Company Summary

Agilent provides bio-analytical and electronic measurement solutions and services to the life sciences, chemical analysis, diagnostics and genomics, communications, and electronics industries worldwide

• Life Sciences segment ($1.6bn revenue, 23% of total, 15% EBITA margin) offers liquid chromatography and mass spectrometry systems; laboratory software and informatics systems; laboratory automation and robotic systems; and nuclear and MRI, and X-ray diffraction systems
• Chemical Analysis segment ($1.6bn revenue, 23% of total, 22% EBITA margin) provides gas chromatography and mass spectrometry systems; inductively coupled plasma mass spectrometry instruments; atomic absorption instruments; and software and data systems
• Diagnostics and Genomics segment ($0.4bn revenue, 6% of total, 16% EBITA margin) offers immunohistochemistry, in situ hybridization, hematoxylin and eosin staining, special staining, DNA mutation detection, genotyping, gene copy number determination
• Electronic Measurement segment ($3.3bn revenue, 48% of total, 23% EBITA margin) provides electronic measurement instruments and systems, software design tools, and related services used in the design, development, manufacture, installation, deployment, and operation of electronics equipment

Why do we have this opportunity?

A was formed in 1999 when HPQ split off its measurement business, with M&A and divestitures driving a broad portfolio rationalization since the early 2000’s.  Over the last decade, the company has made a multitude of acquisitions and divestitures (increasing LST exposure via the Varian and Dako acquisitions and reducing semi exposure via the Verigy and Avago divestitures) that have driven a meaningful mix shift, transforming A from a tech equipment company with high exposure to semis into a diversified life science tool and measurement business.  At the same time Agilent has successfully grown its presence in emerging markets (building upon historical roots) and has invested heavily in R&D (as % of sales) where A ranks near the top amongst diversified peers (rivaled only by BRKR and ILMN). Despite these initiatives, organic growth has been volatile and A has largely underperformed its peers due to numerous issues, including:

• CapEx oriented business model (70% non-recurring/instrument sales) leads to increased macro exposure
• Misperception of A’s growth drivers (strong correlation to the semi index), despite portfolio reorganization and current life sciences focus
• Poor communication from management and a lack of visibility to forward earnings, in part due to recent macro cyclicality as well as from poor execution on acquisitions (Dako / Varian)
• Suboptimal capital structure and a failure to capitalize on the current low interest rate environment to lower A’s cost of capital
• Questionable capital deployment (unclear return profile on Dako purchase, limited use of leverage, unanswered question on use of overseas cash) and a lack of desire to repurchase shares

Entry Catalysts / Why is this interesting?

We believe there are numerous steps the company can take to unlock shareholder value—all of which are easily highlighted by an activist.

• First, revamping the communication process and hitting guidance (2 misses and 2 beats over the last 4 quarters has led to a lack of predictability and therefore multiple compression).  Six of the previous seven guides have led to share price declines.
• Second, unlocking the balance sheet and optimizing the capital structure.  A currently has $100m net cash vs. comps at 1.0-2.5x net leverage.  While management has repurchased $1bn in shares since 2010, these repurchases were primarily to offset option dilution as the share count remained flat at 353m from 2010 to 2012.  Agilent announced a $500m repurchase program in Jan, however, we believe another $1bn+ is possible given the current capital structure.  While management has adamantly opposed repatriating cash (almost entirely ex-US)
• Third, spinning off the EMG business to decrease volatility and remove the perceived semi exposure.  We believe most analysts and investors are likely to focus on either the life sciences business or EMG, but not both—they’re covered by different industry groups and exposed to different factors—it’s too hard/too much work to be an expert on both sides of the business.  Spinning of the EMG business cleans up the story overnight and would lead to meaningful multiple expansion.
• Fourth, shedding underperforming assets to highlight underlying margin opportunity.  As part of the Varian deal, Agilent acquired an NMR/MRI business, which has materially underperformed over the last few years.  While A has taken a number of actions to date (i.e., transferring manufacturing out of the U.S., investing in support/services, and exiting the OEM magnet business), the business posted -30% operating profit margins in FY12 and is not expected to breakeven until the end of FY14.  Ex-NMR, reported LSG operating margins would have improved from 14.5% to 19%, or in-line with TMO’s’ Analytical Tech segment.  A does not disclose revenue for NMR, but based on total LSG revenues of $1.6bn and 450 bps of margin improvement ex-NMR, the division is losing roughly $70m in operating profit.
• Fifth, exploring strategic alternatives, with the potential for an ultimate sale to DHR.  Agilent’s business is highly complementary to DHR and with DHR mostly on the M&A sidelines since the BEC deal back in early 2011, they have significant dry powder for a sizable deal (highlighted $8bn available on the Q1 earnings call).  We estimate synergies could exceed $350m and DHR could sell the Dako business for roughly $2bn on the back end (GE being the most logical buyer).

Event Path

• 5/14/13 – Q2 earnings (estimated)
• 6/3/13 – Jefferies Global Healthcare Conference
• 6/9/13—American Society of Mass Spectrometry Annual Conference
• 6/12/13 – GS Global Healthcare Conference (presentation + group breakfast)

Model Summary

Valuation / Scenario Analysis

Probability weighted upside target is $51.75/share or 24% higher than current levels.

Exit Catalysts

• Shareholder activist announcement with focus on improving corporate governance; improve corporate communication; operational plan and financial engineering
• Exploration of strategic alternatives, including a spin-off of the EMG business or split off Life Sciences business
• Recapitalization / more efficient use of leverage to repurchase shares and create tax shield
• R&D / opex cost reduction plan
• Sale of the company (Danaher - DHR- would be a logical fit)

Risks

• Further acquisitions (i.e., LIFE’s Ion Torrent business as part of LIFE buyout transaction)
• Guidance reduction / sequestration impact.  Mgmt recently revised guidance downward to $2.70-3.00 (from $2.80-3.10) at the 3/7/13 analyst day (halfway through Q2), but has since stated that “the high end of guidance reflects A’s internal forecast”