Some stocks really test value discipline. Investors don't often get a chance to buy Danaher (DHR) shares at especially attractive prices. In fact, it's about a once a year opportunity. With the strong rebound in the shares since the summer of 2011, valuation has become tricky in what is one of the better-run conglomerates around.
Growth A Little Light, Margins Quite Strong
Danaher's quarter was a little mixed, but only in the context of a stock where the expectations are always pretty substantial. Core revenue rose 4% this quarter, with the strongest organic growth coming from life sciences (up 6%) and environmental (up more than 5%). Significantly, all reporting units delivered organic growth this period.
All in all, margins were quite good this quarter. True, gross margin did drop about 250 basis points but that was already widely expected. What was not expected was the 16.5% reported operating margin, nor the segment operating margin of 17.2% - both about half a point better than most sell-side analysts had forecast.
By and large the outperformance was widespread. Danaher is indeed doing well in stripping costs out of Beckman Coulter, but margins in Test and Environmental were also surprisingly robust. Balancing that were slight disappointments in Dental and Industrial, which also had somewhat weaker top-line performances relative to expectations.
Beck Is Back
Beckman Coulter was in some respects a consummate Danaher acquisition target. Although this company had very good market share across a wide range of diagnostic categories, the cost structure was poor, management execution was pretty iffy, and the business lacked clear direction. In relatively short order, it looks like Danaher has made a fair bit of progress.
Margins are already ahead of plan at Beckman and the company should be resubmitting its troponin test to the FDA relatively soon. This has been an embarrassing and costly problem for the company; not only costing the company lost revenue but a fair bit of credibility with labs as the problem was supposed to be fixed about two years ago.
With that mess cleared up, Beckman could be a strong contributor to earnings and cash flow relatively soon. It's a crowded field with the likes of Abbott (ABT), Becton Dickinson (BDX), Johnson & Johnson (JNJ), and Siemens (SI), but the latter two companies have been under-investing in diagnostics just as badly (if not worse) than Beckman and the company still stacks up well against Abbott and BD in most of its core markets.
Recovery Growth And An Organic Kicker?
The slowdown in the electronics sector has done no favors for Danaher's test/measurement business, but guidance from a host of companies so far this quarter suggests that the cycle has bottomed out. Moreover, it's not as though Danaher seems to be losing any share or momentum to rivals like Agilent (A).
Speaking of Agilent, both companies seem to be seeing decent ongoing demand in life sciences. Although government spending cutbacks are hitting academic labs pretty hard, both Danaher and Agilent are more leveraged to life science equipment markets like pharmaceuticals, industrial, and quality control - markets less sensitive to government spending.
Last and not least, Danaher may have some decent organic growth prospects. Although the majority of the company's recent growth has come from acquisitions, management has talked more than once about the multi-billion dollar potential of treating ballast water; more than enough for companies like Danaher and PerkinElmer (PKI) to split. Other new product opportunities in life sciences, diagnostics, automation, and point of sale could chip in a little more growth than is currently in many models.
The Bottom Line
Danaher shares are seldom cheap and it often makes just as much sense (if not more) to consider the shares of its close rival Agilent. Still, it's a quality conglomerate that is increasingly less cyclical and more weighted towards growth markets like diagnostics, life sciences, and water quality. Said differently, the quality of the earnings story is improving.
Crediting Danaher with about 8% compound free cash flow growth over the next decade is perhaps not especially conservative, but it doesn't demand much in the way of free cash flow conversion improvement. With that expectation in place, Danaher shares ought to be worth more than $60 a share - not a huge discount to today's price, but enough to at least be tempting to those looking to add a well-run business to their portfolio.