Agilent Technologies, Inc. Q3 FY2020 Earnings Call

Good afternoon, and welcome to the Agilent Technologies Third Quarter Earnings Conference Call. All lines have been muted to avoid background noise. There will be a question-and-answer session following the speakers' remarks. Thank you. Now, I would like to introduce the host for today's conference, Ankur Dhingra, Vice President of Investor Relations. Please go ahead.

Thank you, Robert, and welcome, everyone, to Agilent's conference call for the third quarter of fiscal year 2020. I hope that all of you and your families are safe and healthy. On the webcast today are Mike McMullen, Agilent's President and CEO; and Bob McMahon, Agilent's Senior Vice President and CFO. Joining for the Q&A after Bob's comments will be Jacob Thaysen, President of Agilent's Life Sciences & Applied Markets Group; Sam Raha, President of Agilent's Diagnostics and Genomics Group; and Padraig McDonnell, President of Agilent CrossLab Group. You can find the press release, investor presentation and information to supplement today's discussion on our website at investor.agilent.com. Today's comments by Mike and Bob will refer to non-GAAP financial measures. You will find the most directly comparable GAAP financial metrics and reconciliations on our website. Unless otherwise noted, all references to increases or decreases in financial metrics are year-over-year, and revenue growth will be referred to on a core basis. Core revenue growth excludes the impact of currency and the acquisitions and divestitures completed within the past 12 months. We will also make forward-looking statements about the financial performance of the Company. These statements are subject to risks and uncertainties and are only valid as of today. The Company assumes no obligation to update them. Please look at the Company's recent SEC filings for a more complete picture of our risks and other factors. And now, I would like to turn the call over to Mike.

Thanks, Ankur, and thanks, everyone, for joining us on our call today. The Agilent team delivered excellent results in the third quarter in the midst of a historic global pandemic. Against this backdrop, Agilent's performance once again highlights the strength and resiliency of our team and our business. Agilent's Q3 revenues are $1.26 billion. Our revenues are down just 1% on a reported basis, despite COVID-19 headwinds in what we expect to be the year's most challenging quarter. On a core basis, revenues are down 3%. These results demonstrate the strong resilience we have built into our business over the past several years. EPS is $0.78 per share. This is a 3% year-over-year increase. Operating margin grew 90 basis points over last year to 23.7%. Our Q3 results are further evidence of the success of our profitable build-and-buy growth strategy. We continue to build a more resilient growth-oriented business. Last quarter, I talked to you about the four key priorities we're focused on during the COVID-19 pandemic: Protecting our people; being open for business for our customers; taking decisive action to deliver our P&L and balance sheet; and unwavering commitment to growth. Staying focused on these priorities has helped us navigate through the COVID-19 effects on our team, customers and business. Our customers continue to respond very favorably to our team's engagement and enhanced digital capabilities. In fact, Q3 customer satisfaction rankings are at all-time highs. In all regions, we're seeing improvement in lab access for our customers and increased non-COVID-19 testing volumes. There are, however, regional and end-market differences in the pacing of improvement. Lab access improved through the quarter, although still not at pre-COVID-19 levels. Globally, lab access remains limited in academia, non-COVID-19 research and testing labs. We're also seeing continued limited access at some private sector research labs in Europe and the United States. Similarly, non-COVID-19 diagnostic testing volumes improved throughout the quarter, but remained down from prior levels. Hospital access in Europe and the U.S. is improving, although disrupted at times by virus flare-ups. While there are indications of improvement in economic growth at varying degrees across the globe, caution remains at customer capital expenditure decisions. Consistent with our thinking coming into the quarter, the pace of recovery varied by region. As expected, China led the way for us and exceeded our expectations with revenues up 11%. China's growth in the quarter is broad-based across all end markets and for all business groups. While improving, the rate of recovery in Europe and the Americas lags China, given the timing when these regions first felt the brunt of the pandemic. European revenues are down 5%. Americas market conditions trailed both China and Europe with revenues declining 10%. However, as we exited the quarter, we are seeing signs of improvement in service activity, consumables and diagnostic testing volumes. On a total company basis, we exited July with modest growth across all major markets. Now, let's talk about our performance by business groups. Our Life Sciences and Applied Markets Group grew 2% on a reported basis and declined 4%. Our team is focused and determined to gain market share despite a constrained capital environment. The strength of our portfolio coupled with an energized and stable sales team is paying dividends. I'm also very proud of the contributions our cell analysis technologies are making in COVID-19 virus research. Our M&A strategy is working and making a difference in the pandemic fight. Our CrossLab Group revenues grew 1%. An increase in customer activity led to increased sales of consumables and an uptake of on-demand services. The CrossLab team continues to win large, multiyear contracts for enterprise laboratory management that will benefit us moving forward. We will continue to increase our competitiveness in this space. Our Diagnostics and Genomics Group revenues declined 8%. While our overall pathology and genomics businesses are down for the quarter, we did see gradual improvement in diagnostic testing volumes and non-COVID-19 lab openings. Partially offsetting this, our nucleic acid solution business delivered another strong quarter, growing almost 25%. We are very excited about the future of our NASD business. As we announced earlier today, we plan to more than double oligo manufacturing capacity at our new Frederick, Colorado site. This expansion helps us meet significantly increasing customer demand. We are growing double-digit and expect to continue this rate of growth in the coming years. We continue to advance in our portfolio across all our businesses. Highlights during the quarter included LSAG launching two new LC/MS products: the Agilent 6470B Triple Quad and the Agilent RapidFire 400 systems. Both products are in high throughput labs, driving productivity and superior resolution. We launched our CrossLab Asset Monitoring service, which is a new subscription service using instrument sensor technologies to provide data-driven usage insights. This helps drive improved customer economics and lab productivity. While early, we are seeing strong interest from customers in this service. During the quarter, our PD-L1 assay was approved by the FDA for expanded use in non-small cell lung cancer, helping guide physicians in selecting treatments using specific immunotherapies. Our team is very proud of the role our company is playing in the global COVID-19 fight. We are supporting COVID-19 research, testing and therapeutic vaccine development. Our efforts in the global fight against the virus delivered 2 percentage points of reported growth. We are accelerating efforts to make a difference in the battle against COVID-19 and have mobilized the entire Agilent team to maximize customer support. Let me close with a few comments on our outlook in the coming quarter. While there's still significant uncertainty regarding the continued pace of recovery, we expect the July trend of gradual improvement in our business to continue into Q4. By region, China will continue to be a positive story for us and lead the return to growth. Europe is starting to trend upward. The Americas are also expected to improve but at a lower rate than China and Europe. Globally, improved lab access, increasing non-COVID-19 testing and a slowly recovering global economy are all positive signs. I remain absolutely convinced Agilent will emerge from this pandemic with a stronger position in the marketplace. Our continued focus and action on four priorities—protecting the team, supporting our customers, preserving our P&L and balance sheet, and our unwavering investment in growth—are delivering. Entering Q4, we are operating from a position of strength and momentum. Yes, this pandemic remains unpredictable. However, I am cautiously optimistic about our continued gradual recovery and return to growth. Before I hand the call over to Bob, I'd like to pause and share my hope that you and your loved ones are staying safe and healthy. Thanks for being on the call. I look forward to taking your questions after Bob's remarks. And now, Bob, over to you.

Thank you, Mike, and good afternoon, everyone. Today, I'll provide some additional detail on revenue, walk through the third quarter income statement and some other key financial metrics. And then, I'll finish up with a framework for thinking about Q4. As with last quarter, there are still too many unknowns, so we're not going to provide formal forward-looking guidance today. However, we will provide a framework for how we see things potentially playing out in Q4. Unless otherwise noted, my remarks will focus on non-GAAP results. As Mike mentioned, our revenue for the quarter was $1.26 billion, down 1% on a reported basis. On a core basis, revenue declined 3.1% in the quarter. Currency negatively affected revenue by 1.3 percentage points, while acquisitions added 3.4 percentage points to growth. As Mike talked about the regional performance, I'll speak to the end-market performance. In terms of our end markets, pharma grew 2% in Q3 against a very strong comparison of 13% from last year. Both small and large molecule applications grew, and biopharma improved throughout the quarter as drug development labs increased production and access. We experienced softness in diagnostics and clinical, as anticipated. Revenues declined 10%, primarily due to conditions in the U.S., driven by COVID-19-related disruptions to patient visits and diagnostic lab opportunities. Encouragingly, we did see an improvement in routine testing throughout the quarter, especially in China and Europe, while the U.S. lagged. Chemical and energy was down 10%, consistent with our thinking. Revenues were generally flat sequentially with conditions largely similar to what we saw in Q2. As we've talked about previously, we expect this segment to ramp more slowly than others. The food segment was a bright spot, up 8%. We're seeing ongoing signals that the market in China has stabilized with the transition of more testing by commercial labs. The food market was just one of several bright spots that contributed to double-digit growth in China, including growth in the low teens for our pharma business. Our environmental and forensics business declined mid-single-digits against the double-digit compare, and the academic and government segments declined mid-single-digits while improving on a sequential basis in Q3. Strength in cell analysis and liquid handling for viral research partially offset the widespread impact of the ongoing academic lab closures. Now, let's turn to the rest of the P&L. I'm extremely proud of how the Agilent team has responded to the challenging environment. During the quarter, we continued our focus on managing expenses while ensuring we continue to invest in our key growth opportunities. These expense management actions we initiated last quarter were on full display in Q3. In addition, our customer engagement model using digital tools continued to gain traction while also delivering savings in SG&A. As a result, operating margins of 23.7% improved 90 basis points over last year on declining revenues. Gross margin at 55.1% was down 130 basis points versus the prior year, largely due to mix and higher logistics costs. However, strong cost management and operating expenses more than offset the decline in gross margin. This combination of factors resulted in non-GAAP EPS for the quarter coming in at $0.78 per share, up nearly 3% from the number we posted a year ago. From a balance sheet perspective, we generated $290 million in operating cash flow during the quarter, which is a $48 million improvement over last year. In terms of capital spending, we spent $25 million, lower than last year and in line with our revised look in Q2. We ended the quarter in a strong position with $2.3 billion in available liquidity, including $1.36 billion in cash. Also during the quarter, we took advantage of low interest rates and refinanced $0.5 billion in short-term debt with a 10-year bond and a 2.1% coupon, the lowest coupon in our portfolio. As you know, we paused share buybacks in Q2, pending improvement in business conditions. In Q3, our visibility into business trends and cash flow improved, and we resumed anti-dilutive share repurchases late in the quarter. In the quarter, in total, we repurchased 360,000 shares for $33 million. Going forward, we intend to resume our normal pattern of regular anti-dilutive repurchases, along with additional opportunistic buying. Our overall capital deployment approach remains balanced with the primary focus on growth M&A opportunities while also returning the cash to shareholders via dividends and buybacks. As we look to Q4, business and trends have gradually improved, but significant uncertainty remains around the evolution of this pandemic. However, let me provide a framework for how we see a range of possible revenue growth scenarios in the coming quarter. We generally expect the trajectory of gradual improvement in business results to continue across all regions. Areas where we see a broader range of scenarios include research spending, both in academia and other markets, non-COVID diagnostic testing, especially in the U.S., and the general CapEx environment. The combination of these factors could result in scenarios where our revenue performance could range from a 4% decline to 1% core growth. Also, as a reminder, the BioTek acquisition closed midway through Q4 of last year. So, the M&A impact in Q4 will be smaller than in previous quarters, roughly 1 point growth, and currency is forecasted to be positive in the quarter. The low end of this range envisions COVID-19 flare-ups occurring in the fall in various geographies, limiting and in some cases, reversing the recovery gains we've seen in a period of time. In this scenario, one might expect to see slower or stalled improvements in research, academia, and other markets, as continued tight cash management leads to lower CapEx spending in the U.S. and Europe. We hope this bottom end of the range is overly conservative, but we wanted to let you know we have plans in place in case this happens. The higher end of the range assumes continued recovery by region, building on what we have seen in July, with the biggest impact coming from the U.S. This would include a continual increase in elective medical procedures such as cancer screenings, as well as continued lab openings. This view would also include continued China momentum, along with the continued improvement in Europe and other areas in the Americas. Again, this is not guidance, but should provide a sense of some of the variables we see for Q4. Overall, I feel we are very well positioned to deal with this challenging environment, accelerate market share gains, and come out even stronger as the global economy continues its path to recovery.

Thanks, Bob. Robert, if you can provide the instructions for the Q&A, please?

Your first question comes from Doug Schenkel with Cowen. Your line is open.

Hey. Good afternoon, guys.

Hey, Doug. How are you doing?

I’m doing well. Nice work in a tough environment. Can we maybe just start with a cleanup question right off the bat, which is just about the prepared remarks? I don't think you quantified COVID-19 tailwinds in the quarter. Again, I may have missed that. But, it just would be helpful to get that so we could try to normalize there?

Yes. Sure, Doug. I touched on it briefly in my comments. So, there's two points of reported growth in Q3.

That's great. Regarding China, I'm curious if you could share the exit rate. Looking ahead, I understand you're not providing guidance, but do you believe that double-digit growth can be maintained, at least in the near term? Also, specifically about food, it's encouraging to see it return to a solid quarter and some stabilization last quarter. Can the high-single-digit growth rate achieved this quarter be sustained moving forward, considering favorable multiyear comparisons? Thank you.

Hey Doug. Thanks for those questions. So, just to make sure it came through the audience. The question was about our view on the growth rate of China for the rest of the year, as well as can that high-single-digit growth rate in food be sustained. We think the answer is yes on both. We're really pleased with our performance in China. It was broad-based. I tried to really accentuate that in my comments. We saw basically double-digit growth across all end markets in China. And we think that a double-digit growth rate is within the realm of possibility for Q4 in China. And I have to say, Doug, it's wonderful we are talking about China food from a different vector. We've been talking about it probably for the last 18, 24 months as one that will return to growth. We saw some early indications in Q2, we saw a strong Q3, and we think that our all numbers are probably sustainable for the rest of this year. Want to say something, Bob?

Yes. I would just say, Doug, to add, I mean, one of the things that was very positive about China was it was pretty consistent across the quarter, and in fact exited slightly higher than that overall 11%, but we saw solid growth all three months.

Your next question comes from the line of Vijay Kumar with Evercore ISI. Your line is open.

Mike or Bob, can you clarify the guidance? Looking at the third quarter guidance, which is projected to be down mid-single digits to down mid-teens, the low-single digit increase was better than expected, although it may not have surprised industry peers, it still reflects solid execution. The Q4 guidance of a decline between 4 percent and an increase of 1 percent suggests downward trends. What is driving these declines, particularly since the lower end of the range seems to indicate challenges in the Life Sciences area?

Yes. Vijay, this is Bob. I'll take that. As I mentioned in the prepared remarks, we hope that our estimates are overly conservative. This suggests a potential reduction due to COVID-19 flare-ups in the U.S. as we approach the fall and possibly face some shutdowns. We certainly hope to perform better than that. However, we wanted to illustrate that this is part of our thinking regarding our spending and other factors. Our results in July showed that our exit rate for the quarter was much higher than our expectations, and we aim to do even better. Nonetheless, there remains uncertainty in the world due to the pandemic, school reopenings, and other factors.

And Bob, I think it’s probably fair to say, the wildcard is the United States, right?

Yes, absolutely.

And we were encouraged by the movement in PMIs. You probably noticed that. But, let's see how that translates into business in the coming quarter. And again, we have to keep in mind ourselves, as pleased as we are with the results we just delivered, there's still a lot of uncertainty out there because the virus is unpredictable at times.

Yes. That's right, Mike. I mean, if you looked at each one of the major markets, each one of the major markets got better in Q3 versus Q2 with the exception of the U.S., which we expected given kind of the state of affairs with the pandemic.

That helpful perspective. So, the minus 4 implies that things get worse. Was July flattish or positive? And I'm curious, Mike, that you mentioned NASD doubling up a while ago. I know, if you turn back the page, we were doubling capacity. So, is this now versus six months of a quadrupling capacity versus where we were last year? Is that the right way to think about the revenues going from 100, 200 to perhaps, is that the math here?

No, it's a slightly different calculation. We have consistently expressed our need to double our capacity. We have decided to start the expansion earlier than anticipated due to the strong demand in the market. Additionally, we challenged ourselves to find ways to maximize revenue within the same physical space. As a result, we are investing a bit more capital than we initially planned. However, we are also developing something that is somewhat different from our first train, which will actually provide us with greater volume than our current train A. We view this as a very positive development, which is why we issued a press release this morning, as we are very enthusiastic about our future prospects.

Yes. And Vijay, let me kind of frame into kind of the numbers. What we were talking about is the Frederick site has the potential of roughly $100 million worth of revenue. And we added capacity that more than doubles that $100 million to give you a frame of the numbers. So, it's not 100, 200, 400, it's 100, 200 and more than 300 to kind of give you a sense. And in terms of July, we actually came in with growth across all three groups exiting in July.

Your next question comes from the line of Tycho Peterson with JP Morgan. Your line is open.

I’ll start with the COVID commentary. I guess, if I go back to last quarter, there was some talk about launching the serology test. You guys obviously have an installed base of real-time PCR instruments. We've got the questions that why you haven’t launched a PCR test. So, can you just talk a little bit about how you think about those tailwinds going forward and how you think about your capabilities on the diagnostics side?

Yes. Tycho, I'll make some initial comments and then the group presidents are kind of quiet today. So, I’ll pull Sam in here as well to provide his perspective. But, we think that there's still tailwinds in front of us and now two points of growth, and we think we can sustain that at a minimum. That's why I tried to put fairly bullish comments about our stepped-up efforts across the Company. Some of these things are going to take a little bit longer. We think there's still room for our own tests of quality tests with some different features. But, I think maybe a few comments there, Sam, from your perspective?

Yes. Sure, Mike. Hi, Tycho. I think you’d have noticed a significant increase in our qPCR instruments, specifically our Aria systems, along with our bioreagents related to qPCR, including reverse transcriptase master mixes. On the antibody front, we've also observed a rise in IgA, IgG, and other antibodies. Regarding our own tests, we are actively exploring the potential for their development. More information will be shared in due course.

And Tycho, I guess, what I’d just close off here is the broad-based nature of our portfolio is allowing us to play in multiple aspects of this COVID-19. Some of these things may take a little bit longer to actually turn into revenue, right? So, if you're working with, say, a pharma partner or something in the therapeutic area, it may take a while for that to come to market. So, we think these tailwinds are here to stay for some time. And we're stepping up our efforts here because it plays right into the broad nature of our portfolio.

I guess that's a good segue on the NASD expansion. Could you maybe draw to what degree that's tied to the COVID vaccine and any updates from your add-on capabilities on APIs for mRNA or siRNA vaccines?

Do you want to take that one, Sam?

Yes, sure. No problem. Tycho, I'd start by reiterating a little bit of what Mike and Bob were talking about. It's interesting that it was just last June that we did a ribbon cutting and starting of the new Frederick, Colorado facility. And quite frankly, we've seen demand that exceeded our expectations, just 12 months ago. So, building really -- sorry, the new manufacturing line that we're building, you can consider it, as we call it, training on steroids as our general. But, it is very differentiated, both in throughput and the molecules it can do, which is a segue to your -- a little bit of your question that we're able to do multiple iterations or types of siRNA or RNA. We're also actively looking at other different versions of molecules that are oligo based. Though I can't reveal the details, we have had a lot of interest related to COVID-19, all of those used for either COVID-19-related therapeutics or even for vaccines. So, I can say that we have started to work on some of those programs now.

Yes. And maybe, Sam, to add. That being said, the capacity expansion isn't tied to COVID-19. We have plenty of demand outside of COVID-19 therapeutics and vaccines. And so, this is a broad-based capacity expansion.

And then, just one more question, I know we don't have official guidance, but there's a framework for the fourth quarter. As we consider C&E and also pharma biotech, should we anticipate any significant changes in either of those end markets for the upcoming quarter? I know you mentioned restoring activities for C&E, but I'm unsure if that indicates a positive improvement in that area.

Yes, I believe C&E will likely remain stable, decreasing about 8% to 10%. We expect the pharma sector to continue improving, so even in a low scenario, it would maintain around 2%, and in a high scenario, it should accelerate, which aligns with the trends we've observed in the third quarter.

And Tycho, the supply chain consideration and discussions still happen, and it adds a level of stability, albeit down into the space. And, again, as you look ahead for the future, this is an area where eventually it'll come back. And again, too early to call. But, I'd say we're pretty confident about the improvement rate in pharma.

Yes. The way to think about those reshoring is those are opportunities and discussions that could happen through the order book, and then will happen actually in '21 and beyond in terms of investments being made. So, that's more future-looking.

Your next question comes from the line of Puneet Souda with Leerink. Your line is open.

The first question is about NASD, which performed well this quarter. However, this suggests that Dako and the clinical business, which you noted, experienced a significant decline. Could you break this down for us? We understand the COVID impact, but are there other factors indicating a possible fundamental shift in the market towards NGS? If you could expand on that and clarify, it would be appreciated. Thank you.

Yes. Happy to do so. So, it's all market; it’s all access to labs and patients going for the diagnostic test. So, it's real all market. I think, we're seeing different pacing throughout the quarter. All of our geographies in the diagnostic testing front ended up with positive growth in July, but it was down sharply in May and June, particularly in the U.S. And keep in mind also, part of our business in our genomics front is so select into NGS-based diagnostic labs and for genetic disorders, for example, those tests aren't getting done either. So, it's really all market.

Yes. I was going to say, Puneet, actually if you bifurcate those two and look at our performance, actually, pathology performed better than NGS testing volumes, given what Mike was just talking about, as well as some of the academic institutions.

That's a good point, Bob. Thanks.

Yes. Thanks for that. And if you could, I know you quantified it last quarter, Bravo contribution. I was wondering if you can provide that for Bravo Magnis liquid handling system, sort of how much of that contribution happened in the quarter?

Yes. That's part of the story for our COVID-19 tailwinds. And I think probably the biggest contribution this quarter actually came from BioTek, Bob, if I remember correctly?

Yes. Between BioTek and Bravo.

So, it's kind of like, now we like a one-two punch kind of going there on the core instrumentation. I’d also remind you, with the Bravo platform comes an ongoing revenue stream associated with the tips that go with those liquid handlers.

Could you elaborate on the larger service contracts you're entering into during these times? What are the COVID-driven factors behind these contracts, and can you provide details on the geographical aspects?

Yes. Puneet, happy to have Padraig jump in here and provide his perspective on that. So, Padraig, in the call script, I talked a bit about the large enterprise deals you guys won. So, why don’t you talk about that in a little more detail?

Yes. So, thanks, Mike. We launched our CrossLab Asset Monitoring service, which has seen a big uptick. And what we're seeing from customers is a large demand for sourcing from one vendor. And because of our capabilities in terms of the asset monitoring capability, relocation services, and our core delivery services, which are extremely in strong demand. We're seeing a big uptick from large customers, and we expect that to continue as we go through the quarter, next quarter.

Yes. And I was going to say that I think the geography, Puneet, is largely in the U.S., but there are some global opportunities as well. It’s really non-COVID-19 related. I mean, this is part of the core growth strategy for Padraig’s business to continue to expand our market share on the Enterprise Services front. And we're really delighted that we made some big pharma deals.

Your next question comes from the line of Derik de Bruin with Bank of America. Your line is open.

So, a couple of questions. Very impressive margin expansion in the third quarter. How should we think about the operating margin into Q4? And then, I guess, how much of these costs are permanent removals versus what has to come back in '21?

Let me take that, Derik. It's a great question and we are very pleased with how the team has responded, as I mentioned before. A large portion of the costs remain intact as we have not implemented furloughs. We have stabilized the team without reducing base pay or similar measures. These are discretionary expenses, many of which we believe could be avoided, such as travel, and our digital tools have allowed us to continue supporting our customers effectively. There were no unusual one-time events this quarter. Looking ahead to Q4, we anticipate a smaller improvement in incremental margin because we are focused on investing to drive growth as the economy recovers. We also have some startup costs associated with the new facility. Therefore, the margin improvement is expected to be lower than the historical range of 30% to 40%, but our aim is to drive growth.

Hey Bob, if I could maybe add a comment on your first remark. So, this is really, Derik, all about a new way of working in Agilent. So, I'm preparing for a manager's call later this week. And what we're talking to our team about is more digital, less travel. And we're really going to make sure that when we get on the other side of the COVID-19 pandemic that we don't revert to our old ways of traveling. And we know from our customer satisfaction scores, they love the responses we have now with our digital platforms.

I have two questions regarding LASG. First, your performance in China has really outperformed that of your major competitors. Could you discuss the share dynamics in that market? There seems to be a significant contrast between your company and your main local competitor. Additionally, could you elaborate on any potential signs of budget changes as we look toward the fourth quarter? What insights do you have regarding budget allocations? Are companies likely to carry over budgets, or will they need to spend them before they expire? I’d like to understand the growth dynamics for the fourth quarter and your general thoughts on customer spending habits.

I'm going to have Jacob handle the first question. And Jacob, you can pass it back to Bob and I for the second question. And I know Jacob would be just delighted to talk about the share dynamics in China, which we think are very positive for Agilent.

Yes. Thanks for that. And the number speaks for itself. It's clear that both in China, but I think actually globally, that we right now will be taking care. And this doesn’t come like coincidence. We have been executing our strategy to make a deal over the past year. And the customers are really buying into our value proposition. We are playing a game where we are leveraging our whole portfolio, not going after one product line versus each other and the customer really likes that we’re outcome-based. So that's what is happening right now. And we see here in the crisis that not only are they excited about the investments we have done over the past year, but also, as Mike talked about, in the digital world, into the work world, we have been very optimistic and super responsive; they have taken off the digital, we take challenges variable very, very good, and the customers responded very, very positive to it. They know that when they work with Agilent that we are there for them in this crisis.

And then, on the other question, Derek, what we're hearing from our customers, particularly in the public sector and we’re seeing it in our order book, while I'll offer my perspective here, and feel free to build on my comments here. But, there's a real sense of making sure they commit to the budgets. So, we're seeing it both in our order book as well as order activity, where there is a lot of uncertainty about what's going to happen post-elections as we go into 2021. So, they want to commit those funds. And it's actually quite amazing the amount of deal activity that's going to occur without visiting a customer face to face. So Bob, I don’t know what you're hearing from the field…

I want to emphasize what Jacob mentioned, as it's not just about China. When we look at our LSAG portfolio, people may not fully recognize how we've transformed it into technology platforms, which are in the best shape they've been in five years regarding new products and more. This improvement is evident globally. Regarding our performance in Q3, LSAG notably exceeded our expectations. In a capital-constrained environment, being only down 4% in core metrics highlights our ability to respond to customers effectively.

Your next question comes from the line of Brandon Couillard with Jefferies. Please go ahead.

Bob, on the gross margin line, you mentioned higher logistics costs in the third quarter. Is that a new trend? And then, could you help us just think through some of the puts and takes, whether it's logistics costs or mix and how those puts and takes might evolve in the fourth quarter?

Yes, we hope that this trend won't persist, but it definitely worsened in Q3. I would estimate that about three quarters of it was related to the mix when we examine the different businesses within each group. The logistics challenges we encountered included reduced capacity in freight and air transport. However, we expect this situation to improve, as we actually observed some easing during the quarter. With the increase in intercontinental travel for both passengers and freight, we anticipate further relaxation in these logistics issues over time.

Okay. And then, Bob or Mike, you're not quite giving formal forward-looking guidance yet, but you do feel comfortable enough to restart the buyback program. Just what are your latest thoughts just around comfort as far as capital deployment goes, and maybe your appetite for M&A right now and what the funnel might look like there?

Yes, I’ll begin here, and Bob can join in. We felt confident resuming our share repurchase program from a non-dilutive perspective and will also look for opportunistic opportunities. Our cash flow remains strong. We believed that the third quarter would be our most challenging quarter this year, and we’ve now moved past that. In fact, the third quarter turned out to be much better than we anticipated, with positive growth seen across all businesses in July. We believe that, barring any major setbacks, we can continue to see gradual growth improvement in the fourth quarter. We have narrowed our guidance compared to Q3, but we need to remember that there is still considerable uncertainty related to the pandemic. Our capital deployment strategy remains the same, focusing on a balanced approach across dividends, cash, share repurchases, and prioritizing investments in the business. We recently made a significant capital commitment with our new NASD expansion and are still actively seeking reasonable deal opportunities for Agilent. Our capital deployment approach remains fundamentally unchanged, although we took a brief pause in the second quarter and early third quarter due to external environmental factors. Overall, we feel confident about our current positioning and see a reasonable level of stability in the business.

Your next question comes from the line of Dan Leonard with Wells Fargo. Your line is open.

So, maybe just to circle back…

Hey Dan.

Hi Mike. So, maybe this is a question for Bob, talking again about the Q4 framework. So, if your business grew in July and the world improves month to month through October, what does that imply then the high end should be above that 1% organic growth number?

It could be. I'll just leave it at that. There's still a lot of uncertainty and so forth. But certainly, we wouldn't complain if it was better than that.

Okay. And then, my follow-up, whoever wants to take it, on the NASD business. Can you elaborate on what's the lead time for that announced expansion? Is it something that would take a year or multiple years to put in the new line, or is it a quicker turn? And can you comment on your willingness to commit capital inorganically in that business in addition to your organic commitments?

I'll take the first one just real quick. And then, Mike, if you want to add something on the second one. We announced that we would make that $150 million investment, and we would expect it to go live towards the end of 2022. So, it's taking a little longer than just a regular train. Sam mentioned train A on steroids. So, it's bigger and probably take a little more capital. And obviously with COVID-19, there's some activity there in terms of little long lead time. But, we feel like we have the capacity to be able to manage through that time, and then that will come online at the end of 2020.

Yes, I believe it may be around the end of 2022. While I won't go into specific targets or areas of focus, it is reasonable to consider further expanding this business inorganically. This is certainly a possibility. I'm not indicating anything will happen in the near term, but we believe we are operating from a position of strength in this business. We are working to get our new factory up and running, which we view as a foundation for growth both organically and inorganically.

Your next question comes from the line of Catherine Schulte with Baird. Your line is open.

I guess, first, despite the relatively good LSAG results in the quarter, it sounds like the outlook on the capital equipment side is still a bit uncertain. Can you just talk to how the services and consumable side of the business trended in July, and what your expectations are for instrumentation trends in the coming quarters?

Yes, I think all three of our businesses performed better in July than they did in May and June, which was very positive. The ACG business led the charge, as expected, due to the resumption of activities. There is some catch up there, as we saw a similar phenomenon in China in April. Ultimately, ACG was strong. I believe LSAG capital will continue to be constrained. However, we have discussed this flight to quality in our business before, and given our instrumentation and strong reputation, we believe that in a capital constrained environment, those dollars are precious. Our positioning in the market is very favorable.

Yes, I mentioned that we are gaining market share in a challenging environment. You can see this in the C&E sector; when there is a decline in C&E capital purchases, they are shifting towards Agilent. Although the market remains cautious, we are noticing a slight increase in PMI.

Yes, Catherine, just one last thing, to give you maybe a little more color. If we look across the groups, we would expect LSAG to still be negative in Q4. I mean, it's probably going to lag, given the big fourth quarter last year as well.

Sure. I think China is in a leading position in terms of almost full recovery. Europe is in second place, and the U.S. is lagging behind. During the first part of the quarter, if I look at Sam's business in the U.S., the first two months showed a decline in diagnostic testing values in pathology. However, we did see an improvement in growth in July. This reflects the overall pattern of how the pandemic has evolved globally. China has recovered, Europe is progressing, and I would say the U.S. is still in the early stages of recovery.

Yes. In the U.S., we are likely at about 80% of pre-COVID levels in diagnostics, which has improved from where it was at the beginning of the quarter.

It does.

Your next question comes from the line of Steve Willoughby with Cleveland Research. Your line is open.

Just one question for you. A lot of my other questions have already been answered. 90 days ago, you made a brief comment about potential onshoring back in the U.S. Just was wondering if there's any update on that at all?

Thanks, Steve. Happy to comment on that. I think, that's still going to happen. And these things take time. But, there's active discussion. And, by the way, I wouldn't say it's just confined to the United States. I mean, many geographies are now looking at the security of their supply chain, both in the pharma side as well as in the chemical marketplace where they're providing precursors into the APIs for the pharma chains. So, there's nothing significant to announce relative to the impact on business, but there does seem to be an overall trend in this regard. And I can say also from an Agilent perspective, we're working hard to make sure that our supply chain is secure as well. So, I think that the COVID-19 pandemic is a real wake-up call to really some vulnerabilities in some aspects of the supply chain. So, we're kind of working both sides of it, which are to ensure our own ability to deliver product under multiple scenarios, as well as we do see some market trends underway. Bob, I know you take a look at this pretty…

Yes. Just to build on that, we talked a little bit about earlier in the call. We would expect that to see some of that opportunity show in our order book. And that's probably more a ‘21 timeframe for revenue. I wouldn't expect any of that to happen in Q4, just given the kind of timing. But you're seeing it in multiple end markets in multiple regions. We think this is a trend that will continue.

Your next question comes from the line of Dan Brennan with UBS. Your line is open.

Maybe first question just on chemical and energy. Obviously, you've already highlighted a few comments throughout the call. But just wondering if you can kind of walk through a little more color separate trends within that segment by customer in chemical and if it's worth seeing if there's going to be divergence here between chemical and A&P and R&M? And then secondarily, maybe just remind us of how much of that business is tied towards like QA/QC versus R&D and kind of what are we looking for to determine whether or not this down 10% begins to improve more reliably, or if it's going to save the slow steady progress that you believe?

Hey, Bob, I’ll start with some initial remarks, and then we can review our notes to see if I missed anything. Unlike last quarter, the dynamics on both the chemical and energy sides are similar, with both showing declines primarily in the instrument area. The chemical sector continues to benefit from low oil prices, but some end markets, like automotive and others, are struggling. There’s some support from COVID-19-related products, but overall, both sectors are down about the same yet stable. Bob and I discussed this in detail during our last call, and we predicted a stable situation, which has proven accurate this quarter. We believe that eventually, the business will begin to grow again. Currently, it's roughly a 70-30 mix, mostly in quality assurance and quality control, which is why these facilities are operational, though not at full capacity. QA/QC equipment will still be necessary along with the associated consumer services. They can only delay the depots on that side for so long. There is a research component as well, but in the chemical and energy sectors, the primary driver remains the QA/QC side of the business.

Yes. And the only thing I’d add, Dan is we would expect this, as you said, kind of steady slow progress going forward.

Could you elaborate on what you observed in the food and generics sectors in China? Clearly, COVID is affecting the global situation and recovery, but there are some specific issues with food and generics that may differ. Depending on whether there is improvement or not, this could lead to significant changes in China. What did you notice there, and what is the outlook for these segments moving forward?

Yes, I wanted to mention, Dan, that we are very proud of the growth across all three of our business groups in China, with every end market expanding, particularly food, which has increased by over 20%. It's been some time since we've been able to report such growth. We believe that the transition from government or central labs to commercial labs has stabilized, allowing our team to gain market share and better utilize capacity in that area. Additionally, the pharmaceutical sector continues to perform well, with a rise of about 10% in China, driven by both large and small molecules. Our thesis remains strong, as the successful bidders in the tendering process are customers where we hold significant shares, and we’re witnessing ongoing positive momentum. We've actually seen an acceleration from the second to the third quarter in both food and pharmaceuticals, with all other business areas also reporting positive growth. Overall, it appears to be a broad-based improvement.

Your next question comes from the line of Patrick Donnelly with Citigroup. Your line is open.

Mike, I have a question for you. There were several inquiries in July. With all the businesses returning to growth, can we assume there wasn't a significant pullback during the second wave in the U.S., especially in the early weeks of August? You seem to be more cautious about the Americas compared to other regions. I'm curious if there were any surprises in the U.S. end market as you navigated through July and early August, given the resurgence of the virus.

No, I'll jump in on this. From our perspective, there were no real surprises. Like everyone, we were observing the pandemic as it progressed across the U.S. and noted that case numbers increased while lab access significantly declined in April, May, and June, although we began to see some recovery afterwards. So, in terms of what we expected, there were no real surprises.

Yes, I would agree. The Americas is the biggest variable because it is further along in its recovery compared to Europe and China. We are monitoring the COVID flare-ups and their potential impact on elective procedures, which would affect our diagnostics business. This aspect has the most variability going into Q4 compared to LSAG and ACG. However, we did not observe any significant changes related to these flare-ups in July and early August.

And then, bunch of that good commentary on the chemical and energy and industrial side. Just want to and just clarify, I mean, it certainly seems like the industrial sentiment feels like it might have bottomed. It seems like your tone is a little bit better from three months ago. Even though, again, chemical and energy is probably going to be down similar this quarter and again next quarter. But, I guess what you're hearing from customers there on spend plans? Again, it sounds like you're a little more optimistic and talking a little more bullishly about '21. So, I'm just wondering, I guess, as we enter into the end of this fiscal year into '21, are you seeing things improve a little bit? Obviously, you’ll come up against very easy comps, but it does seem like the tone is a little more positive. So, are you hearing from customers, things that are trending a little bit better into '21?

Yes, I believe that's a reasonable interpretation of my message today. First, we do think we've hit the bottom. That was our perspective when things began to decline sharply due to the pandemic. We see that trend continuing. However, I don't want to exaggerate and suggest there will be a substantial surge in growth in this area. Customers are actively planning, and Chevron is making significant investments in Iraq. These are ongoing concerns, and while they may delay capital spending, they still aim to keep their operations running at peak efficiency. We are optimistic that the budget situation will improve in 2021. I believe that once we gain more clarity and our customers feel more confident about the economic outlook, they will be able to make decisions with greater assurance. The PMIs provide some insight into how things might be shifting. Once again, I urge caution not to read too much into the fourth quarter, but it does suggest that 2021 could potentially present a more favorable environment.

And your last question comes from the line of Jack Meehan with Nephron Research. Your line is open.

I wanted to return to the NASD business and ask for more details. Are you currently involved with any mRNA-based COVID-19 vaccines? I'm interested because the trials are progressing rapidly. If one becomes available and enters the market within the next six months, how would you manage the business to meet the potential demand from customers?

Hey, Sam, I’m going to pass that to you.

Sure, I can't provide specific details about the molecule or the COVID-19 projects we're involved in. However, I want to emphasize two points. First, as Bob mentioned earlier, this area of business is separate and distinct from what we're currently doing, and it won't replace our existing operations. Second, we believe we have the capacity to meet demand if developments related to COVID-19 and our ongoing work progress. We are confident in our ability to supply the necessary material as needed.

And then, one more follow-up on LSAG. I'm just curious, as you're looking at the research labs around the globe, kind of in this conversation around deferral versus cancellation, what are customers telling you? Is it still mostly deferrals versus cancellations? And on the deferral side, when do you expect these, how far out is it getting pushed something that you think it hits before the end of the year or probably more likely in calendar '21?

Hey Jack. Happy to answer this question. This is something we've been monitoring pretty closely, deferrals versus cancellations. And we've really been pleased, our cancellations are actually lower than last year. And our thesis is they’re being pushed and actually funds will be deployed this calendar year.

Yes, we observed that in Q3. As people return to the labs in person, they are able to install the instrumentation. In line with Mike's comments, we have seen no cancellations or fewer cancellations compared to last year. There is always some level of cancellations, but we have been extremely pleased. I anticipate this will occur within the calendar year.

Yes. So, that concludes the call for today. Thanks, everyone for joining us.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.