Business Breakdowns
· Mark de Vos
[00:00:00] S1: I think Agilent has a really interesting history. It actually starts way back in 1938. Hewlett Packard, or HP, started by two electrical engineers, so Bill Hewlett and Dave Packard working in a garage. Pretty well known story. And 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 their testing and measurement business, both electrical testing, but also over time for molecular analysis. And this included the acquisition of a small business called F and M Scientific in 1965. That business had quickly become the leader in what's called gas chromatography instruments. Their instruments were used for the first full-scale testing for steroids in 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 they spun out several businesses, including testing and measurement into a new business called Agilent. HP kept their computing and imaging business with everything else going into Agilent. It was a bit of a mixture of assets that they inherited, but there was also some real gems in there, 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, that's the most recent significant change. So Agilent spun out their electronic measurement business into a separately listed company called Keysight Technologies. It's still listed today. It's doing well, that's really important. At the time it was about 40% of sales. They were spinning out. And Keysight, whilst it was a great business, was selling equipment predominantly used for testing electronic devices during manufacture. So this was a really cyclical business and didn't really closely align with the rest of what Agilent was doing.
· Mark de Vos, Matt Reustle
The business that remained was entirely focused on analytical equipment for the life sciences, diagnostics and chemicals market. So much more focused. What the management team was trying to do was have a much more clean, predictable, less volatile business, still have those long-term growth drivers. [00:00:00] S0: It's very interesting when you find these family trees, Standard Oil being one that broke up, but all essentially in the oil business. In various forms HP being a new one that prior to this episode I didn't appreciate just how much had been born out of that family. Quite some impressive market caps on those businesses that you reference. You mentioned the electrical testing versus molecular testing feels very different to me in terms of yes, they're both testing something at the surface level, but molecular versus electrical feels like it's very wide gap. Was there a certain cultural DNA or recruiting mechanism that they got people attracted to the overall HP brand that allowed them to do that? This is a bit of a segue, but I am curious how they were able to foster innovation in two relatively different categories, at least to my brain.
· Mark de Vos, Matt Reustle
[00:00:00] S1: I think they inherited a lot of people. So Agilent is still based in Santa Clara. I think they're about 20 minute drive their current HQ from the original HP garage where it all started. There's obviously this sort of HP way culture as well, which we obviously own the shares. We've been impressed with the way that they run the business for the long term, the way they look after their people. You kind of get a sense for it. But we experienced that in COVID-19 where right off the bat they were first out the doors saying no one in this company is losing their jobs or anything like that. I think that builds up loyalty and it's not unusual. When we meet managers, they're generally Agilent lifers that started as engineers. [00:00:00] S0: 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, razor blade approach with their business. How would you categorize what they're doing beyond selling just equipment outright?
· Mark de Vos
[00:00:00] S1: 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 sort of 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. And then 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 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 six to 10 years. Over that useful life, the customer will typically spend another hundred thousand dollars 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 columns responsible for separating out that material and it's degraded by high temperature or extreme pH levels, things like that, and that impacts the resolution of the instrument. These are used for pretty critical applications. You basically have to replace it often. It wouldn't be unusual to hear a customer replace 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 the machine is operating correctly.
· Mark de Vos, Matt Reustle
So we're saying Agilent is one of only two 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. And 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 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 it's gone over the last five years from a sort of high 20s number to a low 30s percent. And we expect it to continue to grow about a 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 consumable 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 also there's some risks attached with that. So it gives a really nice recurring revenue on that consumable service spend. [00:00:00] S0: 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.
· Matt Reustle, Mark de Vos
[00:00:00] S0: 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. [00:00:00] S1: 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's definitely innovations around making the machines higher resolution, 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 one less instrument, then that's a big saving. [00:00:00] S0: 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 one associated with each drug? I'm trying to understand whether it's capacity constraints or what drives that.