Description
Agilent Technologies, the test and measurement business of Hewlett-Packard was spun-out to shareholders in November of 1999. The Company’s first product was a video tester developed for film maker Walt Disney. Today Agilent offers more than 20,000 test, measurement and monitoring devices, semiconductor products and chemical analysis tools for a broad base of end market customers. The Company has multiple operating segments and has struggled through two restructurings and a botched Oracle implementation in the past two-years. However, I believe that Agilent contains some strong businesses that have been underpriced by the market.
Last Thursday the Company announced disappointing sales and earnings guidance and S&P cut Agilent’s debt to junk. The stock has fallen 30% in the past week and is trading at historic lows allowing an attractive entry point for investors with a 2-year investment horizon, (I’m counting on some modest economic growth by then).
The Company splits revenues into 4 segments: Test and Measurement (43% of Revenues), Semiconductors (26%), Chemical Analysis/Life Sciences (19%) and Automated Test Equipment (12%). In fiscal (October year-end) 1999, on revenues of $6.8B Agilent earned $.93 in EPS. In fiscal 2002, on revenues of $6.0B the Company lost $.77 in EPS and has had 6 consecutive quarterly losses. This clearly illustrates both the leverage in Agilent’s business model and the inventory overhang and subsequent margin pressure the company has felt.
Agilent has struggled with an inflated cost structure inherited from HP and the days when capital was allocated based on headcount and assets, not return on capital. The Company has gone through two restructurings to date and will announce a third when it reports earnings later this month. The Company has remained commited to break-even operating performance in the 2nd half of 2003, something they nearly achieved in fiscal Q4.
Test & Measurement ($2.6 Billion, 43% of Revenues)
This business unit is Agilent’s largest and the one that has struggled the most. Broadly speaking test & measurement equipment allows engineers to get product to market faster. According to Agilent’s website, “products in this segment include a broad range of instruments designed to allow an engineer to view, measure, test or calibrate electrical and optical circuits, mechanical motion, sound or radio waves. These instruments are used in a wide range of applications including research, design, testing, installation, manufacturing, and service on semiconductor, computer, telecom, communications network, aerospace, consumer electronics and education industries.”
As circuits and chips become smaller and faster the equipment needed to verify specifications needs to be increasingly complex and high performance. For example, to test Intel’s microprocessor running at 3 gigahertz, engineers need testing equipment running at 6 gigahertz.
Of this segment’s $2.6B in sales, 70% comes from communications test and 30% comes from general test. Agilent has benefited from increased spend by wireless carriers on spectrum analyzers but this hasn’t overcome the weakness from telecom long haul and sales were down 46% Y/Y in fiscal 2002. The past 6-quarters have been largely stable with orders between $590M and $673M and normal cancellation rates of 5%. The General Test business has faired slightly better than Comm Test driven by defense and industrial markets.
The key to understanding the restructuring potential of Agilent is recognizing that the Test & Measurement industry is actually quite cozy with little pricing pressure and that companies typically earn 50% plus gross margins and 10% operating margins through the cycle. Market share shifts are difficult to come by because engineers like to stick with the brand they know. Tektronix, their chief competitor (NYSE: TEK), has been able to remain break-even on an operating basis over the past 8-quarters. The CFO of TEK recently stated that business has stabilized.
Agilent lost $710M in this segment last year and suffered from a difficult Oracle implementation. Internal systems were so bad that in Agilent’s first quarter as a public entity they told investors they missed earnings, then two weeks later issued a press release and said they hadn’t. Over 300 internal systems were consolidated onto Oracle and this business unit couldn’t take orders for 2-weeks during the summer.
Going forward, cost cutting measures like outsourcing manufacturing of printed circuit boards, cutting the number of SKU’s, exhaustion of grey market product and dropping investments in long-haul optical will bring this division closer to break-even.
Semiconductor Products ($1.6 Billion, 26% of Revenues)
The semi group provides product for two groups: Personal Systems like cell phones and printers, and Networking i.e. Ethernet switching and storage networking. Agilent supplies all the top OEM’s (HP and Cisco are 10% customers) and has leadership in opto-electronics, mixed signal, and digital integrated circuits. Top customer, HP released 50 new products this Fall and Agilent benefited with orders up 85% Y/Y in Q2 and revenue following in Q4 up 59% Y/Y.
On the Personal Systems side, Agilent has market leadership in supplying optical mice for PC’s (an optical mouse has a camera in it that takes hundreds of pictures a second – Agilent sold the chips for over 120 million of them last year) and supplies all of HP’s printer ASIC’s and motion controllers. Revenue has been up 4-consecutive quarters and was up 20% in 2002 over 2001. Agilent is gaining share in mobile phone content from TI and RFMD with design wins for power amplifiers and embedded camera’s.
On the Networking side, Agilent has technology for Layers 1, 2 & 3 of the switching hierarchy. They do physical layer IC’s, Ethernet over SONET and fiber channel controllers, and packet processing and switch fabric ASIC’s. They have recently won sockets at Cisco for the new Catalyst 6500 product family displacing IBM, and won business supplying components for Cisco’s storage networking line, Andiamo. Agilent has surpassed Agere to take the #1 position in the opto-electronics market.
The semi business lost $115M last year but was profitable in the 4th quarter with 4.5% operating margins. This business segment has benefited from shutting down 2 Bay Area fabs and consolidating production to Fort Collins, Colorado. Now that the inventory channel is clean, growth in Agilent’s semi business unit should track overall demand for products plus some market share gains.
Chemical Analysis/Life Sciences ($1.1 Billion, 19% of Revenues)
This is Agilent’s top performing segment and an indication of the potential for the other businesses. The unit is solidly profitable with double digit margins and a 25% ROIC. They have benefitted from new products as well as missteps by competitor, Waters Corp (NYSE: WAT) who had patent and manufacturing issues in calander Q4.
Chemical Instrumentation is slightly more than 60% of this group and includes liquid and gas chromatography as well as mass spectrometry. Chromatography involves pushing matter with high-pressure liquid or gas to separate the molecules allowing scientists to interpret the matter. Mass spectrometers are machines that compounds are injected into and light is shined through to analyze the compounds. The Chemical business is a slow grower but generates significant cash flow. Competitors in this business include Thermo Electron and Waters Corporation.
Life Sciences makes up less than 40% of revenue and includes micro-arrays, readers and bio-informatics software. Agilent is taking share from Affimytrix in gene expression because they can do custom catalog arrays. The company is a leader in the emerging field of Proteomics (analysis of proteins) but the priority of spending by pharmaceuticals has shifted to drug development (getting drugs to market) from drug development. Last year this segment grew revenues 2% and had operating earnings of $140M, 12.4% operating margins.
Automated Test Equipment ($706M, 12% of Revenues)
This business is Agilent’s most cyclical, supplying final test and assembly equipment to semiconductor equipment companies. Agilent has taken share from Teradyne (NYSE: TER) and Credence (NASDAQ: CMOS) and earned a profit from operations of $9M in the fiscal fourth quarter. The company’s system on a chip tester has been used by most Chinese handset manufacturers as well as by graphics chip maker, Nvidia. Similar to Applied Materials, this segment has likely seen some order pushouts by customers.
Agilent falls into no specific industry group and often trades like a semiconductor production equipment (SPE) company. This is partly due to the investment bank’s analyst that took Agilent public quiting just before the roadshow, the SPE analyst took over and sold the deal. Some banks classify Agilent as a semi company, others as SPE, and others as a conglomerate. Therefore, the sell-side coverage is spotty at best leaving the company largely underfollowed.
Balance Sheet
Agilent has $1.8B in cash and a $1.1B convert outstanding. Despite S&P cutting the debt rating to junk, there are no outstanding bank loans and the earliest the convert can be forced is in 2006. In addition to the convert, Agilent has an underfunded pension plan ($350M), and has operating leases of $407M ($80M annually through 2008).
There is a ton of cash to be taken out of working capital as the Company tries to go from 140 days of inventory to 70 days and reduce A/R DSO’s. Cash flow will also be enhanced going forward due to Net Operating Loss Carryforwards of $1.1B and a Tax Credit Carryforward of $245M.
Cash Flow
Agilent has burned about $900M in cash in each of the past 2-years. With a lower fixed cost base going forward the Company should be able to generate cash from operations without a significant pick-up in the top line. A loss of $50M in Net Income in fiscal 2003 should allow the Company to be cash flow breakeven assuming a $200M in restructuring, $600M in depreciation and amortization, $200M pension contribution, 200M in working capital improvements and $300M in CAPEX. More normalized cash flow improves dramatically in 2004; assuming 3% top-line growth I get free cash flow of $500M.
Income Statement
Despite losing $360M in net income in fiscal 2002, there is reason to believe that Agilent can do better than this in fiscal 2003 on down 5% revenues. The Company was basically break-even in their fiscal Q4 and most of the benefits of initial cost cutting and systems improvements will begin to kick-in this fiscal year. On revenues of $5.8B and improved margins due to cost cutting, the company should be able to post losses of close to $50M but generate cash as stated above.
Valuation
At $11.75 Agilent has a Market Cap of $5.5 Billion and an Enterprise Value of $5.0 Billion. It is trading at historic lows based on EV to Forward Sales of .9x (assumes sales down 5% Y/Y) and EV to depressed Forward EBITDA of 9.3x.
The company should begin to generate free cash flow as a result of restructuring and better balance sheet management. There is tremendous leverage in Agilent’s operating model and normalized EPS is close to $1.00, (on revenues of $6.8B Agilent earned $.93 in EPS in 1999).
Sum of the parts valuation yields 43% upside:
TEK mult of 1x EV/Sales for Test & Measurement $2.6B
Mult of 2x Sales (discount to RFMD, TI) for Semi’s $3.1
Mult of 3x Sales (discount to WAT) for Life Sciences $3.4
Multiple of 1x Sales (discount to TER) for ATE $0.7
Price with 20% conglomerate discount: $16.85
Risks
Clearly management mis-execution and continued end-market weakness are the biggest risks. In a slowly improving economy the Company will be able to return to profitability and generate cash. Going forward all senior managers will be compensated on their unit and total company return on invested capital. Better internal systems and a leaner cost structure will allow the company to be profitable at lower levels and start generating cash for shareholders.
Catalyst
Significant earnings and cash flow leverage as a result of restructuring actions taken by the Company will illustrate the value of Agilent's operating assets.