Agilent Technologies' (A) CEO Michael McMullen on Q2 2016 Results - Earnings Call Transcript

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Agilent Technologies Inc. (NYSE:A)

Q2 2016 Results Earnings Conference Call

May 16, 2016, 04:30 PM ET

Executives

Alicia Rodriguez - VP-IR

Michael McMullen - President and CEO

Didier Hirsch - CFO and SVP

Jacob Thaysen - SVP, President, Diagnostics and Genomics Group

Mark Doak - SVP and President-Agilent CrossLab Group

Patrick Kaltenbach - SVP, President, Life Sciences and Applied Markets Group

Analysts

Dan Leonard - Leerink Partners

Jonathan Groberg - UBS

Tycho Peterson - JPMorgan

Jack Meehan - Barclays

Brandon Couillard - Jefferies

Ross Muken - Evercore

Paul Knight - Janney Montgomery Scott

Tim Evans - Wells Fargo Securities

Isaac Ro - Goldman Sachs

Derik De Bruin - Bank of America

Dan Arias - Citigroup

Doug Shankle - Cowen and Company

Mira Minkova - Stifel

Steve Beuchaw - Morgan Stanley

Jeff Elliott - Robert W. Baird

Dane Leone - BTIG

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2016 Agilent Technologies, Incorporated Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session, and instructions will be given at that time. [Operator Instructions] As a reminder, this call is being recorded.

I would now like to turn the conference over to Alicia Rodriguez, Vice President, Investor Relations. Please go ahead.

Alicia Rodriguez

Thank you, Sabrina, and welcome, everyone, to Agilent's second quarter conference call for fiscal year 2016. With me are Mike McMullen, Agilent's President and CEO; and Didier Hirsch, Agilent's 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. And please note that 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. 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.

Before turning things over to Mike, I would like to remind you that Agilent will host its Analyst and Investor Meeting in New York City on May 25. Details about the meeting and webcast are available on the Agilent Investor Relations website.

And now, let me turn the call over to Mike.

Michael McMullen

Thanks, Alicia, and hello, everyone. Thank you for joining us on today's call. The Agilent team delivered another strong quarter for the Q2 revenue and earnings were above the high end of our guidance.

Let me highlight three key results. First, revenue growth was up over 8% on a core basis. Second, we delivered adjusted operating margin of 19.4% an increase of 110 basis points from a year ago. Finally, EPS of $0.44 was up 16% over last year.

Before moving on to a view of our Q2 results, I do want to address our year-over-year quarterly comparisons which reflect the unusual event from last year of 8% core growth that we're announcing today about 1.5 percentage points is due to our shift of our revenue last year from Q2 '15 into Q3 '15.

In the second quarter year ago, we experienced $50million of shipment delays due to startup challenges with our new U.S. logistic center. In addition, our process improvement efforts over the past two quarters to convert our incoming orders more quickly to revenue have paid-off. We have reduced our order to revenue cycle times particularly in China.

Consequently some shipments initially forecasted for Q3 of this year were delivered in Q2. Agilent's strong Q2 results were led by double digit core growth in pharma and food markets. We also experienced continued strength in Academia & Government, Environmental and Diagnostic and Clinical Markets. All end markets grew except Chemical & Energy. Growth was broad based across our most of our portfolios. Geographically all regions grew except Japan led by very strong growth in China.

Let me highlight our Q2 results by business group. The Life Sciences and Applied Markets Group delivered core revenue growth of 8% led by strong demand in the pharma and food markets. About three percentage points of the 8% increase was thanks to a softer compare due to the timing issues mentioned earlier from last year's U.S. logistic centre startup.

A combination of strong topline growth, expense management and growth margin improvements partially due to the NMR exit drove LSAG's operating margin to 19%, up 320 basis points from a year ago.

LSAG continues to strength this portfolio in Q2 as it introduced VistaFlux software. This new software speeds up clinical research data analysis, so scientists can more quickly understand the underlying causes of diseases such as cancer. VistaFlux strengthens Agilent’s leadership decision in metabolomics.

Last week we announced a new Agilent 1260, infinity-II LC at the analytical trade show. This instrument provides best-in-class lab efficiency and improves the formats of full backward compatibility.

Next, the Agilent CrossLab Group continued to deliver consistently strong revenue results. Core revenue growth in Q2 was 10% led by strength in contract services, LC columns and lab supplies. Expansion and penetration in Asia continued to be the strong contributors to our growth.

Operating margin was flat versus year ago at 21.5%.CrossLab represents a strategic transformation of our services and consumables business. I’m pleased to report that Agilent was recognized with 2016 Reviewers Choice award for customer service. This award is from Select Science, an independent expert led scientific review. This is the second year in a row, that scientists in North America have judged Agilent's customer service to be the best in the Laboratory products industry.

Finally the Diagnostics and Genomics Group delivered 5% core growth in Q2 against a difficult compare. The pathology business continues on its steady trajectory back to market growth rates., highlighted by the strong demand for our new PD-L1companion and complimentary diagnostic tests. Genomics showed strong market performance led by our SureSelect Target Enrichment and our Array CGH offerings.

DGG's operating margin was flat versus year ago at 15%. In Q2 Agilent announced an $80million investment in Lasergen, an emerging biotechnology company with innovative next-gen sequencing technology. Our two companies will collaborate on building an NGS workflow for clinical applications.

In Q2, Agilent also announced the commercial availability has expanded to the EU for a new PD-L1diagnostic test for non-squamous non-small cell lung cancer. This diagnostic was developed through a collaboration with Bristol-Myers Squibb, the maker of OPDIVO.

Now, I’ll provide an overview of Agilent's core revenues by end market. Life Sciences and Diagnostics markets saw a continuation of our first quarter performance with strength across all end markets. Pharma grew 14% fueled by technology research deals, new product uptick, and sustained growth in the aftermarket. This is the fifth consecutive quarter of greater than mid to high double digit growth in pharma.

Academia & Government grew 7% driven by strong demand in China and an uptick in the U.S. Clinical diagnostics also grew 7% with strength in genomics led by target enrichment in Array CGH.

Applied end market performance was mixed. Flu was up 25% with strong sales in China and the Americas. China also drove 6% worldwide growth in environmental forensics. Chemical energy declined 3%, reflecting continued macroeconomic concerns and the effects of lower oil prices.

Now, I’d turn to an update on our operating margin improvement initiative. Q2 marks the fifth consecutive quarter of year-over-year operating margin improvement delivered by the new Agilent team. This will resolve our ability to outgrow the market while driving operational efficiency improvements. Our multi-year Agile Agilent program continues to simplify the company, making us more nimble and lowering our cost.

Our execution of companywide streamline of organizations, processes, and systems continues to be on track to deliver incremental saving in 2017. For example, in Q3, we will take a major step forward in simplifying the company's system infrastructure with all of our financial systems now on SAP.

On the capital deployment front, we paid $37 million in dividends, repurchased $94 million of Agilent stock and invested 80 million to enable our NGS workflow strategy. Finally, our one Agilent initiative driving was well-received cultural transformation to improve cost company collaboration and delivering of results.

At last year's Analyst and Investor Day described a shareholder value creation model for Agilent to be driven by outgrowing the market, expanding operating margins and a balanced capital allocation policy.

I'd like to take a minute to position the Q2 results in the context of our longer term goals. After delivering our highest annual core revenue growth in 2011 of 6.4% in 2015, we’ve now had two strong quarters to start 2016 including this quarter's 8% core revenue growth.

Since the new Agilent leadership team has put in place, the team has delivered year-over-year operating margin improvements every quarter. We’ve completed the offset the initial $40 million into synergies from the Company's split.

In fiscal 2015, we returned $400 million to shareholders and $370 million year-to-date in 2016 through cash dividends and share repurchase. From 2015 onto now, we’ve also invested our 400 million in new business via M&A and equity investments.

Didier will share more specifics later while we are raising our full year 2016 outlook for core growth, operating margin, EPS, and cash flow. Let me now talk about our second half '16 forecast in light of what we’ve already achieved in 2016 and what we plan to deliver in 2017.

We look at today's overall market environment while we face increasingly tough competitors, we expect strength and pharma are continuing the second half of 2016 and into 2017. China is also expected to remain strong in second half of 2016 and 2017.

Taking a closer look at the chemical and energy market, we’ve been experiencing a more prolong and steeper slowdown than initially anticipated. We are now forecasting overall low single digit market declines for the year versus our initial flat guidance assumptions.

The oil exploration segment of this market has been down significantly for some time with a recent well reported spill over into the refining segment. There are initial indications however of a bottoming with increased deal activity in the large chemical segment of the market.

We have projected an improved chemical and energy market environment in 2017. We are assuming we will continue to face headwinds in this market for the remainder of 2016.

We are currently modeling 2017 with an above market core revenue growth of 4.5%.

This is in line with our projected full year 2016 core growth rates, but higher than our expected core growth rate in the second half of 2016. There are two reasons for this increase. First, we expect to have a very strong new product introduction in the second half of FY '16 which will drive revenue growth in FY 17.

Second, on the end market front, we expect chemical energy to have bottomed out by year end, accompanied by continuing solid conditions and all of our other end markets and in China. Overall, we remain on track with your 2017 goal to outgrow the market and improve our operating margins to 22%.

Looking inside the company, I can share with you today that the one Agilent team is working well together and is driven to win in the marketplace. I look forward to seeing many of you at our Analyst and Investor Day where I will share our progress versus our commitments. How we will sustain our improved performance and the longer term outlook for the company.

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 third quarter and full year 2016. Didier?

Didier Hirsch

Thank you Mike and hello everyone. As Mike stated, we delivered a strong performance this quarter again. 8% core revenue growth, 110 basis points of operating margin expansion and $256 million in operating cash flow. After adjusting for last year’s $15 million slippage in revenue from Q2 to Q3 as we launched our new U.S. logistic center, our core revenue growth of 6.5% remained well above market.

During the quarter, we bought back $94 million of stock and paid $37 million in dividends. Finally, on May 3, we successfully moved all finance applications from Oracle to SAP which is our main ERP. This will result in significant simplifications of our finance and IT operations.

I’ll now turn to the guidance for our third quarter. We expect Q3 revenues of $1.03 billion to $1.05 billion and EPS of $0.45 to $0.47. At mid-point, revenue will grow 1.3% on a core basis, or close to 3% adjusting for last year’s $15 million impact from the U.S. logistics center. And turning to share repurchase, we expect to buy back $93 million this Q3.

Now, to the guidance of fiscal year 2016. We are raising the mid-point of our revenue guidance by $60 million including $50 million due to currencies. As a result, we are increasing our core revenue growth guidance at mid-point from 4.25% to 4.50%.

We are also raising the mid-point of our EPS guidance by $0.06 including $0.03 coming from currency and $0.03 from operational performance. And one important note. After further review, we and our auditors have concluded to account for the Lasergen investment using the cost method account. This means that we will not book our share Lasergen losses as previously communicated.

Finally, we are raising our operating cash flow guidance from $650 million to $740 million and there is no change to our CapEx guidance of $140 million.

With that, I’ll turn it over to Alicia for the Q&A.

Alicia Rodriguez

Thank you, Didier. And Sabrina, will you please give the instructions for the Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Dan Leonard of Leerink Partners. Your line is now open.

Dan Leonard

Thank you. Two questions. First off, can you elaborate on the business trends you're seeing in Europe? And then secondly on the pharma end market, can you talk about what gives you confidence in the fiscal '17 outlook that you have yet another strong year in pharma, following two years then of tough comps in capital markets, which have been more or less shut? Thank you.

Michael McMullen

Thanks Dan. I think I’m actually going to pass that over to Patrick who is just back from a trip to Europe and maybe he can provide some insight on what’s going on in Europe and then also if he can pick up the question on pharma as well.

Patrick Kaltenbach

Sure. I’m happy to do so. Let me start first giving you some insights on Europe. We have seen actually some decent growth in Central Europe, we have seen some weaknesses on what we call the idea was states Eastern Europe and that's mainly driven by the Chemical & Energy market or the Energy market of that site.

In Central Europe there is deadly strengths in Germany and other states around that. We still see some issues on academia and government side is rather flat, but pharma for example is also very strong in Europe.

For your pharma question, overall we are confident that we will continue to see pretty high growth in pharma. For the remainder of this year we target low double digit growth for pharma and looking into 2017 we think the pharma market will be continue to be strong for us driven by two vectors.

We see a continue demand in the replacement business and as you probably know we just launched at the Analytica conference we launched our new 1216-20L series as an example together with the InfinityLab consumables and service and we think that will drive – continue to drive a lot of good replacement for us in pharma.

And then we see also continue demand in the biopharma space that are looking for new solutions helping with these more complex molecules in terms of analysis and we have a very comprehensive offering for a space as well.

Dan Leonard

Thank Patrick. Great, thank you.

Operator

Thank you. And our next question comes from the line of Jonathan Groberg of UBS. Your line is now open.

Jonathan Groberg

Congratulations on another great quarter, Mike. Can you maybe elaborate a little on - I think you said core guidance, and if I'm looking at your presentation, core revenue growth guidance in the third quarter is pretty precise at 1.3%. I think I just heard that you still expect pharma to grow low double digits. Could you give a little insight as to what you're seeing in the third quarter?

Mike McMullen

Yes, what we looked at was what's our growth rate that we've had over the first half of this year and as we look into Q3 and Q4. And what I'd point to is a couple of things, Jonathan first of all tough compares and this is inclusive of a few one-time moves between quarters which actually were driven by improvements overall operation, so as Didier mentioned we had this $50 million shift in Q2 of last year into Q3 - which when we had our start up issues of the new logistics center. So we adjust for that to catch-up about 3% growth.

The other thing we saw happen in Q2 was we’ve been working really hard to improve the overall cycle time from the time a customer places order to actually install and we can recognize a revenue. In Q2 we actually see their expectations and we got there a lot faster we had thought. And what that meant was, we had a significant amount of revenue probably $20 million to $25 million that came from Q3 into Q2 where initially had forecasted into the third quarter.

On all of you kind of take into account those things you've got put in more of a consistent kind of a growth scenario between Q2 and Q3. I would tell you though the chemical and energy is still looking for a bottom and that's why we have that outlook for the year which basically this down it will stay down for the rest of the year. There are some signs that it could be getting better. But we have not convinced yet we've seen the bottom chemical and energy.

So I think the combination of those tough compares as well as our outlook on chemical and energy is what's driving the overall guidance for the second half.

Jonathan Groberg

Okay. That's helpful. And then, I guess just one more. Are there any - sometimes when we see shifts onto one platform, like Oracle to SAP, is there anything at all, any wiggle room you've left there, in terms of hiccups in the quarter, or maybe just --?

Mike McMullen

What we thought to do you're exactly right Jonathan. So the wiggle room we left was we made sure we went live first month of the quarter. And Didier is in the conference room here smiling and Didier if you want to add any additional color on how it's going so far.

Didier Hirsch

Yes, it's going very well the migrations and the start up of the operation there was zero disruption. Obviously we expect to have to deal with some stabilization activities throughout the quarter we'll do too close before we do the quarterly close. So everything we couldn’t be happier about how it went and you're correct, it is a very complex and one that we're pretty used to, we’ve done a few of those in the past, but still it remains a very complex interview and we are really happy how smoothly it went.

Mike McMullen

And Jonathan as I pointed out in my script, this is one of the Agile Agilent initiatives which you'll start to see pay offs in our cost structure as we move into 2017.

Jonathan Groberg

Great, thanks a lot.

Operator

Thank you. And our next question comes from the line of Tycho Peterson of JPMorgan. Your line is now open.

Tycho Peterson

Just following up on that last point on the SAP margins, can you maybe - on the margin impact. Can you maybe quantify how much that could play on margins for this year?

Mike McMullen

For 2016 I think it would be very limited at best Tycho, because we’ll be running some duplicate backup systems and then the other aspects of our external spends, later on come out to 2017. So I really position that in - as you think about this more of the 2017 impact, but prove point why we think we're going to be able to improve our margins again in 2017.

Tycho Peterson

And then academic, 7%, can you maybe just talk as to whether you're seeing an acceleration there? What you saw this quarter?

Didier Hirsch

Yes, what we saw in the last quarter is really strong performance in China and some increased signs of life in the U.S. side of things, I think and that's will be pointing to an uptick. None a lot of significant moves on the European side is mainly a China story, and I think there'll be upside to it to become from the U.S. how we're thinking about it.

Tycho Peterson

Okay. And then lastly, just in terms of pharma, obviously that's been a nice driver. Can you maybe talk about where you think we are in the LCMS upgrade cycle, and how much your growth going forward is going to be contingent on R&D budget expanding versus the upgrade cycle?

Mike McMullen

Yes sure Tycho great question, I know Patrick now look at this pretty closely and what’s the update of you on that.

Patrick Kaltenbach

Yes, so I think the two cycles we’re looking at, the first sight we went through was the upgrade cycle from sell HPLC to UHPLC which is still ongoing but a considerable part of that probably has been done.

But when you look at the installed base of instrumentation it still deals with core LC and this is where we are targeting with the Infinity II Series right now. There's still a lot of foot placement pending out there. Just as reminder, we had probably about 150,000 systems out there based on the 1100, 1200 platform which overtime will be up for replacement and we have positioned extremely well in the pharma platforms because it's 100% bankruptcy compatible and we’re also able to for example to emulate some of our competitor systems on our platforms of a technology we called ISET intelligence system emulation technology.

And that actually compels very nicely based on our customers and gives us a unique advantage in the market.

A – Mike McMullen

So I think we see both those having legs in 2017.

A – Patrick Kaltenbach

Absolutely. I think it goes on into 2017 combined again with the drive we see coming out of biopharma.

Q – Tycho Peterson

Okay. Thank you.

Operator

Thank you. And our next question comes from the line of Jack Meehan of Barclays. Your line is now open.

Q – Jack Meehan

Hi thanks. Good afternoon guys. I just wanted to start, the better - at least relative to what I was looking for, looked like you had better gross margins in the LSAG segment, now two quarters in a row. Can you just talk about what some of the notable changes there are? Is there anything with product mix that's driven the improvement, or do you think this is the new norm to look for?

Mike McMullen

Let me make some initial comments and then Didier or Patrick you can add – build to it. So in terms of product mix, part of what you're seeing is the fact that we are winding down through our P&L the impact of the NMR business, and I think you can see the benefit of that exit decision on the P&L because it really has been contributing to the - improved the gross margins. That's not the whole story.

The other story is obviously the strong demand for the products and the volume benefits we're getting, as well as the focus on taking cost out of our material cost side of our business as well as we talk a lot about the logistics last year, we can also talk about logistics this year, which is we're doing a much better job in terms of overall logistics operations that's blowing through on the P&L as well.

So Didier I'm not sure if I missed anything else.

A – Didier Hirsch

No, you covered it all. Thank you.

Jack Meehan

Great. And then just one more for the adoption of the companion diagnostics, now a few quarters into the launch. Are you in a position, could you maybe help us size what that business is today, or just in the market, what you think you hold in terms of market share? Thanks.

Mike McMullen

Why don’t you take that Jacob?

Jacob Thaysen

Yes, thanks for that question and we are definitely pleased with the pick off the PD-L1 and this continues during the last basically now three quarters. The market is still very early. We still really only in U.S. we’ve had a press releases here lately also that we are entering into Europe but we are just scratching the surface in Europe.

And furthermore it’s still addressing the second line treatment and if that also goes to the first line treatment the market will become significantly larger. At this point of time it’s still small revenue in the biggest scheme of things but I do believe that the PD-L1 has an opportunity to be as big as the other two markets.

However, I will also remind you that of at least four probably five different potential blocks and companion diagnostic outset has to share that market. So, still early days but a great opportunity.

Operator

Thank you. And our next question comes from the line of Brandon Couillard of Jefferies. Your line is now open.

Brandon Couillard

Thanks. Mike or Didier, could you give us the China growth rate, the percentage change in the quarter, and if you could speak to demand in the food area outside of China and Asia, that would be helpful?

Didier Hirsch

Yes. In the China our resolve for Q2 what we've been pointing to is a strong double digit growth. It was a very, very strong quarter for us in China, I would remind you that part of the strong growth was not only the strength of the market but also the operational efficiency improvement I talked about, where we really shortened the improved cycle time from orders to install that was really dramatic in China.

So, the overall business is quite strong here, you should not expect a strong double digit growth every quarter though for Q3, Q4 quarter. But, overall China is - Mr. McMullen completed the story here. When we came into this year, we thought that the overall performance for Agilent in China might be high single digits but now look a low double digit growth in China for the full year.

Brandon Couillard

Thanks. One more for Didier. I notice you bumped the operating cash flow guidance of about $90 million. How much of an impact does the - I noticed the tax refund benefit. If you could quantify that, and just help us bridge the delta between prior versus new?

Didier Hirsch

The over-all tax outlays forecast for this year, were I think about $10 million less than what we had anticipated in our initial guidance, $10million or $15million. And the rest is really operational performance, improvements, working capital, management, FX and then just our operating profits.

Brandon Couillard

Super. Thank you.

Operator

Thank you. And our next question comes from the line of Ross Muken of Evercore. Your line is now open.

Ross Muken

Good afternoon, guys. Mike, since taking over it's obviously been a pretty hectic journey, and your messaging from the beginning has been pretty consistent around growth in margins and returns. Obviously, the last few quarters you started develop a cadence, last quarter results were good, but we had the challenges on FX.

Do you feel like this is the first quarter where you feel like you got to deliver the full bag, where you were able to drop through the top line outperformance, which is clearly better than market, you drove the margins, you're buying stock, the returns are up, the cash flow's good, that you were finally able to show the market that the business model's working, and that feeds, I guess, into your confidence also, I would assume, on 2017?

Michael McMullen

Yes. I couldn’t said have better of myself. Thanks Ross for the question, I think that we’ve been working really hard over last four, five quarters with our new leadership team and as you look at everything came together this quarter, we had strong growth, and we had improvement in our operating margin that pointed out of 2015.

But all of the factors really came together nicely in the second quarter, and I was particularly pleased on the more operational activities that we are working on inside the company. And that may not always be so apparent initially on the outside world, but you're started to see the results.

The fact we are doing, it’s just a logistic challenge, here I have to talk about near year compares but expects – actually is now contributing to improved results. Yes, we had a talk about the shortened cycle time for orders to revenue and burdensome revenues of what we’ve initially planned for the third quarter but we made this operational improvement the cycle times are shorter and this is now the new normal.

So, I guess that was the closing comments, yes with a new normal for the company we have a lot of confidence about 2017. Perhaps, it’s been a little bit of thunder for the Analyst meeting next week but still hope everyone attends, but when you start have these prove points of quarter in and quarter out. I think it starts to show you the team is delivering and I think the results are now starting to be appreciated and believed.

Ross Muken

Great. And maybe quickly just on Seahorse, can you just give us an update on how that business is performing relative to your expectations, and how it's plugged in, and where you're seeing maybe the early fruits and some cross-synergy with the existing business?

Mike McMullen

Yes, we just in fact very timely question Ross, we just had our 180 day review this morning and Patrick you want to go ahead and share a couple highlights from that session.

Patrick Kaltenbach

Sure absolutely, what I really would like to highlight is how seamlessly the integration of Seahorse went, so we are now at now six months in the integration and we will say the targeting full integration by June which means that you have implemented all of the systems which is a pretty fast pace.

At the same time we are seeing the positioning of Seahorse regional portfolio really works out, we see nice deals and combined sales of LCMS and Seahorse and areas like disease research and disease discovery that is actually exactly where we thought it's complementing a lot of strength in metabolomics with the life style metabolism which Seahorse brings today. And this is a very nice story that wasn't really expected well before our customers. Again we on a integration side, we are very pleased with where we stand and we are looking forward to a very successful second half.

Mike McMullen

Yes, Ross I’d add two things. The comment I made to the team this morning this is the fastest I've seen is doing integration. These things usually plod along for many quarters in some cases for years this one is moving along really, really fast. And we're getting some wins the fact we want an LCMS deal because Seahorse , so it’s the complementary nature the portfolio is starting to work.

Ross Muken

Excellent thanks.

Operator

Thank you. And our next question comes from the line of Paul Knight of Janney Montgomery Scott. Your line is now open.

Paul Knight

Mike, the move you made to creates CrossLab seems to be gaining traction. Can you give us a little background on CrossLab, in terms of who do you think is taking -- it's taking share from somebody at that growth rate. Could you give us more color on CrossLab?

Mike McMullen

Yes, so as you mentioned that was a major strategic move where when we some the company we established as CrossLab group. We had this division about how we could really attack and go after the enterprise wide services and consumers' opportunity. And as you see marketing team have really been delivering and we know that customers are responding to the value proposition that Agilent offers both in terms of our service capability is due and that's why I mentioned in my script about the external recognition we recently received.

But they also appreciate the fact we’re able to give them insights in terms of actually helping them improve the business operation and we're seeing a real strong demand for this in the pharma and growing interest in other parts that flag markets. So we know that we're growing faster than some of our competitors in this space.

We also know that there's only a few companies really trying to go after this type of business, I believe this is where the market is already going to, and I think you want to be a player here. And I'll leave it to you guys to figure out who's the losing share. But I think, I can tell you as we're growing close to double digit in the space, so that been attractive move for us.

Operator

Thank you. And our next question comes from the line of Tim Evans of Wells Fargo Securities. Your line is now open.

Tim Evans

Thanks, congratulations on a good quarter. I just wanted to make sure I understand the variance in the quarter relative to what you were expecting. I believe you had called last quarter for 4% core growth, and we saw 8% this quarter. I hear you, that it sounds like about half of that variance, about 200 basis points, was from the better book backlog to revenue conversion this quarter. And I know you also called out the compare relative to last year. But that compare should have already been known. So I just want to understand what's the other 200 basis points, that really surprised you in the quarter?

Mike McMullen

Sure Tim, again thanks for your comment and I can give you a few dollar numbers of the revenue impact the way we look at it in. And you can do them perhaps the math on the impact on the on the growth rates, but what we saw a relative to our initial expectations for the quarter were really – well first let's start with the market right, so the overall market demand came in as we predicted, we saw good growth across entire portfolio led by pharma improve markets in China as you heard earlier.

But I'd ask you to look at two things, one is this higher conversion of water to revenue than forecast so base what we’ve done as we reduce the cycle time and by our estimates it happens lot faster than we had thought, which I think is good news from the standpoint of operational efficiency did create some forecasting challenges, but probably $20 million to $25 million came from Q3 into Q2 the other thing I think you should take a look at is the FX assumptions so around $9 million or so Didier think that’s the number.

Didier Hirsch

Yes, fine.

Mike McMullen

FX added about another $9 million so between the cycle time improvements the FX assumptions and is the fact of the market continues to get we're getting our fair share of markets where they're growing I think those companies those three facts I think will help you bridge the difference between our guided growth and what actually occurred.

Tim Evans

Okay. Just a real quick similar question on the margin side. Obviously a little bit of the margin in the quarter was the drop-through, but it looks like you probably did better than you were expecting on an absolute dollar basis on the SG&A, as well. Can you help me understand maybe what is going a little faster there than you anticipated?

Mike McMullen

Yes, I think on the SG&A front I mean we got a couple of our programs inside in the agile are little bit ahead of plan. But Didier if there's anything else -

Didier Hirsch

Most of the impact was volume driven and obviously the FX, but there was – versus the usual guidance.

Mike McMullen

I will tell you the field structure that we put in place last year. You know it's really stable down I think it's delivering helping us on the growth side and also on the SG&A front as more efficient g to market channel.

Tim Evans

Thank you.

Operator

Thank you. And our next question comes from the line of Isaac Ro of Goldman Sachs. Your line is now open.

Isaac Ro

Good afternoon, thank you. I had a question on margins, as well. On the gross margin side, I was curious if we should expect maybe another wave of improvement, now that you have the ERP integration done. And on the op margin side, curious how satisfied you are with the sales force realignment, and whether or not there's still more synergies to be had there as well?

Mike McMullen

Yes, a couple of comments here then I’ll hand [ph] that over to Didier in a case like to add a few things here. But in terms of the sales force integration and go to market we couldn't be happier I mean that was a major move made last year where we basically went from five sales force into sales forces one focused on the analytical laboratory marketplace and other one focused on the regulated diagnostic marketplace.

As the time I remember sharing with you, hey we're making a big change here and it could affect the top line in the short one that didn't happen. And in fact I submit that as we go out into 2016 and 2017 we're now putting more resources of specialization academia in biopharma, so I think you can see the changes paying off in terms of long term growth.

So we're really happy with both the fact that we've got it all behind us and settle down and think it started to pay off on the initial benefits of in vision when we created that structure.

Relative to gross margin ERP I just keep in mind that what we've been talking about is a financial systems which really go into the SG&A line so it really won't affect the gross margin. That being said we do think we can do more on gross margins as we move forward in 2016 and 2017.

I'll talk a little bit more about in detail next week in New York but as you may know our initial 400 basis points improvement when I came on board we said half a come through OpEx and other operational costs and then others through grow in the growth piece of the a lot of the driven by our ability to capture the gross margin improvements on increase volume. So we think we still have room to improve our material cost. And we think that we've got room to continue to bring down our logistics cost.

Isaac Ro

That's very helpful. Maybe just a follow-up, just to clarify on two topics, one on biopharma, and the other one on the comments you made around China. On biopharma, could you just compare the growth rates you're seeing in the QA/QC setting versus R&D, and then in China, just curious, how much of your improved outlook there is based on the visibility you have with government funding versus end markets that are more on the private industry side? Thank you.

Mike McMullen

I think that on the question – we're not seeing a real significant differences in growth rates across the segment you described in pharma, I do think if you go out a couple years down the road I think we'd expect the growth rate in the biopharma be higher than a small molecule with us not that long at all the case right now and you’ve heard earlier from Patrick we expect that to continue through 2017.

We're getting more clarity about what's going on in China, I think there was a lot of concerns at one point time on the private sector side of the business, but obviously as you know I think the government drives the market there to a large extent and we're getting more clarity on what's happening in funding so that's why we have increased confidence in our outlook for our business in China.

Isaac Ro

Got it. Thanks Mike, see you next week.

Operator

Thank you. And our next question comes from the line of Derik De Bruin of Bank of America. Your line is now open.

Derik De Bruin

Hi good afternoon. Just wanted to clarify. Did I hear you correctly, that you said your initial flash for core growth guidance for FY17 was 4.5% at the midpoint?

Mike McMullen

Yes.

Derik De Bruin

Okay. And so can you like flank that in terms of what you're thinking for the chemical and energy market there? I mean, just what you're expecting in terms of rebound? Could you help us frame that comment a little bit more, in terms of some of the puts and takes.

Mike McMullen

Sure I'd be happy to because sometimes you use colorful language it doesn't really give you the insight you need, so let me try to clarify here. So what we said was in this year we thought our performance would be flat for the entire year. Well in fact it's going to be down, we probably think in the range 2.5%, 3% for the entire year.

And that is the change from our assumptions come in this year and that was the assumption be made at the time our initial guidance which makes our revenue results even much more we're really pleased with the results given the fact that the chemical energy market is not develop the way we initially had and thought.

That being said in 2017 we actually will be improved which means it won't be redo it won't be declining and in fact will probably be flat or maybe low single digits and why do we believe that, if you look at how our business breaks down in that segment we often talk about the oil side, but 50% of our business historically has been in the exploration of another 35% has been in the refining the other half which is by far the biggest, I mean biggest individual segment is the chemical side and they're benefiting by lower feedstock costs they've got pent up investment demands and we're starting to see increased deal activity.

So in fact Patrick and I were talking about this morning the kind reminds me of a pharma a few years ago, basically it’s going to have years of shrinking performance in this marketplace. A lot of pent up demand so long story short our growth assumption would actually assumes the low single digit chemical energy growth for the year.

Again we still believe we're a surge from the bottom, so it's in still early in the year of 2016 but that's our basic assumption for 207 which is an improved environment, not dramatic, but improved from what we've seen over the last 24 months.

Derik De Bruin

Just as a quick follow-up on the chemicals comment. You're not worried that some of the activity between Dow and DuPont, and looks like there may be Monsanto and some of these other companies that are dancing around, are you worried that could stymie investment, if you're using the pharma analogy of combinations of those companies, is there some potential headwinds from the chemicals market?

Mike McMullen

Yes, that’s a great question and we looked at this pretty closely when announcement was first made and although Dow and DuPont are very important customers to us that particular deal activity really is immaterial to the total Company’s performance. And then we don't necessary it is the sign of an acceleration M&A and a consolidation is going on in the space.

So of course there would be some pause if we would see more of that, but we're not overly concerned about that and I guess the beauty of this business has been just the broad based nature of our customer base or not overly dependent on the one single customer.

Derik De Bruin

Thank you very much. I’ll be back in the queue.

Operator

Thank you. And our next question comes from the line of Dan Arias of Citigroup. Your line is now open.

Q – Daniel Arias

Good afternoon, thanks. Mike, can you touch on Japan and things that you saw during the quarter in terms of trends, and maybe what you're looking for at this point on the year?

Mike McMullen

Yes. So Dan, there's a question in and if you know a little bit my history it's been to five years in Japan, so I always been a big support of Japan in terms of a long term view of the market. And I'd ask to take a long term view of the market in Japan, so that was the only market that actually went down for us in the second quarter and we are expecting continued some do performance in Japan, so we're not expecting much in terms of improvement in the overall market environment in Japan.

We do think that it could be a market which often will respond to new technologies and innovative new products. So we do hope that we do hold out hope that we could take some share from our new intros coming out in the second part of this year of an overall market perspective, we're expecting remain some dude in our internal forecasts are not are not based on any type of material improvement on our performance in Japan.

Daniel Arias

Okay. Thanks for that color. And you teased some new product introductions in the back half, that should be meaningful to growth. I'm sure you don't want to give away any secrets. Could you sort of help us with what part of the business you're anticipating seeing the boost in 2017?

Mike McMullen

Yes, so thanks for the caveat on your question. So what we can point to it great confidence and clarity is the recent introduction we made in analytic. But I would say to you, you will see broad based introduction the cross the entire portfolio and who are growth essential to our business plan as you know I came in last year, we spent a lot of time, we were realizing in our R&D structure and also reallocating where we put money and I think we’re going to start to see some of that starting to pay off as we go into a later part of 2016.

So we did want to put a teaser out there and but also just make sure you have confidence in terms what’s behind our view of improved Agilent performance in 2017 second half of this year, but I think you can expect to see is talking about acting to the cross all three business groups.

Daniel Arias

Got it. Okay. Thanks very much.

Operator

Thank you. And our next question comes from the line of Doug Shankle of Cowen and Company. Your line is now open.

Doug Shankle

Hi good afternoon. Mike, I want to go back to some of the comments you made, on efforts to tighten cycle times from order to revenue, which seemed to be yielding benefits sooner than expected, particularly in China. Can you provide a bit more background on this effort, and why it was most impactful in China?

And then maybe talk about similar efforts under way in other geographies? And relatedly, you positioned these, in answering some questions, as if they were temporary. At least it seems like your guidance doesn't treat these as sustainable improvements, yet everything else you said suggests that these are truly sustainable improvements. So I was just hoping you could help us understand that a little bit better.

Mike McMullen

Yes, sure Doug, I really appreciate the question. And maybe may start with the last part of your question which is the takeaway here we do believe this is a sustainable improvement, so in my mind the language I use this is the new normal in terms of ability to convert orders to revenue. And so I would characterize this is new normal how we're going operate so how do we get here and why did they look so significantly different in China, so first of all starts with looking at the entire process from an end to end customer perspective from the time of order placement of shipment into custom installation occurs.

And as you know when I restructure the company I was really trying to break down the silos and we had a very siloed or an approach to this end to end process from a customer respective, in the company we looked at each slice of the process, but nobody looking at the collective process and then you start doing that and you start seeing where the issues are the opportunities are so we found ways to improve our order linearity, we’ve improved the quality of booked orders and this really gets to your question about China often you're dealing with letters or credit issues and then other trade issues that in the past have delayed our ability to actually book them as clean orders and turn them into revenue.

We call the delivery box, we've been working on making sure we had material availability. I think we hit one of our best quarters ever in terms of having material ready for all our shipments so we improve our ability to get in orders in a linear fashion. Make sure those orders are clean and not have lot of rework. And then we have improved our delivery performance and then spent a lot of time improving our efforts between shipment installation which sometimes can go on for several weeks.

So I think it all starts with this looking at the whole process from an end to end perspective and the result has been a significant improvement in a cycle in orders turned into revenue more quickly than in the past.

I do think this represents our new way of operating and again as I mentioned in my remarks it did create some, it did have implications of how we guide the company for the second and third quarter but I think we’re delighted to be able to actually have ongoing strong operational efficient improvement in place so, that we know how to predict revenue even better in the future.

Doug Shankle

Okay. That's really helpful, Mike. But just to be really clear, recognizing these are well-learned sustainable improvements, it's not apparent that this is fully - these improvements, the sustainability is fully reflected in guidance? If that's the case, is that just because you want to see this play out for a couple of quarters before you start baking it in?

Didier Hirsch

I think the confusion might be that what we have stated is that this quarter in Q2 we got $20 million to $25 million of revenue that we had anticipated to be recognized in Q3 as a we were bringing all those program to fruition. We had earlier results which is great from where we are now, the order to revenue cycle time is sustainable but we will not see further improvement that will bring Q4 revenue into Q3 or what already is.

So the 022 to 25 that’s the one time we’ve got to the level we wanted to be at and from now on it’s just business as usual without any fundamental change in the order to revenue cycle time.

Doug Shankle

All right. Thanks for that, Didier. Just one last one for you. On the change in Lasergen accounting, was there any dilution in the quarter, and based on the accounting change, should we no longer expect this to be a $0.02 to $0.03 dilutive deal for the year?

Didier Hirsch

Yes, correct, you are correct. So, there was no dilution in Q2 and it will not be in a dilution in for the rest of 2016 or 2017 until we exercise our call option and then we will just fully consolidate if we do that obviously - fully consolidate the Lasergen revenue.

So that’s a change that, there was a lot of I mean discussions with the auditors, they surprise us a little bit by going to national to get especially some kind of challenge kind of the accounting that we had anticipated locally among the two teams and then we agreed to the recommendation and therefore no dilution to EPS coming from Lasergen in the next two years.

Michael McMullen

Right, and we were pleased where to get this closed off before we finish the quarter.

Doug Shankle

Okay, great. Thanks guys.

Operator

Thank you. And our next question comes from the line of Mira Minkova of Stifel. Your line is now open.

Mira Minkova

Yes, hi good afternoon guys. Congratulations on the quarter. Maybe if I could focus on operating margins again for a second. Just help us, remind us, there's a lot going on there, in terms of the programs you have in place and improvements you have going on. Help us, remind us, the bridge between fiscal '16 and fiscal '17, what gets you to the 22% operating margin?

A – Michael McMullen

Well, as a teaser, we are going to go through this in some details.

Didier Hirsch

Slide on the topic next week.

A – Michael McMullen

But what I can share with you conceptually is that we will be continuing and completing off the integration of the Darko acquisition. We have a series of operational programs we talked to about one of those already which is the implications of the ERP and the continued focus on gross margin for its specifically material cost reductions in logistics savings.

So, I think that combination of those three factors plus with the overall core growth assumption that will currently model around 4.5 get us to the 22.

Mira Minkova

Okay, great. And the strength in the food market, was this all China, or are you seeing strength elsewhere as well?

A – Michael McMullen

Actually it was both in food market, both in China and in the United States. As you may recall from Q1 announcement this business tends to be little lumpy whereas I think that performance in food market in China has been sustained but we saw a nice rebound in the U.S. in the second quarter.

Mira Minkova

Got you. Okay. And maybe finally, give us your view of the M&A pipeline. We've seen you do a couple of deals just recently here. Now that you have many of the operational initiatives for the new Agilent in place, should we expect that you're more active with the tuck-ins going forward?

A – Michael McMullen

Again this is teaser number two, which is we’re going to talk about this little bit more detail on next week but I do feel that the company’s foundation has really firmly established and as I mentioned earlier, I think we’re getting lot better in terms of speed they have to integrate but what I think you inspect to us do still remain disciplined and focus in terms of finding those opportunities that makes sense for us and I would ask you to think about as been complimentary M&A in nature, we’re going to continued to look for those.

So, our balance sheet is a huge asset for our shareholders in one which you like to deploy relative to M&A but it has to be the right target.

Mira Minkova

Okay. Thank you very much.

Operator

Thank you. And our next question comes from the line of Steve Beuchaw of Morgan Stanley. Your line is now open.

Steve Beuchaw

Hi, good afternoon. Thanks for taking the questions. Just two clarifications on how you're thinking about the 2016, 2017 progression. The first is actually on the NIH. To what extent, if any, are you anticipating a pickup in the research channel from NIH funding, when we start to see that get disbursed in the second half of the year?

And then second, this may be even a longer term question, but how do you think about the evolution of FSMA regulations in the food space in the US? Is it too soon to start getting incrementally optimistic about how they could contribute to the outlook? Thanks.

Michael McMullen

Yes, thanks glad to adjust both of your questions. So on the NIH front I think we talked about the uptick in the sort of our improved confidence about the spends in Academia and Government in the U.S. I think we do think that the NIH stuff will start to flow through to our business.

Relative to some in our space we don’t have as a higher percentage of our business tied to the NIH but it will be a positive for us and I think again one more fact pattern which points to continue to - this market will be solid for us as we move into 2017.

I think I have to agree with the comment which is - I think it’s always too soon to get overall excited about this from a U.S. spending, I’ve seen this before where legislation is announced and there is a lot of fanfare about it, but we don’t obviously a backed up by investments although we did – we're seeing some looks like some may be more friendly government allocations to this agency unlikely to seem to the EPA.

So, we’re not expect anything dramatic to occur differently in the market because of this but if it would that would be clearly good news for us.

Steve Beuchaw

Thanks for all the perspective, Mike.

Operator

Thank you. And our next question comes from the line of Jeff Elliott of Robert W. Baird. Your line is now open.

Jeff Elliott

Thanks for the question. Mike, on the margins, overall a really good quarter. Then when you look at the margins in DGG and CrossLab, basically flat year-over-year. I guess, is that what you were expecting? Anything that you could call out in the quarter? I know there's some moving pieces in that topline.

Michael McMullen

You want to take this one Didier.

Didier Hirsch

It’s a great question and the answer is yes, preciously what we had expected one of the obviously - there is from one quarter to next that could be some one time add-ons that adds a little bit of volatility. For example last year both the ACG and DGG had very favorable hedging gains which have gone away for the whole company the hedging gain last year into two was over $7 million and this Q2 was about $1.5 million.

And it was mostly in the ACG and DGG and there are other onetime items including regarding the allocation of our shared services among the different businesses which explain but both businesses are on the way to contribute to the operating margin expansion and 22% that we're committing too.

A – Michael McMullen

Didier we also ask Mark too. We talked about this earlier this last week as well about spending operational efficiency improvements underline were booked to be flat margins that will field back hedging gains other things are actually some real operation stuff.

Mark Doak

Thanks Mike and Didier. As Didier said, there were several things that were factors in it last year that didn’t come into play this year but we were working on lot of things in terms of improvements, the mixes is somewhat favorable in the context of what we're selling but overall when we look our plans for the first half we are up 70 basis points in the first half over last year.

So, our ability to actually due to margin improvements when you pull back and look in the first half regardless of all those things is quite positive.

Didier Hirsch

And is our fastest growing business he's been thinking about more of the corporate shared services.

Jeff Elliott

Okay. Thanks guys.

A – Mike McMullen

Hope that was helpful?

Q –

Yes it was, thanks.

Operator

Thank you. And our final question comes from the line of Dane Leone of BTIG. Your line is now open.

Dane Leone

Thanks guys. Just had a quick clarification from earlier. So you were talking about the replacement cycle in biopharma and quoted 150,000 LC systems, based on the 1100, 1200 platform. Can you clarify if that's what you think the opportunity is ahead of you, or that's the opportunity in progress? And if so, what - how far are you into that?

Patrick Kaltenbach

This is Patrick, let me answer these questions. First and foremost this is not biopharma, this is pharma and biopharma compliance. And when I talk about 150,000 systems out there, it's to installed base of LC systems in all markets.

So it's not only in pharma and biopharma, but we think it is the biggest push is actually right now coming from pharma and biopharma. And I would still see we are in the midst of the replacement cycle, and we don't see that to be over in the next couple of quarters.

So is a healthy demand and we are in negotiation is a lot of work for our core customers on upcoming replacements and how we place these systems and how we plan it out for them, so it works for them.

Mike McMullen

And Dane if I could add just one other comment to Patrick's response, we've been focusing a lot in today's call on pharma and biopharma, but you know keep in mind that the replacements like been very, very subdued on the implied market side in the chromatography.

So we have several - we have tens of thousands of systems on that side of the house as well. Again this is why we look out in 2017 and 2018 we think that our growth rates are sustainable.

Q – Dane Leone

Any way you could handicap, using a baseball analogy or something like that, what inning you think you're in?

A – Mike McMullen

On the pharma side probably anything five or six - I think is and my point would be that I think the ball game and this getting started. Maybe in the first inning, we hope to be in the first innings soon that cycle on the implied market side.

Q – Dane Leone

Okay great. Thank you guys very much.

Operator

Thank you. And I'm showing no further questions at this time. I'd now like to turn the conference back to Alicia Rodriguez for closing remarks.

Alicia Rodriguez

Thank you everybody and I'd like to thank you all for joining us today on the call. If you have any questions of course please give us a call in IR and just would hope that we'll see you next week at our Analyst Day in New York City. Thanks again. Bye, bye.

Operator

Ladies and gentlemen thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone have a great day.

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