Agilent Technologies - Attractive Business Model, Fairly Valued

Agilent Technologies is a good business protected by a strong moat with ample room to grow. Bill Ackman and Pershing Square initiated a position in Agilent late last year around the current share price, so I decided to take a more in-depth look to assess the potential.

After a quick industry overview I will do a deeper dive into the structural advantages of the business and discuss prospective returns

Source: Q3 2019 Institutional Investor Meeting

Industry

Agilent competes in the analytical measurement space and provides instrumentation, consumables, and services to testing labs across the world. The company operates in three reportable segments: Life Sciences and Applied Markets, Diagnostics and Genomics, and CrossLab. Each of these segments serve the attractive and growing end markets shown to the right.

Agilent essentially supplies instrumentation such as chromatography machines, mass spectrometers, and cellular analysis devices along with the associated software and consumables (like test vials and reagents). The equipment is used to perform tests such as cancer and DNA diagnostics, chemical properties of drugs and food, and environmental contamination.

Source: Q3 20129 Institutional Investor Meeting

The nature of the industries served and services provided lead to an attractive business model and a number of structural advantages.

Competitive Position

Agilent checks several boxes that I look for when identifying businesses with enduring competitive advantages that lead to attractive economics. Specifically, the company operates in an oligopoly and enjoys high switching costs across a vast client base.

Oligopoly

Agilent operates in an oligopolistic space and occupies the #1 or #2 spot in each of its end markets. Per the company’s estimates they control approximately 20% of their market, with the top 5 players accounting for 75% of the market share. One does not need to do a deep dive on all of their products to understand they are highly technical and require significant precision. Agilent spent $400M on research and development, or almost 8% of revenue, last year alone to maintain and advance its technologies and IP. Additionally, the end markets – pharma, food, academia, environmental services, energy, etc. – are all highly regulated. The combination of the required investment in R&D and regulatory hurdles create fairly strong barriers to entry. This results in the largest players controlling the market and insulating themselves from new entrants. This is especially desirable given the end-markets growth prospects where value should accrue to these top players for years to come.

Switching Costs

Whether a bank holding customer deposits or an analytical testing company performing DNA analysis, a sticky customer base is one of the most important aspects of any business. Agilent enjoys significant customer switching costs because of the ongoing relationship post-instrument sale with customers as well as the aforementioned quality and regulatory requirements of its devices.

For example, once the company lands the sale of a chromatography instrument to a lab, the relationship with the customer is just beginning. Every time the device runs a test it requires reagents, analytical columns, and other consumable items. The test results need to be analyzed and stored with a high-degree of traceability through customized lab software. Also, the machines need periodic service and replacement parts. All of these regularly occurring activities are serviced and supplied by Agilent’s CrossLab segment. So long as these products and services are reasonably priced, customers are much more likely to go with the original manufacturer who they already have a working relationship with than outsource the recurring revenue to a third party forcing them to deal with more vendors.

Additionally, the cost of receiving an inaccurate result for any of Agilent’s customers is high. Imagine the impact to a lab by giving a doctor an incorrect cancer diagnostic result. Or if a pharmaceutical manufacturer received an inaccurate result related to an Active Pharmaceutical Ingredient. The customers in these markets can’t afford to receive inaccurate test results, so once they have a relationship with a business that: a) provides reliable test results and b) the scientists using the equipment are comfortable with, they are unlikely to make a change as the risks outweigh potential cost benefits. This dynamic further reinforces the oligopolistic nature of the industry, as labs are incentivized to go with the big “known entities” instead of a start-up equipment provider.

Agilent has put intense focus on maximizing benefit from these high switching costs in recent years to drive a higher mix of recurring revenue and reduce the cyclicality of the company’s earnings. Roughly 60% of the company’s revenue is recurring in nature, comprised of services and consumables, up from around 40% in 2008, a trend management intends on continuing. Ackman has described investing in the business as almost like owning a fast growing annuity, which makes sense with this favorable mix of recurring revenue.

I’d classify the regulatory and technological hurdles that result in an oligopolistic industry with high switching costs as a fairly solid moat protecting the economics of the business. The company may not swim in the deep end of a two-sided network effects moat like an Amazon or Facebook, but at the very least their core business appears to be well protected from significant disruption from new entrants. This should allow the company to benefit from the growth prospects of the markets it serves.

Growth and Intrinsic Value Compounding

As noted above, all of Agilent’s core markets are growing at a reasonable clip, and between 3-5% in aggregate. As the company outlines when discussing their transformation plan, they intend to outgrow the market modestly by pushing resources into faster growing areas such as China and the BioPharma space. They’ve achieved this goal thus far, compounding revenue at 6% annually since 2015.

Consistent with recent years, Agilent was expecting a mid-single digit increase in revenue in FY20 (5-6% growth with 40 bps FX headwind) pre-COVID19. Revenue growth is split relatively evenly between core business and M&A as the company has been a consistent acquirer of businesses in adjacent spaces. While acquisitions pose a risk, which I’ll discuss more later, the results have been solid under the current management team with M&A revenue growing double-digits and comprising just under 10% of revenue, highlighted below.

Going into a little more detail, the company breaks out revenue segments growing faster than the core. I won’t pretend to be an expert in the technical aspects of each market, but the takeaway for me is that the leadership team is clearly focused on continuing to grow and has delivered on this target since taking the helm in 2015. All told it seems reasonable to expect mid-single-digit revenue growth to persist for the foreseeable future.

Turning to earnings growth – ultimately the intrinsic value of the business will grow in line with the capital that can be invested into the business and the incremental returns that are earned on that capital. I think it’s important, and perhaps not enough attention has been paid, to look at what returns Agilent has produced in its current form after the spinoff of KeySight Technologies in late 2014. Looking back further obscures the value of the core business and doesn’t paint an accurate picture of the future. This also coincides with when the current leadership team has been at the helm. Below, using results from 2015 – 2019, I break out invested capital, incremental returns on invested capital (I-ROIC), impact of improved margins, and buyback yield to provide an estimate of per share earnings growth over the next several years.

Source: Pershing Square February Investor Presentation

When Pershing Square built a position part of the thesis was that Agilent could continue closing the margin gap with its closest peer, Waters Corporation. Waters earns around 58-60% gross margins compared to Agilent’s 54-55%. Further, Waters appears more efficient on the SG&A front, resulting in around 30% operating margins compared to Agilent’s 20% operating margins on twice the revenue base. The gap has closed in recent years, with operating margins expanding nearly 500 bps since 2015, but there is clearly room for that to continue. According to their February presentation, Ackman thinks Agilent could further expand margins 800 bps if they achieve a best in class operation. Product mix and moderately differing R&D spend muddy the water a bit, but when comparing to peers and with managements 50-70 annual bps margin expansion target, I can get on board with another 300 bps – 500 bps expansion or so of operating margin expansion over the next ~5 years. This could add somewhere between 2-5% annual growth to intrinsic value and shouldn’t be ignored.

Pulling all of this together, here is how I see per share intrinsic value growth shaking out over the next 5 or so years.

Source: Author’s analysis from company filings

A quick note when deriving the I-ROIC I use a normalized operating cash flow margin so as to not conflate returns on capital with improvements in efficiency. Reported operating cash flow since 2015 has actually increased by about $500M because of the margin expansion, and my estimate of I-ROIC likely is a bit conservative. This is also why I highlight future benefit from margin expansion separately.

If you can get comfortable with the future looking reasonably close to the past, I think you can expect 10%+ per share intrinsic value compounding over the next several years. Given the barriers to entry discussed earlier, the company’s end markets, and the management team’s commentary on growth opportunities, it seems quite likely the company can actually deliver higher annual returns.

One final note on fundamentals – despite the M&A activity the company maintains a solid balance sheet with net debt to LTM EBITDA less than 1x, compared to 3x of competitors. Liquidity should not be a concern and Ackman points out there is further upside to equity holders by levering up the balance sheet in-line with peers. This is sensible given the predictable cash flow profile of the business.

Ackman thinks the company can do mid-to-high teens annual eps growth. If they hit his targeted margin expansion and benefit from lower taxes as he projects, I think it’s certainly plausible, though I wouldn’t bank my investment on it.

Valuation and Expected Returns

Below are current valuation multiples against historical median multiple since 2015 for Agilent and industry peers. I also compare earnings per share annual growth rates over the same time period. Obviously this is a good industry with generally respectable returns on capital which results in premium valuations. It does appear that Agilent has higher growth prospects and can reinvest more of its earnings than its peers. This should result in faster growth than competitors as has also been the case over the past several years.

Source: Author’s analysis and ValueLine Review

At the end of the day the question investors need to answer is: what would they be willing to pay to acquire a business that:

- Operates as a top player in an oligopolistic industry

- Enjoys high customer switching costs

- Can reinvest ~50% of earnings into fast-growing end markets (and should itself outgrow the industry) at decent incremental returns

- Is free cash flow generative without significant maintenance capex requirements

- Has a 60% and growing recurring revenue base

- Should grow per share earnings above 10% for the foreseeable future

- Has meaningful margin-expansion upside and an under-levered balance sheet

To me, if I can buy a business with those characteristics for anywhere near the market average or even a slight premium, I would be thrilled. As laid out below, anywhere in the mid-$60s is a great entry into this business in my opinion. Assuming a purchase price of $65, about 13% lower than current prices, and an exit multiple of 21.5x - lower than the 5-year average and matching the lowest average valuation for the stock since 2015 – I think investors can pencil in solid 14%+ annual returns. Add in upside from further margin expansion execution (and with it a likely higher valuation multiple) and/or balance sheet leverage and returns should easily approach 20% annually. Below I compare prospective returns from the current market price of ~$78 per share vs. where I would be more comfortable entering at $65.

Normally assuming a 21.5x exit multiple would be a stretch for me, but I think given the high quality nature of this business combined with the long-term secular industry tailwinds, not to mention a near zero interest rate environment, I actually think this will prove conservative. If the market values the business in-line with the last 5 years (~24x) that’ll add another couple percentage points to annual returns.

Risks

The biggest risks I see to earning the returns outlined above are capital allocation mistakes, a prolonged slowdown in Agilent’s core industry spending, and, to a lesser extent, new entrants taking market share.

Capital Allocation

Agilent’s growth is partially reliant on finding acquisitions in target markets at acceptable valuations. Consistently finding these opportunities for the right price is certainly no guarantee. The outcome of the M&A activity is also reliant on management accurately assessing the prospects of the businesses and successfully integrating them. That said, so far the current management team appears to have done well by shareholders on this front. Recent acquisitions have contributed above-average growth for the business. Operating margins, including acquisitions costs, have marched steadily higher, implying acquisitions have not been a drag on margins. As an aside, the company adds back acquisition related expense to adjusted operating income, which I am not crazy about as these are real costs most years.

If the company fails to identify attractive acquisition targets for a period of time, presumably they could dedicate more of their free cash flow to shareholder returns, which could approach 3-4% of the current market cap if no acquisitions are undertaken and the focus shifts to enhanced buybacks and dividends. Couple that with 3-4% core growth and some margin expansion and the investment is still far from a disaster, although not nearly as attractive as my base case.

The more dangerous scenario would involve value-destructive acquisitions that actually impair the earnings power of the business. I’m not sure how to quantify this possibility, but it definitely exists. It’s somewhat comforting that Ackman is involved, albeit passively as far as I can tell, as he would certainly begin to attempt to enact change if capital allocation goes awry. I lean towards giving the current management team the benefit of the doubt given they’ve proved capable so far, though others may see it differently.

Capital Spending Slowdown

Agilent recently withdrew 2020 guidance amidst the COVID-19 lockdowns and will undoubtedly feel some impact this year. It’s tough to predict the exact impact from the closure of some university testing labs and general slowdown in global economic activity on this year’s results, but as long as investors have a multiple-year time frame it seems unlikely that testing requirements and volumes in the company’s core industries feel any lasting negative impact.

New Competition

Breakthroughs in testing technology, new market entrants, and losing market share to existing competitors are other considerations for Agilent. As discussed above, because of the nature of the industries Agilent serves, I find it unlikely that the current order is disturbed meaningfully. It’s also not as if Agilent is reliant on one niche testing method or instrument for the bulk of revenue and profits. They serve tens of thousands of customers across dozens of testing methods, so the risk that a meaningful percentage of these are disrupted does not greatly concern me. Finally, Agilent spends hundreds of millions of dollars each year in R&D to stay on the cutting edge of analytical methods, further minimizing the risk of missing out on new technology.

Summary

Agilent is a solid business with a defensible market position in desirable industries protected by technological and regulatory hurdles. They provide mission-critical testing services to a variety of customers that have little incentive to switch to competitors. Their defensive business model has evolved to provide an increasing mix of high-margin recurring revenue with room to reinvest capital at decent rates of return for the foreseeable future.

Even at the current premium valuation, investors should do reasonably well over the long-term, though I would wait for higher prospective returns and would consider building a position around $65 per share.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.

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