Danaher Proves Even The Nimble Can Stumble

By Stephen D. Simpson, CFA | May 14, 2013 AAA

I don't want to sound like too much of a fan-boy when it comes to Danaher (NYSE:DHR) (many, if not most, sell-side analysts seem love it more than I do), but I do think it's fair to say that when even Danaher is struggling to put up a good quarter, you know the industrial sector is in a tough spot. With growth decelerating across the board, even Danaher's much-vaunted margin improvement has come up a little short. Even so, this is still a bull market and the shares are just shy of a 52-week high.

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Stop Me If You've Heard This Before
As I have mentioned repeatedly over the past weeks, this was a rough quarter for the industrials, as demand has slowed down in almost all geographies and in almost all markets. To that end, Danaher is scarcely alone with its weak and disappointing organic revenue growth (up 1%).

Growth decelerated across the board for Danaher. Test & measurement was flat, environmental was up just 1%, and the life sciences and dental businesses were up about 2.5%. Industrial technology was the lone decliner, though, as organic sales pulled back 1.5% with ongoing struggles in motion offset in part by product ID.

Danaher is much loved (and much rewarded) for its margins, but this quarter was more mixed than usual. Gross margin improved a half-point, but operating income declined slightly (less than 1%), leading to a 60bp pullback in operating margin – disappointing the analysts and the Street. Danaher's highest-margin business (test & measurement) saw the biggest decline (down 70bp), while industrial tech (up 30bp) and dental (up 40bp) were the only gainers.

SEE: Understanding The Income Statement

Who Is Next?
The Danaher story has always revolved around acquisitions (and the successful integration and management of those acquisitions). Since 2008, Danaher has done more than 60 M&A transactions (buys and sells) and the company has bought more than 400 businesses since 1984. All told, about three-quarters of the company's growth in recent times can be tied to acquisitions, and it's quite simply a cornerstone of the story.

SEE: Analyzing An Acquisition Announcement

Consequently, “who's next?” is almost always a good question to ask. I wasn't surprised that Danaher passed on Life Technologies (Nasdaq:LIFE), as the company now gets about one-third of its revenue from life sciences and diagnostics, and Danaher management has always prized a more balanced arrangement. Even so, it wouldn't quite shock me if Danaher were tied to names like Bio-Rad (NYSE:BIO) or Techne (Nasdaq:TECH) in the life-sci space.

The interesting thing about Danaher's set of options is the value provided by the Danaher Business System – the company's philosophy that pertains to cost management, reinvestment, product development and so on. This management approach has allowed Danaher to buy some “scratch and dent” businesses like Beckman Coulter and AB Sciex and achieve quite a lot of success with them.

As it stands now, I would think Danaher would be looking at deals that would fit into the “industrial technologies” bucket or that would represent entirely new verticals. Maybe Danaher could be a bidder for Emerson's (NYSE:EMR) embedded power business (or the whole network power division), but I wouldn't bet on it. Frankly, it's pretty much a situation where the sky's the limit – Danaher's management has built a track record and reserve of goodwill such that they could likely buy almost anything and get the benefit of the doubt.

A Quick Turn Could Be Optimistic
We'll hear more soon about the test & measurement and life sciences tools world soon, as Agilent (NYSE:A) reports later today. Beyond that, though, I think Danaher could see a little more muddle-through this year. Diagnostics is really the only business segment where I think growth is pretty likely, as I think economic concerns are going to keep a limit on new capex/instrumentation purchases. That said, Danaher has good emerging markets exposure, so the company's growth could perk up if those regions lead the global economic rebound.

The Bottom Line
It's a little hard to reconcile warm and fuzzy feelings about Danaher when the organic growth is weak (and with it, opportunities for margin leverage) but the stock is near a high. Even so, long-term growth in the 5% to 6% range is still enough for a fair value in the mid-$60s, and Danaher is a stock that frequently trades above fair value. Although Danaher isn't my favorite idea today on an absolute risk-adjusted expected return basis, it's hard to argue with buying a high-quality name when it's trading at a reasonable price. Still, don't lose sight of the risk that the industrial sector has overshot the mark and could be due for a correction – a correction that could be pretty indiscriminate.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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