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Msg  33 of 39  at  5/27/2022 1:41:01 AM  by


Agilent Turns in Solid Fiscal Q2 Despite China Lockdown; Shares Still Mildly Rich

Agilent Turns in Solid Fiscal Q2 Despite China Lockdown; Shares Still Mildly Rich 
Julie Utterback
Senior Equity Analyst
Analyst Note | by Julie Utterback Updated May 25, 2022

Wide-moat Agilent released solid second-quarter results, and management slightly increased its fiscal 2022 bottom-line outlook. We are raising our fair value estimate to $115 per share from $107 primarily to account for cash flows generated in the past couple quarters and slightly higher 2022 profit expectations.

In the quarter, sales grew 7% year over year on a core basis (adjusted for currency rate changes and acquisitions/divestitures). Notably, the Chinese lockdowns created a 350-basis-point headwind in the quarter, as Agilent's Chinese operations were down from late March through the entire month of April. With strong underlying demand and orders in China, though, management suspects those sales were not lost and should be realized in calendar 2022. Management highlighted that its Chinese operations resumed on a limited basis in May, so it should regain some momentum soon. However, we are interested to see if these lockdowns were the reason that Agilent underperformed its key peer, Waters, in the biopharmaceutical end market by delivering 13% year-over-year growth versus 19% at Waters' comparable segment in the first quarter. The comparable period is not on an apples-to-apples basis since Waters' quarter did not include the heavily impacted month of April. Other factors could be at play, though, since Waters' results have been rejuvenated by a late 2020 management transition, and it could be stealing some market share from peers like Agilent.

More positively, Agilent's 2022 margin profile looks stronger than we were anticipating, and in the quarter, Agilent's adjusted EPS grew 16% year over year. While we suspect that margins may face more headwinds as we move from a pandemic to an endemic situation, we have increased our 2022 margin assumptions due to recent trends. That increase in 2022 margins raises our fair value estimate by about $2; the rest of that increase ($6) was based on cash flows generated since we last changed our fair value estimate.

Business Strategy and Outlook | by Julie Utterback Updated May 25, 2022

After its spin-out from Hewlett Packard in 1999 and its divestiture of the electronic measurement business (Keysight Technologies) in November 2014, Agilent focuses 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 diagnostics, remain Agilent’s largest end market, Agilent generates about half of its sales from nonhealthcare fields.

Agilent'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 35% 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 and with some share repurchases. While internal growth opportunities look solid, acquisitions should continue to boost its bottom-line growth prospects, as well.

Economic Moat | by Julie Utterback Updated May 25, 2022

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 more than 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 35% 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 a 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 maintainability 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 maintainable 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 most 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 Utterback Updated May 25, 2022

We are raising our fair value estimate to $115 per share from $107 to account primarily for cash flows generated in the past couple quarters and slightly higher profit expectations for 2022. Our fair value implies a multiple of approximately 23 times fiscal 2022 expected earnings.

After strong growth in the high teens on the top line and over 30% on the bottom line in fiscal 2021, we expect Agilent's growth trajectory to return to more normalized levels. Specifically from fiscal 2021 to 2026, we expect 6% compound annual revenue growth, or within management's 5% to 7% core revenue growth target. By end market from fiscal 2021 to 2026, we expect Agilent's growth to be led by biopharmaceuticals with 9% overall growth expected on strong biologic-related sales 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 EPS will rise roughly 11% compounded annually from fiscal 2021 to 2026, or well above sales growth primarily on margin expansion and share repurchases. We expect cost-control efforts to continue with the potential to improve margins primarily through expanding gross margins and 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 through 2026.

Risk and Uncertainty | by Julie Utterback Updated May 25, 2022

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.

Capital Allocation | by Julie Utterback Updated May 25, 2022

Agilent earns an Exemplary capital allocation rating. 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. Overall, though, we expect the firm to remain relatively conservative with its balance sheet in the long run, given 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 (NASD) and its cell analysis acquisitions. We appreciate its focus on liquid biopsy technology (primarily therapy selection), too, through internal and external means, which should help offset some of this risks associated with its tissue biopsy business, as new liquid biopsy (early cancer detection) entrants emerge. 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 spinoff 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.


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