Danaher's Management Presents at Morgan Stanley Industrials and Autos Conference (Transcript)

Sep.16.13 | About: Danaher Corporation (DHR)

Danaher Corporation (NYSE:DHR)

Morgan Stanley Industrials and Autos Conference Call

September 16, 2013 17:10 ET

Executives

Dan Comas - Senior Vice President and Chief Financial Officer

Matt McGrew - Vice President, Investor Relations

Analysts

Nigel Coe - Morgan Stanley

Nigel Coe - Morgan Stanley

So very, very pleased to welcome to the stage the Danaher guys, SVP and CFO, Dan Comas, and what a clean out, Matt, this is CFO of Life Sciences and Investor Relations or just CFO of Life Sciences?

Matt McGrew - Vice President, Investor Relations

For now, both.

Nigel Coe - Morgan Stanley

Okay, alright, CFO of Life Sciences and Investors Relations, Matt McGrew. Dan?

Dan Comas - Senior Vice President and Chief Financial Officer

Thanks, Nigel. Good afternoon everyone. Nice to be out here. I will not read this. I will leave that for your reading pleasure. I was out last week in Loveland, Colorado, with Larry, my boss, the CEO and we had our – we went through the strategic plans for our water quality group. And I thought what I would do is give you an update, quick update on the heels of that. It was a very good week.

So we look at our water quality platform today. It’s roughly $2 billion platform and what I’ll go through is a couple of aspects of the business. I will talk about DBS has impacted the portfolio, our businesses there, how it’s impacted the top line growth. We had a long history of kind of margin expansion. I think we have been able to evolve that to a good balance of good organic growth above market organic growth as well as margin expansion. A big part of that growth has been the evolution of that portfolio in the high growth markets and I will hit on that as well. And then finally I will wrap it all up and talk about the economic returns that we have been able to generate in that platform over the last 15 years.

So roughly, today we operate in about $10 billion market in our water segment. The market growth has been kind of mid single-digit probably a little bit below mid single-digit the last couple of year given the environment that we have been able to continue to grow at above market rates the last couple of years. We have a little bit under $2 billion of revenues and you can see a fair amount of geographic dispersion. 10 years ago, this was marginally a business that was in the U.S. and Western Europe. Today, we have much greater presence in the high growth market.

Three different key operating businesses here, the largest business being Hach Lange. Here we are the leader in the world by a factor of probably 3, 4 or 5 in analytical instrumentation and consumables to test drinking water, wastewater, ultra-pure water. The second business is our Trojan business. This is our water treatment business, where we primarily use UV disinfection to treat both wastewater and ultra-pure water. And the final business there is ChemTreat, this is more of a service business in the specialty chemical area again servicing the industrial water market, often in cooler and boiler applications.

So let me talk a little bit about how we have grown this business in the high growth markets. As you can see we have grown at a 20% CAGR in the high growth markets over the last 7 years. That’s largely been organic, but we have done some selective acquisitions to accelerate our growth there. We believe we are growing about roughly 2 to 3x the overall market in the high growth markets. And today, we generate over $100 million in revenue in China as well as in Latin America as well.

The growth has been nicely balanced over time. We have been able to drive that by adding feet on the street in the high growth markets, both organically as well as buying distributors, which we then go in and accelerate the investment and feet on the street as well as bringing in localized developing product locally that better address the needs of those markets. And you can see all rolled up at the bottom here. That business today has gone from about $125 million of revenue, and again, this is just in high growth markets, to what is rapidly approaching $0.5 billion revenues in the high growth markets or more than 25% of our revenues coming from these regions versus less than 10% about 10 years ago. So a big part of our out-performance relative to the market has been in the high growth regions.

Another key part of our growth area has actually been in the area of service. We recognize the need going back about four or five years ago, that historically our customers by and large had the infrastructure and the personnel to treat their own – treat the instrument and service the instrument that we were selling to them. I think both due to some of that skilled workforce retiring and moving into other areas, they had more of a gap and more trouble servicing their own product. We saw this opportunity to go in and step in and provide more service for the products, for the instruments that we were selling.

We did this in a couple of different ways. One, we significantly stepped up our investment in our own service technicians. We went from about 500 service technicians just a couple years ago to over 700 today. Two, we made a much more concerted effort when we were selling instruments to try to get a service agreement attached to the instrument of the system that we were selling. So go back just a couple years ago, on average we were only getting a service agreement about 5% of the time when we were selling an instrument or system to a customer. Today we have about a 20% attachment rate and we think that can continue to increase. So if you think about the fundamental market of servicing the instruments out in the marketplace, it’s a 3%, 4% growing market, but over the last four years because of these activities, we’ve been able to compound our service business at 10%. And as importantly, we’ve been able to take up the operating margins of our service P&L 750 basis points over this last 4 years or 5 years time period.

We have also been successful in leveraging the internet. For any of you who are out there our Product ID Day out in Wood Dale, Illinois last – this past July and so what we are doing to leverage the internet to drive digital leads. We have adopted a lot of the same tools here at our Hach business. And you can see the evolution of how we’ve used – leveraged the internet over the past decade, whether its web-based promotions, search engine optimization and we have actually built a very large e-commerce business in adhoc.com. Again, similar to the service business, we’ve been able to take then what is fundamentally a mid-single digit growing market and be able to drive our e-commerce business up double-digits annually over the last four years.

So you kind of roll this up for Hach Lange, again, our biggest business in our water segment. 15 years into the acquisition; we bought Hach in 1999. We continue to take share and expand margins. Over the last four years, despite some economic challenges, we have been able to consistently grow at a mid-single digit rate or better. In addition to that we have been able to expand margins annually on – about 70 basis points per year. Again, the growth has been driven by the high growth markets, new product introductions and new initiatives, whether it’s around the web or whether it’s around service.

So we’ve invested very heavily. In some cases, in the areas of feet on the street in the high growth markets in service, we are investing faster than our growth rate. But we are still delivering margin expansion. The way we are doing that is one, the consumable business provides very attractive pricing opportunities. We take advantage of that every year. Two, as you know, we are in a constant mode of restructuring, looking at opportunities to take out costs out of the business. And three, we have been able take a P&L, for example, in our service businesses we talked about which used to be a marginally profitable business and make it a nicely profitable contributor to the bottom line. So 15 years in, a mature business, where I think that we continue to build around it inorganically, but organically, we are growing faster than the overall market while expanding margins each year.

So ChemTreat, ChemTreat came to us about – in acquisition in 2006 time period. And when we acquired it, it had a 30-year track record of growth by having both best-in-class customer service on the one hand and two, constantly adding feet on the street salespeople on the other hand. And we very much view it as kind of a flywheel model. And it’s interesting; it’s actually a lot like our M&A process. They are constantly maintaining a funnel of new sales people, they are trying to attract, they are cultivating those individuals and they developed kind of longstanding relationships with people that they are trying to bring into the organization. In other words, they do extensive diligence on people before they become – before they can come into the organization. And you can see one of the elements of the flywheel model here is it's about a 3-year payback on a new sales person.

So if you’re doing this every year, it’s in our run rate – the cost of doing this is in our run rate, run rate in our P&L. And you think well, why can’t a competitor do this? And the answer is they could, but if they start from scratch where I think most of our competitors would be today they would have a 2-year to 3-year period of funding losses to try to develop this. So I think the salespeople we are adding this year are hurting our P&L, but because we have been doing it every year going back, we are getting the benefit of what we’ve done a couple of years ago and that just continues. So again, thinking about the flywheel model. And it’s a real competitive advantage and we know all the pressure that investors put on us various companies around margin, it’s hard to say well, I am going to try to do what ChemTreat does, I am going to really get committed to expanding my sales force when you know you probably have about a three-year payback and you have got to deal with that margin dilution for that time period. Again in a market that is fundamentally growing 2% to 3% per year, in the last seven years we have compounded on a 10% rate, that’s largely organic, that’s maybe a point or two of acquisition growth in there. And you can see we have expanded the margins about 500 basis points during that time.

I will end up with a word on Trojan here before talking about the financial summary. This is our business leader in UV disinfection – equipment for UV disinfection for dredging water and wastewater applications. One of the big opportunities here we have been talking about, it’s still in the making is around ballast water. So you think of a tanker loading up with supplies or commodities in Asia. It often takes on water to provide the balance to the tanker. So it takes on the organic matter from a port in Asia. It then sails all the way to say a U.S. port. And when it discharges its goods, it releases the water so that organic matter that it picked up in Asia is discharging into the U.S. waters. That caused a lot of havoc in the environment. So you have had the International Maritime Organization working on this for a number of years. We don’t have passage yet, but we think they will soon ratify rules that say when that water gets discharged from one port to another, it needs to be treated. So you don’t bring foreign organic matter into a different body of water.

We think this is potentially a $30 billion opportunity over the next decade for both retrofitting the existing ships as well as the new ships. There will be multiple technologies to address this, but we think UV disinfection is very well positioned to be one of those key technologies. And again, this is a business that we are investing a lot of money in. So we have no revenue here today. We are incurring losses if you will or investments if you will, but still again providing margin expansion across the segment. Time will tell here, but we think over the next, probably starting at about 2015, there could be substantial revenues coming out of this initiative. So that’s largely been the organic story, but we have continued to build out the water platform through M&A as well. We have completed 27 acquisitions in the last eight years, deployed about another $1 billion of capital versus our initial deployment back in 1999, and really generated very good returns on these bolt-ons as well. And again, strategically have used it to build out the portfolio.

So what does this look like all ups? And we go through these numbers with the board every year. So if we go back to 2004, 2004, we were about five years into the Hach acquisition. So we have that 10% threshold, and we are actually a little bit over 10% on our return in invested capital. But that’s just a point along the way. We want to hit that 10% level within five years, but then we want to grow that return in the subsequent years. You can see the acquisition activity subsequent to 2004 the organic efforts both from the top and bottom line, you can see where we are today, where we have about $1 billion, $1.8 billion of revenues, almost $500 million of operating profit, and we have total invested capital of a little bit under $2 billion. So the last eight years we have been able to take despite additional dilutive acquisitions, but dilute the returns, we have been able to take that return on an after-tax return on invested capital from about 10% eight years ago to about – we are about 18%, 19% today.

So I will end there and now we are going to get into some other things. We wanted to give you just start with the water business. It’s a good story to tell. We continue to perform quite well in that business, again both in the top and bottom line and happy to get into some Q&A.

Question-and-Answer Session

Nigel Coe - Morgan Stanley

Great, thanks, Dan. Yes, so before we get into the M&A backlog, maybe couple questions on – that was a joke, by the way, actually, it wasn’t. A couple of questions on the (indiscernible) of $5 billion, that’s a big market, but we have been talking about this now for last three years, it seems still moving (indiscernible). When do you think – when do you actually think we will see that inflection point where we see the growth coming through, and how would this rank against other growth, you said the balance move opportunities the best growth initiatives with the top five, top 10?

Dan Comas

I mean, it would be in the top three or four. It’d be like an AQT type opportunity that we’ve had at Radiometer. We are still awaiting IMO ratification. We think they are getting close, and the signs are such they are getting close. It will then take some time. You are not going to retrofit these ships overnight. But we are working a lot with ship builders and ship yards to position our product to take advantage of that retrofit market.

Nigel Coe - Morgan Stanley

Okay. Go ahead. And you’ve – maybe you mentioned you’ve done a lot of acquisitions, nothing has been very smooth bolt-ons, maybe, a couple things. Number one, when you took a small acquisition, technology acquisition, how do you create value with that, I mean, how do you then globalize that? And then secondly where do you see the opportunities Trojan versus ChemTreat business, Hach Lange, where do you see the opportunities to significantly expand this piece of the acquisition?

Dan Comas

Well, I think we have a lot of the bolt-on acquisitions, what is a good example, we will take a $50 million to $100 million business that may have a particular strength in a region or geography, we will strip out a lot of the G&A manufacturing costs and then we will often take the brand over to Hach because of the strength of the Hach brand. And we’ll take some of that money that we’ve opened up to the G&A and overhead restructuring and accelerate them to R&D and the sales and marketing. And what we find is that a lot of these small acquisitions, they’ll have a decent presence in the developed markets, but be very weak in the high growth markets. And we have such a good infrastructure and footprint and go-to-market in the high growth markets, we can take their products into those regions and accelerate their growth.

Nigel Coe - Morgan Stanley

Okay, and then going back to the e-commerce comment on Hach, and this is something you’re doing as well with Videojet as well I mean what is the e-commerce opportunity across the whole portfolio. And obviously a lot of your products go through distribution and I am wondering is there a potential conflict between your distributors and on what you’re trying to achieve?

Dan Comas

Yes, there is always conflicts you’re navigating. Hach fortunately has been more of a direct model, so it’s easier. One of the nice things about the e-commerce is you can strip out some of your sales and marketing expense or take some money out of selling and put more into marketing. Our e-commerce business would be a sizable standalone e-commerce business just in the United States, that’s sort of the presence we have built in that business. It varies by business. The direct businesses are easier to leverage that. Where we go through distribution it’s an e-commerce initiative, but it’s probably more in the marketing area than maybe on the direct sales.

Nigel Coe - Morgan Stanley

Okay, great. Maybe – and then just on e-commerce, do these carry sort of e-commerce type margins, i.e. higher margins, not…?

Dan Comas

One of the nice things about Hach is it’s a $1 dollar business and the average order is $500. So it’s kind of talking to the pricing power you have, in that sort of structure.

Nigel Coe - Morgan Stanley

Okay, great. Maybe switching gears now to the M&A backlog, so obviously there has been the perennial debate about you got all this surplus capital to redeploy, it’s been a little while since you have seen a significant deal of any size, so just maybe just give us some color in terms of what you are seeing, how active you are and how you would handicap a deal?

Dan Comas

Yes. So we’ve spent a little less than $1 billion year-to-date. We have talked about the possibility of spending $8 billion in ‘13 and ‘14, so we are not at that pace though we never would expect that $8 billion would be a $1 billion a quarter, over eight quarters. I think we continued to be very, very active, very encouraged by the quality of the conversations, with a variety of the platforms where we are looking at sizeable opportunities. But obviously we have had a hard time, as have others, sort of getting to deals. We are still confident that we are going to be able to deploy that money. We’ve now been doing this for over 20 years. M&A goes in cycles. This has been a little bit of a tougher cycle just generally speaking and you’ve seen that lack of the front page articles announcing deals in The Wall Street Journal here the last six months. But we feel good about where we are. And we stick to our discipline, we stick to our metrics and in time, our view is, things will get done.

Nigel Coe - Morgan Stanley

And what’s the – what’s been the biggest impediment to getting deals done, is it simply multiples. Is it...?

Dan Comas

It’s primarily around price. It’s sometimes terms and conditions, but it's largely I would say that a number of the situations where we were talking to a company 6 months ago, we are still talking to them. It’s not like they sold to someone else. It’s not like they have gone away, but it’s an evolving conversation. On the margin, the rise in the interest rates helps us a little bit. It makes a little bit harder for both private equity and the more leveraged companies to look at opportunities, but it’s – at least year-to-date, it’s been challenging to get things to the finish line.

Nigel Coe - Morgan Stanley

So if we are here next year and you still haven’t deployed significant capital, you’ve got $7 billion in the balance sheet, let’s say, what happens?

Dan Comas

Well, I don’t – that’s not my forecast. But I mean, it could happen, and we spend a lot of time with our board around capital allocation every quarter. And we recognized the cash flow we generate. We might have to think about in time a different approach to capital allocation. I don’t think we are anywhere kind of – we are not anywhere near that. And one $4 billion, $5 billion deal would change that to, you are not doing enough deals, Oh my God, Danaher is going crazy again and people were saying after Beckman. So we know it can change pretty quickly.

Nigel Coe - Morgan Stanley

Right, right, correct. Let’s have some questions from the audience. Questions?

Unidentified Analyst

Two questions actually. The first one is expounding on this gentleman’s discussion about looking at how much you pay for an acquisition, what restraints do you place upon your M&A acquisition team? And secondly, if you stop acquisitions say tomorrow, what would you be your internal growth in relative earnings per share, please?

Dan Comas

Sure. We are very strict and we were very public with our metrics. So for most of these, what we call, bolt-on and adjacency type acquisitions, we want to exceed a 10% after-tax cost of capital within three years. We will give ourselves up to five years for a large acquisition as we did with Hach, but we only do that with a point of view that if we can get to 10% in five years, we are then up in the mid-teens or higher as we showed here somewhere down the road. That’s the fundamental metric we look at. We obviously look at accretion and dilution, but our number one metric is return on invested capital, exceeding our cost of capital within a reasonable period of time.

Now, the reality was the 10-year treasury even at 3% today our cost of capital is not 10%, it’s less than that, but we stick to 10% because we know things go wrong and we think it’s important to have that buffer in how we think about the cost of capital. So if we stop doing acquisitions today, you might have to give me a little bit of a framework of what you think global GDP is, but if we think we are in a low global GDP environment like we are today, I think we can grow organically 3% to 4% and I think we can grow mid single-digit, a little better than that. We are about 17.5% operating margin business today. I think we would be 20% within a three to four-year period. So we could grow organically 3% to 4% and grow bottom line maybe 7% or 8% without deploying any of the capital. And that’s obviously if we put all the capital into buybacks we could grow double-digit, but putting that aside, that’s what I would view as the organic model today.

Nigel Coe - Morgan Stanley

Anymore questions?

Unidentified Analyst

Can you talk a little bit about the economics of the feet on the street model, you mentioned if the ChemTreat told to be a special case, but if you take the Hach, for example, just in terms of adding using 35% overall. Have we been talking about (indiscernible)?

Dan Comas

Yes. Well, with ChemTreat, it’s easy because you are doing it every year, but when we started this up at Hach the first couple years we were taking a P&L hit in doing that. But our experience in the feet on the street adds, we tend to get a two to three-year payback. And if you look at our overall expansion of feet on the street in the high growth markets, we are pretty confident we have grown at least two and as much as three times the overall market by taking that feet on the street expansion. So the net present value of those investments, are very high.

Unidentified Analyst

So maybe we can talk a little bit about Beckman Coulter, what’s been the biggest driver to better than expected sales performance year-to-date? And then secondly, can you just provide an update on the integration and when you expect to get to that $350 billion run rate this year?

Dan Comas

Sure, sure. So we have been – we went into the year as you know when we bought Beckman the business was negative growth organically. We felt we could get to kind of flat to slightly up this year. We have been more kind of in a 3% low single one quarter we did a little bit better than that. I think the developed markets have played out largely as we thought. They would be the more challenging part of it to turn around. That continues to be the case that we make progress, where we are ahead of schedule has been the high growth markets. We continue to grow double-digit there. In China we have had some quarters of 15%, 20% growth. So very pleased with the build out in the high growth markets and I think the challenge, we continue to work on it. We see progress in the underlying metrics is getting the developed markets back to some modest growth.

In terms of the margin side, we are up about 500 basis points in – from 10%, 11% to 15%, 16% today. We have ripped about $300 million of costs out of the business. We have about another $50 million to go to with that $350 million target. But we also see the opportunity to have above that, even beyond that $50 million above average margin expansion over the next 3 years to 5 years. We have done a lot to freeze and continue to take down their manufacturing overhead, their G&A structure. That’s relatively stable now and I think we have it in a position that if we can get back to mid-single digit growth we will sort of have above average fraught around that.

Nigel Coe - Morgan Stanley

So what is back on that 10% cash on cash, are we – is it a 3-year, is it a 5-year?

Dan Comas

Yes, we said 4-year. We are right on track, true cash on cash we are ahead of that because of all the working capital. We don’t give ourselves credit for that, but a lot of companies when they look at cash on cash they would then look at both working capital and the actual cash tax rate. If you factor that in we would already be at 10% today, but the way we look at it we are not. So we're right on track for four years.

Nigel Coe - Morgan Stanley

You mentioned that China has been very strong for Baton Rouge property, the question of what are you seeing in China, U.S., Europe?

Dan Comas

In terms of what we have seen over July, July and August and was a caveat of those a little bit like January and trying to read that REIT. We have seen incrementally better performance in the U.S. and less worse performance in Europe, if I can say that.

Nigel Coe - Morgan Stanley

That’s a good thing.

Dan Comas

We have been negative, slightly negative for a while in Europe. We have kind of been relatively flat over the summer. I think the slight offset to that has been a more challenging high growth market. In China we have not seen a pickup of our Industrial business. They remained pretty weak again at least through August. And our life science and diagnostic was still growing, it’s probably not at the 20% rate it's been over the last 6 quarters. On (indiscernible) is not a comp issue, we think we are still – we are still growing double-digits through the summer. So I sense it’s not a real slowing, it’s just catching up to some very large numbers. So net, net it feels about where we would have thought, what we talked about in July, but maybe with a little bit geographic mix.

Nigel Coe - Morgan Stanley

Okay. So you are on track with different mix. Okay and some businesses of standards are strong in 2Q and the environmental platform across the board is very strong and profits of life sciences and diagnostics is very strong as well has that continued or...?

Dan Comas

Yeah, I think we had a good – obviously September is a big month here, but through 2 months we have environmental both our water business that we talked about here and our Gilbarco business has been pretty strong this summer. The only maybe noteworthy thing at Gilbarco is we have seen an improvement in the equipment business in Europe though slightly slow in the U.S., a little bit of offset there. Matt’s business, I don’t want to give him too much of a plug, a life science – diagnostic basically on track through the quoted life science and had a very strong month – very strong summer bookings.

Nigel Coe - Morgan Stanley

So that’s fantastic news. Any more questions from the audience? Do we see any hands? In that case, maybe I’ll ask one more question. You’re raising R&D by about 30 bps this year. What is the payback on that 30 bps and how do you assess that payback?

Dan Comas

We really look at it in two areas. One is around our vitality index and two is around gross margin. And it’s obviously been a big thrust for us for the last couple years. We have stepped it up again here and as you would expect, we are not perfect everywhere, but we actually saw two specific cases in the second quarter. One was our water business and two was our cash in dental consumable business which is interesting because both of those businesses we have a pretty conservative user base, vitality index tends to be pretty modest compared to our other businesses and we really stepped up some investment there.

In both of those businesses we saw a 50% increase in meat product revenue in Q2 versus what we had in Q1. And that made the difference of about 200 basis points of core growth for both of those businesses and we actually think we outgrew the market by about that amount in the second quarter in dental consumables and water. And we also saw a nice step up in gross margin. One of the things we do a good job when we launch a new product it by and large tends to come out of the higher gross margin than the product we placed. So that’s easy to measure. The payback on the revenues, I would say we have got more of a mixed record though I like our slope right now.

Nigel Coe - Morgan Stanley

Great. Okay, Dan, we will leave it there. Thanks very much.

Dan Comas - Senior Vice President and Chief Financial Officer

Thank you, Nigel. Very helpful.

Matt McGrew - Vice President, Investor Relations

Thanks.

Nigel Coe - Morgan Stanley

Thanks, Matt.

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