Business Breakdowns
· Mark de Vos, Matt Reustle
[00:00:00] S1: Yes. Unsurprisingly. Consumables and servicing is a fantastic business. I think the instrument sales is definitely more competitive than the servicing. I think consumables is probably the most competitive. So the instrument sale business depends a bit where they're selling to. Selling to life sciences, they're making around a 20% operating margin. But selling to the applied markets I spoke about a little bit higher sort of 24% or so operating margins. If we think about that consumable and servicing business, that's the 34% margin business. It's grown pretty steadily over time. It's also been amongst the fastest growing divisions. [00:00:00] S0: At 50% of revenue, obviously 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 and the history would be useful as well.
· Mark de Vos
[00:00:00] S1: I think rolling back 10 years, if talk 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 two different teams. One team would go yes, we sold an instrument. And then maybe six months later someone from Agilent, they call it CrossLab, it's their servicing division, would walk in and try and sell their services. By which point maybe a local technician group, maybe 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. New instruments sold is obviously a fair bit higher. And if we were to look at some of their peers, Waters, who's been much better for much longer at selling those servicing contracts with instruments there in the 50s percent, there's definitely a pretty long runway I think on that. And then when you think about the economics of that service business, it's a classic density business whereby you're in a city, you've got five technicians that operate in that city. To take on 5% 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, you've got an admin team there. It really scales quite nicely as you build up density in a local area.
· Matt Reustle, Mark de Vos
[00:00:00] S0: 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, anything around free cash flow for the business over time. [00:00:00] S1: The company generates around $1.4 billion or so free cash flow a year. It's about 90% of adjusted net income. It's been pretty stable in recent years, that 90% number. 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. [00:00:00] S0: 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.
· Mark de Vos
[00:00:00] S1: Perhaps new business segment is actually a little bit harsh. It's actually an old business segment which is growing rapidly. So they have a notable business that they call NADS, Nucleic Acid Solutions Department. NADS. It produces what are called oligonucleotides, oligonucleotides we can call them. They're 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. So these oligonucleotides are a key part of the production process and they're used typically 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 these. It's interesting as it was actually initially a tiny part of Agilent. It was formed in 2006 by merging some technology Agilent already had in-house, which was around knowledge on RNA molecule synthesis, with a business they acquired called SynPro. Again, 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 20 years. And then in 2018 they start to see a lot of orders both to the development and potentially commercialization of some of these drugs. At that point they had an interesting decision to make. They had to either invest $185 million in growing this production facility or not, and give away the business either to someone else or try and sell that asset. They decided to invest organically back their engineers and so they spent $185 million in 2018 and demand continued to grow. So actually in 2023 they broke ground on a further $725 million expansion of that facility. It's in Frederick, Colorado. So far, demand's 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 to what they've done in the past.
· Matt Reustle
[00:00:00] S0: If chromatography was not 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. And I'm just curious if you could expand on that a bit more.
· Mark de Vos, Matt Reustle
[00:00:00] S1: They're not generally tied to a single pharmaceutical company. They work with all of the main manufacturers of these types of drugs. There is 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 sort of oligonucleotides to support the project. But the payback is if they make it to commercialization and some of them are now moving to commercialization, that the volume really ramps. And that stays with Agilent. There's no other company that has equal capacity or larger capacity than Agilent for producing these specialist oligonucleotides. Most things, it's probably easy to make in really small quantities. But if you want to make production-grade stuff where you can make 100,000 vaccines, then really it's only Agilent you can work with who have 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-in-one drug or nothing. [00:00:00] S0: Is it tied to the mRNA more broadly? That theme within pharma broadly. [00:00:00] S1: Correct. The step back of RNA-based drugs is unhelpful and things like changing in the funding environment and things like that. 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.