| 2006 | 2007 | ||||||
| Price: | 30.44 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 12,400 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
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SUMMARY
Agilent (A) is a leading international player in the electronic measurement and bioanalytic testing markets. The company’s business model and dominant market positioning will enable it to generate strong Free Cash Flow (FCF) of $740 million in FY 07 and $1B+ in FY08 and ROIC (25%) along with reasonable top line growth (high single digits). Management has taken significant restructuring actions which have resulted in a more focused test and measurement company run with a strict EVA approach. Over the next couple years, I believe that management will continue to increase margins on both the Electronic Measurement and Bio-Analytical segments. With the stock trading at 10x FCF for Fiscal Year 2008 (yr end October 2008) and at a significant discount to its peers, I view Agilent as an excellent risk/reward proposition with approximately 30%-45% upside over the next 12 months.
INVESTMENT THESIS
COMPANY DESCRIPTION
A, which was spun out of Hewlett Packard in 1999, provides bio-analytical and electronic measurement solutions to the communications, electronics, life sciences, and chemical analysis industries. In fact, its test and measurement business is the original business started by technology pioneers William Hewlett and David Packard in 1939. Their first product, developed in Packard’s garage, was an audio oscillator for testing sound equipment.
Today, A operates in two primary segments: Electronic Measurement (EM) and Bio-Analytical Measurement. Its Semiconductor Test Solutions business, Verigy (ticker: VRGY), was recently carved out of the company in a public offering and will be spun-off in the fall.
A’s major subsegments on the EM side are general purpose (37% of total revenue), wireless (11%), wireline (6%), and operations support systems (
The Bio-Analytical Measurement segment provides application-focused solutions that include instruments, software, consumables, and services that enable customers to identify, quantify, and analyze the physical and biological properties of substances and products. It offers microarrays, microfluidics, gas chromatography, liquid chromatography, mass spectrometry, software and informatics, and related consumables, reagents, and services. The segment serves life sciences markets and chemical analysis markets. Agilent is particularly strong in gas and liquid chromatography, and has an emerging position in mass spectrometry. Major competitors include Waters (WAT) on the chromatography industry and Applied Biosystems (ABI) and Thermo Electron (TMO) on the mass spectrometry industry. On the chromatography side, Waters is the market leader in life science customers (large pharmaceuticals), while Agilent has a strong position in chemical analysis (petrochemical, environmental, food safety, and forensics).
The Semiconductor Test Solutions segment, now known as Verigy (VRGY), provides semiconductor test equipment for systems-on-a-chip, systems-in-a-package, and memory semiconductor devices. It serves semiconductor manufacturing markets. The company sells its products through direct sales, distributors, resellers, manufacturer’s representatives, telesales, and electronic commerce. Verigy went public on 6/13/06, raising $128 million in gross proceeds on 8.5 million primary shares at $15r/sh (slightly below the $16-18 original range). A’s Verigy stake is valued at $752M (15.34 stock price x 58.7M sh x 83.6% stake). At expects to spin off its remaining stake to shareholders by the end of October 2006.
INVESTMENT HIGHLIGHTS
A is worth between $40 and $44 per share, representing a 30%-45% upside to its current price. I calculate this value based on a dcf, comparable company analysis using a sum-of-the-parts approach, and by applying a reasonable multiple of expected FCF in F08. Please see figure 1 of the excel file at the following link http://www.geocities.com/grady181818/agilentfigures.xls .
DCF Valuation-- I use a 10% discount rate and a 7.5x terminal value multiple of EBITDA (based on a 2015 estimate). The dcf calculation results in a fair value of $44.
FCF Multiple Valuation--Agilent will generate $737 million of Free Cash Flow (FCF) in F07 and $1.06B in F08 (october 2008). A high quality business like Agilent should trade at a free cash multiple of 14x-17x. Applying the low end of this multiple range to Agilent’s F08 FCF would result in a fair value of approximately $43.
Sum of the Parts/ Comparable Company Valuation --A sum-of-parts comparison using comparable company valuations for each of the two segments (see comp section below) is a good barometer of value. See figure 2 at the link http://www.geocities.com/grady181818/agilentfigures.xls for the assumptions I made in breaking out the operating results for the two segments of the business.
Based on P/E CY07 (ex-cash), A should trade at approximately $41. This assumes a P/E multiple of 14x for the EM side and 19x for the Bio-Analytical side based on their comparables. See table 3 at the link .
Based on 2007 Ebit multiples, A should trade at a little less than $40. This assumes a 11x EV/EBIT multiple for the EM side and 15x multiple for the Bio-Analytical side, based on comparable companies. See figure 3 at the link http://www.geocities.com/grady181818/agilentfigures.xls.
Company has executed on its restructuring plan to emerge as a pure-play in test and measurement. Since 2005, A has been busy restructuring the company into a simpler entity. The following are the key actions recently taken by the company:
2) In 6/2006, spun off its semiconductor test business, Verigy (VRGY), as an independent company. Verigy went public on 6/13/06, raising $128 million in gross proceeds on 8.5 million primary shares at $15r/sh (slightly below the $16-18 original range).
3) Sold interest in 50/50 of its LumiLeds JV to partner Philips for $1 billion.
4) In 9/2005, retired $1 billion convertible debt.
5) Launched and concluded a $4.5 billion share repurchase program, representing about 25% of its market cap (completed in 6/2006).
Core Electronic Test and Bio-Analytical segments generate significant FCF and high returns on invested capital. A is now focused on the Electronic Measurement and Bio-Analytical segments, which both generate significant free cash flows. As the company has shed less its less attractive businesses, returns on invested capital have been increasing into the mid 20% range (see table below) and the company’s free cash flow generation will continue to improve.
Margin expansion opportunity. Table 4 at the link http://www.geocities.com/grady181818/agilentfigures.xls summarizes the gross margin (GM) and operating margin (
On the GM side, much of the increases have come from recent cost improvement efforts. Additionally, A is outsourcing more of its production, and moving manufacturing operations to
One of the main takeaways after visiting competitors on the life sciences side is that there will be solid industry growth which will provide plenty of operating leverage to expand margins. For example, Thermo Electron has a stated goal of 150bp
Dominant player in Electronic Measurement market. Agilent is the #1 supplier of electronic test and measurement products, including data generators, millimeters, and oscilloscopes. It is 3x larger in terms of revenue than its nearest competitor. Agilent’s major subsegments on the EM side are general purpose (37% of total revenue), wireless (11%), wireline (6%), and operations support systems (
Bio-Analytical segment offers interesting growth opportunities. A is a solid player in the Bio-Analytical market, which the company sees as a $20 billion market. The company further segments its addressable markets into Life Sciences ($14 billion market) and Chemical Analysis ($6 billion market), both of which are growing at a healthy long-term rate. The Life Sciences subsegment includes instruments for integrated biology, such as disease and drug, genomics, proteomics, metabolomics, and diagnostics, as well as pharmaceutical analysis, for things like drug discovery, drug development, and drug manufacturing. The Chemical Analysis subsegment includes end markets like petrochemical, environmental, food safety, and forensics. Overall, the Bio-Analytical end market probably has a high single digit medium to longer term CAGR (~7-9%) driven by regulations in environmental and food testing; solid GDP growth in emerging markets like China, India, and Eastern Europe; increasing demand for automation and informatics; and more aftermarket and replacement business. New products include its LC 1200 and 6000 series in chromatography and its expansion into mass spectrometry. In addition, the current market overall is very fragmented in life sciences, with ample opportunities for bolt-on acquisitions. Accordingly the Bio-Analytical market presents attractive growth opportunities, both internally and through selective acquisitions. M&A could add an additional 2-3 percentage points of annual growth.
Company trades at a significant discount to its competitors. The main competitor to A on the EM side is Tektronics (TEK). Tektronics competes with Agilent in wireless test, wireline, (signal sources & spectrum analyzers), and general purpose (scopes, logic analyzers, etc.). The general view seems to be that Tektronics is a more aggressive company and has done a good job executing particularly in general purpose instruments. On almost any metric TEK trades at much higher multiples. In addition, other comps include National Instruments (NATI), Lecroy (LCRY), Aeroflex (ARXX), EXFO (EXFO), IXIA (XXIA), and Keithley (KEI). They all trade at higher multiples than A. For detail table 5 in the link .
On the Bio-Analytical side, three competitors include Thermo Electron (TMO), Applied Biosystems (ABI), and Waters (WAT). Thermo competes with A in Chemical Analysis and Integrated Biology, whereas Waters and Applied Biosystems compete more on the Integrated Biology side. Again, on almost any metric, A trades at a pretty big discount. However, it is fair to note that Agilent’s Bio-Analytical revenue is only 30-35% of the revenue mix going forward. One of the keys for Agilent will be to increase the overall impact of Bio-Analytical revenues and operating profits. This will be done both organically and via acquisitions. Other comps include Varian (VARI), Affymetrix (AFFY), and Illumina (ILMN). For detail see table 5 in the link http://www.geocities.com/grady181818/agilentfigures.xls.
Strong management team with a focus on ROIC. A management, which includes CEO Bill Sullivan and CFO Adrian Dillon, run the businesses with a disciplined EVA approach. The company targets ROIC of 20%+, and rewards its employees when it reaches that target on a quarterly basis. The company has done a very good job increasing ROIC in the core businesses (see table below). In addition, the company sees further room for increases in ROIC as the up-cycle continues. ROIC has increase from 18.3% in the 1st quarter of 2005 to 24.7% in the recent 3rd quarter of 2006. See figure 6 in link http://www.geocities.com/grady181818/agilentfigures.xls for more detail.
Clean balance sheet and ample cash flow generation capability should translate into additional stock buybacks. As of 7/31/06, A’s cash and equivalents was $3.9 billion and debt was $1.5 billion. Agilent will generate annually $700 million in 2007 increasing to 1 billion of free cash flow in each of the following few years. As a result, A has to decide on how to best deploy that cash. The company has stated that its priorities are 1) Reinvest in the business; 2) Add “fold-in” acquisitions that reinforce and potentially extend / 20% ROIC hurdle; 3) Offset dilution from option exercises; and 4) Return capital to shareholders via share repurchases and/or dividends. While I expect a combination of all of the above, the company will be very aggressive in buying back stock over the next year or two.
BALANCE SHEET & CASH CONVERSION CYCLE
As of 7/31/06, A’s cash and equivalents was $3.9 billion and debt was $1.5 billion. A’s cash conversion cycle (CCC) is summarized below. The co has done a good job improving DSOs (from 71d in 2002 to 59d LTM) and DOIs (from 136d in 2002 to 115d LTM). Overall, Agilent’s CCC has decreased from 160d in 2002 to 115d LTM. See figure 7 in link http://www.geocities.com/grady181818/agilentfigures.xls for more detail.
SOME OPERATING ASSUMPTIONS
Revenue
Overall, I have modeled total core A (just EM and Bio-A) to grow revenue 6% in F06 and 10% in F07.
I have modeled EM revenue growth increasing 4% in F06 and 10% in F07. On the EM side, A has 3x sales of its nearest competitor, Tektronix. The company has a dominant share in the wireless handset test market, with 80% market share. The main end markets are Communications (45% of sales within segment), Aero/Defense (20%) and Electronics (35%). The increased growth in F07 is driven by strong growth in Asia R&D, new product introductions and sector growth. Two key initiatives for growth on communications side is R&D for 3G and increased government spending on specialized infrastructure.
I have modeled higher growth for Agilent’s Bio-Analytical segment – 10% in F06 and 11% in F07. The overall industry is probably growing high single digits, and I expect Agilent to grow faster in part due to its strong new product ramp, which should benefit Agilent more in F07.
Operating Margins
From an operating margin perspective, as mentioned above, this is a margin expansion story. I have modeled overall operating margin of 14.8% in F06 increasing to 17.0% in F07. On the EM side, I have margins increasing to 14.1% in F06 to 16.5% in F07. I also forecast expansion on the Bio-Analytical side, from 18.2% in F06 to 20.0% in F07. The increases are due to new product introductions (which carry higher margins than existing products) and cost saving initiatives as well as operating leverage.
Taxes
A has an NOL which is valued at $629M or approximately $1.5/share. See fig 8 at the link http://www.geocities.com/grady181818/agilentfigures.xls for detail on the NOL.
D&A / Capex
D&A will be ~$150 in FY07 and FY08. The company expects FY07 capex to be $125 million, down significantly from FY06.
FCF
FCF is defined as cash flow from operations (assuming zero working capital changes) less capex. FCF increases from $737 million in F07 and $1.1 billion in F08 due to the increase in revenues, the decrease in capex from the prior year and margin improvement.
EV Calculation
The table below summarizes A’s enterprise value (EV) calculation. One thing to keep in mind is that A results will continue to report VRGY’s results until the rest of the shares are distributed, which the company has stated will most likely be completed by October 2006 (its fiscal year end). See figure 9 http://www.geocities.com/grady181818/agilentfigures.xls for the EV calculation.
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