Raising Fair Value Estimate After Agilent Boosts Outlook for Fiscal 2021 on Broad Strength
Raising Fair Value Estimate After Agilent Boosts Outlook for Fiscal 2021 on Broad Strength
Senior Equity Analyst
Analyst Note| by Julie UtterbackUpdated Feb 17, 2021
Wide-moat Agilent reported first-quarter results that significantly beat FactSet consensus on the top and bottom lines, suggesting the company is continuing to gain market share and allowing management to boost its outlook for fiscal 2021 after only one quarter of results. We have raised our fair value estimate to $95 per share from $77 after increasing near-term estimates above management's new outlook ($6 of change), recognizing cash flow generated since our last update ($3 of change), and raising our longer-term cash flow projections given Agilent's continued investments in fast-growing end markets, such as its oligonucleotide business ($9 of change).
In the quarter, Agilent's core growth accelerated sequentially to 11% from 6% in the fourth quarter, and its $1.5 billion in sales was above FactSet consensus of $1.4 billion. By end market, only the academic/government business (down 1%) still appeared constrained by the pandemic in the quarter. Its other businesses grew at a fast pace and typically above management's outlook for the full year. The pharma and biotech end market grew 20% (up from 12% in the fourth quarter and above the high-single-digit growth expected for 2021), and the food business grew 22% (up from 16% in the fourth quarter and higher than the mid-single-digit rate expected for 2021). Environmental and forensics grew 10% year over year, up from a 5% decline in the fourth quarter and higher than the low-single-digit growth expected in 2021. Agilent's diagnostic and clinical end markets grew 9% on a core basis, or in line with the high-single-digit view for 2021. Chemical and energy contributed to growth, too, with 2% core growth in the quarter, and management highlighted that easy comparables in this segment could lead to upside versus its previous flat outlook for 2021. With these strong top-line results and cost controls, Agilent grew its bottom line 31% to $1.06 adjusted EPS in the quarter, well above consensus of $0.88.
Business Strategy and Outlook| by Julie UtterbackUpdated Feb 17, 2021
After its spin-out from Hewlett Packard in 1999 and its divestiture of the electronic measurement business (Keysight Technologies) in November 2014, Agilent focuses primarily on providing tools to analyze the structural properties of various chemicals, molecules, and cells. Agilent is one of the leading providers of chromatography and mass spectrometry tools, which have applications in a variety of end markets, including the healthcare, chemical, energy, food, and environmental fields. While healthcare-related applications, including clinical diagnostic tools, remain Agilent’s largest end market, Agilent generates about half of its sales from non-healthcare fields.
The company's strategy revolves around placing analytical instruments and informatics with relevant customers and then providing related services and consumables such as chromatography columns and sample preparation tools, which account for the rest of Agilent's sales. About half of Agilent's sales recur naturally. However, even instrument sales can be relatively sticky at the end of the instrument's life cycle, especially in the highly regulated pharmaceutical end market (about one third of Agilent’s sales) and some of its other applications where intensive, time-consuming training is required to master the scientific analysis. Agilent aims to increase its exposure to these sticky customer relationships.
Overall, we think top-tier positions in most end markets, innovation, marketing operations, and ongoing cost controls should help Agilent grow revenue in the midsingle digits compounded annually and boost margins overall during our five-year forecast period. Overall, we expect double-digit earnings growth from Agilent, organically. While internal growth opportunities look solid, acquisitions and share repurchases continue to boost its bottom-line growth prospects, as well.
Economic Moat| by Julie UtterbackUpdated Feb 17, 2021
We believe a wide moat surrounds Agilent’s analytical instrument business, consisting primarily of chromatography (gas and liquid), mass spectrometry, and other testing tools. Intellectual property and ongoing innovation create an intangible asset moat source while regulatory and reproducibility factors contribute to switching costs for end users. Both moat sources are crucial to Agilent’s ongoing advantages in its target markets, and with these advantages, Agilent enjoys strong returns on invested capital including goodwill of roughly double its capital costs, by our calculations.
Agilent offers differentiated technology that is protected by various intangible assets, including patents, copyrights, and trademarks. This portfolio of intellectual property and its innovation prowess in chosen fields keep competitors from directly copying its technology. Since even slightly differentiated technical features can cause an end user to prefer one tool over another similar tool in Agilent’s precise scientific end markets, we see intangible assets around its differentiated technology as a significant moat source. The differentiated proprieties of Agilent’s tools affect the performance, accuracy, and speed of the various research projects they enable, and differentiated product features create intangible assets that inform decisions to use those tools in specific applications, particularly at the beginning of a project. In order to remain relevant to scientists in early project phases, Agilent must continue to innovate, and that ability to innovate contributes to its intangible assets in this business, as well. Agilent has significant incentive to innovate since new products contribute to positive mix benefits, although it enjoys like-for-like pricing power as well.
After the initial choice of tools based primarily on intangible assets, Agilent benefits from substantial switching costs in most of its end markets. For example, about one third of Agilent’s revenue is generated from the development and manufacturing of biopharmaceuticals, which is an extremely sticky business. In this end market, Agilent’s analytical tools are critical components of the production methods for various drugs, which are specified directly in each molecule’s regulatory approval application. Regulators require the same production method throughout the drug’s lifecycle, and any changes to the manufacturing process, including the quality assurance and quality control tests often performed on Agilent’s tools, would require approval from regulators. Regulatory requirements and reproducibility concerns, including employee training and learning curves, create switching costs for biopharmaceutical customers, which results in a very long potential benefit period for Agilent in this highly regulated market. For branded small molecules, that period can last up to 20 years from discovery until patent expiration. For large molecules (or biologics), that period can last even longer due to the difficult manufacturing process. Also, once a drug’s key patents expire, generic manufacturers often seek to utilize the same production methods that were used by the branded manufacturer to reduce product variability, and that adoption by generic manufacturers can create an even longer benefit period for Agilent on a specific molecule.
We see narrower, but still strong, moats around Agilent’s analytical instruments that are used in other less regulated end markets--including chemical, energy, food, environmental, and other research applications that represent nearly half of Agilent’s sales--and intangible assets and switching costs support Agilent's moat in most of those end markets, as well. Importantly, Agilent leads the market in gas chromatography tools that are often used in its less regulated end markets. Agilent generates more than double the revenue of its closest peer in gas chromatography products, and we believe its differentiated technology, strong reputation, and innovative capabilities create an intangible asset advantage in gas chromatography in particular. Also, Agilent’s gas chromatography instruments have a very long useful life around 10 years, and that long life contributes to the sustainability of its economic profits even outside the highly regulated biopharmaceutical end market. Specifically, while a customer uses these tools, Agilent should generate recurring consumable and service revenue, but we also believe other switching costs persist due to training and workflow productivity concerns for end users in these highly specialized applications. As scientists and technicians travel up the learning curve on new instruments, testing reproducibility and consistency may suffer, so end users probably would need a very significant technology improvement to induce them to switch providers at the end of a tool’s useful life. Overall, we think intangible asset and switching cost advantages associated with its highly specialized analytical instruments create the very stable market shares that Agilent enjoys even in these less-regulated end markets.
Agilent’s diagnostics segment, which represents about 15% of sales, also has advantages with intangible assets associated with its differentiated testing platforms as the primary moat source along with some switching costs. In this division, Agilent’s tools primarily help clinicians diagnose and then develop therapeutic plans for patients with a concentration in oncology indications. Through its 2012 acquisition of Dako, Agilent enjoys a top-tier position in the anatomical pathology market for tissue-based cancer diagnostics, making it a major player with top-tier diagnostic firms Roche and Danaher. The company’s installed instrument base in this business and related consumable sales make this a decent specialty segment where pathologists perform sophisticated and time-consuming tests relative to the broader diagnostics market. However, this end market could come under some pressure in the intermediate term primarily as liquid biopsies emerge that could reduce false-positive rates (and related tissue biopsies) in individual cancer screening indications (like colorectal and breast cancer), which represents a moderate threat for the company. Agilent also operates in the companion diagnostic tool market where it makes consumable tests to help physicians tailor therapeutic options to their patients, and it provides sample preparation tools for the important next generation sequencing market. Overall, we think this division’s solid growth prospects combined with intangible assets and the switching costs associated with its large installed base contribute to Agilent’s sustainable competitive advantages.
From an environmental, social, and governance perspective, Agilent faces limited risks, in our opinion, and is one of the few companies in healthcare that could benefit from ESG-related efforts to exercise quality controls on the products humans ingest, such as food, water, and pharmaceuticals. We think the biggest risk for the firm relates to corporate governance, specifically the potential for ROIC-reducing acquisitions, and Agilent's appetite for acquisitions appears to have increased recently. While such activities are possible, we see this as a hypothetical risk that probably affects more corporations that a shareholder does not fully control. Also, Agilent faces some intellectual property concerns, such as patent disputes and the potential for key employees in this IP-driven organization to leave the firm. Overall, though, these ESG risks do not materially affect our wide-moat view of Agilent.
Fair Value and Profit Drivers| by Julie UtterbackUpdated Feb 17, 2021
We are boosting our fair value estimate on Agilent to $95 per share from $77 to reflect near-term estimates above management's new 2021 outlook ($6 of change), recognizing cash flows generated since our last valuation update ($3 of change), and raising our longer-term cash flow projections given Agilent's continued investments in fast-growing end markets, such as its oligonucleotide business ($9 of change). Our new fair value implies a multiple of approximately 24 times fiscal 2021 expected earnings.
On the top line, we incorporate 6% annualized growth (up from 5% previously) during the next five years, including acquisition activities that add nearly 100 basis points to its organic growth prospects. By end market, we expect Agilent's organic growth to be led by biopharmaceuticals with 8% overall growth expected on strong biologic-related and solid growth in small molecules. We expect low- to mid-single-digit growth rates in Agilent's other applied markets.
On the bottom line, we expect adjusted earnings per share will rise roughly 13% compounded annually during the next five years, or well above sales growth primarily on margin expansion and share repurchase activities. After retreating slightly to 18% in 2019 and 2020, our base case scenario assumes that operating margins will rise to 23% by 2025. We expect cost control efforts to continue with the potential to improve margins primarily through control of the SG&A line. We also expect share repurchase activities to account for about 200 basis points of Agilent's annualized earnings growth prospects. Beyond this timeframe, we have increased our longer-term free cash flow expectations for the firm, as well, to reflect its growing organic growth opportunities such as in the oligonucleotide field.
We discount all of our assumptions at a weighted average cost of capital around 8.5%.
Risk and Uncertainty| by Julie UtterbackUpdated Feb 17, 2021
We give Agilent a medium uncertainty rating thanks to its sticky end markets that should result in relatively steady demand trends, despite its dependence on one-time instrument sales that can be delayed during weak times in the general economy or in specific end markets.
Only about half of Agilent's business is recurring in nature, which means the other half in particular can experience volatility due to macroeconomic conditions and budget constraints. For example, Agilent's chemical and energy end market suffered after oil and gas prices plummeted from 2014-16. In those weak conditions, Agilent's clients delayed capital spending, which cut into Agilent's results in that end market. Fortunately, Agilent's diverse customer base offset most of those pressures, although the firm's overall growth did decelerate before rebounding in recent years along with stronger demand trends from its chemical and energy clients.
Additionally, Agilent remains a technology company that must innovate to remain relevant to end users. If established competitors or new entrants introduce better products or develop stronger relationships with customers, Agilent may lose market share as well as its ability to extract price increases in the future. Those factors could cut into its growth and margins.
Stewardship| by Julie UtterbackUpdated Feb 17, 2021
After using our new methodology framework, Agilent still earns Exemplary marks for capital allocation, in our opinion. This assessment includes its sound balance sheet management, its exceptional investment strategy, and its appropriate shareholder distributions. All in, these practices should help Agilent generate economic profits for the long run and allow minority shareholders to participate in that performance.
On the balance sheet front, we appreciate that Agilent maintains a strong balance sheet with very low leverage, limited debt maturities in the near term, and low debt relative to its overall enterprise value. We do not expect the company's balance sheet to weaken materially in the near future, either, although investors should know that management's acquisition appetite has increased somewhat, which could boost leverage temporarily in the near future. Overall, though, we expect the firm to remain relatively conservative with its balance sheet in the long run, given its historical precedence and some cyclicality in its end markets.
From a strategic investment standpoint, we think the company has invested well, especially from an organic perspective. In fact, Agilent's R&D investments in its core technology platforms and significant investments in its service operations (the CrossLab Group) appear to have allowed it to steal market share from its key peer Waters in recent years, which is a significant feat in the very sticky pharmaceutical/biotechnology end market. Also, the company continues to invest in higher-growth components of the building blocks of innovation in pharmaceuticals and biotechnology, such as its ongoing expansion in oligonucleotides and its cell analysis acquisitions. Future acquisitions could include complementary end markets, including liquid biopsy, in our opinion. Overall, though, unlike some of the more aggressive consolidators in the industry, we appreciate that Agilent selectively uses acquisitions and divestitures, such as its recent BioTek acquisition in cell analysis and the KeySight Technologies spin-off in November 2014, to improve asset productivity and build capabilities in new markets. Although one could argue that valuations paid have been somewhat rich in the highly valued life science/diagnostics industry, management’s selectivity relative to some of its more aggressive peers has helped Agilent consistently deliver attractive returns on invested capital while also maintaining a healthy balance sheet.
Additionally, the company returns value to shareholders through a modest dividend and opportunistic share repurchase program, and we generally view these activities as appropriate given the potential cyclicality in some of its end markets. However, if Agilent aggressively repurchases shares at recent prices under its new $2.0 billion share repurchase program, those share repurchases could be value-dilutive if made above fair value.