets. .
** CONCLUSION: While there has been some change with an acquisition of Varian that bolstered their presence in life sciences, and a restructuring of the measurement business, Helens general take on the company is mine too. I couldnt imagine trying to figure out the competitive positioning of the MANY different submarkets they compete in. Much of Agilents business is somewhat outside our area of expertise. That said, their business has rebounded nicely and their operating model has improved. If we move forward, we might consider this as a long.
** REMINDER: PROMISE: Agilents promise is to improve the quality of research and products developed by a variety of industries and customers.
** REMINDER: DESCRIPTION: Agilent Technologies provides core bio-analytical and electronic measurement solutions to the communications, electronics, life sciences and chemical analysis industries. The Company’s operations include electronic measurement, bio-analytical measurement, semiconductor and board testing.
The company operates in 3 segments:
• Electronic Measurement 51% of sales
• Life Sciences 26%
• Chemical Analysis 23%
** ESTIMATE & VALUATION UPDATE
** Current headline #s:
- Rev Growth (2005-2012E): -28%, -3%, 9%, 7%, -22%, 21%, 14%, 7%
- EBIT Margin (2005-2012E): 6%, 10%, 11%, 14%, 7%, 17%, 18%, 19%
- EPS (2008-2012E): $1.96(08), $0.80 (09), $1.95 (10), $2.39 (11), $2.69 (12)
- Valuation: Agilent is up 25% over the last year, and 11% year to date.
** Estimate revision:
EPS estimates for 2010 started the year at $1.45 and have steadily risen to $1.95 (+27%), driven by quarterly outperformance. Revenue estimates have risen from $4.8B at the beginning of the year to $5.4B (+13%).
For FY2011, EPS estimates have gone from $1.71 to $2.39 (+40%) over the course of 2010, while revenue estimates have gone from $5.1B to $6.1B (+20%).
** SO, HAS THERE BEEN A CHANGE SINCE JUNE 2009?
NODE #1: Agilent still primarily benefits from Naked Without Data in the Health, Food/Bio Agriculture, Environmental, and Petrochemical industries.
NODE #2: The success of Agilents business is still is levered to a variety of end markets that utilize their testing equipment. Among them are:
ELECTRONIC MEASUREMENT (50% of revenue):
Geographically 40% Asia, 39% Americas, 21% Europe
Semiconductors: the core test and measurement equipment
Communications (Broadband & Wireless): network equipment manufacturers, service providers, and handset operators – - very high market share here – over 60% of cellphones globally are tested with Agilent testing equipment. They are also geared to improvement in networking technology, where Agilent has a 33% market share in R&D spending on test equipment by networking companies.
General Purpose Manufacturing : this is a broad end market their equipment is used to test devices ranging from healthcare products to TVs to consumer electronics
Aerospace and Defense:used to test radio/microwave frequency components and surveillance and communication equipment.
CHEMICAL ANALYSIS (25-30% of revenue):
Geographically 27% Asia, 36% Americas, 37% Europe
Petroleum Market: Petroleum refiners use Agilents measurement solutions to analyze crude oil composition, perform raw material analysis, verify and improve refining processes and ensure the overall quality of gasoline, fuels, lubricants and other products.
Environmental Market. Agilents gas chromatography, liquid chromatography and mass spectrometry solutions are used in laboratory and field analysis of chemical pollutants in air, water, soil and solid waste. Customers here include government, industrial and manufacturing sectors, engineering and consulting companies, commercial testing laboratories and colleges and universities.
Forensics and Homeland Security Market. Agilents liquid chromatography, gas chromatography, mass spectrometry and microfluidics solutions are used by health and forensics laboratories to analyze evidence from crime scenes and to detect and identify biological and chemical warfare agents.
Bioagriculture and Food Safety Market. Mass spectrometers are used to analyze contaminants and residual pesticides in food, and to analyze food for pathogen contamination, accurate verification of species type and evidence of genetically modified content.
LIFESCIENCES (20-25% of revenue):
Geographically 27% Asia, 36% Americas, 37% Europe
75% of segment sales come from Pharma & Biotech Markets: Agilents measurement solutions are used in therapeutic research, discovery & development, clinical trials, and manufacturing and quality assurance and quality control of pharmaceutical drugs.
–Went and looked at a few sellside pieces on the drug companies, and the aggregate level of R&D spending is massive well over $100B, but growing at less than 1% a year, owing in part to companies still holding back on spending after the economic downturn, and also due to industry consolidation, which has reduced the number of firms doing R&D.
25% of segment – Academic and Government Markets. Customers here include the National Institute of Health, the National Cancer Institute, the European Organisation for Research and the Treatment of Cancer (EORTC), the European Molecular Biology Laboratory (EMBL), the Singapore Genomics Institute (SGI), the Wellcome Trust Sanger Institute, and National Translational Cancer Research Network (NTRAC).
–This segment has gotten some boost from the Obama Stimulus Act, which directed $800m in funds for major life science instrumentation to the DOE, National Science From a more macro perspective, the National Institutes of Health (NIH), distributes more than $30 billion annually via extramural grants, typically to fund academic research activities. These sources of funding provide close to 1/5th of spending on life science equipment, and are a cushion for Agilent and other equipment makers when commercial spending declines.
NODE 3: this is a hard thing to quantify and is a leading concern of mine going forward I am unsure how to grow conviction here.. Because Agilent makes such a wide variety of products across many different industries, they compete against many different types of companies.
In Electronic Measurement, Agilent competes against the traditional semi test companies like Applied Materials, along with Yokogawa Electric and Teradyne.
In Chemical Analysis, they see Danaher, Perkin Elmer, Thermo Fisher, and Shimadzu In Life Sciences, they compete with Waters, Life Technologies, Thermo Fisher, Bruker, and Danaher.
The one positive is that Agilent appears to have a larger % of revenue from faster growing Asian markets then some of their competitors.
NODE 4:
There has been a change here. Since we last looked at Agilent, they acquired Varian for $1.5B in July 2009, which closed in May 2010. Varian is a niche life science instrumentation manufacturer that extends Agilents reach in bio analytics by bolstering the depth and breadth of its product offering and pushing Agilent into the adjacent life science analytical instrumentation markets (atomic and molecular spectroscopy), while adding a presence in nuclear magnetic resonance (NMR) continuums. Varian also brought new vacuum technology that is used in the Chemical Analysis Group.
The company has been in engaged in an almost decade long effort of asset sales (Avago for example) and more recently acquisitions to reposition itself as a maker of equipment for lifesciences and not a semi test and measurement company. The reasoning is management doesnt want the company subject to the highly cyclical forces of the semiconductor universe that have caused major upheaval (30-40% revenue declines in the measurement segment) to the Agilent over the last two downturns (tech bubble and mortgage crisis).
The acquisition of Varian is another step in that direction. They are making progress; a look at the difference in impact by Electronic Measurement to Agilents operating model from 2008 to 2010:
2008 EM made up 62% of revenue and 54% of EBIT
2010 EM made up 45% of revenue and 34% of EBIT
Another way to look at this is by comparing EM segment revenues/EBIT margin and ROIC through cyclical downturns. This is something Agilents management focuses on:
2001/2002:
- Peak Revenues were $5.4B, Trough was $2.8B
- Peak EBIT Margin was 14%, Trough was -27%
- Peak ROIC was 26%, Trough was -15%
2008/2009:
- Peak Revenues were $3.6B, Trough was $2.4B
- Peak EBIT Margin was 13%, Trough was 0%
- Peak ROIC was 24%, Trough was 1%
TARGET for a future Cycle:
- Peak Revenues $3.6B, Trough $2.4B
- Peak EBIT Margin was 21%, Trough was 12%
- Peak ROIC was 33%, Trough was 15%
So what?
That is a sizable jump in EBIT margin for the EM segment. How does that happen? The company took 3 restructurings during the 08/09 time period to cut out costs. In December 2008 they eliminated temps and did a wave of layoffs which amounted to $65M in annual savings. In February 2009 they exited the inspection business and did a global infrastructure restructuring (closing plants, etc.) that will save $150M annually. In March 09, they streamlined the semi test business through another restructuring, which they anticipate will save $310M annually. This adds up to $525 M in annual savings for the EM segment.
There is a lot more to dig into on their operating model because of the complexity and number of their business lines, but am going to stop here for this extended look.
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***AGILENT MODEL REVIEW (LONG CANDIDATE) – NOVEMBER 2010 – HELEN
Context: Pip wanted me to dig into the Electronic Measurement business given Agilent’s talk of altering the peak and trough margins of the business (to remain decently profitable throughout the semi cycle).
So what? Unsure what to do but my bias is to STALL Agilent – though I think we should do a brief call with management first. My thought is that much of the change in Agilent’s operating model has already occurred, and that the resulting benefits are already reflected in consensus expectations. So, while the company demonstrated meaningful operating leverage recently (with EBIT margins expected to go from 9% to 17% in FY10 on revenue growth of 21%), on a go forward basis, there is considerably less leverage (in terms of margin expansion) remaining.
All that said, it’s probably worth having a call with management to better understand exactly how they altered the business model in the Electronic Measurement segment. This may provide us with more context to evaluate whether there could be additional leverage going forward – beyond what is already anticipated. The company is reporting its Q4 results over the next few days so perhaps we could set up a call after that.
**
#1) What’s changed in the Electronic Measurement business?
-As Aaron mentioned in his extended look, management has restructured this business (reduced headcount, divested of businesses, etc.). The company now expects to remain profitable throughout the cycle, and targets average EBIT margins over the cycle of 15%. This compares to 4% average EBIT margins over the last 10 years.
#2) How did they do this (beyond headcount reductions and divestitures)?
Management hasn’t provided specific details in their conference calls and presentations but has provided some general commentary as follows:
-shifted manufacturing to low-cost regions in Asia
-outsourced more to contract manufacturers
-have shifted pay structures to have larger variable components to them (for sales, etc.).
-have shifted more of their sales towards channel selling.
I’d like to ask them for more specific details (what exactly have they outsourced, how much more could be outsourced, etc.).
#3) What has the impact been on EM’s margins to date?
-In FY10, Agilent expects to generate >100% incremental margins in this segment…Hmmmm – it’s clearly not sustainable to have incremental operating profits exceed incremental revenues. But for now, it’s working.
-Operating margins for the EM segment are expected to be 15% in FY10 (Oct), up from 0% last year on about 14% revenues growth.
#4) What’s expected going forward?
Management is targeting roughly 40% incremental margins going forward.
As noted above, management targets average margins for the EM segment of 15%, with a range of 12% to 21% from trough to peak of the cycle.
Based on one street model I have seen, EM EBIT margins are expected to be 18% in FY11 and 19% in FY12. This is based on revenue growth of 9% and 6% in FY11 and FY12 (following 14% growth in FY10).
So what?
While it sounds great in theory to remove the cyclicality in the profitability of the business, I’m not convinced that they will be able to consistently achieve their targets. If it was that easy, why wouldn’t they have done this previously? Why wouldn’t the entire semi industry do the same? Presumably if they are getting someone else to take on the risk (eg. outsourcing so they don’t have to have excess capacity on hand, etc.) they have to pay them to do so -> which would mean that perhaps they end up experiencing higher lows but at the cost of lower highs? Will it reallllly end up being higher average profitability over the course of the cycle? I think it would be helpful to have management walk us through this.
Here’s a brief recap of Agilent’s model.
**REVENUES
Historical revenue growth (FY04-FY09A): 19%, -28%, -3%, 9%, 7%, -22%
Expected revenue growth (FY10-FY12E): 21%, 14%, 7%
Business Mix (% of revenues, growth in FY10E):
Electronic Measurement = 51% of revenues, up 14% Y/Y
Life Sciences = 26% of revenues, up 20% Y/Y
Chemical Analysis = 23% of revenues, up 41% Y/Y
**EBIT MARGINS
Historical (FY04-FY09A): 8%, 6%, 10%, 13%, 16%, 9%
Expected (FY10-FY12E): 17%, 19%, 21%
Consensus is assuming incremental margins of about 40% over the next few years (which is in line with management’s targets).
Segment EBIT margins (FY10E):
Electronic Measurement = 15% (vs 0% in FY09)
Life Sciences = 16% (vs 14% in FY09)
Chemical Analysis = 24% (vs. 26% in FY09)
Business Model (FY10E):
Revenues = $5.4bn
Gross Margin = 56% (up from 54% in FY09)
R&D = 11% (down from 13.5% in FY09)
SG&A = 28% (down from 31.5% in FY09)
Adjusted EBIT = 17% (up from 9% in FY09)
*excludes stock based compensation and amortization of goodwill
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***AGILENT EXTENDED LOOK 2 (LONG) – HELEN – NOVEMBER 2010
Context: For today, Pip wanted me to focus on the Chemical Analysis and Life Sciences businesses at Agilent, given that these two businesses have been growing quickly recently.
So what? Let’s do another round of Extended Look 2 on Agilent. Agilent seems to fit very nicely into our NODE #0 Population Growth/Change and NODE #1 Naked without Data shifts. However, the company’s Chemical and Life Sciences businesses are pretty complex (lots of different products that do lots of different things across numerous markets) – so there is plenty more to learn before taking an investment position. I think a few things to focus on in the next round are:
i) Management expects the growth rate of the Chemicals business to slow notably in 2011. Is management simply being ultra conservative or is there a secular or cyclical change that is driving the expected slowdown?
ii) Can we simplify the business into a couple of key areas/products within the Life Sciences and Chemical Analysis markets?
iii) Did the acquisition of Varian meaningfully enhance Agilent’s NODE #3 competitive positioning in the Life Sciences market? If so, in what way?
**
#1) Reminder of Agilent’s business mix (Q4/FY10, September):
Electronic Measurement = 48% of revenues, up 23% Y/Y. Up 35% ex divestitures
Chemicals = 25% of revenues, up 73% Y/Y. Up 17% Y/Y organically
Life Sciences = 27% of revenues, up 35% Y/Y. Up 17% Y/Y organically.
For FY11, Agilent is guiding to revenue growth (total) of 13% at the midpoint (including M&A). On an organic basis, growth is expected to be 8%. By segment, the company is guiding to the following organic growth rates:
Electronic Measurement up 9% Y/Y (at midpoint)
Chemicals up 6% Y/Y (at mid point)
Life Sciences up 14% Y/Y (at mid point)
So what?
Hmmmm. That suggests a pretty notable slowdown from the organic growth rates in Q4 in both the Chemicals and Electronic Measurement businesses. On the flipside, Life Sciences seems to be holding steady. Key question to follow up on: what is driving the expected slowdown in the Chemicals business?
#2) Overview of the Chemicals and Life Sciences NODE #2 market opportunities:
i) LIFE SCIENCES
-Life Sciences = $19bn market, growing at 5-7%.
-Agilent focuses on two segments of the market: Pharma Biotech and Academia/Government.
-Pharma/biotech makes up about 80% of Agilent’s Life Sciences revenues, and Academia/Government accounts for about 20%.
-Key growth drivers here include:
i) the growth of the generics market as drugs come off patent and are being produced in India, Korea, Brazil, etc. Drives new testing opportunities for Agilent.
ii) increasing focus in the pharma industry on developing new generation therapeutics that are based on biological entities rather than traditional organic chemistry, small-molecule pharmaceuticals. Drives testing opportunities for Agilent in DNA, protein, RNAs, etc.
iii) NIH (National Institutes of Health) funding in the US and EU -> lots of stimulus activity (macro related)
ii) CHEMICALS
-Chemical analysis = $9bn market, growing at 5-6%.
-Agilent is focused on 4 primary segments: chemical and entity testing, environmental testing, food testing and forensics and drug testing.
-It sounds like this fits very nicely with our NODE #0 Population Growth as well as Naked Without Data. In a nutshell, we have 2.6bn people who are becoming *middle class* citizens who can afford to care about the quality of their water, their air, their food.
-Agilent notes that a key growth driver for the company relates to food safety regulations. Per Agilent, historically, this market was primarily centered in Asia with concerns on meeting the export requirements to Japan and the EU. The market is evolving as new regulations develop in China, India and the US.
#3) What was the strategic rationale for the Varian acquisition?
Varian is a supplier of scientific instrumentation and associated consumables for life science and applied market applications.
Per Agilent, with this deal, the company will have the broadest product offering in the industry for the bioanalytical/life sciences markets.
Agilent says the deal is largely complementary. For example, Agilent is a leader in food safety, while Varian is well established in the energy industry, and has a broad spectrum of products for environmental analysis.
Transaction details:
-Varian’s revenues in FY08 were about $1bn.
-Agilent paid about $1.5bn in the deal.
-Agilent is targeting $75mn in annual cost synergies and expects to achieve a 20% ROIC in 4-5 years post the deal close.
So what?
Hmmmm. I tend to be a bit weary when M&A is justified with *we will have the broadest product offering*. Sometimes customers may actually value that (you are their one stop shop) but sometimes I think this is code for *we just want to be big*. I think this is something to follow up on here. From what I’ve read in sellside notes, people are largely positive on this transaction. But when I listen to some of management’s explanations for the deal, I’m not convinced. Case in point: why would a food company (that cares about food safety) care about Agilent’s offerings in the energy industry? If this is a case of diversification, we (as security holders) could manage that ourselves.
#4) Dig into the Asia angle of the Agilent story.
Agilent’s investor presentation definitely emphasizes the Asia angle. The company notes that:
i) 37% of revenues come from Asia. My add: that’s a reasonably large percentage but it’s not unheard of among larger, global companies.
ii) 7,400 of Agilent’s 18,500 employees (or 40%) are based in Asia. My add: that’s more notable for a North American company.
iii) its presence in Asia gives it advantages in terms of access to low-cost supply chain and admin functions. The company is also well positioned to capitalize on opportunities in higher growth markets such as India and China.
iv) In 2009, $800mn of revenues (18% of total) came from India and China. Agilent expects this to exceed $1bn in two years’ time (FY12) driven by Electronic Measurement and Bio-Analytical.
v) Agilent sees specific opportunities in China related to food safety, chemical and energy testing as well as environmental testing.
So what?
Agilent also highlights that HP was one of the first companies to start doing business in China (and Agilent is a spin out from HP) – and that its long presence in the country positions the company well to capitalize on opportunities there. All makes sense.
That said, the company also notes that some of the recent growth the company has experienced in the region in its Chemical and Life Sciences businesses was driven by extraordinary stimulus at the end of the government’s current five year plan. Some of that stimulus is not expected to recur – which could serve to mute the growth rate going forward (specifics not quantified).
So, a few questions to ask the company on this front are:
i) How specifically does their long presence in the region translate into a sustainable competitive advantage?
ii) How much of their revenues come from China specifically and what is the growth of that business?
iii) How big of a boost did the stimulus provide (eg. what % of their revenues in China in FY10 would they attribute to the stimulus)?
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Agilent Extended Look 3 November 2010 — DAVE
** Conclusion & Context: Let’s keep this in Extended Look 2. Long. Date dependent on setting up another call with the company. I’m positive but have a whole host of questions. It’s my first look at Agilent, so much of my time was spent building knowledge from a low base. But I spent a lot of time on the phone with IR and like what I see. I was focusing my questions on a few threads: (1) gain a better understanding of the underlying growth drivers, (2) learn more about what thinking has shaped their EBIT margin improvement, and (3) simply learn more about the soul of this company.
** NODE #2 GROWTH DRIVERS
Helen adequately laid out the market size and growth characteristics for each of Agilent’s segments. My focus was less about sizing and more about the underlying drivers, focusing primarily on the life sciences and chemical segments. For context, each segment is about 20-25% of total revenue.
SEGMENT #1: Life Science: two major segments – Pharma and Not-for-profit.
#1: Pharma: 14-15% of total revenues
** Drivers: (1) Pharma co’s shifting development to emerging countries – a byproduct of (a) do more with less and (b) be where the end demand is. While this isn’t a *new* change, it’s a trend that’s continuing. (2) Pharma co’s are changing protocols to new biological entities.
What on earth does that mean?
I didn’t spend much time with IR on this, but I looked it up and at the risk of over-simplifying things, NBEs and NCEs (new chemical entities and new biological entities) are new approaches to drug discovery and development by the pharma companies that involves looking at the genomic or molecular level. Is the change here enough to be a major growth driver? It’s not clear to me. On one hand, yes, I can see how pharma companies are trying new methods to develop drugs and I can also see why new measurement tools would be needed. On the other hand, I suspect this has always been the case. So is it a major *new* change? Maybe not. But I can see why life sciences would be a secular, solid grower for a long-time to come.
#2: Not for profit. 7% of revenue.
This involves the academic and gov’t sector and has to do with continued investment in life sciences research. One recent example: NIH, which consists of $32bn in annual spending for 50,000 competitive grants to more than 325,000 researchers at over 3,000 universities.
Another example: China, which has been putting a lot of money in life science research and which looks to be continuing and perhaps accelerating in the upcoming five year plan. A specific example in China? BGI (Beijing genomics institute) is one of the world’s leading gene sequencing centers and will apparently receive $1.5bn in grants over the next 10yrs by the China Development Bank.
At any rate, this is now 7% of revenue up from “very small” 4-5 years ago and seems to have plenty of room to grow.
So what? With all the changes taking place in life sciences – and in China! – I can understand why this is a secularly growing business. That said, considering the end customers are pharma co’s (under the strains of do more with less) or not-for-profit academics, the NODE #2 market doesn’t seem like one that’ll suddenly put up 15-20-25% annual growth. But the 5-7% CAGR that Agilent predicts seems completely reasonable, if not a bit conservative.
SEGMENT #2: Chemical analysis
Split in 4 ways.
- Chemical / energy testing: 11% of total.
- Environmental testing: water /air. 9% of total.
- Food testing: lot of attn. lately. 6% of total.
- Forensics / drug testing: 2% of total.
Are any of these particularly fast growers? Nah. Forensics is kind of slow, but all others are growing double digits.
Drivers?
- Petro-chemical: development of energy resources. Some impact from gulf oil spill.
- Environmental: quality of air / water – particularly impt in China / India. Developing countries becoming increasingly aware of air / water risks.
- Food testing: again, particularly relevant in developing economies care.
So what? One of the questions that Helen had was – is there a single (or even just a handful) of growth drivers we can point to as the key levers? And my sense is that – no – there isn’t. That is, any secular growth story wouldn’t come from the rapid take up of … say … a new product or even a single industry but rather from the on-going evolution of science and the societal needs it aims to address … from cell phones to energy to food / water.
** Question: What synergies are there among all these segments?
Answer: This isn’t crystal clear. But the company’s answer helped me learn a lot about who the company is and what their ‘soul’ is.
Thought #1: The soul. Agilent’s soul *is* “measurement”. It believes the foundation of science is measurement. If you want answers or insights, first you have to gather data, then you have to measure it, then you analyze it. Agilent says it’s become really good at all three. And all three can be applied to all sorts of industries: to measure / analyze air quality or food, you break down the material into its analog components …. then you turn it into digital bits / bytes … then you analyze it. This abstract is applied to all the segments Agilent participates in even if the product they sell (hardware + software) is different.
Thought #2: While the company doesn’t sell the same Electronic measurement products into life sciences, it WILL sell the same life sciences product for either a food or air / water application. So there is some synergy there. Again, it all involves breaking down analog components into digital, gathering the data, and then analyzing it.
So what? “Synergy” might not be the right word here. It doesn’t seem to fit. But “clear vision” does. “Focus” does. They’re about ‘gathering and measuring data’.
** Question: Why the expected slowdown in chemicals in 2011? (from 17% in 2010 to 6-8% in 2011).
Answer: This was one of Helen’s questions. IR said that 17% was the result of an easy comp. While the Electronics segment took the brunt of the 2009 downturn, all businesses were affected and were left w/easy comps in 2010. The point: don’t expect 17% growth on an on-going basis.
** VARIAN – WHY BUY THEM?
What’s the synergy here?
It’s *not* technological. That is, it’s not as if Varian technology is being added to Agilent products to make them “better”. Agilent is still selling regular old Varian products. But the benefits are that the Varian products can fill gaps and sell into the Agilent customer base and vice versa. Also, they were a bit better penetrated in academia / government. That’s synergy #1 – filling gaps, selling more into a customer base.
Synergy #2 is cost… particularly on the COGS side. Varian’s gross margins were 1000bps lower than Agilent’s. Agilent intends on bringing it up to their level.
Incidentally – a few of the small divestitures that Agilent did were forced on them because of the DOJ and EU. While there wasn’t much overlap w/Varian business, there were a few and the company was forced to divest. This is why the deal took nearly a year to close. Interesting tidbit I thought was worth knowing.
So what? All seems sensible to me… and when we model, we’ll want to assess how far along we are in the margin expansion for the Varian business.
** EBIT MARGINS
Helen talked a good bit about the efforts by Agilent to reduce their big margin swings and the cyclicality of their business. I asked the company to tell me more of the thinking behind the moves. They walked me thru three transformations…
- Transformation #1: Post bubble. The company was spun off from HP in 1999. It was the bubble and no one was thinking ‘efficiencies’. Then bubble burst. EMG business was nearly cut in half and the company (like many) entered survival mode and took a hatchet to expenses. Lot of streamlining of infrastructure – cutting a lot of fixed costs. My add: got it. Many went thru the same thing. Nothing special here.
- Transformation #2: 2005. New CEO came on board. What Agilent realized then was that even though biz was profitable, it was still being penalized by investors (via its share price) as being tied to the semi cycle. So, transformation #2 was to reduce cyclicality and the tie to semi equipment. Hence the spin offs. Semi Equipment was 45% of revenues in 2005. 6% today. My add: did we know a new CEO took over? I think that’s important to learn more about since this seems to be when the real *transformations* started. (I don’t count the bubble as being one). (Separately: I don’t like the “we were being penalized by investors” comment. Not sure if there is anything to make of it, but I’d rather they focus on business as opposed to share price).
- Transformation #3: More recently, while the company had effectively reduced its cyclicality by divesting semi equipment, it still had a large Electronics business that was more heavily tied to the economic cycle than … say … life sciences was. And, Electronics fared very poorly in the economic downturn in 2009. So – after the big drop in that business (and margin decline), the company set more cost cutting measures. Helen laid these out in her work and they seemed like fairly run of the mill type stuff: more outsourcing, headcount reductions, use of channel, shifted pay to more variable.
** CEO: WHO IS HE?
Who is he? Where is he from?
Bill Sullivan: 59
He’s been CEO since March 2005.
Prior to that, he was COO since 2002 and ‘shared the responsibilities of the president’s office’ with then CEO Ed Barnholt. He had been at HP with Agilent prior to that.
So what? So … he’s not an outsider and likely didn’t bring radical change with him when he became CEO in 2005. But I’d still like to know more about him and whether he has, in fact, been a change agent. Maybe Carl knows him…
** CONCLUSION
I’m positive. I see a company that:
- Has transformed itself such that it is selling into secularly growing markets – probably more like 7-10% as opposed to 15-20%.
- Has a fantastic foothold in China where it’s been for 25 years and which it absolutely considers a NODE #3 advantage.
- And has made smart divestitures + sensible (if not mind-blowing) cost cuts with an eye on margins.
At any rate, I’m quite positive but I have a WHOLE batch of questions to follow up on:
- I’d like to know more about its CEO.
- I’d like to learn more about its competitors. Do they have *any* presence in China? How – specifically – is Agilent leveraging its position there?
- I’d like to learn more about Agilent’s users. What is their crisis? Who exactly customer makes the purchase decision? Is that person’s budget rising or falling? *When* exactly would that person decide to pick up the phone and call Agilent? Is Agilent’s growth driven by new customer growth? Selling more into their installed base? Higher ASPs? Is there a recurring revenue stream?
- In Electronics, what’s a good proxy for growth? End unit sales (of handsets, or whatever)? When would … say … Nokia have to buy more test equipment? After X # of handsets are sold? Or when new handsets are launched (with new specs)?
- Ditto in life sciences and chemical? What’s a good proxy for growth? How does Agilent think about sizing its NODE #2 market opportunity and growth? What’s it tied to?
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Agilent Model – December 2010
** Conclusion: Nothing terribly new here. Pretty straightforward, and I’d like to keep working this one as a long candidate. Next step: line up list of key questions and chat again with the company. As a reminder, this is only my 2nd round on Agilent, so I have more knowledge to build, but the model work today suggests that if (a) their new, non-cyclical end markets can in fact support 7-10% trend line growth and (b) they can keep margins at the current levels in the mid-term post “transformation”, we ought to keep pursuing this one.
I think the next round of questions should focus on NODE #3 (pip, your comment about Nat’l Instruments’ claims) and NODE #2 (can we get a better understanding of what the trend line growth rates of life sciences and chemicals are?)
** HEADLINE NUMBERS: 2007 to 2013E
- Revenue growth: 9%, 7%, (22%), 22%, 15%, 6%, 6%
- EBIT margin: 16%, 16%, 9%, 17%, 18%, 18%, 19%
- EPS: $1.81, $2.05, $0.80, $2.00, $2.48, $2.81, $3.10
- Valuation: 17x CY 2011 EPS
** BY SEGMENT
- Life Sciences: 27% of revenues. Organic growth exp to be 11-12% in 2011. EBIT margins 15%.
- Chemical Analysis: 22% of revenues. Organic growth exp to be ~6% in 2011. EBIT margins 23%.
- Electronic Measurement: 51% of revenues. Organic growth exp to be high single digits in 2011. EBIT margins 16%. Of this, Communications is about 1/3 of the mix and general purpose test is 2/3. Communications is currently a low-single digit grower but the talk is that in 2012, LTE might help boost growth a touch more. General purpose test, on the other hand, is growing mid-high single digits. It consists of Defense (US DoD, Raytheon, Lockheed) and Industrial / Computers / Semis (Foxconn, Intel, Flextronics, IBM, HP).
So what? We’ve talked about the transformation here and the most compelling part of this investment case is that Life Sci and Chemicals now make up ½ the business. The burning question, I think, involves NODE #2 and just how large are those markets and how fast can it grow? I like that they aren’t cyclical, but are we talking 4-5% trendline … or 8-10%…. and why?
** MARGIN PROFILE: 2007 to 2011E
Gross margin: 56%, 56%, 54%, 56%, 56%
SG&A: 28%, 28%, 32%, 28%, 27%
R&D: 12%, 12%, 14%, 11%, 11%
EBIT: 16%, 16%, 9%, 17%, 18%
So what? Each of the major line items has improved since 2007, notwithstanding the blip each of them had in 2009 when revenues fell 22%. My sense is that – yeah – management is committed to making money on the bottom line.
** BALANCE SHEET & CASH FLOW
Nothing dramatic here, though there is one question I want to ask the company.
On the balance sheet, Agilent does carry long-term debt but it (a) has an even more cash (leaving it with a net positive cash position) and (b) generates plenty of cash to service the debt.
- Cash on hand: $4.2bn.
- Long-term debt: $2.2bn
- FCF: 2007 to 2011E: $815mn, $602mn, $280mn (the down-cycle), $594mn, and minus $475mn.
What’s up with the minus $475mn expected in FY 2011?
I’m not sure. Nominally, it’s caused by an expected $1.6mn “outflow” from Working Capital that looks to be the result of paying down short-term debt. At least that’s what the broker model I’m looking at shows. Without that, FCF would be strong.
My thought here is that it’s worth asking the company what this line item is about (or, even, if the broker is accurate), but it’s not a burning question. My sense is that it simply involved some movement of capital to make the Varian acquisition last year.
Separately, yes, Agilent has been acquisitive. IT’s Investments / Acquisitions line item shows $340mn in 2007, $172mn in 2008, and $1.1mn+ in 2010. This isn’t a surprise, given the “transformation” we’ve talked about before. Still, in our follow-up work, I may do a quick recap of the acquisitions just to make sure they all seem sensible.
** DECISION ENGINE
I ran two scenarios here and both get Agilent into the 4th and 5th (least expensive) quintiles.
#1: 10% mid-term growth and 20% EBIT margins (as a reminder, they’re presently at 18%): “Upside” = 67%, which would make it the 4th least expensive company in the portfolio.
#2: 7% mid-term growth and 16% EBIT margins: “Upside” = 18%, which would put it in the lower end of the 4th quintile (borderline 3rd).
** CONCLUSION
This work hasn’t driven me far toward “wisdom” but after completing it, my conviction that we should keep working on Agilent remains high. Still an “accelerate”.
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Agilent Follow-up December 2010
** Conclusion: Move to Pre-determined game plan, Long. This work is the result of a quick, 30min chat with IR from the road in Europe, but it does inch the ball forward enough to move forward. My conviction is relatively high that Agilent’s NODE #2 can grow consistent with their goals. In NODE #3, I’m still not quite to “wisdom generation” … and I haven’t yet done work to assess the veracity of the claims they make (below) about their advantage, but the company’s demonstration of results and its ability to adapt to the changing world have been impressive and leaves me with a positive bias in NODE #3. I think it’s time to condense the ‘knowledge’ into ‘wisdom’ and do a Pre-determined plan.
** Context: We had several questions after our model work, and I had a (relatively quick) chat with IR from the road in Scotland to address some of them.
** Question: How do you go about assessing the growth rate of your end markets? i.e. determining that life sciences is 5-7% …chemicals is X and electronics is Y?
IR started to walk me through each of their divisions, but the short story is that they start with GDP and then tack on some add’l growth due to the end markets they sell into and the demands that they presently have. Nothing too scientific, which is ok by me. So, between the emerging markets exposure to the changes taking place in pharma testing to things like food safety, I can see why these markets are growing faster than GDP – and in a secular fashion.
In talking it through, IR got a bit more specific about whom some of the users are and what forces are driving growth. It brought the “change” to life a bit for me, so I’ll pass them along:
- Pharma: we talked about the shift in therapeutics development, but the growth of generic drugs in developing countries is something that Agilent is benefiting from too. The # of participants is growing (in developing regions). So, even though large pharma is struggling, there are more players getting into the game …which is good. (Follow-up: makes sense … but who are some of these folks? How many are there?)
- Academia: there’s a Human Population Change tie here. Growth is being driven primarily by an increased focus on the human condition … the aging of population … the focus by the gov’t on providing better healthcare in both developed AND emerging countries.
- PetroChemical: The drivers: simply … the consumption of oil and the build-out of refineries. The increased use of fine chemicals. Alternative energy research.
- Forensics / Environment: Driven by environment – clean air, asia, latam. Who are the spenders? Private enterprises that have to ensure quality air & water. Also gov’t entities testing air and water for their community.
- Food: fastest grower at 8%. Food safety regulation / Food safety bills. As the world population grows and as more food is distributed around different countries, food safety is a growing concern. The customers: private enterprises to ensure food is up to the standard. Also exporters of food to other countries to world. India testing spices they send to rest of world so there are no added dyes or anything like that.
So what? This is useful and while my conviction level about whether trend-line growth is 6-9% or … say … 9-12% is low, I do see Agilent’s bogey for high single digit organic growth as being reasonable.
** NODE #3: Whom do you compete against?
Answer: From IR: there’s no Agilent clone. That is, there’s no company that competes head to head in all these different areas. Yes, there are a lot of small, focused comps. But the closest regarding scale and diversification – Danaher – a publicly traded, $31bn market cap company in Washington DC. According to Agilent, Danaher has been growing thru acquisition … they do it well … they bought Techronix in 2007 … bought Ab Sciex in 2009 for their first foray into life sci and chemicals … and recently acquired Kiesley to get into lower end test & measurement.
So – they’re the most diversified comp.
Among the more focused comps:
• Thermo Fisher Scientific.
• Waters – competes more in high end LCMS
• Perkin Elmer
• Low end LCMS: Shimatsu. (Agilent has LCMS that’s low end and high end).
And … what’s Agilent’s advantage?
They talk about product breadth and their wide portfolio. A good follow-on question: how many customers buy more than one product from you? Does product breadth really matter? I’m not sure…
Additionally, they talk about how scale and their China roots have helped them have higher gross margins than peers and that THAT allows them to spend more on R&D. This makes more sense to me.
Now … in the electronics market, they say their biggest comp is privately held Rode & Schwartz in Germany. Ditto for Danaher. As for Nat’l instruments, Agilent downplayed them. (I’m not sure they would have mentioned if I didn’t keep asking). IR said the key area that Nat’l leads the mkt is in modular components – they pioneered that. Agilent *did* announce its own line of modular products earlier in 2010, but Nat’l Instruments has been in that space for much longer.
What are modular components?
Well described in an old Scientific Computing article: “Measurement systems have historically been ‘islands of automation’, in which you design a system to meet the needs of a specific application. With virtual instrumentation, modular hardware components and open engineering software make it easy to adapt a single system to a variety of measurement requirements”
So – how much of Agilent’s business is exposed to modular components? “Very small”. They wouldn’t speak to #s …but they dismissed it as very small.
Important follow-up questions: Are modular components and the type of measurement systems Agilent sell distinct entities? (Agilent’s answer suggested as much.). Why can’t modular components grow and infringe on Agilent’s business that is currently NOT modular components? What is special about the NON-modular approach that modular can’t match?
So what? I’ll follow up with Agilent and ask this question. I think it’s an important one.
At any rate, I hadn’t done much work on Agilent’s NODE #3 – so this was useful. That said, I’m relying on their word and to really gain some conviction, I think it’d be a good use of time to learn more about this competitive landscape to assess the legitimacy of Agilent’s claim. I haven’t done that yet, but it might be worth another 2hrs to see what some of these other companies are experiencing. At the very least, it’ll make up a key part of our “Burning Questions”! Let’s do a Pre-determined game plan.
