Agilent: Back To The Lab - [Business Breakdowns, EP.223]

All right, Mark, I am excited to have you here to talk about Agilent. We were laughing a bit last week before the episode. One of the key things is just going to be establishing what Agilent actually is and what they do. I love these niche industries and niche businesses that don't get as much airtime or coverage. Let's just start there. Do your best simple overview of what Agilent does as a business.

1. Agilent Supplies Critical Labs

Agilent is a leading provider of instruments, services, and consumables for labs. Sounds simple. You can picture one of their typical Agilent instruments as being about the size of a small fridge, maybe on a lab bench, and its core use case is to tell you what molecules are in a sample that you're testing.

A real-world use case might be a pharmaceutical company producing a drug. Let's say they're making aspirin, and they take one tablet off the production line for every 1,000 tablets that they make or something like that. Those samples could be run through an Agilent piece of equipment to check that they have the right amount of the active ingredient in them and, importantly, that there are no contaminants as well. Agilent will sell them the instrument that can analyze that sample and also provide the ongoing service support and consumables needed to run the instrument.

If I'm thinking about this right, it's mostly biomedical-type work that they're operating around, and specifically in the labs of those businesses. Is that a fair way to categorize their end market?

Yes. The business itself is actually pretty broad today. They're in 110 countries and 285,000 labs, so it's pretty broadly split between the Americas, Europe, and APAC.

In terms of the actual markets and end customers, pharmaceutical customers are the largest end market for them, at about a third of their sales. Academia and government—you can imagine universities use this stuff—is another 10% or so. About 20% of the business is chemicals or advanced materials, which is interesting. You could think of battery testing for EVs or semiconductor production. Another 20% is actually food and environmental testing, which would be for contaminants perhaps in your water supply, something like that.

Is there any way to measure how big of a market this actually is? I'm always curious with these niche industries that revolve around very big end markets as it relates to drugs or anything along those lines. How do you categorize the overall market size for Agilent?

Agilent does publish a sort of total addressable market statistic, and it's $160 billion, which is unsurprisingly a really big number when you think about all the companies and businesses in the world that need to test samples. Agilent's revenue today is about $6.5 billion, much smaller than that TAM number.

In reality, when you dig into those niche end markets, they generally have a number-one or number-two position in most of their key markets. It's generally a pretty stable competitor set.

If a company publishes a TAM number, it's probably going to be a big one. That's a fair way to look at it, but it's interesting to get that context of $6.5 billion versus $150 billion, just for perspective. Let's go back to the origin of the business. Where did Agilent come from? What is the origin story? How long has it been around? Is there anything key to its history that you would include?

2. Agilent Emerges From HP

I think Agilent has a really interesting history. It actually starts way back in 1938. Hewlett-Packard, or HP, was started by 2 electrical engineers, Bill Hewlett and Dave Packard, who worked in a garage. It's a pretty well-known story. The first product they developed, of course, was actually a testing instrument. It was used to test audio equipment used by Disney in the production of Fantasia, the movie, way back then.

Over the years, HP built out its testing and measurement business, both electrical testing and, over time, molecular analysis. This included the acquisition of a small business called F&M Scientific in 1965. That business quickly became the leader in what's called gas chromatography instruments. Its instruments were used for the first full-scale testing for steroids at the 1972 Munich Summer Olympics.

The business continued to grow over the years that followed. In 1999, HP focused more on its computer business, and spun out several businesses, including testing and measurement, into a new business called Agilent. HP kept its computing and imaging business, with everything else going into Agilent. It was a bit of a mixture of assets that they inherited, but there were also some real gems in there. There were obviously years or decades of R&D, particularly in chromatography.

In the years that followed, the Agilent management team refocused on its molecular testing business, so they sold their medical business to Philips in 2001. They actually had a pretty successful semiconductor component business that they sold in 2005 to KKR and Silver Lake. This would go on to become Avago, which then became Broadcom after they bought it, so it's been tremendously successful on its own.

In 2014, there was the most recent significant change. Agilent spun out its electronic measurement business into a separately listed company called Keysight Technologies. It's still listed today and it's doing well. That's really important. At the time, it was about 40% of sales that they were spinning out, and Keysight, whilst it was a great business, was selling equipment predominantly used for testing electronic devices during manufacture. This was a really cyclical business and didn't closely align with the rest of what Agilent was doing.

The business that remained was entirely focused on analytical equipment for the life sciences, diagnostics, and chemicals markets, so it was much more focused. What the management team was trying to do was have a much cleaner, more predictable, less volatile business, while still having those long-term growth drivers.

It's very interesting when you find these family trees, with Standard Oil being one that broke up, but all of the businesses were essentially in the oil business in various forms. HP is a new one. Prior to this episode, I didn't appreciate just how much had been born out of that family. There are some pretty impressive market caps among those businesses that you referenced.

You mentioned electrical testing versus molecular testing. That feels very different to me. Yes, they're both testing something at the surface level, but molecular versus electrical feels like it's a very wide gap. Was there a certain cultural DNA or recruiting mechanism that attracted people to the overall HP brand and allowed them to do that? This is a bit of a segue, but I am curious how they were able to foster innovation in 2 relatively different categories, at least to my brain.

I think they inherited a lot of people. Agilent is still based in Santa Clara. I think their current headquarters is about a 20-minute drive from the original HP garage where it all started. There's obviously this sort of HP Way culture as well. We own the shares, and we've been impressed with the way that they run the business for the long term and the way they look after their people.

You get a sense for it, but we experienced that during COVID, when right off the bat they were first out the door saying, “No one in this company is losing their jobs,” or anything like that. I think that builds up loyalty. It's not unusual when we meet the managers; they're generally Agilent lifers who started as engineers.

It's interesting where you might have a separation, but there still exists some type of relation to the original family tree and some of the talent that comes along with it. You mentioned, when we were talking before, a bit of a razor-and-razor-blade approach with their business.

How would you categorize what they're doing beyond selling just equipment outright?

3. Recurring Revenue Powers Agilent

In terms of how I think about the business, about a third of it is selling instruments, the largest category of which is chromatography instruments. These are large initial sales, and then two-thirds of the business is selling consumables, servicing, or software, which are mostly related to the instruments they're selling. So it's that roughly one-third, two-thirds split.

I've mentioned chromatography a few times. What this actually is is a machine that forces a sample—it could be a liquid or a gas—at pressure through something called a column. You can think of a column as a metal tube that's stuffed with material that slows down the molecules in that sample at different rates. This means that the liquid or gas separates into different molecule groups as it passes through that column. On the output of the machine, you've got a sensor that detects the molecules now that they're separated, and depending on the type of sensor, it could also quantify how much of those different molecules are coming out.

So it's a powerful tool. Typically, when they're selling one of those instruments, a chromatography instrument, it will cost around $100,000. Obviously, there's a huge range, but let's go with that for now, and it's got a useful life of about 6 to 10 years. Over that useful life, the customer will typically spend another $100,000 on ongoing consumable and servicing spend. That spend is split roughly equally between physical consumables and service costs.

So just talking about the consumables for a second, the bulk of that expense is those columns that we just described. They've got a limited period of use, perhaps maybe 2,000 samples, something like that, and you need to replace them, as the column is responsible for separating out that material and it's degraded by high temperature or extreme pH levels, things like that. That impacts the resolution of the instrument. These are used for pretty critical applications, so you basically have to replace them often. It wouldn't be unusual to hear a customer replace one every month or so.

Servicing is a bit different. It's more focused on repairs, recalibration, cleaning, or a service called qualification, where they will be validating that the machine is operating correctly. We're saying Agilent is one of only 2 companies that has the ability to service other companies' equipment in the same lab as well. So it's a pretty big benefit if you're dealing with a large customer.

Increasingly, Agilent services are sold as part of a broader service contract that's agreed when they sell the new instruments. One of the ways to judge it would be that they publish a number that's the percentage of instruments out there that have active service contracts. It's called the attach rate, and it's been steadily increasing over time. So over the last 5 years, it's gone from a high-twenties number to a low-thirties percentage, and we expect it to continue to grow about 1 percentage point a year.

This is a great business. It sounds boring, but the bulk of Agilent's customers are operating in regulated industries where they need to spend on consumables and servicing if they're using the instrument. The example I gave earlier: quite often, the quality-control process will be written into the FDA approval for a drug, and they might even mention the exact instruments and consumables being used. Once that happens and it's approved, it's expensive for the customer to move to a different instrument, and there are also some risks attached to that. So it gives a really nice recurring revenue on that consumable and service spend.

Is it right to think about the Agilent equipment being used in the assembly line, essentially, once a drug has already passed the approval, rather than in the original testing or drug development stage?

They straddle both. I think probably you're right, though, in that the sales split would skew towards production. They definitely make those cutting-edge instruments which you use for your research and development. There's just a lot more production out there.

When you look at the innovations, there are definitely innovations around making the machines higher-resolution and more accurate, but actually a lot of the innovations are focused on throughput, where this is a lab that's testing 10,000 samples a day, and if you can do it with 1 less instrument, then that's a big saving.

My next natural question was going to be, what governs the decision for a lab to buy another piece of equipment, another Agilent system? Do you see labs with multiple on their assembly line, or is there typically just 1 associated with each drug? I'm trying to understand whether it's capacity constraints or what drives that.

Typically, in a production center, you'd have a lab attached to it, and they would have several instruments as part of that. Generally, they will choose a single primary supplier. They may have a secondary supplier there as well, but just for simplicity in terms of having spare parts on site, ongoing service, and support, it's generally just easier to have 1 instrument supplier.

When they're considering going from that 4th to that 5th machine, they're considering the service they've received. I think most customers would probably highlight service as the primary driver of their decision. It's worth saying the machines are complex. There is a technical capability, so it's not like there are 500 options out there. It's a reasonably small group that you've got to choose from.

But Agilent's this one-stop shop where you can get your instrument, your consumables, and your servicing, all in 1 package.

Talk a little bit about the competition. You mentioned there's 1 other competitor that can actually service third-party machines as well. What does the competition look like? Maybe we can start just in the equipment segment and branch out from there.

4. Agilent Wins Stable Niches

Generally, they're competing, I'd say, against 2 main businesses. There are others, but 2 main ones: 1 being a company called Waters, and another called Thermo Fisher Scientific.

Waters is a strong competitor in liquid chromatography, but it's more narrowly focused on the pharmaceutical market. Around 60% of their sales are from pharmaceutical customers. They're also a smaller business, so revenue for Waters is about half that of Agilent's, around $3 billion. Agilent's is just above $6 billion.

Thermo Fisher's almost the opposite. It's a huge business: $43 billion of revenue, built largely through acquisitions. If you were to open a Thermo Fisher Scientific catalog, you would see there's a much broader array of products. They sell everything—lab fridges, test tubes, hot plates, centrifuges, lab shakers, water baths, et cetera—as well as the chromatography instruments that actually compete with Agilent. So maybe a bit less of a specialist in that sense.

What drew us to Agilent was its diversified exposure by end market, but also its focus on niches where it has high market share.

Can you talk a little bit about those niches? If you take Waters, who's entirely focused on pharma, what would be the other categories or niches within those categories that would be highlights for Agilent?

Gas chromatography is the golden business within Agilent. That's obviously where it came from. F&M Scientific originally, which HP bought, was a gas-chromatography specialist. Agilent is still by far the market leader in gas chromatography. They're probably two-thirds of the global market for those instruments. They really dominate there.

The difference between gas and liquid is predominantly driven by the sample. With gas, unsurprisingly, you're testing a gas. The way you get it to a gas is you heat it or burn it. If you're a pharmaceutical company and you're testing a complex protein or something, you can't heat it up because you'll destroy it in the process. Therefore, you have to test it as a liquid.

Generally, gas chromatography skews toward what we'll call applied markets. You can think of that as battery testing, environmental testing for contaminants and pollutants, and things like that. They're really uniquely strong, I would say, in applied markets for gas chromatography.

These examples are reminding me of refineries from oil and gas, just in the way that they can handle this input and turn it into many byproducts or outputs. There are a lot of differences, but it's interesting how much similarity there is.

One of their customers is testing the outputs of refineries, basically. There are other areas as well where they're pretty strong. Liquid chromatography is the other one. They're probably about a third of the market. Waters probably has about a third of that market as well, and then the balance is smaller players, with Thermo sharing the rest.

They're also pretty strong in spectroscopy, so that's 40% to 50% of the market. I'd say that gas chromatography and applied is a poster-child market.

I would assume that a lot of the consumables and maintenance has somewhat of a recurring or straightforward measurement from year to year. The new equipment sales have this 6-to-8-year useful life. Are there major cycles, boom-bust-oriented, that don't just revolve around customer losses? From an industry perspective, have there been tailwinds or headwinds that have resulted in shocks over time?

5. Cycles Shape Equipment Demand

In short, yes. Agilent's obviously pretty diversified by end market, which has meant when there have been cycles in some of their smaller markets, they've kind of been able to weather it. One end market's a bit weaker, and another market's doing a bit better. Generally, they struggle when their largest pharmaceutical customers are doing badly, which we've just hopefully seen the other side of now.

They’re just coming out of a sort of downturn there. You obviously had the COVID-19 pandemic. There was a lot of investment from pharmaceutical companies into building out lab capacity and spending on R&D, and they bought well above the normal level of instruments. So you saw this boom in instrument sales growth, and then the CFO turns around and goes, “We’ve got lots of instruments. We don’t need to buy any more for a couple of years.” You see the other side of that.

It looks like we’re just returning toward normal purchase levels now, so hopefully that’s behind them. The other notable area is China. China is 18% of group sales. It’s half of the Asia-Pacific region. Obviously, there have been challenges in China. It’s a market that’s led quite heavily by government grants to local companies that then go on and buy Agilent pieces of equipment. We’ve been through a down cycle there. Again, it looks like that’s improving at the moment.

For something like the COVID shock, where you had this major investment, when you think about the useful life of that equipment and, at some point toward the end of the decade, you’ll come up on that 6-to-8-year mark, is the expectation that there would be renewals? Do pharmaceuticals tend to take capacity offline if it’s related to something that has a shorter life cycle? How does that work in terms of the visibility that you might have around the 6-to-8-year life and the replacement cycles coming through and showing up in revenue?

I think, just talking about pharmaceuticals, there should be growth in pharmaceutical R&D spending over the long term. We expect to see growth there driven by increasing demand for healthcare, whether that’s from aging populations. I know the World Health Organization has the population over 60 nearly doubling by 2050. Things like that are just going to drive healthcare spending, in our opinion, in one direction, and that’s a tailwind for Agilent.

The reality in the short term is that if an instrument is 6 years old, they could run it until it’s 8 years old. There’s nothing—it doesn’t stop working. The parts are still available. They definitely could.

The drivers for that upgrade tend to be that these instruments operate at high temperatures, with sometimes nasty chemicals inside them. All the components in them will eventually wear out. You’ve got the consumables, which are designed to be replaced, but you can think of all the valves, the heaters, and everything else that will just start breaking more after a long period of time. Lab downtime is problematic for these pharmaceutical companies. They’ll want to get rid of these instruments before they start to see a fair amount of downtime, which will naturally happen as the instruments become older. They’ll just be looking to upgrade.

The other thing is that there are typically reasonably significant upgrades to the platform every 3 years or so. After 6 years, you’re probably 2 upgrade cycles in; maybe after 8 years, 3 upgrade cycles in. There should be a meaningful upgrade in terms of either resolution or throughput, which should help justify the upgrade spend.

With the competition, you mentioned that service is a major driver of the decision-making there. When it comes to innovation, has there been a historical trend line for Agilent or maybe a competitor where innovation has really driven market share gains or someone moving up the chain in terms of what they’ve captured of the market?

I don’t think so. We talk to the companies a fair bit, and they talk about reasonably stable market shares overall. I think if you do a really good product launch, after a couple of years you might gain 1 percentage point of market share. These are very entrenched, stable market shares.

Waters actually had a chart in one of its investor days that showed sales of a specific type of column over time. We’re talking over decades, and it was basically a flat line. This was because of the point about it being tied into drug certifications. Once it’s tied in, people just use the instruments again and again and again. If it works and they’re getting good service, they generally don’t change it. That’s why the service component is so key.

You mentioned there are stable market shares. Do those tend to be stable with the same existing customer base? Is there a lack of switching that tends to happen?

It’s pretty rare that a customer will build out a whole new lab. They’ll generally be upgrading one section of a lab. There’s that incumbency bias.

We have seen companies talk about some opportunities where pharmaceutical companies are thinking about reshoring labs. That’s one of the few examples where whole new labs are being set up, and that’s an opportunity where you can kit out a lab. Increasingly, the service part is being folded into the discussion on instruments as well, and this is benefiting those large incumbents.

Agilent has 4,000 service technicians that it employs directly. It’s pretty hard to compete with that. Seventy-five percent of their technicians hold a degree in chemistry or biochemistry. Twenty-five percent have a master’s degree or PhD. So these are really skilled, bright people who are out doing 2,500 on-site service calls a day. They’re trying to fold that into the discussion around instrument sales more, I’d say.

The point on the risk associated with switching providers might be the most meaningful thing. I’m curious: do you have any data points or measurement for what the cost of this equipment represents to the end customer? Is it a large percentage of the overall cost of production or anything else that represents a large or relatively small piece of that?

We think about a production facility that maybe has 5 or so of these sorts of instruments, maybe slightly different types. Over those 5 instruments, let’s say over an 8-year period, they’re spending 1 million dollars on the instruments, servicing, and consumables. It’s a rounding error in the scale of a pharmaceutical production facility over 8 years, both from revenue generated, profit generated, or the other costs in that business.

This is one where the cost of a product failure—if you’re failing to spot a contaminant or a problem or something like that—is almost unquantifiable. The damage alone to the brand would be huge.

One of the main things you will hear in these niche markets that represent a very small percentage of the overall product but are mission-critical is that it’s a very good spot to be in if you’ve captured market share in those industries. I’m curious how that impacts the revenue model broadly. We can break it down if possible.

You gave us some sense in terms of volume trends over time. How do they decide on price? It might be different, obviously, for new equipment versus service and everything else, but is there a general framework for how you think about pricing as it revolves around the business?

They don’t give full disclosure on price and volume, but from our conversations, it seems like they’ve been reasonably cautious on price—low-single-digit price increases per year in recent years. Certainly not the 10% or 15% we’ve seen in the food companies, for example.

Generally, I think they’re aware that they’ve got relationships with these businesses that have been going on for 30, 40, or 50 years. They’re much more focused on maintaining that business and that strong relationship. They take a little bit less on price, but maybe the customer takes a service contract or something like that, which more than pays for any lost pricing. Generally, I’d expect low-single-digit price growth, with the balance driven by volume.

How has revenue trended? Whatever periods you want to pick—whether it’s 3, 5, or 10 years—I know you have various things that impact those, but where does this business tend to grow, and where does the industry tend to grow?

I’ll pick 9, if that’s okay. Not because I’m being selective with my date range. It’s the longest that I can go post the Keysight spin. It all gets a bit noisier around that time.

Since 2015 or so, sales growth at the business has averaged about 5% organically and about 6% reported, so they’ve done a little bit of bolt-on M&A. They’ve had decent margin growth over that period. EPS has grown a fair bit faster, at about a 13% CAGR over that 9-year period.

We can get into margins a bit. Is there a drastic variance to the extent that they split it between the various segments? Is there a massive variance between equipment sales versus service and consumables in terms of margin profile?

Yes. Unsurprisingly, consumables and servicing are a fantastic business. I think instrument sales are definitely more competitive than servicing. I think consumables are probably the most competitive.

The instrument sales business depends a bit on where they’re selling. Selling to life sciences, they’re making around a 20% operating margin, but selling to the applied markets I spoke about, it’s a little bit higher—around 24% operating margins. If we think about that consumables and servicing business, that’s a 34% margin business. It’s grown pretty steadily over time. It’s also been among the fastest-growing divisions.

At 50% of revenue, it’s a higher percentage of profit. Where does that go over time, and where did it come from in terms of it being a business that’s split 50–50 between those two? What do you expect that trend line to be, and maybe some context in the history would be useful as well?

I think, rolling back 10 years, I’ve talked to the very smiley former CEO. He would say they didn’t do an amazing job, perhaps, at selling services at the same time they were making instrument sales. So typically, it was 2 different teams. One team would go, “Yes, we sold an instrument,” and then maybe 6 months later, someone from Agilent—they call it CrossLab, their servicing division—would walk in and try and sell their services, by which point maybe a local technician group or a competitor had already gone in there and signed a deal.

One of their core strategic focuses in recent years has been increasing that attach rate that I talked about—the percentage of instruments that have an active service subscription—and they’ve been pretty successful at that. So they’re in the low 30s percent of active instruments out there. For new instruments sold, it’s obviously a fair bit higher. If we were to look at some of their peers, Waters, which has been much better for much longer at selling those servicing contracts with instruments, is in the 50s percent. There’s definitely a pretty long runway, I think, on that.

Then, when you think about the economics of that service business, it’s a classic density business. You’re in a city, you’ve got 5 technicians that operate in that city, and to take on 5 percent more business, you don’t need an extra person. They’re just filling out their calendar. You’ve got a fixed cost for the office and an admin team there. It really scales quite nicely as you build up density in a local area.

In terms of the conversion, you mentioned earnings growth and that being quite a bit higher than revenue growth, driven by that margin expansion. How has the cash flow profile evolved, whether it’s cash conversion or anything around free cash flow for the business over time?

The company generates around $1.4 billion or so of free cash flow a year. It’s about 90 percent of adjusted net income, and that 90 percent number has been pretty stable in recent years. The primary difference has been an increase in CapEx spend in recent years. They’re basically building out a facility for a new business segment that they’re working on.

I would love to hear more about a new business segment. That always adds something interesting to what feels like a pretty straight-and-narrow business story thus far.

6. Agilent Expands Into Oligos

Perhaps “new business segment” is actually a little bit harsh. It’s actually an old business segment that’s growing rapidly. They have a notable business that they call NASD, Nucleic Acid Solutions Department, NASD. It produces what are called oligonucleotides, or oligos, as we can call them. They’re basically short strands of lab-made DNA or RNA, and they’re used to treat some genetic diseases and, importantly, in some RNA-based vaccines or drugs, including the COVID-19 vaccine.

These oligos are a key part of the production process, and they’re typically used to help stabilize the RNA during production. It’s a chemical that’s used during the production of these advanced drugs and vaccines, and Agilent is the clear leader in producing them. Interestingly, it was initially a tiny part of Agilent. It was formed in 2006 by merging some technology Agilent already had in-house, involving knowledge of RNA molecule synthesis, with a business they acquired called SignPro.

Again, it was a tiny company they bought back in 2006. They merged it, kept it running, and then this really took off a few years ago. They continued to develop it over basically 20 years, and then, in 2018, they started to see a lot of orders, both for the development and potential commercialization of some of these drugs.

At that point, they had an interesting decision to make. They basically had to either invest $185 million in growing this production facility or not invest and give away the business, either to someone else or by trying to sell that asset. They decided to invest organically and back their engineers, so they spent $185 million in 2018, and demand continued to grow. In 2023, they broke ground on a further $725 million expansion of that facility. It’s in Frederick, Colorado.

So far, demand has been really strong, and they’re by far the leader in this sort of niche CDMO sector. It’s the same customers, but it’s a different product from what they’ve done in the past.

If chromatography wasn’t complex enough, I’m glad we’ve introduced something else here. It’s very interesting to hear how this has evolved. Am I right to think that the legacy business is, in some ways, selling the picks and shovels to the gold rush? Here, they’re developing an actual molecule.

I’m just curious about the demand profile for that molecule and how it might vary versus what you look for in their legacy business, or what else you would point to in terms of the differences, because you tapped into it there. I’m just curious if you could expand on that a bit more.

They’re not generally tied to a single pharmaceutical company. They work with basically all of the main manufacturers of these types of drugs. There’s definitely more customization for each specific project, so they generally partner with them quite early during the development phase. Agilent probably won’t be making very much money on it while they develop these custom oligos to support the project.

The payback is if they make it to commercialization, and some of them are now moving to commercialization: the volume really ramps, and that stays with Agilent. There’s no other company with equal or larger capacity than Agilent for producing these specialist oligos. Like most things, it’s probably easy to make in really small quantities, but if you want to make production-grade material where you can make 100,000 vaccines, then really, Agilent is the only company you can work with that has that facility.

There are definitely differences—I think you’re right—but it’s similar in that it’s not tied to a single, all-or-nothing drug.

Is it tied to the mRNA theme more broadly within pharma?

Correct. The setback for RNA-based drugs is unhelpful, and changes in the funding environment are unhelpful as well. You definitely see that in some of their results, where companies focus less on R&D one year and more on commercialization to respond to funding changes, basically.

You mentioned it’s gone from small to—not huge, but a much bigger portion of the business now. What does it represent versus what it was before?

Their core NASD, developed internally, is now a little over $300 million in revenue. They’ve also acquired a business for about $1 billion called BioVectra, which is in a similar space. It does slightly different things, but it’s very similar. So altogether, they’re about $470 million in revenue, or about 7 percent of Agilent’s sales.

It’s impressive to come from something so small, especially when the rest of the business is growing alongside you. When you think about that as a shareholder, you mentioned a bit about the margin profile not being great in the early stages, so you’re investing with this long cycle of return. I’m curious to get into your head about how that all felt years back versus where we are today, because it is a bit different within the business.

They’ve gone from, if we go all the way back to the HP days, being a conglomerate in many things to being much more of a pure play. How do you frame that type of somewhat strategic adaptation to include this, with some of those things in mind?

Way back at the start of the conversation, in Agilent’s history, I went through an example where they gave away or sold for a tiny price a business that went on to be a core part of Broadcom today. Obviously, it would’ve been nice if they’d kept hold of that one.

Agilent engineers have clearly developed something that’s unique and are seeing demand from customers. It’s a healthy sign that the company is willing to back them with the capital that they need. They run a pretty cautious balance sheet. They’ve got 1 times net debt to EBITDA.

If it’s a choice between basically giving away the opportunity to someone else who’s going to spend that money backing your own engineers, we were pretty glad to see they had a culture, firstly, where they could reach the right people to make that kind of decision, and then also where they decided to back their team and build out that facility. We viewed it as a positive.

When it comes to other capital allocation decisions, you have CapEx there, reinvesting in the business and some of the opportunities. You tapped into some bolt-on M&A historically and some bigger acquisitions. How core to the overall Agilent thesis is M&A, and how important is the willingness to continue to look for bolt-ons and other deals that fit the general thesis of what they’re doing?

I think they’ve got a decent, long track record of doing small bolt-ons. We think that’s a pretty good thing. I wouldn’t say it’s a significant driver of growth, at least in the short term. They’ve generally used them for 1 of 2 purposes.

One would be to fill in a small technology gap. For example, they recently acquired a software business that specializes in lab productivity software. So now you can buy your Agilent instrument, consumable, and service, and plug it into this Agilent piece of software that will track usage, reorder consumables, and call service technicians automatically if a machine breaks. All of that kind of stuff seems pretty logical to acquire from a small business that’s doing that. So we like that.

The other would be to add adjacent products where they’re selling to the same customers.

So that would be BioVectra recently, where they've got this NASD business that was organic. BioVectra had some additional capabilities, particularly around filling and packaging some of the products that benefited that NASD business. That, to us, felt reasonably sensible. Of course, there's always an element of risk, and as the deals get larger, the risk goes up. So we're keen that there's a sort of upper level on acquisition prices, but so far they seem to be being sensible, and I wouldn't say it's core to the strategy.

There's a history of it. It's not core to the thesis from year to year, but it can be a nice tack-on when executed well. When thinking about valuation for Agilent, or this type of business in general, how would you say investors generally frame valuation for this type of business? Is there a specific methodology? And feel free to group yourself in there with any type of methodology that you think is relevant.

7. Valuation Frames The Opportunity

We tend to focus on either free cash flow yields or price-to-earnings multiples. I think we find them the right mix between simple enough to ensure usability, but also comprehensive enough to actually be useful. Agilent, for example, was trading above a 4% free cash flow yield in recent months, which is close to the highs it's been over the last 10 years, basically since the Keysight spin-off, which we view as pretty reasonable for a business that we think should be growing earnings high-single-digit. That equates to a just-sub-20-times price-to-earnings multiple. Again, it looked reasonable for a business like Agilent where cash conversion is pretty stable; the 2 are largely interchangeable. Generally, we're trying not to overcomplicate it. If we really like the business and we're confident about the long-term growth, then as long as the valuation looks reasonable, we're likely to invest.

I admire it. I will not poke any holes in it. Oftentimes, I love a simple P/E multiple inverted into a cash flow yield when the earnings conversion is fairly smooth into free cash flow. So bonus points for me on that. Simplicity is often a good thing.

You outlined it fairly simply even in that response, where there's visibility into high-single-digit earnings growth. You do have this cash flow conversion. Would you say there are any tailwinds that could result in more material outperformance? I rarely have to mention this in an episode because usually we get a very bullish presentation of the different things. I think this has been very balanced and fair in terms of presenting the business and the outlook. Is there anything that you think is missing or not mentioned as a potential upside lever or catalyst?

I wouldn't underestimate the need for testing what is in a sample and the unusual use cases that pop up for that. The most recent example of that I'd point to is PFAS testing, or “forever chemicals,” as they're often referred to in the press. There's a huge amount of regulation that's appeared in the last 2 or 3 years around testing food and the environment and chemicals as well for the presence of these PFAS.

They're long-lasting chemicals. They're used in everything from nonstick pans to firefighting chemicals. The problem is they find their way into food and water and humans and children as well, and they've been shown to be harmful to consumers in several studies. There's a lot of regulation coming in. This is already a $400 million market growing 20% per year, and Agilent is the clear leader in this market.

So this is a sort of market that popped up overnight where we need to test this sample. Agilent's the clear leader in applied markets testing, and it's growing like an absolute weed. So there's definitely upside from these testing markets seeming to appear out of thin air.

Interesting example that paints the picture quite well. On the opposite side, when you think about the risks, you referenced some of the cyclical exposure that they might have. Is there anything else—any customer-concentration risk or anything else, whether it be from overseas, cheaper products, or things along those lines—that stand out to you?

The primary risk to the business we spoke about earlier is the cyclicality based on those big end markets. So if a farmer isn't spending, that's not a great environment for them. They're not too reliant on U.S. government funding or anything like that. So academia and government are only just under 10% of sales, and actually the NIH-related funding, which is the one that's particularly under pressure, is only about 1% of their sales, so it's not a huge part.

China's the only other part that's hard to forecast. I think we can be confident about the need for testing there in the long term. In the short term, of course, it can be hard to predict. They're the main ones I'd point to.

This question will come a bit out of order, but the M&A thesis that I described within the business—I'm curious if this is ever a target of M&A in terms of them being acquired, Agilent being acquired. Does that come up? Because it does have certain characteristics which would fit what acquirers would look for, and I just wonder if that's ever out there in the market or in the headlines.

I haven't seen that in the market, if I'm honest. It'd be hard for one of their direct competitors to acquire them. Thermo Fisher would, I'm sure, love to buy them. It's a very acquisitive company. It's much larger. It probably could if it really wanted to. I think the challenge would be you'd attract competition scrutiny. I'd struggle to see that one happening. Otherwise, we certainly hope they remain a sort of independent business.

Yes. Don't get in the way of compounding. Well, this has been fascinating, and I think you simplified some pretty complex topics, so I appreciate that. I can say that personally. The way that we close out these conversations are with the lessons that you could potentially take away and apply elsewhere as an investor. What would stand out from doing your research and your experience with Agilent that might be a takeaway for other investment work?

There are 2 that came to mind. The first one would be not to underestimate the quality of what sounds like a boring business. If I was to tell you at the pub about a business that services lab instruments, you might be forgiven for telling me to move on. Actually, this is a fantastic business: 33% operating margins, growing high-single-digits, with a really good long growth runway as they grow that attach rate. Not to be underestimated.

The other one would be that actually, often it's better to be in the businesses that are supplying tools. In this case, the life science tools companies have outperformed the pharmaceutical sector hands down, and Agilent is a testament to that.

Picks and shovels. It's been working for almost 200 years now. Well, Mark, this has been an excellent conversation. It's been a pleasure. Thank you so much for joining us.