Description

Agilent (A) write-up (Long)                                                                                                                          

Last print: $67.55 per share on 4/20/2018

Thesis (30-second elevator pitch)

    Agilent is what I call a “compounder-plus” idea: not only does it operate a fantastic business in an industry with multiple long-term secular tailwinds allowing it to grow revenue at global GDP+ and operating profit at high single digit organically over the medium term, it has a set of specific product cycle opportunities and margin expansion initiative that will supercharge its revenue + earning growth over the next 3 to 4 years. In addition, Agilent is in a prime position to take advantage the tax reform to efficiently repatriate significant cash balance currently trapped off-shore, which can be deployed holistically to drive value creation, not to mention further capital allocation upside from increased use of debt given this company has net cash position while peer TMO runs with 3.6 turns of net leverage.  The combination of the above drivers will enable Agilent to achieve 2020E free cash flow per share materially above street (by 20%) and allow for continued multiple expansion closer to the best-in-class comparable of the Tools group, Mettler-Toledo (MTD). I believe the stock is a double over the next 3 years with strong downside protection.

Index

1.       Company/product overview and industry background

2.       Discussion on business quality and high-level growth algorithm

3.       Elaboration on key thesis points

4.       Valuation, price target, and risk/reward

5.       Key risk

Company Overview

    Agilent is one of the leading players in the tools and diagnostics space. From a high-level standpoint, Agilent sells tools/instruments, consumables and services that aim to improve research outcomes for R&D professionals across diverse end-markets (life sciences, chemical & energy, food & environment, academic).

• It is the global leader in providing application-focused solutions for entire lab workflow in life sciences, diagnostics, and applied chemical markets.
• In fact, most of the world’s ~270,000 labs are using some forms of products and solutions from Agilent.
• Competitors and peers in the space include Thermo Fisher, Waters, Danaher, Bruker, Mettler-Toledo, PerkinElmer, and etc – each of these tools companies has specialty/dominance in different niches/product category.

    For some background, Agilent used to be wholly owned by Hewlett Packard in the last century and gained independence after Hewlett Packard IPO’d it in 1999. In 2014, Agilent further span off Keysight Technologies, its electronics test/measurement business with little commercial synergy/overlap.

    Today, Agilent generates roughly $4.5bn of revenues at ~20% operating margin in a ~$50bn Total Addressable Market (TAM). The business operates a razor (instrument) and razor-blade (consumables) model – it leverages its leading position in instrumentation (45% of revenues) to grow its services and consumables business (55% of revenue).

    Agilent has three separate business segments that leverage a shared services infrastructure, which provides centralized order fulfillment, supply chain, legal, finance, and HR capabilities. Here is a breakdown of each segment’s key products and sample applications

Here is what these products look like:

    In the top row, from left to right, you’ve got a Gas Chromatograph (GC) instrument, a Liquid Chromatograph (LC) instrument, and a Mass Spectrometry (MS) system; in the bottom row, you’ve got a Dako Omnis machine that runs diagnostics for pathology labs on the left and GC columns (consumables) on the right

Quality of business is high and drivers of earning compounding algorithm are sustainable

    Agilent has a strong value creation model with a dependable management team lead by CEO Mike McMullen, who has demonstrated an impressive track record since his appointment.

• Revenue growth above end-market:

o Agilent’s core revenue has essentially outgrown the end market every year, and shareholders have been treated with consistent “beat & raises” given a conservative management team.

o Agilent’s long-term goal is to grow 50-100bps above end-market growth rate (~4%) and has beaten its own goal every year. Peers’ blended organic growth rate has been in the ~5% range and Agilent’s organic growth rate has been closer to 6%.

o Agilent achieved this by targeting growth markets/segments in a more strategic/innovation-driven way, and by listening to customers closely.

o In addition, Agilent benefits quite a bit from its higher-growth EM exposure, with ~20% of revenues from China.

• Consistent operating margin expansion with runway:

o Agilent has driven 400bps+ of EBIT margin improvement since FY2014 despite the Keysight-split-related dis-synergies of $40mm in 2015. The company has achieved this by diligently restructuring operations, rationalizing portfolio, streamlining R&D and integrating bolt-on M&A (such as the Dako business acquired in DDG)

o There is still a lot of margin improvement potential being left on the table as management turns to its COGS base: it has laid out compelling rationale to reduce procurement costs ($900mm of annual material spend) and further optimize its supply chain infrastructure

o Product cycle is another accretive margin driver: new products command higher price points and are typically designed with lower cost of materials (Agilent has a relentless focus on value engineering)

o For the past two years, cost inflation has resulted in 50bps of annual margin compression, but that has been more than offset by more than 50bps of benefits from COGS/OpEx efficiency programs and more than 110bps of annual benefits that were volume-driven (result of operating leverage from strong core growth)

• Disciplined yet efficient capital allocation that takes advantage of its low cash tax rate:

o Agilent is committed to return 85%+ of annual FCF to shareholders via a combination of dividends and buybacks, while constantly being on the look out for bolt-on deals that could enhance its strong IP portfolio

o Agilent has historically paid cash tax rate run-rating ~10% (of adj. EBT), materially below its book/effective tax rate of ~18%. The company enjoys tax holidays in several jurisdictions, most significantly in Singapore. Management believes the 10% cash tax rate will be sustainable for foreseeable future despite some tax holidays due for renewal between ’18 and ’23.

§  Having a low tax rate is not abnormal in the tools space, Thermo Fisher and Waters have 12% and 14% for effective tax rate for example

o Agilent clearly has an impressive tax team, as the company has repatriated $4.7bn with little tax-related cost since 2005

Elaboration on key thesis points

    Buying Agilent today is about more than just “buying a great/dominant business”. Frankly, the headline multiple (~22x consensus 2019 EPS, or roughly ~20x consensus cash EPS) isn’t exactly in the “value” category. The reason it is a great buy today is that it has a series of idiosyncratic opportunities that are still under-appreciated by the sell-side and the broader investment opportunity.

   These opportunities are in the following three brackets: 1) product cycle opportunities that can substantially accelerate organic growth, 2) margin opportunity that can transfer more of that accelerating top-line growth to bottom-line profit, and 3) capital allocation opportunity that makes more efficient use of the conservatively-run balance sheet.

    I think this is a compelling buy here because I believe the combination of the above opportunities will lead Agilent to crush organic revenue growth and FCF growth expectations in the next few years

• Product cycle opportunity #1: Intuvo 9000 Gas Chromatograph Instrument

o GC instrument is a key product offering in the LSAG segment, and Intuvo is a $1.8bn cumulative product cycle opportunity that will meaningfully ramp starting in 2018

§  $20,000 ASP, 90,000 installed base suitable for this upgrade

o It has been a long time since there was a significant product upgrade in the GC space: the existing 6890 series was launched in 1995!

o The age of current installed base is quite old: management has commented that this installed base is at “historic levels of aging” and the company knows that these equipment are being used (by observing consumable sales)

o There are multiple core advantages with the new product including lower total cost of ownership, increased productivity, ease of use – so there is real economic ROI by upgrading

o Scientists and technicians are excited about it given increased ease of use, digitalization, and touch screen capability; press coverage is 100% positive and customer response is also very positive to this introduction despite the reality of constraints they may have in their capital budgets

o In fact, it is resulting in a halo effect around Agilent’s entire GC offering as it is spurring a lot of discussions about the other products in the GC portfolio and driving sales there

o 2018 is the first year of meaningful adoption cycle – going to start driving numbers

§  This product missed the 2017 budget request window of its customers but there should be material ramp starting in 2018. Sales cycle has been a little longer for this product given how revolutionary it is – customers want to trial the product given the way it changes the lab workflow and Agilent has placed a large number of demo units over the past year

§  Upgrade cycle is likely to be an S curve, and at the sharpest part of the curve (likely 2019-2020), 25% to 30% of the installed base could upgrade in a year, and assuming a significant cannibalization rate (the customer pull back spending on other potential purchases at Agilent), you are still looking at material net revenue contribution from this product that can lift organic growth of the entire company by up to ~500bps (sounds crazy but the math can get there)

§  There is potentially extra juice from winning share from Shimadzu: Agilent has just under 50% market share in GC and Shimadzu has just over 25%. I believe the Intuvo could capture some of the replacement need from the existing Shimadzu installed base

• Product cycle opportunity #2: Ultivo Liquid Chromatograph/MS Instrument  

o LC/MS instrument is another key product offering in the LSAG segment, and Ultivo is a likely a $1.5bn cumulative product cycle opportunity that will meaningfully ramp starting in 2018/2019 – this is a very new product that just got recently unveiled (mid-2017) at the American Society for Mass Spectrometry

o This is a revolutionary project – standing at 70% smaller in size than previous instruments yet delivering the same/better performance (higher throughput, highly automated and higher sensitivity).

o The advantage is space efficiency as lab space is a valuable commodity and customers can increase lab space capacity without compromising on performance or uptime

o Similar to the Intuvo, it has created a lot of excitement among the customer base who can’t wait to get their hands on the prototype

o 2018 is also the first year of meaningful adoption cycle – going to start driving numbers

§  Management believes it is well-positioned to ramp this product in fiscal year '18 and capture the market opportunity specifically in the environmental and food application space where this product is really front and center in terms of the specifications and the application domain

§  Installed base information is not as transparent as the Intuvo but we can triangulate to a number given a few data points we do know:

§  Agilent is only 1 out of the 4 leading players in MS with 20% market share (opens up for share grabbing opportunity);

§  The end-market itself is bigger than GC at more than $1bn (annual revenues), while GC is less than half of that;

§  Typical replacement cycle is shorter at ~7 years

§  Upgrade cycle is also likely to be an S curve, and at the sharpest part of the curve this product is likely to lift organic growth of the entire company by ~300-400bps

• Product cycle opportunity #3: NASD (Nucleic Acid Solutions Division) within DGG

o One of the product offering in Diagnostics and Genomics Group is called NASD – and this division has the unique capability to produce synthesized oligonucleotides under GMP (Good Manufacturing Practice) process for use as API (active pharmaceutical ingredient) for a new class of drugs called RNAi drugs

§  RNAi drugs are gaining a lot of awareness right now post Alnylam’s RNAi drug development success, and Agilent views itself as “one of very few companies in the world that have these capabilities” to manufacture these specialty API

§  RNAi stands for RNA interference: Alnylam’s patisiran drug uses the RNAi mechanism to manipulate ribonucleic acid, which interferes with or “silences” targeted genes, and stops the formation of proteins that can cause diseases

§  After FDA’s validation, the very first commercial launch of RNAi drug can come as soon as 2018, and Alnylam is one of Agilent’s customers

§  Most customers today are still doing clinical trials and there is a continued increase in investments, this can be a 10-yr secular growth story if this category of drugs takes off. Agilent will start crushing it really hard once commercial phases start

o NASD today makes up low teens % of DDG segment revenue but is poised to more than double to $180mm by FY2020

§  Agilent is aggressively investing in building further capacity to address the demand for the oligos

§  Broke ground and initiated construction on a $120 million 3-yr investment in a new factory in Colorado to expand nucleic acid production capacity

§  Train 1 will reach full run-rate by 2020, adding $100mm of revenue (already contracted under a take-or-pay contract)

§  Agilent can add 3 more trains (at less capex/line given shell infrastructure has been built) to drive another $100mm revenue per train if there is demand – again, there is huge optionality here if more RNAi drugs gain commercial approval.

• Margin opportunity #1: the 3 product cycle opportunities will be margin-accretive

o Given the innovative features embedded in the newly launched Ultivo and Intuvo products , they are priced at a premium vs. last-gen products and will be commanding materially higher gross margin.  This is on top of the rest the organization continuing to find ways to reduce materials cost and squeeze efficiencies

o The NASD/RNAi API business is extremely profitable in terms of margin – far above the DGG segment’s profitability (I estimate NASD likely contributed 25% of DGG’s segment profit despite low teens % in terms of segment revenue for FY2017)

§  You can talk to ST Pharm, a publicly-traded + Korea-based specialty API manufacturer who is one of the very few players that can also make oligonucleotide API for RNAi drugs – it has shockingly high GM %.

§  Let’s face it, despite the high price these specialty API producers charge for oligonucleotides, the COGS to biotech/pharma companies is still a tiny % of the drug’s net selling price.

o Bottom-line, not only will these new product cycles drive organic growth acceleration, it will also translate into margin momentum.

• Margin opportunity #2: DGG is underearning relative to its full margin potential

o Agilent has improved the margin at DGG substantially over the past few years, with most of success being attributed to Dako integration (cost integration savings and simplification of the platform post a bolt-on deal) and better sales force alignment

o Looking at comparable segments at the peer group, you can see a margin opportunity continues to exist at DGG (500bps+ lower than peers despite NASD having robust profitability), and more improvements will come despite progress to date

o Agilent’s management is particularly enthusiastic about DGG’s margin given this segment has high fixed cost base + high top line growth

o Management continues to see capacity in OFS (Order Fulfillment and Supply Chain team) to improve gross margin going forward in this segment

• Capital allocation opportunity: Agilent can use its balance sheet a lot more aggressively

o Agilent is running at negative 0.6x net leverage vs. tools comps on average run at positive 1.6x net debt to EBITDA – so that is 2 fully turns of delta

o Historically, a lot of the financial conservatism had to do with the fact that 95%+ of Agilent’s $2.7bn cash pile was held offshore. With that said, Agilent could have taken up more gross debt at the US subsidiary to do more aggressive deals/buyback (the net leverage across its global subsidiaries will still be low), but Agilent didn’t prefer that, I assume.

o Post tax reform, corporations are allowed to repatriate foreign  cash and cash equivalents at 15.5% tax rate, allowing unlevered companies like Agilent to aggressively “capital-allocate” its vast offshore cash

o I believe Agilent can repatriate some cash and easily buy back $4bn of stocks or almost 20% of market cap (using 150% of annual post-dividend FCF to repurchase stocks) over the course of FY2018-2020, while still leaving the balance sheet under-levered (resulting in PF 2020E gross debt/EBITDA of 1.1x and net debt/EBITDA of 0.3x). Could Agilent do more/double that? Sure it could.

o The company has historically done very shrewd deals to expand the breath of its portfolio and enhance offerings. The leverage capacity/dry powder also helps to the extent management wants to pursue bigger/chunkier deals that make strategic sense.

Discussion on earning power and valuation

    To pull it all together, there are layers and layers of opportunities that can translate into accelerating organic growth, which is the #1 idiosyncratic determinant of multiples in the tools space.

• Agilent should see organic revenue growth (core growth) accelerating from its recent, market-leading ~6% area to high-single-digit/10% range in the next 3 years

o You can certainly get to a higher organic revenue cadence given how scarily big the Intuvo, Ultivo and NASD opportunities can be, but I’ve chosen to haircut some of my assumptions to make numbers more “sane”

o Is 10% unrealistic? No. Just for reference, Agilent printed 10% organic growth in this past quarter (Fiscal Q1 2018) vs. midpoint guidance of 5.25%, with broad-based strength

• Meanwhile it will also experience continued margin expansion given multiple cost initiatives are in the middle innings and new products/growth areas have strong gross margin tailwinds

o My model suggests consolidated adj. EBIT margin can reach ~26% by 2020 from ~21.8% for FY2017

• Capex is fairly high in FY2018 and FY2019 given continued growth capex to build out the NASD facility, but management has stated it’s likely to return to a lower and more normalized maintenance capex range by 2020, resulting in much better FCF conversion (from earning) by 2020.
• I value Agilent on FCF as that takes into consideration of its ~10% cash tax rate vs. 18% book tax rate. Given the accelerating revenues, high incremental margins, and capital allocation levers, Agilent should produce $4.50 of FCF per share by FY2020, 20%+ above Street.  The adj. net income to FCF conversion is around 111%-112%.
• Tools group has recently been trading at roughly ~23-24x NTM P/E and ~24-25x NTM P/FCF (TMO may have an optically low-looking P/E but the “earning” is heavily adjusted and it’s fairly levered, it’s just as expensive as the rest of the sector on FCF metrics).

o The number one driver of multiple is organic growth cadence, and last year’s best-in-class organic grower Mettler-Toledo (put up ~9% organic growth over CY2017) saw its multiple expanding to 33x P/E and 36x unlevered FCF towards the end of last year.

• I’m not saying 33x P/E and 36x FCF are the fair multiples if Agilent’s organic growth truly accelerates into the ~10% range. Frankly, I think tools group should trade at ~20x for mid-cycle (a touch above S&P given more secular growth potential + better earning visibility), lower than the group’s average multiple today. In that environment, a best-in-class grower that can grow organically at 1.5x-2x peers’ pace should be able to commend 25x NTM FCF (25% premium).
• As a result, 25x on $4.50/share 2020E FCF gets to a price target $112.5 by Oct 2019 (fiscal year end) , which represents 67% of upside in 18 months plus ~1% annual dividend. That translates into an astounding IRR for a high-quality business in my opinion.

o If you are able to look out further (another 18 months out), the stock would be a double over ~3 years.

o What if Agilent actually gets MTD’s current 30x multiple? Well, that would be a champagne problem.

• Downside is $61, or < 10% including dividend

o If none of the 3 major product cycle opportunities materializes to a significant extent and Agilent just grows at bare end-market growth rate of ~4.5%, and let’s say NTM FCF multiple de-rates to 17x (way below average group multiple of ~21x over the past 5 years), you get to $61, or down 10%. This is a reasonable-case downside assuming the economy doesn’t fall into full-on recession.

Key Risks

    The most important risk to watch out for is cycle risk – ultimately a decent portion of Agilent’s revenues is made of capex purchases, where the appetite will be tempered in a recession/global slow-down. One can track various PMI and capex investment indices to monitor that risk.

• Currently, these indices/indicators suggest global economy is pretty strong with particular tailwind for Agilent’s Chemical and Energy end-market.
• After almost 2 years of zero-growth, the C&E end-market finally started inflecting from the bottom in early 2017, surprising to the upside

o C&E end-market make-up: 60% chemical/manufactured materials, 30% refining, and 10% tied to energy production

o Agilent is seeing chemical and refining customers are increasing their CapEx purchases + customers in material and mining segments have also started reinvesting after a prolonged period of declining sales

• China is 20% of revenue mix and has structural-reform tailwind to offset cyclicality

o Agilent is capturing China’s 13th Five Year Plan opportunities: its tools/instruments are required for China’s intended healthcare reform (generic drug quality improvement), environmental improvement projects, pollution control implementation, etc

o There is growing appetite for enterprise-wide services (increasing acceptance of fee-based services from formerly inexperienced and growing user base) in China, and there is high utilization rate of instrumentation out of China

o Agilent’s China ops grew +21% in 2016 and +10% in 2017, HSD % is expected for 2018

Catalyst

Beat and raise on organic revenue growth and earning/FCF metrics