Agilent's Growth is Driven by Strong End Markets

Agilent $A is a pure analytical and electronic measurement company that provides solutions to diversified sectors involved in industrial output. I like this stock because it combines diversified cyclical growth and a secular growth story that is dependent upon new product development and regulatory and legislative drivers.

Agilent has been very active in research and development over the last few years and is starting to see the benefits of this. Furthermore, this transformation has seen the company shift from relying on over 40% of its revenues from the semiconductor industry towards becoming a truly diversified company. It is highly cash generative and promises strong growth.  It's time to take a closer look.

Agilent's Profit and Revenue Drivers

The three main divisions of Agilent are broken up as follows

Agilent	2010 Rev (bn)	2010 Op Margin	Growth Rates	Market Size (bn)
Electronic	2.8	16%	4-5%	12
Chemical	1.2	23%	5-6%	10
Life Sciences	1.5	15%	5-7%	19

In addition, Agilent sees its end markets as growing at 5-7% over the long term but the opportunity looks larger in the markets (particularly life sciences) where Agilent has the chance to expand market share. This doesn’t come without risk because the academic and governmental markets (not for profit) within life sciences could come under funding pressure going forward. However, this makes up only 8% of total revenues with the ‘for profit’ sector (biotech/pharma co’s) making up 14% of revenues. In addition, within life sciences, Agilent is seeing strong growth from the shift towards generics and biologic. Furthermore, Agilent is wel placed to benefit from the movement towards Ultra High Pressure Liquid Chromatography (UHPLC) from High Pressure Liquid Chromatography (HPLC).

Agilent is well diversified with the largest single segment (industrial, computing and semiconductors) only making up 21% of current revenues. The second largest segment is communications which is driven by technological change and LTE rollout as well as China’s 3G expansion. Agilent looks well placed in many markets.

Emerging Market’s are Key to Agilent’s Growth

Agilent are well placed in emerging markets and all three of the divisions are seeing an increase in the share of their revenues coming from Emerging Markets. In addition, Agilent’s strong market position in Electronic Measurement Group (EMG) puts them in good stead as manufacturing production shifts increasingly out to Emerging Markets like India, China etc. The return in investment is higher in EMG than in the other two divisions but Agilent is more established in this sector.

It is a similar story with the Chemical Measurement Group whereby there is strong growth from Asia. In addition, global trends are towards increased awareness of food safety and environmental awareness, which is all positive for measurement solutions like Agilent.

Somewhat surprisingly, Agilent is also seeing strong growth in Life Science’s group from Asia and this division appears to be the most exciting for Agilent overall. In essence, it is an opportunity that is categorised by the chance to grab market share in a fast growing (probably around GDP+3%) sector which is driven by proprietary technological change.

Agilent Stock Evaluation

Agilent currently trades at around $51.66 which gives it a market capitalisation of around $18bn and $17.3bn in Enterprise Value. The company is highly cash generative with diversified revenue streams and has invested impressively in R & D over the last few years. I like the diversification and the opportunities for upside potential given the tendency for greater quality control in increasingly complex manufacturing and research processes.

Analysts have forecasts of $2.88 and $3.28 for the year to Oct 11 and 12 respectively from $2.00 in 2010.  However, as ever, this doesn’t tell the full story. Free cash flow generation over the last three years has been $600m, $280m and $497m respectively and I think it is reasonable to expect around $900m for the year to Oct 2011. This puts Agilent on a FCF/EV of around 5.2% and that is too cheap for a company growing earnings in the mid teens.

I bought some with a target price of $58.

Fastenal Set for Good Growth but What About the Evaluation?

Hardware wholesaler and retailer Fastenal gave results recently and, the market bid the stock down, they beat on revenues but earnings were slightly shy. For Q4 Fastenal reported revenues of $573.8m and EPS of 44c. Analysts forecasts were for $563m and 45cents respectively.

Before I get into more detail on Fastenal, I want to outline the Co’s main objectives as laid out in the ‘pathway to profit’. I do these write-ups to serve as a reference point for future research and I find this sort of benchmarking useful.

Fastenal Pathway to Profit

This is a set of strategic end points that was originally laid out in 2007, but it has seen adjustment due to the effects of the recession.

1.  to continue growing our business at a similar rate with the new outside sales investment model
2. to grow the sales of our average store to $125 thousand per month in the five year period from 2007 to 2012
3. to enhance the profitability of the overall business by capturing the natural expense leverage that has historically occurred in our existing stores as their sales grow, and
4. to improve the performance of our business due to the more efficient use of working capital (primarily inventory) as our average sales volume per store increases
5. 85% of earnings in operating cash flow

As a consequence of the recession the Co reduced the growth of new store openings and headcount additions. Furthermore in 2010, Fastenal pushed out the $125k a store target until 2014 but announced that it was possible to hit the profit objectives (23% operating margin) anyway, thanks to cost cutting.

Scorecard on the Pathway to Profit

Firstly, I want to outline how Fastenal is now increasing the share of sales force outside the store…

	Q1 2007	Q3 2008	Q4 2009	Q1 2010	Q2 2010	Q3 2010	Q4 2010
Store Personnel	6383	8280	7007	7004	7118	7450	7611
Non-Store Sales	616	599	597	594	591	639	712
Percentage	8.8	6.7	7.9	7.5	7.7	7.9	8.6

 source: Fastenal, Earnings View

Secondly, as discussed earlier the aim of sales of $125k per month per store has been pushed out by two years but, they think they can hit the 23% operating margin target early.

Thirdly, the development of leveraging up on sales has been held back by the recession. I want to highlight the percentage of pre-tax profits generated by stores with sales of over $100k a month.

Stores Selling over $100k per month	2008	2009	2010
Percentage of Stores	20.7	12.7	19.1
Percentage of Pre-Tax Profits	53.3	48.8	52

 source: Fastenal, Earnings View

Again, there is a return in the numbers but they are still not back to 2008

Fourth, looking at working capital as a percentage of sales tells a similar story.

	2008	2009	2010
Accounts Receivable	244940	214169	270133
Inventories	564247	508405	557369
Working Capital	809187	722574	827502
WC/Sales %	34.6	37.4	36.5

source: Fastenal, Earnings View 

In essence, Fastenal have been held back from achieving the ‘pathway to profit’ objectives but look set to get there in future.

Fastenal End Demand is a Combination of Industrial and Residential Construction

In these results, Fastenal has benefited most strongly from a cyclical recovery in industrial production and less so from ongoing demand from maintenance. However, commercial residential construction customers (which usually represent 20-25% of their business) are still in a funk, despite the recorded growth. I would guess that this growth is coming of a very low base and, until the US housing market recovers, it will not come back in a meaningful way.

Fastenal Revenue Growth

On the conference call, Fastenal argued that

‘think it's a reasonable target. Some of the puts and takes would be if you look at the historical patterns, we normally touch start our January at or above where our October daily average was, which puts us in the 20% range in January. If you start out there, even if it slowed down a little bit, you should be able to hit the 15% to 20% for the year. Right now, we do not predict that it will be slowing down. So we're pretty confident in the 15% to 20% sales range at this point.’

Looking at the October number for stores opened for more than two years, it is 18.8% growth. Considering that most analysts have 2011 GDP growth to be similar to 2010, they could hit this again in 2011. Moreover, they are opening 150-200 new stores in 2011. Assuming $10k per month for 175 stores over the year gives another 21m or about .9% to 2010 revenues. Adding these two numbers together gives 19.7% for the year.

On top of that, 2010 saw very weak housing starts data. I think this will continue into 2011 as there remains a substantial amount of shadow inventory. However, the market has stabilised and I think there could be stronger activity in the second half. In addition, increasing employment and discretionary spending should aid Fastenal. I think they could achieve 16% revenue growth next year. I’ve shaved off 2% points to reflect on the slowing in the rate of growth of industrial investment spending.


Fastenal Evaluation

This would give $2.62bn in sales, which could give $2.20 in EPS or $324m in net earnings. If operating cash flow is again around 85% this gives $275m in operating cash flow, if capex is around $70m (new stores etc) this gives $205m in free cash flow.

I would want to buy it at a forward FCF/EV of around 4% which would give it a share price of $35. I find myself in a curious position of thinking forecasts are too light but that the company is overvalued. Frankly, I don't buy the analysts forecasts of 20% growth for next five years. Fastenal maybe recovering, but we are not going back to a housing boom anytime soon.