I was skeptical about Agilent's (NYSE:A) prospects for outperforming its peers back in the summer of 2015, but since then, Agilent shares have comfortably outperformed peers like Waters (WAT), Thermo Fisher (TMO), PerkinElmer (PKI), Bruker (BRKR), and Shimadzu with a 30% run that has also handily beaten the S&P 500. Management has done a better job than I'd expected of improving margins and streamlining/refocusing the business, and Agilent has also done better than I'd expected in the pharma space on the back of a strong liquid chromatography product cycle.
At the risk of sounding like a broken clock, the valuation on the shares still concerns me. The new (and improved) Agilent has been generating FCF margins in the mid-teens and while I think management can deliver upside on operating margins and asset efficiency, I'm not sure that meaningfully exceeding 20% FCF margins is highly likely. So while I do think Agilent is a good company in the life sciences tools space (and performing well), it's hard for me to get comfortable with a valuation that already assumes double-digit long-term annualized free cash flow and/or a forward EV/EBITDA multiple more than twice the likely growth rate over the next three to five years.
A Strong Player With A Somewhat Different Mix
Agilent remains a strong, diversified player across the life sciences tools market, with strong positions in mass spec, liquid and gas chromatography, and spectroscopy, as well as a diagnostics and genomics business that appears well-placed for where those markets are growing. What's more, Agilent is quite well-diversified in terms of its revenue base (with a 45% mix of instruments and a 55% mix of consumables and services), geography, and end markets.
Agilent is a top-three player in mass spec. While its mid-teens market share is behind the 20%-plus share of Thermo and Danaher (DHR), it is ahead of Waters and comfortably ahead of Bruker and Shimadzu. Agilent has a stronger position in higher-growth niches like Q-TOF, Triple Quad, and ICP-MS, while Thermo and Bruker have strong positions in other high-growth segments like Orbitrap and MALDI-TOF. Waters and Thermo are likewise comfortably placed in higher growth segments like Q-TOF and Triple Quad.
Agilent also stands out in the chromatography field, where it is a leader overall and a leader in both liquid and gas chromatography. Waters is relatively close on the company's heels in LC (a roughly $3 billion to $4 billion market) and Thermo isn't too far behind, but Agilent dominates the $1.5 billion to $2.0 billion GC market with around 40% to 50% share (well ahead of Shimadzu). Agilent has also been successful at combining its product expertise, giving it strong positions in GC-mass spec (where it is number one) and LC-mass spec (where it is #1 in industrial markets).
On the diagnostics/genomics side, Agilent has a growing presence in next-gen cancer diagnostics (part of its pathology segment), including a test that determines the level of a patient's PD-L1 expression (which can be a gating factor for getting new drugs like Keytruda or Opdivo). The genomics segment includes the company's competitive front-end sample prep business (used before sequencing) and its end-to-end microarray business. Agilent also has a small but growing nucleic acid solutions business - a business that manufactures oligonucleotides as active pharmaceutical ingredients.
Agilent also generates meaningful revenue from its CrossLab (orACG) business. This business provides various lab/tool consumables (like chromatography columns and sample prep supplies), as well as equipment service and lab enterprise management tools. This business is increasingly "platform agnostic" (Agilent will service non-Agilent tools) and while it competes with Thermo and PerkinElmer, those companies haven't devoted as much attention to the "lab management" side of the equation.
One of the areas where Agilent stands out is in its revenue mixes. Agilent has above-average exposure to "industrial" markets like chemical companies, refiners, oil/gas companies, and food, with these markets contributing approximately one-third of the company's revenue. Another 15% or so comes from environmental testing and forensics (which some, but not all, analysts also consider "industrial"). Agilent is actually the leader in the chemicals/energy vertical, as well as the environmental/forensic markets it targets, and enjoys a #2 position in food safety.
The pharma/bio market contributes close to a third of revenue (where the company has a #2 position on the back of its strength in LC and supplies/service), but the company is comparatively weak in academics (a number five market position). The company's position in diagnostics is a little harder to describe as like-for-like comparisons really aren't easy here, but the company is a leader/among the leaders in sample prep, anatomical pathology, immunohistochemistry, and microarrays.
Multiple Avenues For Growth
I like the overall outlook for growth at Agilent. The company's pharma/bio business has been its strongest segment for a couple of years (surprisingly so to me), as the company has ridden a strong LC product cycle that likely still has a little room left to run. While increased consolidation in the pharma space would be a threat, the increasing complexity of drug development should support healthy tool demand.
Agilent has also been doing okay in the chemical/energy space recently despite the well-known weakness in those end markets. Agilent isn't getting much out of the refining or oil/gas segments right now, but chemistry companies are upgrading their GC instruments and Agilent's new Intuvo 9000 system is getting a good reception (it's smaller, more energy-efficient, and simpler to use). As it will likely take at least four or five years for this cycle to run its course, Agilent should be looking forward to strong results here, and maybe some competitive share gains.
China is a growth market for life sciences tools, and Agilent is well-placed here. With over 15% of its revenue coming from China, Agilent is up there with Mettler Toledo (MTD) and Waters in terms of meaningful Chinese exposure, while Bruker and Thermo have more limited leverage.
Management at Agilent is also looking to stimulate growth below the top line. The company's operating margins have been a touchy subject for a few years, but under the "Agile Agilent" program the new management team (in place since 2015) has done a pretty good job of restructuring its portfolio and operational footprint and streamlining its R&D process. There's still work to do on integrating Dako and improving the supply chain, and management is expecting most of the incremental improvement to come from better gross margin, as it targets mid-20%'s EBIT margins.
The Opportunity
While increasing production volumes of biopharmaceuticals is an important driver in the life science tools space, it's one that I expect will benefit companies like Danaher and Thermo more than Agilent due to the respective product mixes. Nevertheless, Agilent is still well-placed for the overarching theme of drug development becoming more complex and more focused on biologicals. Another mixed driver for Agilent is the outlook for government-funded spending in areas like environmental monitoring and academic research.
The new administration doesn't seem particularly friendly to either of these categories, but Agilent's vulnerability to lower academic funding levels seems more modest. On the other hand, if trade disputes with countries like China become sharper, it could harm the business as almost two-thirds of the company's revenue comes from outside the U.S.
M&A is a wildcard. Agilent has generally not been richly praised for its M&A history, and I think there are still some concerns that the company will do expensive and/or dilutive deals. I'm not so worried about this now; I think more deals are likely, but I think they'll be small tuck-in deals for more specialized products, services, or technologies (like specific diagnostic tests/testing technology).
In terms of the flip-side, I don't really see Agilent as a prime target given its size; other life science tool companies would likely get pushback from regulators, though I suppose a low-probability bid from a company like Abbott (ABT) could be theoretically possible.
I believe Agilent can outgrow the global economy and generate mid single-digit revenue growth over the next decade. With improving margins and asset efficiency, I expect FCF margins to climb into the high teens and drive high single-digit growth. Unfortunately, that doesn't support today's price even with a high single-digit discount rate. Likewise, the shares trade at an EV/EBITDA multiple around double my estimate for near-term EBITDA growth. It's not uncommon for quality life sciences companies to trade at rich valuations, but it is nevertheless a concern for me.
The Bottom Line
I wish I could find a better balance between liking Agilent as a company and being concerned about the valuation on the stock. To their credit, management has answered a lot of the concerns I had about the strategic outlook for the company a couple of years ago, and the share price outperformance at least somewhat reflects that growing confidence. The company is doing pretty well now, with good core revenue growth and improving margins, and I'm reluctant to harp too much on valuation, but I do think investors that emphasize value over growth may struggle with this one.
