Agilent: Beyond The Spin-Off

Global mobile data traffic is expected to grow from 127 mb/month in 2012 to 1078 mb/month in 2017, at a compounded annual growth rate, or CAGR, of 53%. Also, the global number of mobile users is forecasted to grow from around 4.3 billion in 2012 to 5.2 billion by 2017. These forecasts look promising for the communications testing business of Agilent Technologies (A). The communications business comes under the company's electronic measurement group, or EMG, and accounted for 34% of EMG's revenue, or 14% of Agilent's total revenue in fiscal 2013. The company has listed the following growth drivers for its communications market.

End market	Long term market growth	Growth drivers	Market position
Communications	4%-6%	Mobile data traffic growth Subscriber growth in China, India, Brazil Complex components and chipsets	No. 1

Agilent anticipates the overall communications testing market to grow by 4% to 6%. Considering the company's No. 1 market position, I expect its communications testing business to grow in line with the overall market.

Even though the communications division reported a 20% year-over-year decline in revenue this fiscal year, primarily due to the loss of a large wireless manufacturing customer, Agilent's wide range of products and services will help it generate better revenues in the future.

Communications test products and services	Network equipment manufacturers	Used in developing and installing network technology for transmitting voice, data, and video traffic.
	Wireless device manufacturers	Used in designing, developing, manufacturing, and repairing mobile devices.
	Communication service providers	Used in monitoring and evaluating network performance and identifying communications failures.

Apart from its wireless network, the company manufactures testing equipment for microwave, voice, broadband, data, and fiber optic networks covering the entire communications market. The global unified communications market, which includes all forms of real-time communication services such as telephony, instant messaging, and data sharing is expected to grow at a CAGR of 15.8% from 2012 to 2016. Long-term, Agilent is in a good position to take advantage of overall growth in the communications market.

Will spin-off lead to better efficiency?

Agilent's split into two separate publicly traded companies is expected to be completed by November 2014. The LDA group, which will concentrate on life sciences, diagnostics, and applied markets, will retain the Agilent name. The second company, which has yet to be named, will focus on electronic measurement. In fiscal 2013, Agilent posted a 1% decline in revenue, largely due to a 12.6% decline in EMG's revenue.

Even though Agilent did not report impressive top-line growth in 2013, the company's income statement reveals a different story. In the last three quarters the company has improved its cost structure, thereby reflecting better operating efficiency.

Parameter (as percent of revenue)	Q2 2013	Q3 2013	Q4 2013
Cost of sales	48.56%	48.18%	47.15%
R&D expense	10.45%	10.35%	10.07%
SG&A expense	28.70%	27.18%	26.19%
Net profit margin	9.58%	10.17%	12.28%

In terms of efficient use of funds, Agilent has been posting a decent return on capital employed, or ROCE. In the last three years the company posted a double-digit ROCE, as seen below:

Agilent	2010	2011	2012	2013
ROCE	8.64%	15.48%	14.11%	12.91%

Further, Agilent's split will allow management to strategically focus on running the LDA business and EMG business separately. The two businesses are unrelated, and the spin-off will allow more efficient allocation of the company's capital. I expect separate management teams to maximize the profitability of both businesses, thus improving its ROCE.

A glance at competitor's capital efficiency

Agilent's peer, Thermo Fisher Scientific (TMO), was cleared by the European Commission to acquire Life Technologies (LIFE) in November 2013. Thermo Fisher now awaits the clearance from the U.S. Federal Trade Commission and expects the acquisition to be completed early in 2014. Earlier this year, Thermo Fisher announced the acquisition of Life Tech for $15.8 billion, which includes Life Tech's assumed debt of $2.2 billion. The transaction will increase Thermo Fisher's total debt by $10.8 billion in addition to $7.1 billion of debt reported at the end of third quarter. To fund the acquisition, the company has already raised $3.2 billion in debt. With the increase in debt, it becomes important for the company to generate sufficient returns to pay off future debt obligations.

Thermo Fisher	2010	2011	2012
ROCE	6.38%	5.74%	6.04%

The ROCE for the past three years is disappointing for Thermo Fisher compared to the ROCE for Agilent. Moreover, the company's increase in debt will require a higher ROCE as interest expense is bound to increase. For Life Tech also, the ROCE in the past three years has been a single digit number. However, the ROCE improved consistently during the period, mainly due to the company's long-term debt reduction from $2.7 billion in 2010 to $2 billion in 2012.

Life Technologies	2010	2011	2012
ROCE	7.62%	8.08%	8.79%

Dividend, earnings, and free-cash-flow yield

In November, Agilent increased its quarterly dividend by 10% from $0.12 to $0.132, boosting investor sentiment. Last year, Agilent distributed its first quarterly cash dividend of $0.10 and has been paying regular quarterly dividends since then. Below, I have analyzed Agilent's dividend, earnings, and free-cash-flow yields with that of Thermo Fisher.

Dividend yield	Agilent	Thermo Fisher
2012	0.98%	0.85%
2013 (TTM)	0.86%	0.55%

Earnings yield	Agilent	Thermo Fisher
2011	7.69%	7.69%
2012	9.08%	5.03%
2013	3.68%	3.31%

Free-cash-flow yield	Agilent	Thermo Fisher
2011	8.14%	8.23%
2012	8.14%	7.36%
2013	5.70%	4.18%

Agilent generated a better dividend yield than that of Thermo Fisher in the last two years. Agilent's higher earnings yield showcases its ability to earn more than Thermo Fisher for every dollar invested in the stock. Also, the company has generated an impressive free-cash-flow yield in the past three years. On the basis of all three yields, Agilent appears to be relatively undervalued.

Conclusion

I expect the growing subscriber base and mobile data traffic to drive Agilent's communications testing market growth. Moreover, the company has displayed improved profitability and efficient use of capital compared to its peers, and its plan to split up will improve its ROCE, as I expect better capital allocation. Finally, Agilent's yields analysis suggests an upside in its stock price. I recommend a buy on Agilent.

Source: Agilent: Beyond The Spin-Off

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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