Danaher Remaking Itself Once Again

| About: Danaher Corporation (DHR)

Summary

Danaher's generally acyclical business mix helped deliver one of the best revenue performances of the industrial conglomerate sector, along with segment-level margin improvement.

I'm concerned by the multiples that DHR was willing to pay for Nobel and Pall, but I can't really argue with the basic rationale for splitting the company in two.

The company looks fairly valued on the basis of over 7% annual FCF growth, but its lack of cyclical sensitivity and demonstrated model make it a relative safe haven.

If you're going to pay up for a stock, you should at least get what you think you're paying for - I believe 3M (NYSE:MMM) fits that bill given its strong record of innovation and returns on capital, and I think there's an argument to be made that Danaher (NYSE:DHR) fits on the growth side of the ledger. There are going to be readers who take issue with Danaher's continuous M&A and the resulting high level of goodwill and intangibles on the balance sheet. Likewise, some investors have been alienated by the high multiples the company paid for Nobel Biocare and Pall.

The company also deserves a lot of credit for its Danaher Business System. I have no problem turning my high ambient level of cynicism against all manner of corporate-speak nonsense, but Danaher has acquired more than a couple of companies that I followed in my sell-side days, and hearing back from my contacts, acquaintances, and friends in those companies leads me to believe that DHR really does have a strong set of policies aimed at driving ongoing customer-focused revenue growth and margin improvement.

I still value Danaher on a pre-split basis, and I don't see the shares as especially cheap on the assumption on mid-single-digit revenue growth and high-single-digit free cash flow growth. As a strong competitor with ample non-cyclical exposure, it's not the worst place to wait out this industrial recession.

One Of The Better Performances In Q4

Only around one-quarter of Danaher's business is customarily cyclical, and that's a mark in the company's favor right now. Although a couple of large conglomerates outperformed DHR in the December quarter, its flat organic revenue performance in the quarter was still one of the best performances. The company was also one of the only companies in its peer group to show growth in China this period.

Revenue in the Test & Measurement business fell 5% on a core business, with a high-single-digit decline in the instrument businesses. Danaher's Fluke business has been a pretty good real-time indicator of the state of the economy in the past, and if that's still the case, that's a pretty grim outlook.

Environmental was quite a bit healthier, with low-single-digit growth in Water boosted by high-single-digit growth in the Gilbarco Veeder-Root petroleum retail business. Danaher's performance was consistent with Xylem's (NYSE:XYL) 2% organic growth, but Ecolab (NYSE:ECL) and Calgon (NYSE:CCC) have yet to report.

Life Sciences & Diagnostics saw 2% core growth, with both of them up by low-single digits. Danaher's Dental business continues to see destocking in the U.S., limiting core growth to less than 1%, and it seems that 3M outgrew DHR this quarter in dental while Roche (OTCQX:RHHBY) and Abbott (NYSE:ABT) definitely outperformed in diagnostics. Danaher's Life Sciences' performance looked fairly similar compared to what Thermo Fisher (NYSE:TMO), Waters (NYSE:WAT), and Bruker (NASDAQ:BRKR) collectively reported, but it wasn't a great quarter for the group.

Last but not least, the Industrial Technologies business saw a greater than 4% core decline as a high-single-digit decline in automation and controls outweighed the low-single-digit growth in product ID. Dover (NYSE:DOV) did noticeably better in product ID while the performance in automation was weaker than what companies like Rockwell (NYSE:ROK) reported for the quarter.

Gross margins declined a bit in the quarter (60bps) while segment profits grew 19% on strong growth in Environmental, Life Sciences & Diagnostics, and Dental. Three of Danaher's units posted margins above 20%, and all five were above 15%. Operating income rose 12% for the fourth quarter, and full-year free cash flow was basically flat on a year-over-year basis while net debt jumped on the Pall buy.

Is Danaher Seizing Initiative Or Getting Cocky?

It wasn't that long ago that a break-up of DHR was unthinkable, and yet that is what's going to happen later this year, as the company has cherry-picked the growth businesses to stay under the Danaher banner while spinning the rest off as Fortive. I don't really have a problem with Danaher refocusing around businesses with higher growth potential, strong recurring revenues, and minimal cyclicality, and it's definitely worth noting that Fortive will have pretty attractive margins despite the lower growth outlook.

What concerns me more is the two latest big deals at Danaher - Nobel Biocare and Pall. Management is going to have its work cut out to drive a double-digit ROIC from the Nobel Biocare deal, and it doesn't look like a double-digit return is in the cards for the Pall deal. I understand that Pall was a rare asset, and the company only just edged out Thermo Fisher in the bidding, so it's not as though Danaher paid an outlandish price that no one else would consider. Still, when I see a good company paying such high multiples for growth, I get a little concerned that management has started to buy its own hype and is overestimating the magic it can work with the acquired businesses.

And Now?

I don't see any reason why Danaher would stop using, or even seriously modify, the strategy that got it to this point. Not many companies of this size have generated double-digit annualized FCF and book value per share growth, and I believe what the company has accomplished with acquisitions like SCIEX, IRIS, and Beckman supports the buy-and-improve model. The new Danaher will likely continue to look for deals in the water, life sciences, and diagnostics space, but deleveraging might not be a bad idea.

As for Fortive, I'll be very curious to see what direction management takes with the new business. I see no reason why it won't be an industrial version of Danaher and a better version of what investors and analysts seem to want to believe Colfax (NYSE:CFX) can be. Acquiring more businesses in automation would certainly be one option, but I'll admit I'm biased toward that space. A business like Lincoln Electric (NASDAQ:LECO) is probably too large, but maybe businesses like MTS Systems (NASDAQ:MTSC) or Mocon (NASDAQ:MOCO) would fit.

Calculating The Value

As I alluded to in the open, there will be investors who can't get past the fact that the goodwill and intangibles on Danaher's balance sheet are 50% larger than the shareholders' equity. I would argue that this speaks to the limits of using the balance sheet as a reflection of underlying business value, but that's a subject for another day. Although I'm not thrilled with the premiums that DHR paid for Nobel and Pall, I don't have a problem with the basic strategy of buy-and-improve.

I'm looking for Danaher (including Fortive) to grow revenue at a long-term rate in the mid-single digits, with FCF growing in the neighborhood of 7% to 8%. Discounted back, that supports a fair value of around $80 to $85 today. I'm looking for the surviving Danaher to have a somewhat higher revenue growth rate by slightly weaker margins and vice versa for Fortive (lower growth, better margins). I'm also expecting that DHR will continue its relatively uncommon strategy of simultaneously looking to be ahead of the curve on growth opportunities (like water and product ID) and looking for fix-er-up opportunities that can be bought and bettered (like Beckman).

The Bottom Line

Danaher doesn't leap out as being cheap, but then 3M isn't cheap, and Honeywell (NYSE:HON) is only a little bit undervalued. Relative to those two companies, though, I think the company has less near-term economic risk, and I think healthcare and life sciences are going to be growth sectors for 2016. I actually wish Danaher were a little less popular, but I think it is a good place to hide out during this industrial downturn and it would definitely be a good stock to consider as a longer-term holding were the price to go below $80 without an obvious negative catalyst.

Disclosure: I am/we are long MMM, RHHBY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.