For a company that rarely misses earning expectations and is typically viewed as a credible commentator on near-term economic conditions, Danaher's (NYSE:DHR) third quarter results can't leave investors feeling too great. Although the company's long-term strategy of growth-through-acquisition and fierce cost efficiency is very likely to continue, the near-term outlook has definitely worsened. Given that this stock has often sported a premium multiple, performance could continue to lag until investors feel more optimistic about the macro outlook.
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Another Disappointing Quarter
Although Danaher management lowered guidance back at the second quarter, apparently they did not go far enough, as the company posted a modest miss. Perhaps more concerning for long-term shareholders are the signs that the focus on M&A in the life sciences/healthcare space hasn't yet really paid dividends.
Revenue fell 2% as reported for the third quarter, with organic revenue up just 1%. Although only a relatively small number of major industrials have reported so far, Danaher's results fit broadly in with Dover (NYSE:DOV) and Honeywell (NYSE:HON), though behind longer-tail names like General Electric (NYSE:GE) and Textron (NYSE:TXT).
Gross margin improved more than three points for the quarter. Operating performance was more mixed, due in large part to various charges and items. Looking at the core segment earnings, profits were pretty much flat on a year-on-year basis.
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No Real Areas of Strength
Unfortunately, Danaher didn't really have any particularly bright spots for the quarter. The economically-sensitive test and measurement business was down about 5% as reported, with Fluke down in the double-digits. That's reason for pause, as Fluke has often been a pretty solid barometer of real-time economic conditions. It's also not great news for Agilent (NYSE:A), though their businesses do not line up exactly.
Environmental segment revenue rose 3%, while life sciences and industrial tech fell 3% each and dental dropped 1%. Contrary to some of the early reports I've read, I'm not that bothered by the life science results. I don't see any particular reason to think that Agilent or Thermo Fisher (NYSE:TMO) are going to have great quarters in their life science businesses. On a more positive note, Beckman continues to come along, and I think this will be a case of "slow and steady wins the race."
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Judging a Long-Term Story by Short-Term Results
I've long had some issues with Danaher's valuation, but I have never questioned the company's model or its prospects for better-than-peer long-term growth. Said differently, I'd be careful about selling a long-held position just because of rocky going in the short-term.
The short term does seem to be getting rockier. Management lowered guidance again and seemed pretty cautious (if not bearish). At the same time, it seems like some investors and analysts are raising more questions about the company's recent M&A dealings and questioning whether management has lost its mojo. Once again, I think this is a case of differing time horizons; the life science and healthcare markets are definitely soft right now (and softer than most companies thought they'd be), but I have a hard time seeing how or why the long-term growth won't materialize as emerging markets spend more money on healthcare and more developed economies deal with their aging populations.
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The Bottom Line
Danaher has a history of delivering better growth than other industrial comps like Dover and Illinois Tool Works (NYSE:ITW), and the valuation reflects that higher ongoing growth expectation. That said, I have my doubts as to whether that outsized growth can continue - more as a consequence of Danaher's size than any emergent deficiencies in the business.
Even with an estimate of high single-digit free cash flow growth, these shares don't look especially cheap. For these shares to be undervalued by the market today, management needs to either lift (and sustain) free cash flow margins in the high teens or revenue growth in the high single digits. Either implies a decade-long average of over 10% compound free cash flow growth, and that's a pretty aggressive assumption, even for a well-run company like Danaher.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.
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