Agilent Technologies, Inc. (A) Q3 2016 Earnings Report, Transcript and Summary

Good day ladies and gentlemen, and welcome to the Third Quarter 2016 Agilent Technologies Earnings Conference Call. [Operator Instructions] As a reminder, today's program is being recorded. I would now like to introduce your host for today's program, Alicia Rodriguez, Vice President of Investor Relations. Please go ahead.

Thank you, Jonathan, and welcome, everyone, to Agilent's Third Quarter Conference Call for Fiscal Year 2016. With me are Mike McMullen, Agilent's President and CEO; and Didier Hirsch, Agilent's Vice -- Senior Vice President and CFO. Joining in the Q&A after Didier's comments will be Patrick Kaltenbach, President of Agilent's Life Sciences and Applied Markets Group; Jacob Thaysen, President of Agilent's Diagnostics and Genomics Group; and Mark Doak, President of the Agilent CrossLab Group. You can find the press release and information to supplement today's discussion on our website at www.investor.agilent.com. While there, please click on the link for financial results under the Financial Information tab. You will find an investor presentation along with revenue breakouts and currency impacts, business segment results and historical financials for Agilent's operations. We will also post a copy of the prepared remarks following this call. Today's comments by Mike and Didier will refer to non-GAAP financial measures. You will find the most directly comparable GAAP financial metrics and reconciliations on our website. We will refer to core revenue growth, which excludes the impact of currency, the NMR business and acquisitions and divestitures within the past 12 months. Please note that we are reporting results for the Americas, Europe and Asia on a ship-to basis. Previously, we assigned revenue to these regions based on where the order was placed. This change aligns with individual country reporting, which has always been on a ship-to basis. Historical restatements are available on the Investor Relations website. Unless otherwise noted, all references to increases or decreases in financial metrics are year-over-year. Guidance is based on exchange rates as of the last day of the reported quarter. 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 let me turn the call over to Mike.

Thanks, Alicia, and hello, everyone. Thank you for joining us on today's call. I'm pleased to report that the Agilent team delivered another quarter above expectations. Now let me highlight 3 key results: First, core -- Q3 core revenue growth of 3% was above the high end of our May guidance. Second, EPS of $0.49 was also above the high end of our guidance of $0.45 to $0.47. Finally, we delivered adjusted operating margin of 20.6%, an increase of 70 basis points from a year ago. As for the third quarter results echo many of the same themes that we saw last quarter, the pharma, food, clinical and diagnostics end markets remain strong. In the chemical and energy market, while demand for our services and consumables was strong, capital expenditures for new equipment purchases remain challenged. Geographically, Asia, led by China's double-digit growth, drove Agilent third quarter core growth with strength across all business segments. Let me highlight our Q3 results by business group. In line with our expectations, Life Sciences and Applied Markets Group core revenues were down 2%. Our strong growth in pharma, environmental and food markets was offset by continued weakness in chemical and energy capital expenditures. Academia and government revenues were also down across most regions. Despite this mixed market environment, LSAG's operating margin for the quarter was 19.1%, up 40 basis points from a year ago. Let me shift gears and talk about some of LSAG's new products. We are seeing very strong demand, the newly released 1260 and the 1290 Infinity II LC systems. The 1260 systems are part of the launch of the InfinityLab portfolio at Analytica in May. The InfinityLab portfolio consists of this new line of LC instruments along with columns, supplies and services. In Q3, LSAG also introduced the new -- 2 new 7000 Series Triple Quad GC/MS analyzers, one for pesticides and another for environmental pollutants. And we continue to strengthen our ICP-MS market leadership with the new Agilent 8900 Triple Quad ICP-MS system. This new system offers customers improved speed and accuracy of analysis. Turning to the Agilent CrossLab Group. The business delivered another strong quarter with 8% core revenue growth. This growth is driven by strength in the food, pharma and environmental markets. ACG's operating margin for the quarter was 22.7%, up 10 basis points from a year ago. Portfolio expansion efforts also continued in ACG. In Q3, Agilent signed a definitive agreement to acquire the assets of iLab, and we just closed the transaction in early August. iLab is the market leader in cloud-based solutions for core laboratory management and provide services to leading universities, research hospitals and independent institutions around the world. This acquisition further expands Agilent's portfolio in the academia and government market. iLab enables Agilent to deliver broader value for our customers in this market segment. We also see an opportunity to expand the iLab business both geographically and into the pharma market. Finally, we saw a continued momentum in the Diagnostics and Genomics Group where the business delivered 8% core growth in Q3. We saw strength across all DGG businesses, driven by growth in the pharma and clinical and diagnostics market. Our pathology business continues on a steady trajectory of improved growth. This was highlighted by demand for our new PD-L1 companion diagnostics. Growth in genomics reflect a strong market performance in the U.S. and China across our Array CGH, Target Enrichment and SureSelect products. We also saw healthy demand for our Nucleic Acid Solutions offering. DGG's operating margin for the quarter was 18.8%, up 200 basis points from a year ago. Q3 highlights for DGG include the announcement of an expansion of the intended use of our PD-L1 pharmDX test in Europe for patients with melanoma. This test was previously proven in the U.S. and available in Europe for patients with non-squamous, non-small-cell lung cancer and in the U.S. with patients -- for patients with melanoma. We also announced a $120 million investment over the next 3 years to expand production capacity for our Nucleic Acid Solutions business. This includes the purchase of 20 acres of land in Colorado. We plan to build our factory on this land that will double our manufacturing capacity for nucleic acid active pharmaceutical ingredients and grow our business. Now I'll provide an overview of Agilent's core revenues by end market. In our life sciences market, pharma saw its sixth consecutive quarter of double-digit growth with core revenue up 10%. Academia and government core revenues were down 5%, down across most geographies except China. Clinical and diagnostics grew 4% with strength in North America and Asia and led by growth in pathology. Applied end-market performance was mixed. Food was up 11% with strong demand in China and the Americas. These regions also drove growth in environmental market for both instruments and aftermarket products. This performance was offset by continued challenges in the chemical and energy market, down 4% globally, with only Asia posting growth on a regional basis. The overall result was due to prolonged effects of the macroeconomic concerns and lower oil prices. Now I'll turn an update on our operating margin improvement initiatives. Q3 marked a major step forward in simplifying our company's infrastructure. In May, we completed the migration of the company's financial systems onto a single SAP platform. This was a culmination of a 20-month cross-company effort and represents a major step in simplifying Agilent's systems infrastructure that will deliver incremental cost savings as planned in fiscal 2017. In summary, our multiyear Agile Agilent program continues to simplify the company's business processes. This program is designed to make us more nimble and lower our costs. It will continue to deliver incremental savings in 2017. On the capital deployment front, we purchased iLab, paid $37 million in dividends and repurchased $94 million of Agilent stock. We continue to deliver on our strategy to drive sustainable growth while expanding operating margins and balancing deployment of our capital to drive shareholder value creation. At our recent May Analyst Meeting, I described our shareholder value creation model: outgrow the market, expand operating margins, balance capital deployment. Let's look at our Q3 results in the context of these longer-term goals and shareholder value creation model. In 2015, we delivered our highest annual growth rate in 4 years while increasing adjusted operating margin 170 basis points and completely offsetting the $40 million of dissynergies from the company split. We have sustained this trajectory of improved operating results in fiscal 2016. In the first 3 quarters of 2016, the team has delivered strong growth and earnings above our initial expectation despite a challenging chemical and energy market environment and global macroeconomic concerns. We have continued to leverage our balance sheet and deployed capital in a balanced manner, buying companies that bring new capabilities to Agilent while repurchasing our stock and increasing cash dividends. The new leadership team continues to transform the business and deliver results. We continue to demonstrate our ability to deliver above-industry organic growth while expanding margins and leveraging our balance sheet strength. Our Q3 results in a challenging global economic environment reflect the strength of our team combined with Agilent's scale and broad differentiated portfolio of products and services. Looking at today's overall market environment, we expect continued strength in pharma, along with growth in the food, environmental and clinical research and diagnostics markets and in China on a regional basis. As I highlighted in our last call, we are experiencing a steeper and more prolonged slowdown in the chemical and energy market than initially projected entering fiscal 2016. We subsequently revised our forecast for this market segment last quarter to overall low single-digit market declines for the year. While there are some signs of an impending bottom in the market, we remain cautious in our outlook and expect Q4 to be in a similar range as the past quarter. Against this market drop (sic) [ backdrop ], we are well positioned to capture growth in these end-market segments and geographies where growth is expected to remain strong. The combination of our expanding our customer channel reach and continual strengthening of our portfolio positions us well to achieve our previously raised full year guidance of 2016 and our longer-term goals. Our One Agilent team continues to work well together and is energized to win in the market. Overall, we remain on track with our 2017 goal to outgrow the market and improve our operating margin to 22%. Thank you for being on the call today. I will now turn it over to Didier who will provide additional insights on our financial results and guidance for the remainder of 2016. Didier?

Thank you, Mike, and hello, everyone. As mentioned by Mike, we delivered higher core revenue growth, operating margin and earnings per share than the high end of our guidance. Earnings per share grew 11% in the quarter versus a year ago. We also generated $194 million in operating cash flow, more than double last year's amount, which gives us increased confidence that we will achieve our previously raised operating cash flow guidance for the full year. FX had a negative impact on revenue of about $10 million or 1% versus previous guidance and $7 million or 0.7% versus last year. It had a negative impact on operating profit of $3 million versus previous guidance and $1 million versus last year. I'll now turn to the guidance for our fourth quarter. We expect Q4 revenues of $1.05 billion to $1.07 billion and earnings per share of $0.50 to $0.52. At midpoint, revenue is expected to grow 1.2% on a core basis. Versus previous guidance, FX is estimated to have a negative impact of $9 million on revenue and $2 million on operating profit. Our 21.3% adjusted operating margin at midpoint will be up 70 basis points sequentially. Now to the guidance for fiscal year 2016. The Q4 guidance results in the following fiscal year guidance. At midpoint, revenue is projected to grow 4.5% on a core basis, no change from the previous guidance. Our earnings per share guidance of $1.90 at midpoint is also unchanged from previous guidance and corresponds to a 9% year-over-year increase. Adjusted operating margin for the year is expected to be 20.4 basis points or 80 basis points higher than in fiscal year '15. And finally, FX is estimated to have a negative impact on a year-over-year basis of $68 million on revenue, $10 million on operating profit related to currency translation and an additional $21 million related to currency hedging. With that, I'll turn it over to Alicia for the Q&A.

Thank you, Didier. Jonathan, will you please give the instructions for the Q&A?

[Operator Instructions] Our first question comes from the line of Brandon Couillard from Jefferies. Our next question comes from the line of Steve Beuchaw from Morgan Stanley.

I want to start with the one regional trend that seems to be on many people's minds, which is what's going on in Europe. I wonder if you could speak to the trends that you saw in Europe over the course of the quarter. To some extent, it's a macro question. To some extent, it's a research question. And of course, there's the -- their U.K. referendum that's still out there. So I apologize for the nebulous nature of it all, but any color on how Europe progressed over the course of the quarter would be really helpful.

Yes, sure. Glad to provide some insight there, and then I'm going to actually have Patrick jump in on this conversation, given your recent travels in the region. But what we saw in the quarter was, obviously, a lot of big macro events, the Brexit, Turkey. There's a number developed [ph] in the quarter. We did not see any material impact from those events in our performance in the third quarter. What I will say, though, it is raising an increased level of uncertainty amongst our customers in Europe, and we've seen the questions around when will budgets be released. So it's more of an uncertainty question right out there. People are just sort of waiting to see how it's going to develop. Again, no material effect on the third quarter results. But as we thought about our guidance for the fourth quarter, obviously, it's influenced us to think about how will Europe develop through the quarter. And Patrick, I know you had a pretty deep conversation about this yesterday. So any additional thoughts you'd like to add?

Yes. Thanks, Mike. In talking to our field, local field in Europe, you certainly get the feedback there is some uncertainty as Mike -- as you said. The Brexit had -- with some of the government in traditional [ph] deals had probably some minor impacts. I think what's concerning us here a little bit is also there are a couple of other countries standing on the sidelines and have other referendums this year. So we are cautious right now, looking at Europe and the growth scenario for Europe for the remainder of the year and also going into fiscal year '17.

Thanks, Patrick.

And then one bigger-picture question, Mike. I mean you made a pretty significant investment with a pretty long horizon -- long-term horizon on this facility in Colorado. So it speaks to your confidence in the long-term outlook for and the scale of the opportunity there. Can you just talk us through how you frame the opportunity, remind us how big that business is today, and how you think about the medium-term drivers that you're investing in the pursuit of?

Great. So I'm going to handle your -- well, I'm going to handle the first part of this question. And then I'm going to turn it over to Jacob, and he'll reassure you about the long-term growth potential, which is the reason why I supported the investment. But just as a reminder, I think this is roughly about 5% or so of DGG's overall revenues in the range of maybe $16 plus million or so. We still have capacity at the current site, but we've got a -- more demand than we can handle in terms of long-term outlook from our customers. So we can't bring on this capacity fast enough to satisfy the customer demand. We think this will be a bigger part of our growth story as we talk to you about 2017 and 2018. And I think as you'll hear from Jacob, there's a high degree of confidence that the business is going to be there. And perhaps you can provide a little context of what exactly is this business and why are we so confident that the market is going to be there for us.

Yes, let me try to provide a little more color there. So first of all, a reminder that the Nucleic Acid Solutions Division business out in Boulder is providing oligo APIs that constitute a new type of drugs with a significant potential. These drugs are primarily, right now, opportunities within orphan genetic diseases that today there has been no treatment and have devastating outcomes. And these drugs have actually the opportunity to change the expectancy of, you could say the survival and also the quality of life for such patients. We are working with the leaders in pharma within these new type of drugs, and Agilent is chosen again and again due to our deep technical experience to optimize oligos for performance and consistency, combined with our ability to scale in DNP. We have seen a significant demand accelerated over the last few years. And as Mike mentioned, we're currently expanding our current site to actually take up double capacity. But we also see that, that will run out. That opportunity is really limited and will run out in a few years from now; and thereby, the new investment in the new site will allow us to further double our capacity and even double again if we choose to do so. We have decided, and based on a deep dive into the strategy and so on, to place the site in close proximity to the other Boulder site at approximately 20 minutes' drive away so we can releverage critical mass, high -- the highly experienced staff we already have and capabilities and processes. The overall market is in the hundreds of million dollar business right now, and it's growing something between 20% to 30%. However, when you commercialize drugs -- when you get the commercialized drugs, this might be a significant step-ups, but we see a lot of demand right now just in the clinical trial studies.

Our next question comes from the line of Jonathan Groberg from UBS.

I know you have one more quarter to go here, but any initial thoughts on the puts and takes you're seeing on how we should be thinking about fiscal '17?

Yes. Jonathan, I'd be happy to share my thoughts here. And in fact, I, perhaps, will build on some of the comments I made in my prepared remarks. But we're still -- we are still seeing ourselves on the same path that we talked about just a month or so ago in New York. I think it actually was 2 months ago when I think about it, but our position remains the same. We are still confident we're going to be able to achieve the overall projected core growth of 4.5%. And there's some new -- there really are some new factors that we think support this level of growth. First of all, we've -- we have a rich pipeline of new product introductions coming in Q4 and in FY '17 on top of what we've already introduced this year. We think our customers are going to be really excited about what we're bringing to market, and that's going to help drive share. So we know we got this NPI pipe going through the system right now with releases coming up in the several quarters on top of what we've done. The second thing, I -- we also have recognized the fact that the Agilent business model has really changed a lot over the last 18 months or so. We have a lot more recurring revenue. And if you look at the ACG and DGG business, which now represent over half, I think it's 52% the last time I did the math, of Agilent's revenue. These are just inherently much more predictable revenue streams, and you saw in our Q3 results how both groups delivered high single-digit growth. And they're not subject to the same types of issues we're seeing in the capital-intensive chemical and energy market, for example. And then the third thing I'd say is when you think about our LSAG instrument business, in addition to the impact of these new product introductions I mentioned, we do expect that pharma and China market is going to remain significant growth drivers, although I think they will be below these double-digit levels we've seen in 2016. And as mentioned in our last call, we still expect that the chemical and energy market will have bottomed by the end of calendar year 2017. We're not ready to...

'16.

Excuse me. Sorry. Thanks, Didier. I got my ears confused there -- by the end of the calendar year 2016. We're not ready to call bottom, but we do see in 2017 that we're forecasting that we could be in low single-digits growth in a market which has had 18 to 24 months of pent-up demand for equipment that supports the production process. So they're the 3 factors that have gone into our thinking as we have thought about the 2017's growth rate. Honestly, we'll give you the official guidance at our next call. But I would just reinforce our view today is that we're still on track to what we told you in May in New York.

Great. That's helpful. And just one quick follow-up, on the capital equipment business, I know you mentioned going into the quarter, last time when you gave guidance, you thought there'd been a little bit of pull forward and you highlighted why you thought it would be a little weaker. I'm just curious, was it in line with what you thought? Or was there anything unique in the quarter that maybe wasn't right along the lines of what you thought?

Absolutely. I think the quarter was actually in line and actually a little bit better than we had anticipated coming into the quarter, so no major surprises in our Q3 results. And as you can imagine, we were delighted with the ability to deliver above our expectations, both top and bottom line.

Our next question comes from the line of Jack Meehan from Barclays.

So I just wanted to ask about the LSAG business and some of the moving parts there. And could you maybe just talk about the chromatography markets? A couple of your peers have had really nice results there. Just what you're seeing there would be helpful.

Yes, absolutely. And then, Patrick, if you could break it out, obviously, between liquid chromatography and gas chromatography as well.

Yes, absolutely. Happy to do so. As Mike mentioned earlier in his remarks, we definitely see very strong growth right now in the liquid chromatography business, which has been, for the entire year, double digits. And that is what we see, clearly, also taking market share right now. We had a very strong launch of several waves of the Infinity series starting in 2009 and 2012. And now this year with the 1260 series with another big round of instrumentation and solutions in liquid chromatography, that is very well received by the end markets. We see very healthy replacement business as well, and it's driven by the fact that these solutions are 100% backwards compatible and also compatible with some of our competitors' instrumentations, which makes method transfer very simple and seamless for our customers. So -- and we project this cycle to continue for several more quarters. We don't see yet a loss of momentum. What we see, of course, is that we're getting now into quarters with tougher compare because we have double-digit growth for several quarters now. On the gas chromatography side, again, very strong portfolio as well. The issue we're seeing there is that the core market or one of the big markets for gas chromatography is the energy space. And that, of course, pulled some of our results down at this point in time. If the market comes back, we think we are in an exceptional position to pick up this pent-up demand that we see.

When the market comes back.

Yes, when the market comes back. Yes, when the market comes back, sorry. So I think we are in a great situation there as well. We have an outstanding product portfolio and ability to capture the growth when it gets back.

Yes. And the reason why I asked Patrick to segment his remarks in liquid chromatography from gas chromatography, we have an outsized exposure in gas chromatography. And when the -- relative to the #2 competitor space, we're at least 2x the #2 person. And so when our major market is down, it really hits us. And that's why, again, we were really quite pleased that we were able to deliver the growth we've done so far, with our #2 market actually being down below our initial expectations coming into this year.

Yes, that's really helpful, and I appreciate all the details in the different segments. If I could just follow up with one more. The Americas growth, negative 1% in the quarter, I know it's on a tougher comp relative to last year. But could you maybe just talk about the mix of the end markets there and whether there was any other notable changes worth pointing out?

I think the big one there is the chemical and energy market. So it's down pretty sharply, and I think that's bringing down the overall numbers as well as our academia and government business was down over last year. Although we think some of that -- the way we're thinking about our plan for the rest of this year, we think the federal money will be there in the fourth quarter for us.

Yes. And in addition, if I may add, we had a very strong quarter Q3 last year in Americas. So it's a tough compare.

Yes. I'm not always willing to let my guys do the tough compare argument, but thanks, Patrick.

Our next question comes from the line of Tycho Peterson from JPMorgan.

Maybe first on -- just on the academic front because it is a big swing from what you reported last quarter. I understand the Europe dynamic, but frankly, what we hear from you is a little bit different than we've heard from most of the other life science peers. So can you maybe just talk a little bit about why you felt more pressure in Europe academic than maybe most of your peers?

I think it's -- I think -- I'd point to 2 factors. I'm not sure exactly what all our peers are saying about Europe. I think they're probably saying the same thing, which are the European budgets are constrained and funding has not been released, and has actually been withheld in some situations. I also think you may be hearing a more positive spin on the U.S. environment because of many of our competitors have much more business coming from NIH. So there's a lot of positive view of the NIH budget, but we pick up a relatively small piece of that overall budget. The agencies where we do a lot of our business in the U.S. government, we know the money is coming in the fourth quarter. Anything else you'd add to that, Patrick?

Not a lot. And as you said, there's -- a lot of our competitors definitely have also a mixed bag, on average, I would say.

And then similarly, environmental is flat after growing 6% last quarter. Can you maybe just comment on dynamics there?

I think the biggest dynamic there is there's a subsegment within environmental as well where we pick up our forensics business. And we report externally just the total environmental business, but a lot of big deal activity in forensics. So last year, we had a lot of big deals at this point in time. The overall environmental market has given me big deals in the second quarter. So it's really a forensic-driven phenomena, which is where we didn't have as many big deals in the third quarter. And this business tends to be a little bit more lumpy than our base environmental business.

Okay. And then -- and last one, a little bit of an esoteric question. But on the PD-L1 data sets in frontline lung, can you maybe just talk about whether there's kind of any change in your outlook? Obviously, Bristol attempted to go without a companion and failed. Merck is doing a companion. So can you maybe just talk about whether some of those developments have changed your view of the market opportunity overall?

Sure. Sure, Tycho. In fact, we just had a conversation on this yesterday. So Pat -- I mean, Jacob, why don't you share the latest thoughts from Agilent on this topic?

Yes, I will say, first and foremost, we are very pleased with the performance we have seen on PD-L1 over the last 10 months, and we continue to see strong traction. You're right. There has been some announcement recently on some studies that has not come out as expected. It really supports our thesis about the importance here of CDx and, really, that you need to make sure you stratify your patient group the right way. So clearly, there is a short-term opportunity, at least from one of our customers that is a little less than we hoped for. But I don't think that, that overall change is really the thesis, and we continue to see a big opportunity here.

Our next question comes from the line of Ross Muken from Evercore.

So it seems like most of the confusion we're hearing is sort of on the sequential progression of core revenues. And so I look at the last 2 years, and it looks like, sequentially, the comp is roughly, I don't know, 200 basis points easier on core. And it looks like you have a little bit heavier of an NMR headwind in 4Q than you did in 3Q. So one, can you confirm that? And then two, as we just think about the crosswalk, what are the other sort of underlying assumptions in terms of what is different sequentially versus 3Q, whether it's end markets or any of the key segments? And then where have you built in, I guess, some conservatism or some of that uncertainty?

Yes. Thanks for the question, Ross. And why don't I go ahead and just share some thoughts about the Q4 guidance. And then, Didier, maybe you can dig through your notes on the NMR impact. But I think it's important for me to share with the audience here today about how we thought about our Q4 guidance. I think this may get to the root of some of your questions. As you heard on our call, first of all, we're quite pleased with the higher-than-guided core revenue growth that we delivered for Q3 after having raised last -- in last call. And I think we've got this increased confidence to achieve our previously raised core growth guidance for the year. And listen, we realize by not raising our core guidance for this year that this question could arise. But the way we looked at it, we said, listen, there's a raised level uncertainty in the markets centered around Europe. And we saw some weak European government budgets in the third quarter. Is this going to continue? We've seen some downward revisions in terms of market overall economic forecasts for Europe, so we're really not sure exactly how it's going to develop. So we just thought it's prudent to reflect some of this uncertainty by not raising again the full year guidance. So that's how we thought about the process. We really didn't look over the years sequentially. We do know that last year, though, I said I don't like the tough compare argument, we did have a blowout fourth quarter last year. But anything else, Didier, you can remember unusual or...

No. NMR is not a factor.

NMR is not a factor.

You pointed out really what we intended to do is maintain the overall core revenue growth for the whole year, and that's how we derived Q4.

Yes. We'd raised last quarter, and the business is developing in the third quarter actually better than we had thought as you saw in our results. And as we look to the fourth quarter, listen, we don't know how this Europe's going to play out, so let's just be cautious as opposed to raising again for the quarter.

So that makes total sense to me, Mike. I mean, I think given some of the uncertainty, I certainly don't want to get in front of your skis. And you guys have been beating numbers, so that's good. I guess as you think about the key product cycles for the business, how do you think about the cadence now that you've had some releases of when we could start seeing that also draw up the core growth overall? And then secondarily, when do we start to comp through? We've now, I guess, comp-ed through some easier compares on the Diagnostics business, which has been going hot for, I don't know, 4 or 6 quarters now. How long do you think we've got left on that trajectory of sort of high-single to almost double-digit growth in that business?

I think longer, but I think that for the foreseeable future, we're highly confident on the growth rates in this business. And that's why I made the comment earlier about, hey, when you think about Agilent's long-term growth perspective, if you think about '17, think about that we've got over half of our revenue in markets that are going to have a steady trajectory of growth. And you heard Jacob talk about what's going on in the companion diagnostic PD-L1. We talked -- that's why I wanted to highlight the investments we're making in NASD, which is a part of the business we haven't really talked a lot about with you. So I think there are a lot of genomics, there's SureSelect next-gen sequencing. There's a lot of fundamental, very attractive markets we have a strong position in. So Jacob, I don't want to necessarily speak for you, but I guess I have that we expect that this growth rate will be sustained. Anything else you'd add to my story?

You're absolutely right, and I'm definitely pleased with the excellent growth. Last quarter, we had 5%. So I really want to make sure that you saw that we were -- when I -- when we talked also at the Analyst Day, we believe the right -- the direction is 6% to 7%. I'm happy to beat that. But we do not see any change in trajectory right now, and we'll continue in those high single-digit growth rates going forward.

And Ross, I think perhaps your earlier question was around product cycle replacement. Yes. So I think, as you may know, when I came into the role a little over 1.5 years ago, we had really spent a lot of time redirecting our R&D programs. We restructured the company. We reorganized our R&D programs, and I think you're starting to see the cadence. So you've seen some of the product come out. We highlighted earlier on the chromatography side some updates and new products around spectroscopy, ICP-MS. And we know this cadence is going to continue throughout the next quarter and into '17. So that's why when I got the earlier question about, hey, what are you thinking about in terms of '17, I know what's in our road maps, and I know what's coming to the market over the next 12 months. And I know what's already come to the market, and I know how customers are responding. That's why we have this level of confidence about our ability to continue to grow this company in what has been very mixed market conditions, to say the least.

Our next question comes from the line of Doug Schenkel from Cowen.

My first question -- I guess both are going to be on guidance. So for fiscal Q4, your guidance essentially tells us that you're assuming operating margin declines year-over-year in fiscal year Q4 in spite of what seems like could be, I guess mix-wise, a pretty favorable quarter year-over-year based on your commentary. So keeping that in mind and the fact that you've actually expanded operating margin year-over-year, I believe 6 straight quarters, can you just explain why this makes sense?

Yes. I think you've got the string of consecutive quarters. It's been 6 quarters in a row. And Didier, we looked at this. I think it's purely volume related, but...

Yes, absolutely. As same thing for operating margin, our approach -- as for revenue, our approach is we didn't -- we wanted to maintain our full year operating margin because, obviously, it's linked to revenue. So we maintain our core revenue growth assumption of 4.5% and our operating margin assumption of 20.4%. Now you are absolutely correct that, that would mean that 50 basis points reduction from the significant operating margin we had in Q4 of last year of 21.5%, still a significant 70 basis point sequential improvement. And you have to take into account, as Mike said, that this is based on only 1.2% top line growth. So a slight reduction in operating margin, still very significant increase sequentially, but slight reduction related to the one -- the assumption that we'd made on the top line growth of only 1.2%.

Right. And if we do better on the volume, we'll do better on the margin.

So I guess that's a segue to, I guess, the second guidance question. And I don't mean to be redundant here because there's been a lot of questions on this already. But I'm going to ask anyway. I mean, your guidance is for around 1.2% core revenue growth in the quarter. If we think about this by end market, you actually have an easier compare in environmental forensics, academic government and food relative to certainly what you had in fiscal Q3. Diagnostics is a little tougher, but you have some real momentum there. So if we just, kind of to make it simple, assume all those end markets grow 3% to 5% and that chemical and energy is down mid-singles, it would imply that you guys are thinking pharma is only going to grow low single digits maybe at best in Q4. It's a tough compare in pharma in the quarter, but you've talked about continued strength in pharma in fiscal '17 in response to an earlier question. Again, recognizing the uncertainty you talked about in Europe, this is -- I guess some of this is hard to reconcile. Can you help out a little bit? And specifically again what are you assuming for pharma in the quarter? Is that because of the compare? And what's your assumption for Europe growth in the quarter?

Yes, sure. Glad to walk through this, Doug. In fact, we spent a lot of time modeling our end market views for the rest of the year, anticipating that this might be a question that would arise. And as I recall, Didier, I think that we had a less optimistic view relative to academia and government than I think Doug's math was, where we were seeing -- where we were concerned about Europe. And we had -- we basically have it flat for the year, and I think we still have pharma overall double digits. So if you want to just maybe do a little walk-through?

Yes. The -- maybe, I mean, again, considering how we explained how we came up with the Q4 guidance, the makeup of the Q4 guidance by market in that academic and government and chemical and energy will show the same core revenue growth reduction year-over-year as in Q3, so minus 5% for academic and government, minus 4% for chemical and energy. So the assumption is no change between Q3 and Q4. And then for the rest, pharma, you mentioned pharma, we're assuming mid-single digit. And again, on a very tough compare and to -- in line with the way we've been very conservative on the...

Yes. And just to be clear, my comment earlier about double-digit pharma, that's for the full year.

For the full year or -- yes, double digit, absolutely.

Yes, Doug, maybe just one of -- as we thought about the company coming in, I think we thought that the pharma growth would be lower. We thought China would be lower, and we thought chemical and energy would be higher. And in fact, what's happened is pharma has actually been stronger, and China is stronger than initially forecasted. And you know the story on chemical and energy.

Okay. The only thing I don't think we got there was just -- and maybe I missed it. But what is the assumption for Europe in the quarter?

It's about flattish, down low-single digits, mostly on the basis of chemical and energy.

Yes. And the academia and government.

And academia and government, yes.

Our next question comes from the line of Tim Evans from Wells Fargo Securities.

This one's for Didier. It seems like cash flow is something that's going better than expectations or better than our expectations at least. Wondered if you could talk a little bit about the remaining levers that you have to pull on that as you go into 2017. Do you think that free cash flow growth in 2017 is really just going to be a matter of earnings growth? Or is there more than you can do there to improve free cash flow faster than earnings?

Yes. There is more that we can do. Certainly, the profit before tax is going to be a factor. But Henrik, who heads our order fulfillment and the supply chain organization has also committed to a material decrease in inventories.

And he's here in the room to hear that directly.

So that is also something that we are counting on that will help us continue expanding our operating cash flow as a percentage of revenue or percentage of profits.

Okay. And then a quick one, going back to one of Tycho's questions on the forensics end market. Of that 12% slice of pie that's environmental and forensics, would you be willing to tell us how much is forensics?

I don't think we disclose that and it's fairly small but enough to move it directly when big deals happen.

Our next question comes from the line of Isaac Ro from Goldman Sachs.

Just had a question on margins and then a follow-up on Europe. On the margin side, if I look at sort of the components of gross margin, it's interesting that the LSAG division is your highest gross margin segment in most quarters, but that was one where you saw a little pressure. So can you help us think a little bit about kind of the key initiatives you guys have under the hood there to continue driving better gross margin versus expectations and same goes through SG&A?

The question was what are the initiatives we have? I just want to make sure I understood the question.

Yes. Over the last, I don't know, 12 or 18 months, you guys talked a lot about some of the things you're doing to drive gross margin higher. This particular quarter, you had a little weakness in your most profitable segment. So I'm wondering kind of, aside from just the top line contribution, what you guys were able to achieve this quarter on the gross margin line that allowed you to put up a slightly better result.

Great, great. Thanks for the question. So what we've been focusing on are really 3 dimensions around what we call our value-engineering program, our logistics model and also our strategic procurement approach with our suppliers. And as I look at the results in '16, the program that Henrik is driving across this company, I think we probably have seen the biggest impact so far in our improved logistics model. And you may recall we talked about logistics costs as being problematic in 2015. That's no longer the case. In fact, we've benchmarked ourselves, and we've got ourselves down to the best in our space. And there actually is more to come, which is the other 2 elements of the program have a little bit more longer tail in terms of payoff, which is value engineering, when you're reengineering product platforms to ensure both the continuation of the high performance but at a lower cost. And then as we also continue to transform our supplier engagement model and how we leverage the scale of Agilent. So I think those latter 2 parts of the program are going to carry us forward into '17 and '18 beyond, so I think that's how we're really working the gross margin side. And by the way, I also [indiscernible] of your comments were focused on LSAG. A lot of logistics costs and some of these other factors I mentioned, procurement, show up as impacts on the DDG and ACG business as well. And then relative to the SG&A, a couple of things that you may recall I highlighted in New York and I just reemphasize again, major focus on our systems infrastructure. So as you heard in my prepared remarks, we're now on one SAP instance, simplifying a lot of our work for our financial team and taking a lot of cost out of the system. The next big wave will be when we move the former Dako company into the Agilent environment in 2017 where we can really start to leverage the scale and take out costs and have an improved customer experience there. So there's a couple of big initiatives as well as we look at -- we're looking at other aspects of our benefit structure as we made some change, as you may know, earlier to our U.S. pension plan and the Agile Agilent program I mentioned is live. And we have a lot of initiatives underway to ensure that we can continue to take costs out while simplifying the company. Didier, anything else you would add to that?

I'd just mention the currency hedging. It had a big impact. It will have a big impact on a year-over-year basis. It's all impacts to gross margin. And ACG and DGG, because of their footprint, have been more penalized. So ACG on a year-over-year basis lost $6 million in gross margin just because of the hedging programs; and DGG, $2 million. So that also explains the difference between ACG, DGG and LSAG. LSAG has a different footprint, obviously with a stronger presence in Europe, for example. And so that can distort a little bit the percentages.

That's helpful. Let me just follow-up on Europe. I want to make sure I understand kind of how -- what you're seeing now in that respect to the guidance end. So 2 items there. One is did the weakness in Europe, did that pick up in the month of July, just given you guys are off calendar versus the peer group? And secondly, does your guidance assume that the academic end market in Europe weakens further as the year progresses or that it sort of stabilizes from here?

Yes. So nothing unusual in July, and I think the assumption of the Q4 is basically a continuation, not any worse but not any better. And we just thought that was a prudent way to think about the company's performance fourth quarter. I would love to be wrong, and I hope I'm wrong. But we thought from a planning and guidance standpoint, we should be prudent in terms of how we looked at the European market overall.

Our next question comes from the line of Derik De Bruin from Bank of America.

So a lot of the revenue questions have been asked. And I mean, it certainly seems prudent to me your guidance, just given that Europe, even under a good -- even in a good year, this -- the calendar third quarter is always a little bit choppy anyway, so there's clearly some heightened uncertainty this year. So I think it's prudent to be a little bit conservative. But could you just talk a bit about some of the -- I noticed the share count was a little bit higher this quarter than what you previously guided to. Are you still looking at buying back 1% of the outstanding shares as we sort of go into the -- going forward?

Yes. Why don't you talk a little bit about the -- our share repurchase activity in the quarter and how we're thinking about it going forward, Didier?

Yes. We filed back in, what, November 20, I think, of last year a 10b5-1 on an annual basis, and we intend to file a new one, to register a new one also in November of this year. And it's a formula-based instructions that we have provided between buying 350,000 shares a day under certain conditions to buying 0 kind of thing with a cap as you can imagine. So we don't know exactly how it's going to play out in Q4. And the only thing that we know is that if there's any kind of shortfall at all in our intended buying in Q4 because of the formula in the 10b5-1, it will all be carried over into the following year. So we intend to spend exactly what we committed to spend.

Great. That's really helpful. And could you just give us a metric on what instruments versus consumable growth was in the quarter as an overall number for the company?

I think probably the best way to think about it is just look at the respective business groups. So you have the LSAG results of down 2%, and then the...

ACG up 8%; and DGG, up 8% also.

And Dako. So minus 2%, plus 8%. And that's why I -- again, as you think about '17 for the company, if you really want to look at the growth rates of those 2 business units in the recurring revenue space, ACG and DGG, perhaps differently than you might think about how you model the risk profile for revenue projections for the instruments side of the company.

Great. That's really helpful. And I guess, could you -- when you sort of -- you're still feeling good about the margin target for '17, and it sounds like that your IT initiatives are well underway or finished to do like that. Are you -- do you still feel confident about getting what you're expecting for next year for the margin improvement?

Yes, absolutely. So that's why I made a few comments about it earlier because as we said, if we can be in a 4.5%, 5% kind of growth range, perhaps even low 4%, it makes it a little bit more challenging. But we can see -- we see the path to 22%. It's not just around margins. I mean, especially not just around margin improvement from volume. But there are specific real programs. It's something we review once a month, then we have active programs, and the costs will continue to come out on some of these big programs. Actually, I must say I'm really pleased with the team because we've -- we went through and did the -- we call project Nunu [ph] is the finance program we just finished up. And then right on the heels of that, we're going to go live in early '17 with our integration of Dako. So the teams are still energized and working hard, and I think these are going to have a material impact on our results in '17. And that's why we have confidence about the -- assuming no major change in terms of the macro environment that we can reach what we think are pretty challenging goals, but they're -- we've got a path to get there.

Our next question comes from the line of Dan Arias from Citigroup.

Patrick, just going back to your comments on share gains in LC. I know you guys don't like to get too specific on winners and losers. But as was mentioned, it does look like all of the major players are doing fairly well there. So who would you say you're taking share from? Is it the small column providers or does that actually extend into some of the box companies as well?

Well, I -- thanks for the question. I can give you only a general flavor here on what we think is going on in the market. I will not comment on the individual competitors, but your assumption that the smaller suppliers probably take a larger hit is also our observation.

Okay. And then maybe a specific one on C&E. Mike, at the Analyst Day, you called out a Saudi Arabian refinery build-out that was getting going. Have you started to see some demand there? And is that something that you think contributes at all to the back half of the year?

The major projects that were underway haven't been canceled, so -- but we're not seeing any major new projects underway. There's a lot of -- there's actually a lot of positive news by a lot of studies about where this market's going, but we're not seeing -- what we're -- just to clarify here, the major project that we knew about, whether it be the one I mentioned in Saudi or the -- there's a major project down in Texas. These programs, they're going to come online. So people aren't canceling capacity increase projects, but we're not seeing a lot of new projects. And that's why we have taken a fairly conservative -- probably be a bit pragmatic view of that marketplace. Again, I would remind everybody, too, that when we talk about chemical and energy, 50% or so is actually chemicals -- chemical processing not directly tied to the exploration and production of oil.

Our next question comes from the line of Paul Knight from Janney Montgomery Scott.

I guess specifically what is the GC business doing? What's its growth rate? What was it doing in the July quarter? And what's the backlog or what are the -- what's July or August look like, I guess?

Well, thanks, Paul, I appreciate the question. As you probably will understand, I'll give you more a high-level result because we don't actually comment specifically at a product category level, beyond, I think, I would just reemphasize the point that Patrick made when he characterized the chromatography market. That business is down relative to last year because the chemical and energy market is down. And we have seen no movement at all, downward pressure on our share position. It's really a market phenomena we're dealing with right now. And that's why when that replacement market does turn, and we've been through these cycles before, when it does turn, we'll be in a strong position to capture that growth as given the strength of our position in that market, which right now happens to be down.

And then last, on the applied markets in a broader sense, do you think it's still a GDP growth rate normalized or what do you think the applied markets should be for Agilent?

We actually don't think about it that way because the segments that -- or big segments of the market like your food and environmental testing, we think are independent to some extent of GDP. So the only way I think that we really think about that as relative to is our chemical and energy space. So if you could just kind of think about tying GDP to that subsegment of the company, I think that's -- would be good place to start. But I would not apply it to the whole what we call Applied Markets because these are being driven by quality-of-life investments in the food and environmental area. And I think that's why -- I think this composition of our end markets is the reason why we're being able to put up these kind of growth rates even when our #2 market as a company has shrunk this year.

And then last on -- you had your Analyst Day, obviously. You've been talking about a 22% operating margin. Are you more or less confident in that number for FY '17 at this juncture?

Yes. I think the confidence level is the same as it was back in May. And again, I'd maybe just share a few points here, which as you know, we have this confidence of delivery on that given our belief that we can get that growth rate that we're putting up growth rates right now in that territory. We've got this pipeline of new products coming out. We've got this nice recurring revenue stream with ACG and DDG that will carry this momentum into '17 and that where our instrument business is going, hey, pharma looks -- still looks good. Of course, you have these double-digit compare issues. China looks to continue to be strong. And chemical and energy has got to turn at some point in time because the market requires these tools to support production. Our thinking is when we look at chemical and energy is we know our customers are looking for productivity improvements to help improve their company profitability. We think that's a value proposition that Agilent has. We think as they go through their budget justification processes and their budgets start in calendar 2017, that this is why we can say, "Listen, the decline in this business after 18 to 24 months will start to turn," and we could see low single digits by the end of 2017 for the chemical and energy market. If that happens, which we believe it will, that will give us the confidence to get the growth and then we know we'll get the margin, given both the volume but also in terms of gross margin improvement initiatives as well as our SG&A cost.

And our final question today comes from the line of Catherine Ramsey from Robert W. Baird.

We've heard a lot of commentary from your peers on Japan; strong pharma environment, weak academic government. So I was wondering if you could walk through your exposure by end market there and what you're seeing across those customer groups.

Didier, do you remember the total Japan numbers? I think were...

About 5% of overall...

5%. Yes, just to give you a sense of -- 5% of the total market. Historically, we've been stronger, and I can share this from my experience having been the country manager for Japan for a few years in the early part of my career. We tend to be much stronger in the chemical and energy segment of that marketplace. We are doing well in the life science research and in genomics, but the majority of the business sits in the chemical and energy space, which is -- which has been down. I think Japan has been part of that story. Pharma, the pharma business for us is a relatively smaller portion of the market for us. I think they're doing well in pharma but not enough to really drive significant overall growth rates for Japan.

Okay, great. And then any color on the progress of Dako integration? What's left to do there? Had some nice op margin expansion in DGG this quarter, so are you still thinking that 20% in fiscal '17 or could there be upside to that number?

Jacob happens to be sitting right next to me in this conference room. I don't think he's ready to sign up for more than 20% because it is quite a improvement from where we started. But I think he remains quite confident in the 20% achievement of that goal of an O&M perspective. You saw we had 18.8% operating margin this quarter, 200 basis points over last year. And the big next wave of integration efforts will really be starting in our Q1 '17, So we have a major program we call it project de Gaulle [ph]. We seem to like a lot of these French names, Didier. I'm not sure why that may be the case, but -- and that really will be the next big step to move the former Dako company into the Agilent environment. And it will take a little bit of while to get the cost out, but as you go -- as you think about exiting '17, you're going to have a much lower SG&A spend than you started the year. And Jacob, I don't think you'd share anything else?

No. I think you captured it correctly. I just want to reinforce what you said, that the path to 20%, actually delivering 20% in 2017 is a significant turnaround of where we were a few years ago. So right now, that's our full aim, and I'm very happy where the team is and executing this right now.

Thanks, Jacob.

And this does conclude the question-and-answer session of today's program. I'd like to hand the program back to Alicia Rodriguez for any further remarks.

Thank you, Jonathan. And on behalf of the entire management team, I'd like to thank everybody for joining us today. If you have any questions, please give us a call at IR. Thanks again. Bye-bye.

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.