Agilent Turns in Phenomenal End to 2022, Guides to Continued Strength in 2023; Raisin
Agilent Turns in Phenomenal End to 2022, Guides to Continued Strength in 2023; Raising FVE to $127
Senior Equity Analyst
Analyst Note| by Julie UtterbackUpdated Nov 21, 2022
Wide-moat Agilent released strong fourth-quarter results that helped it exceed our expectations for fiscal 2022. Management also delivered 2023 guidance above our prior expectations. Considering those strong trends ($5 of increase) and recently generated cash flows ($7), we are raising our fair value estimate to $127 per share from $115 previously.
In the quarter, sales growth accelerated to 17% on a core basis (adjusted for currency changes and acquisitions/divestitures), up from 13% in the third quarter, on broad-based strength. Agilent's largest segment, pharma and biotech, grew 20%, as the biotech division (18% growth) grew at a rapid pace only to be surprisingly eclipsed by the small-molecule business (21%) for the first time in recent memory. Also, the chemical and advanced materials division grew 27%, which was helped by robust commodity prices which allowed its customers to invest in Agilent's tools. Agilent also delivered strong growth in food (20%) and environmental and forensics (18%). Even its weakest divisions still grew in the mid-single digits on a core basis, which is what we would view as normal for Agilent's medical diagnostics and research markets. Geographically, China stood out with 44% growth, more than making up for recent COVID-19 lockdowns. With this strong growth, supply chain pressures could not constrain Agilent from a margin perspective, and adjusted EPS handily beat our expectations for 2022.
Looking to fiscal 2023, Agilent's overall revenue outlook appears to include currency challenges, but the company still expects 5%-6% core revenue growth, reflecting its solid backlog of new business. Also, management's call for margin expansion in 2023 was somewhat surprising given the macroeconomic challenges mounting, but with strong recent instrument placements likely to generate higher-margin consumable and service sales, we suspect it can even beat management's (typically conservative) 7%-9% adjusted 2023 EPS growth target.
Business Strategy and Outlook| by Julie UtterbackUpdated Nov 21, 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, 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 (over 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 high-single-digit earnings growth from Agilent, organically and with some share repurchases. While internal growth opportunities look solid, acquisitions could add to its bottom-line growth prospects, as well.
Economic Moat| by Julie UtterbackUpdated Nov 21, 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, over 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, advanced materials, 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 durability 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 remaining diagnostics business 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 that would not affect our wide moat view of the firm. Also, it 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.
Fair Value and Profit Drivers| by Julie UtterbackUpdated Nov 21, 2022
We are raising our fair value estimate to $127 per share from $115 to account for strong recent growth trends and cash flows generated in the past couple quarters. Our fair value implies a multiple of approximately 22 times fiscal 2023 expected earnings.
After strong growth during the pandemic years, we expect Agilent's growth trajectory to return to more normalized levels in 2023 and beyond. Specifically from fiscal 2022 to 2026, we expect mid-single-digit compound annual revenue growth, or within management's 5% to 7% core revenue growth target. By end market, we expect Agilent's growth to be led by pharma and biotech on strong biologic-related sales and solid growth in small molecules. Also, we expect solid low- to mid-single-digit growth rates in Agilent's other applied markets.
On the bottom line, we expect adjusted EPS will rise roughly 9% compounded annually from fiscal 2022 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 UtterbackUpdated Nov 21, 2022
We give Agilent a Medium Morningstar 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 a bit over 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 advanced materials 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 affected 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 UtterbackUpdated Nov 21, 2022
Agilent earns an Exemplary capital allocation rating from us. 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 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 its strong organic growth prospects and the potential cyclicality in some of its end markets.