Agilent Technologies, Inc. (A) Earnings Call Transcript & Summary

[Audio Gap] the 2 of you for being here with us today.

Yes, our pleasure.

So Agilent has long been one of our favorite larger cap tools names. We feel that the company has built to grow at a level that should be sustainably higher than the peer group. And there's tons of opportunities with the pristine balance sheet to not only use strong cash flow, but the existing balance sheet, be more aggressive in pursuing growth, both inorganically and organically. So one of our favorite names, one of the more exciting names in the group. So I want to unpack that a little bit more in a few minutes. But much like we've done throughout the conference thus far, we want to just start by digging in a little bit on the COVID-19 situation and how Agilent is positioned for good or for bad in that context. So you -- just to set this up, you provided guidance on China-specific revenue headwinds of $15 million to $40 million in fiscal Q2 or about $10 million to $15 million per week, at least so far during the outbreak. Since your guidance, we've seen an expansion of potential economic implications of this outbreak, Korea, Italy and beyond. So maybe with that in mind, let's start on China specifically, recognizing this isn't just China, but China's the epicenter. How should we think about Agilent's exposure from both a revenue perspective as well as from the perspective of the supply chain?

Supply chain. Yes, yes. So that's a great question. So we were in a unique position because our first fiscal quarter actually ended on January 31. So we actually saw some of the impact of the extension of the Lunar New Year as associated with COVID-19 in our Q1 as well as had a couple of extra understandings of it in our Q2. So our guidance actually incorporates some of that in China. So China is about 20% of our revenue. And we have said for the first half of the year, we expected a $25 million to $50 million impact, $15 to $40 million of that being in Q2, as you mentioned, Doug. What I would say is from the standpoint of our expectations, kind of where we are today, we have 2 factories in China. As of the end of February, they're basically up and -- they're up and running. The first -- the largest factory is almost 100% capacity. The second one is about 75% capacity. And when we look at kind of how the order base is and so forth, it's kind of tracking to our expectations. So I think we're -- we feel good about where we are. Still, a lot that is still evolving and not only in China in terms of how fast it will ramp up. But we feel good about kind of where we are today. From a supply chain and a logistics standpoint, I kind of mentioned that it -- from our supplier standpoint, we've been able to confirm supply, either within China or get additional supply, so we don't feel that, that's going to be an impact. The biggest impact is actually maybe slightly higher cost in terms of logistics, getting a product in and out of the country. But it hasn't resulted in any significant backlog or back orders or inability to produce.

How much of what you produce in China is for China versus other geographies?

I would say it is -- outside of the U.S., production for our GCs is all produced in China. And China is our biggest market for GCs, but it is probably in the mid-teens in terms of supply chain for the total globe.

Okay. Beyond China, I mean, is it too early to say...

Yes. So obviously, we're watching the situation on a day-by-day basis. We've provided a range within China, and so that provides us a little buffer. We haven't seen any material impact in places like Italy or Japan or South Korea, but we actually have a meeting we have 2 times a week. First, focusing on our employees to ensure kind of the safety and well-being of our employees and everything.

Of course. Yes.

But then also from a customer and a supply chain standpoint. So it's still early days and fluid, but we haven't seen any material impact.

Okay. So I guess if we just think about how things have progressed since you guided. I mean, your guidance assumes a 1.5 to 3-week impact from coronavirus in China based on the fact that you got a factory up and running. The second factory is 70%, 75% up and running. It feels like things are not worse than what you -- at least in China specifically.

Yes, that's correct. I mean, things are tracking to kind of we expected. Now I think we said this on the call -- our earnings call, we expected February to be the brunt of it. And we've seen that. And -- but we're exiting February kind of where we expected it to be, not only from a factory perspective, but one of the other areas that we look at is service calls. And the service call rate at the end of this month was tracking pretty in line with where it was the end of February last year, which is actually very positive. Now how we're actually doing the service is very different. So the investments that we've been making in WeChat over the last 2, 3, 4 years is really paying dividends because we're actually doing service calls via WeChat as opposed to having people on site in certain factories and so forth.

Okay. Yes, that makes sense. I mean, it's really interesting talking to some other companies that have said, on one hand, we're up and running, we're able to get the components we need to produce things. We're having more challenges getting copy paper. And we're having -- and what we're concerned about is our customers are up and running. But there -- they'll ask -- they'll say, "Well, how productive would you be if you were told your kids are going to be home for 2 months?" So it's things like that, that are really hard to quantify.

Yes, exactly.

Yes, the good thing is our customers don't really need to visit our sites to be able to place an order. So much of the business is transacted online. And as you look at the trajectory of the business, as we've looked at it, the trajectory, it's actually even working from home or wherever people can -- that, that flow, that demand is...

It's working, it's happening, and it -- which is, I guess, in some ways, you're better positioned for because of some of the investments that you've just wrapped up.

Yes. Interesting. Just one of the biggest components that was important to -- so here, it was actually masks, so people could actually come in and out of the factory. So -- and we were able to do that fairly quickly. So that's good.

Yes, I guess, last question on this, to that point, I mean, are there areas where you're seeing an opportunity for Agilent to play a role in actually helping with the management of the virus?

Yes, we have provided some equipment to some researchers in China, primarily on the flow cytometry side to be able to help and analyze the virus and so forth. We don't have a big infectious disease business, but certainly providing support where we can.

Okay. All right. Super helpful. Thank you for all that. To the extent we can put that aside and just think about the core business for a few minutes, maybe just starting on LSAG and spend a little bit of time on cell analysis within LSAG. So just to make sure we're all level-set here and, as always, just correct me if I'm missing anything out. But LSAG comprises really Agilent's instrument and software sales to analytical lab customers. It represents about 45% of total sales. LSAG revenue actually declined on an organic basis in the first quarter of the year, and that was due largely to challenges in China. But on a reported basis, you grew largely because of cell analysis and really, biotech growth. So just in terms of the long-term growth outlook, we've historically viewed LSAG as being built to generate core revenue growth of 3% to 4%, maybe a little bit below the corporate average, at least as we think about Agilent. That's absent cell analysis. I mean, is that a reasonable way to think about LSAG?

Yes, it really is. I think if we look across our businesses in the end markets that we compete in, I think 3% to 4% is a reasonable number. And the opportunity around cell analysis could be better.

Yes. So I mean, interestingly enough, and I think people are paying to this -- paying attention to cell analysis, I'd argue maybe we should be paying a little more attention to it. I mean after the acquisition of BioTek, total business revenues for cell analysis, I think you're going to be north of $275 million annualized. And you're growing double digits, which essentially, just mathematically adds about 100 basis points of growth to LSAG. I mean, this is an area you guys just -- you weren't in 3, 4 years ago. So is that like, based on what you have now and seemingly increased strategic focus on cell analysis, is it right to conclude that cell analysis can take LSAG from being a 3% to 4% grower to something sustainably higher than that?

Yes, we do. We're super excited about the performance of the cell analysis business, and you've got the numbers as usual, kind of spot on in terms of the size and so forth. And it's -- so it's obviously more than 10% of the overall LSAG business. And that was a strategic intent several years ago, starting with the Seahorse business, and now culminating with the BioTek business that we acquired late last year -- last fiscal year. And when you think about this opportunity, we think we're really at the very beginning stage of cell analysis. When you think about all the work that's being done in immuno-oncology, gene therapy and so forth, the manipulation and interrogation of cells and the understanding of cells is really just starting. And we're largely in pharmaceutical and academia research today in that business. That market is growing high-single digits. We're growing faster than that. We have a broad portfolio, probably one of the broadest portfolios of anyone being able to provide this. And we think that over time, this business will continue to be -- play an important role in both research and academia, but increasingly also in production at the front end. And so we think that this has long legs going forward. We're super excited about the BioTek business. And now it's really hit the ground running for us, grew double digit on a pro forma basis in Q1 and shows no signs of slowing down.

How big a market is this?

It's a -- the way we define it, it's $3 billion to $4 billion market. And if you think about us being, call it, $275 million-ish, there's still a lot of opportunity and upside for us. And that market, again, is growing at probably 7% to 8%. And so we think that there's a tremendous potential going forward.

Realistic to think this could be $0.5 billion business for you as currently built in 3 to 5 years?

Yes, that's in the realm of possibility, yes.

Okay. Okay. And then you talked about production. Is there a role for these technologies in QA/QC at some point?

Too soon to say. Too soon to say. If you start mapping on where all the cell and gene therapy could eventually land and what the supply chain of that could be in a full -- how do you administer a gene therapy in this area?

Yes, yes.

You could build out a scenario where there is a play, but too soon.

That's all. That's down the line. That's down the line, okay. Let's pivot to CrossLabs ACG. So again, setting the stage, ACG compromises your service and consumable sales to analytical lab customers. Last year, it was about 36% of total sales. And CrossLabs has posted a core revenue growth rate of more than 7% for 7 straight years, including 10% growth last fiscal year. So simple but important question, any reason to think ACG can't continue to grow at least at high single-digit levels for the foreseeable future?

No. We certainly are super excited about that business. And when you think about the long-term secular trends here and the opportunity for us to improve our attach rates and provide solutions and capabilities to our customers over time, there's no reason to think that, that shouldn't be able to continue to grow at that high level and be the fastest-growing sector that we have.

What is -- so that attachment rate, that's a perfect set-up for the next question. So earlier this year, I think you said the service attachment rate for instruments is in the low to mid-20s.

That's right.

Percentage-wise. And you think that, that can go to 50% to 60% over the very long term, I think you said. So what does that mean in terms of what -- like, what actually does that mean for Agilent if you get that attachment rate up in terms of revenue and margin, keeping in mind that services represented, what, 65% of total ACG last year.

That's right. Yes. So if you think about ACG, yes, 2/3 of ACG is service. Not all of that is -- of this, we have an enterprise services business in the network. But the -- what it tells you is that there's a long runway. This is not something that's going to go in chunks of 5 or 10 points per year and so forth. It is probably more a point a year or something like that, just given the size of our installed base and the number of instruments that we have out there. And so what that shows you is, one, is sustainability or our belief in the sustainability and then also long-term margin opportunities here. If you think about our ACG business, it ended FY '19 as the most profitable segment of the company and more profitable, obviously, than the overall company. If you parse that out, our consumables business has always been the most profitable business. That's about the 1/3 of that business. Where we've actually seen tremendous margin improvement is on the service.

Is that right? Okay, okay.

And that's because of scale in providing that value proposition to our customers. And so the more contracts you have, a lab, as an example, you don't need more so the same number of service techs to add. And so when you think about this, it's what our customers want. They don't want to be managing their instrumentation, their fleet. They want to be able to have somebody else do that so that their technicians or their scientists could be doing more productive experiments and sample activities and so forth. And so we think that this is a long-term growth driver for the company.

And then probably a very complicated answer. So I'll just ask in a way where, hopefully, we can try to keep it tight. But in terms of -- just how do you do this? I mean, is it upfront? You place an instrument, doing a better job, give them a service agreement? I mean, essentially, how do you drive that?

Yes. It's threefold. I mean, there's an element of focus in ensuring that we've got the right incentive compensation for our sales organization to do it and be compensated and cognizant of it upfront. That's where you -- the best opportunity is, when you're selling an instrument. So there's one of that. There's also ensuring that you get the right solutions in - both from a portfolio standpoint on the consumable side, but also on the services side that are compelling to customers. And then the second is kind of design and technology. And so working with the instrument side earlier on in the development process to ensure that you've got a portfolio of either solutions on the software side or consumables that fit for purpose in the instrument. And historically, we hadn't done that. And now we're doing that more, which actually makes it more compelling to have a Agilent column in a LC or a GC that provides unique benefits that perhaps a third-party column does not. And an example of that would be, hey, when you need to change it to keep your output at the highest level.

Last one on ACG. Last topic I want to cover. I mean when folks simply look at your percentage of sales exposure on the whole, not just ACG. U screen is a bit more exposed to cyclical customers than some of your peers. One of the things that I think gets overlooked is within ACG, this is actually a pretty noncyclical segment. So if we look through the 2016 oil and gas downturn, recognizing -- I think chemical energy is 28% of ACG sales, you still grew a lot. So I'm just wondering how much emphasis to put on that as a sign that even in a downturn, even though you're targeting more growth, high single-digit growth over time in a pronounced downturn, is ACG still built to grow mid-single digits?

Yes, we do believe that. If you think about some of the transformation of the company over the last 5 years, you're also seeing a huge -- an increase, I shouldn't say huge, but an increase in our recurring revenue, ACG being a big piece of that as well as the DGG piece. But when you think about what customers will do is they'll defer capital purchases. But as long as that capital is there in the lab, actually, the service piece can be countercyclical to that. If you think about just a car, the longer you have the car, the more service you're going to require to actually keep it running. And so we actually see this as an opportunity to actually help balance that and do think that it can grow in any market.

Let's pivot to DGG, diagnostics and genomics. This comprises everything that you do in diagnostics and genomics and represents about 20% of total sales. Looking at DGG growth from the bottoms up: One, pathology is growing at least at mid-single digit levels, if not a little bit higher. Two, NGS-related revenue is growing at a pretty strong clip as well. And then third, NASD alone should be adding 2 to 3 points to annual DGG growth for probably the next 1 to 3 years based on your ability to keep expanding that facility. So when you pull these things together, is it fair to conclude that this should be at least a high single-digit top line grower for the next 2 to 3 years?

Yes, there's really -- yes, there's no reason that it shouldn't.

Okay. We're not missing anything there?

Yes.

Okay. And then from a margin standpoint, DGG, if you look at your 3 segments, it looks like that has the greatest opportunity for operating margin expansion. You've faced some headwinds over the last few years from growth-oriented investments like Lasergen, the new NASD facility. But it looks like -- if we just look at some of your comps, I mean, this could be a mid-20s operating margin business over time. Is that fair?

That is fair. Yes.

Where do you think you can be in the next 3 to 5 years? You knew this is where I was going.

Yes, yes, yes. So I think you hit the nail in the head. I mean, first of all, if I think about our pathology business, which is the largest piece of that business, we've been very pleased about the performance of that. 2, 3 years ago, we couldn't say that it had been growing in that mid-single digits.

Right. Right.

And so I want to give kudos to the team that's really been able to operate that business in a more effective fashion. I also think our automation solution has provided some benefits there. And we continue to invest in portfolio and menu on that automated solution. So we still think there's future growth. And our genomics business is probably the most profitable business in that book of business and continues to grow nicely. And we've made some incremental investments inorganically there as well from a -- from an -- AATI as an example and kind of a QA/QC sample prep. And then NASD has been a period of investment as well as Lasergen. All that being said, I do think that it could be in that -- what -- I think over time, it could be into that mid-20s, probably in the next 3 to 5 years. It's probably not up to that par yet because we'll continue to make investments. Hopefully, we're successful with NASD. That will require some additional investment in capacity, which will certainly play itself out over the next 3 to 5 years. So we're not going to constrain growth in order to be able to do that. But certainly, it has opportunities to improve, and I would expect over time that it would be at the company average.

It'll go higher, but there's a little bit of a toggle right now in the near-term where you don't want to start growth opportunities. Okay. Maybe to close on some more fundamental financial questions. So starting on capital deployment and really the balance sheet. So even after the acquisition of BioTek, net debt-to-EBITDA stands at just under 1x. Leverage is still well below most peers. I think you've made it pretty clear that you have a desire to do larger, though not transformational, deals.

That's right.

How -- maybe just to start on that last point. How should we think about your M&A objectives over the next year or 2?

Yes. So it's a great question. So I think what we've talked about is -- we got questions early on that said, "Hey, is BioTek the largest deal that we're ever going to do?" And what we said is "No, we have the ability to do more than that." It's not to say that, that's the only thing that we're looking at in terms of size and so forth. But I think, as we think about it, it's areas across all 3 of our groups that are in faster-growing areas. And a perfect example would be the cell analysis where we think we can bring something to the table. It's within lanes that we already know and is generally profitable. And so that would be the first area of focus. We don't need -- and then Mike said this before, we don't need M&A to make our model work. So it's additive as opposed to something that is core. But that being said, we -- if you look at where we have been over the last 18 months, we have become -- we went from a net cash position to levered probably for the first time since the, certainly the split off, and in a long time in the company. And I would expect us to continue to drive that leverage over time, maybe not all the way up to where the peers are, but certainly more in line with where the peers are, and a combination of acquisitions but also deploying some capital.

Other ways of -- yes. Earlier, we talked about cell analysis for a bit earlier in our conversation. I mean, I think that's a really nice case study for you guys of identifying an area of focus 3 to 4 years ago and really executing well from both an organic and inorganic standpoint. Are there other areas that are like cell analysis right now that you've identified?

There are. We're not going to tell you what they are. But what I...

You sure?

Yes. But there are areas. And they -- if I think about our 2 business, I'll bucket LSAG and ACG together because that's really the analytical lab, there's opportunities there, depending on kind of the markets. But then also the diagnostics and genomics areas as well. And you see, if you look at where we've done investments over the last 18 months, they've been across all of those. And I would say that there are areas we continue to refresh our focus, our lens. And you could see us building on extensions into areas. So if you take cell analysis is an example for the things that are beyond that, that we can also provide expertise to and the same on -- in the diagnostics and genomics. Our core spot is probably more in the private sector than the public sector.

Okay. Okay. Interesting.

But we have the ability to do both.

Yes. I think the only thing I would add to that would be the common theme across the businesses, if you look at the broader large molecule business, and if you think of it across oligonucleotides or proteins or cells as the 3 areas, right, our intent over a period of time is to keep building our capabilities across all the 3 areas.

Yes. That's a good add.

You have the core LSAG instrumentation focused on those 3 areas or the oligo side in the DGG. Or you've seen us even going inorganically and organically in the ACG business, where we've launched a series of chemistries aimed at that market as well. So that's just the certain theme in those markets.

In terms of -- I mean, we've talked about areas of focus. We've talked about the sort of size, private versus public, is important for these deals to be accretive immediately or not necessarily? I guess, put differently, would you do an accretive deal -- I'm sorry, a dilutive deal?

Yes. Never say never, but that would be -- one of our criteria is to be immediately accretive.

Immediately accretive. Okay.

It would be something that would be -- it would have to be large, very strategic and -- if it was dilutive.

Okay. On margins, I mean, we've talked about this a little bit on a segment basis, but margins expanded from, what was it, 19.6% in 2015 to 23.5% last year. Pretty impressive in spite of some pretty pronounced areas of investment in that period. How do you think about the long-term margin opportunity for the business as a whole?

Yes. We still think that there's margin opportunity. We're certainly not done yet in terms of being able to expand margins really across all 3 of our businesses when you think about it. We've been making some investments, but we're expecting those to pay off over time. And we've talked about the ability to get 50 to 70 basis points margin expansion per year certainly in the near term, and don't see any reason why that shouldn't happen or even maybe even better.

Okay. And is -- I mean, I think the peak margin we see across the group of larger cap diversified companies is around 30%. I mean, is that a realistic target? Or is there actually an argument to be made that, like, if you're getting 30%, you're actually not investing in some growth areas?

Yes, I think we would probably argue for the latter there. If you look at our business, we have a broader perspective. There's only one market, one company out there that's at that high level and they're certainly not performing at the top line the way that we would expect to. And we're not going to jeopardize the top line growth at the expense of a margin percentage. Because our belief is that if you can grow margin dollars, which actually are the most important things, that ultimately will win the day. And so when you think about our broad portfolio, I think it serves us well because we can target multiple end markets as well as multiple technologies and take advantage of those various areas. And not all those margins -- all those markets have the same margin opportunity. But I'm sure glad we're investing in places like NASD right now because that's in cell analysis because those are certainly driving a significant top line growth, and it will pay off for sure in a more robust business going forward.

Just closing on tax rate. I mean, as we've talked about, and I know you've talked about with others, your cash tax rate was already well below your non-GAAP tax rate. And that's even after making some -- taking tax rate down a bit over the last year or so. How should we think about the long-term impact of the recent move you made to further optimize your tax rate?

Yes. So we've been very pleased with the progress we've made. If you went back, call it, probably 3 years, we were probably close to 20%. And we ended last year a little over 16.25%. And this year, we're already below 16%. And we've been on this belief that we could get roughly 50 basis points per year. This investment that we've been making in the cash outflow in Q1 with the IT transfer will help us along that line, probably starting in '21. And so we feel good about our ability to continue to drive the tax rate down.

So that's the right way to think about the long-term trajectory?

That's long-term. That's right.

Okay. All right. We're out of time. We're going to have to leave it there. Thanks, guys. Really appreciate you doing this.

Great. Thanks, Doug. Appreciate it.

Thank you.