There are several companies we've been watching, but we have yet to pull the trigger on them. One such name is Agilent Technologies (A).
Agilent made an interesting case for itself at its recent investor day meeting. Yes, the stock lagged through 2012 and has continued that trend year to date, with slowing growth last year and flattish performance so far in 2013. But, long-term, the market for its products and the company's positioning in the industry promise better days ahead.
For some background, Agilent was the instruments business at the core of Hewlett-Packard (HPQ), and was spun out in 1999. The company sells instruments and related supplies and services in four segments: life sciences, chemical analysis, electronic measurement and diagnostics/genomics. The last division was forged through the $2.2 billion acquisition of Dako last June, the biggest deal the company has inked to date.
In general the instruments business is a good one. It's a segment driven by increased innovation in end customers such as universities, pharmaceutical and biotech companies, hardware developers and chemical producers. Instruments constitute a capital-spending decision, and demand for Agilent's products slowed in 2012 along with the global economy.
There is a lock-in effect from a large installed base, in part for consumables but also due to customers' comfort and experience with a specific company's product operation and reliability. Operating margin here is high and stable in the 20% range.
That said, the current fiscal year (ending October) is shaping up be Agilent's second consecutive poor year for organic growth, mainly but not solely due to the tough macroeconomic environment. Its business and geographic mix have not been kind to Agilent in this cycle, and it has lost market share as a result. But the company is committed to outgrowing its markets in fiscal 2014, and this should work in part due to easy comparisons and the nascent global recovery. In addition, Agilent has put in efforts to fix its loss-making MRI/NMR business and to boost gross margin by cutting related costs. These will all assist in operating margin by perhaps 250 basis points over the next three years.
Management seems to be somewhat more cognizant of shareholders than it had previously been, as well. It boosted the paltry dividend by 20%, and the yield now stands at 1.2%. The acquisition of Dako, a strategic plus, was funded completely by offshore cash -- an intelligent approach. Further, the company has aggressively expanded its share-repurchase program, having targeted buybacks of $500 million this year.
Overall, the company generates well over $1 billion annually in free cash flow. That gives it the flexibility to make thoughtful acquisitions, and it also allows compensation of shareholders.
Agilent shares trade at around 14x this fiscal year's earnings estimate, which is interesting for a company for which forward earnings growth can be in the 10%-per-annum range for the next couple of years. Its balance sheet is strong enough to comfortably support its business, and management is using the low-interest-rate environment to optimize its debt structure. Our assessment of fair value is in the low-$50s range.
We think Agilent is a reasonable, though not table-pounding, investment at the current level. It would become even more compelling in the high $30s. In the past we have recommended and still prefer Thermo Fisher (TMO), a similar operation that has performed better and more consistently over the last few years, and is valued at a slightly more attractive level. Thermo's business and geographic mix is also better, with a larger proportion of high-margin consumables. We like the instrument industry and believe it's an attractive and timely investment space.
That said, we believe both stocks should do well from here. Bottom line: For those seeking recent laggards with favorable longer-term outlooks, Agilent should be of interest.