Description

Agilent Technologies (Ticker A) is a compelling value opportunity in the tech space. Simply put, they make the shovels for the gold diggers in technology and biotech. Fundamentally, they will have a net cash position on their balance sheet; they have #1 positions in virtually all their markets; they are prudent and cautious when it comes to capital allocation and they are sure to benefit from the recovery. Upside in the stock is +80% conservatively for here and downside is ~10% to 15%. The risk/reward is in our favor. In sum, I like the business, I love the valuation and I am optimistic in the log-run about technology.

First let me explain why I like the “instruments” business: Agilent basically sells test equipment to high-growth industry players in the telecommunications, life sciences and semiconductor industries. The company is very profitable and generates very strong cash flow. Agilent also has dominant market share in most markets it competes in and has the widest global footprint than any other competitor. For example, over 80% of all digital cell phones are tested using Agilent equipment. Agilent Technologies is a diversified technology company that provides instruments and components to high-growth markets in the communications, electronics, life sciences, and health care industries. The company was spun out of Hewlett-Packard (HP) in June 2000. Agilent currently has four business segments: Test & Measurement, Semiconductor Products, Chemical Analysis and Healthcare Solutions (which was sold to Koninklijke Philips Electronics, NV. for $1.7 billion in cash—expected to close soon). A quick snapshot of each division:

TEST & MEASUREMENT DIVISION: {Cyclical growth} There are three areas to the T&M business segment: 1) general purpose test equipment, 2) test equipment for communication components and 3) test equipment for chip manufacturing. In aggregate, these products include: RF and microwave devices, test and measurement equipment for optical, wireless and cable networks, printed circuit boards, semiconductor equipment, etc..
Revenues FY2001E: $7.0 billion
Geographic mix: Americas 48%, Europe 24%, non-Japan Asia 16%, & Japan 13%.
Growth driver: R&D capital spending by the end markets. Communications test equipment has grown 30% historically and has the greatest upside potential. General purpose equipment and chip test manufacturing has grown 10% - 15%.
Operating Margins: FY01E: 8% down from 15%
Top line strategy: Growing the consulting business, increase services and support and invest in the next generation of communications technology.
Market positions: Agilent’s 23% share of this market is more than 3 times the closest competitor.
Customers: Customers include Ericsson, GE, IBM, Intel, Motorola, Nokia, Tyco, Siemens, Hitachi, etc..
Competitors: The next closest are Tektronic (general purpose), Wandel & Golterman (communications test) and Teradyne (automated test equip).

SEMICONDUCTOR DIVISION: {Cyclical growth} Makes over 9,000 semiconductor components, computing devices, mobile information appliances, high performance telecom infrastructure, etc. A good percentage of sales are from HP.
Revenues FY2001E: $8 Billion
Geographic mix: Americas 45%, Europe & Asia 19%.
Growth driver: Drivers which grew this division by 20% historically includes 1) growth in bandwidth demand, 2) Internet and high-speed data transfer, and 3) data and graphics processing and transmission.
Operating Margins: FY01E: 5% down from 12%
Top line strategy: Focus heavily in the RF/analog/mixed signal technologies either internally or through partnerships.
Market positions: #1 in fiber-optic components, #1 in high speed networking integrated circuits.
Customers: Customers include Cisco, 3Comm, Alcatel, Nortell, Samsung, Jabil Circuit etc.
Competitors: Competes with Tyco (from AMP and Siemens acquisitions), Lucent, LSI Logic, Motorola, NEC, Mitshbishi, etc..

LIFE SCIENCES DIVISION: {Less Cyclical } Makes analytical instruments targeted to the pharmaceutical, petroleum, life sciences and chemical
Revenues FY2001E: $16 Billion
Geographic mix: Americas 45%, Europe 36%, & Asia 19%.
Growth driver: Three primary growth drivers: 1) Pharma/biopharma research and drug discovery, 2) regulatory compliance in environmental and healthcare, and 3) process controls and productivity improvements.
Operating Margins: FY01E: 7% up from 2%
Top line strategy: Invest more in pharma/biopharma applications in disease research and drug development and eliminate low profit products.
Market positions: Agilent is positioned in five areas and has the #1 position in gas chromatographs and in bench top mass spectrometry systems.
Customers: Customers include large pharma, biotech, environmental companies, etc.Competitors: The next closest are Tektronic (general purpose), Wandel & Golterman (communications test) and Teradyne (automated test equip).
Competitors: Competes with Thermo Electron, PerkinElmer, Waters, Varian Instruments, and Shimadzu.


VALUTATION: $28.68 is a fair price for Agilent. To arrive at my purchase price valuation, I triangulated around a valuation using three metrics—P/S, DCF and sum-of-the-parts analysis. First, on a P/Sales basis, I am comfortable paying 1.2x for Agilent given its prospects for 10% to15%+ growth (on a recovery, who knows when that will happen!). A 1.2x multiple implies a $27.59 share price on 2002E estimates. For my DCF assessment, I incorporate very low levels of growth for each division, which I consider to be an inexpensive way to own the company. Specifically, I used a 4.5% growth for Test & Measurement, 4% for Semiconductor Products and 7% for Chemical Analysis. This generated a stock price of $32.45. Lastly, on a sum-of-the-parts basis, I employed favorable revenue multiples to each business segment and assumed the healthcare business is sold-off as expected. I used 1.3x multiples for both T&M Chemical Analysis and used a 1.1x multiple for Semiconductor Products. This generated a stock price of $26. In sum, I get to a purchase price for the business of $28.68 per share.

Agilent is worth at least $52 per share. I used a similar method to get to my fair value price for the business. On a P/Sales basis, I am using an exit multiple of 2x on 2002 sales. For my DCF analysis, I assumed a 15% to 20% growth rate for T&M, 10% from Semiconductor Products and 13% for Chemical Analysis—all in concert with management’s new long-term expectations. For my sum-of-the-parts exit valuation, I applied a 2.5x revenue multiple for T&M a 3x multiple for Semiconductor Products and 2.3 x for Chemical Analysis—exit multiples I consider to be reasonable give historical performance. I also used a trading sum-of-the-parts valuation monitor as well on a P/E and P/S basis. From the results, I get to a fair exit price for the business between $57 and $61 per share, with a mid price of $52.

Margin of Safety Levels and Downside Risks: Downside risk is ~$21 per share assuming a very bear case valuation multiple of 0.5x to 0.8x revenues. Safety levels are in the company’s strong balance sheet (net cash position after the completion of the healthcare division sale), free cash flow and the value of Agilent Labs. Also, a break-up possibility is feasible: I believe if the stock languishes for a prolonged period of time, the management will split the company into 3 pieces to unlock shareholder value due to the fact that the pieces would be worth more on a stand-alone basis and the fact that they are easily separable.

Catalyst

1. Signs of a stabilization or rebound in technology capital spending on R&D projects;
2. Growth in new communications devices;
3. An increased presence in the life sciences in a meaningful way via new products and/or acquisitions;
4. The success of the optical switch. Agilent made an announcement last year that the company used its proprietary technology to control optical signals. When the company made this announcement Agilent’s stock spiked up $50 per share to $120. If this technology meets expectations, many believe that this product can be the foundation of an independent company, which could eventually be spun-off.
5. Realizing cost cutting opportunities: The company believes it has a tremendous opportunity to reduce costs, given Agilent’s higher-than-optimal expense structure. Management indicates that for every 100 basis points per year in lower SG&A results in $0.15 per share in savings. SG&A is currently running at 27 to 28%, which is about 400 basis points too high.