Danaher Still A High-End Conglomerate, And Priced Like One

By Stephen D. Simpson, CFA | January 29, 2013 AAA

Nothing seems to change all that much at Danaher (NYSE:DHR). The company has a time-tested formula and business plan, and management executes it quite well. The value that this business creates tends to be obscured by GAAP accounting rules, but the valuation shows that most investors appreciate what the company can do. Though I believe management is probably playing it conservative with 2013 guidance, valuation is a little steep right now, even if you believe in the company's ongoing ability to produce value for shareholders.

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As Expected, a Strong End To The Year
Danaher updated its guidance back in December, so the actual final results for the quarter were not much of a surprise. That said, the company delivered meaningful top-line upside relative to initial expectations for the quarter, and margin performance was solid.

Revenue rose by 5.5% on a reported basis for the December quarter, with "core" or organic growth of 3.5%. As is usually the case for Danaher, some businesses led and others lagged. The relatively more economically-sensitive test & measurement (up 1%) and environmental (up 5%) were on the softer side. However, industrial technologies was up 10%, dental was up 4% and life sciences rose 6%.

Even with OK revenue growth, the company delivered solid reported and incremental margins. Gross margin improved almost two points, while operating income rose about 11% on a reported basis. Segment profits rose about 7%, with all segments except test and measurement showing flat-to-better margins.

SEE: How To Decode A Company's Earnings Report

Is Industrial Stabilizing?
Danaher management tends towards the conservative with its guidance, but I believe investors can draw some positives from the company's report. Test & measurement and motion control both seem to suggest that conditions in industrial markets are stabilizing. Admittedly, companies like Rockwell (NYSE:ROK) and Parker Hannifin (NYSE:PH) haven't had blow-out quarters, but most industrial CEOs have been maintaining the idea that conditions aren't getting any worse and should improve after mid-year.

Beckman Keeps Delivering, and China Awaits
Danaher management deserves significant kudos for how it has integrated and operated Beckman Coulter. Not only have the deal synergies been better than advertised, but the company has turned around faster than I thought likely. More to the point, Danaher has shown that it is unlocking the potential that I always thought Beckman had.

Management talked about a strong finish in healthcare for the December quarter, driven in part by demand in China. Like General Electric (NYSE:GE) and 3M (NYSE:MMM) before them, Danaher management has remained pretty positive on their opportunities in China - particularly in more basic care areas like core diagnostics and dental care. This could be a sizable growth opportunity; while every med-tech company wants to get bigger in China, I think the immediate opportunities are bigger in basic care than in premium-priced oncology drugs or orthopedic implants.

To that end, I wonder if Danaher has a deal or two left to make. Danaher has allowed healthcare/life sciences to become a very large part of the mix (arguably too large), but I wonder if the company would consider a deal or two for local companies - particularly in areas like value-priced dental implants or routine diagnostics.

SEE: Can Earnings Guidance Accurately Predict The Future?

Where Do They Go Next?
Management did 14 deals in 2012, and I have no reason to think that the company is going to change its pro-M&A policy. The only real question for 2013 is whether the company sticks with volume over deal value (in other words, doing a relatively large number of small deals) and what areas the company targets. With plans to shift the focus in test and measurement a bit and the increasing significance of software in industrial automation, those could be likely targets and I also would expect to see more tuck-in deals for the industrial technologies segment.

The Bottom Line
We're about midway through the reporting cycle, but it looks like Danaher is going to be one of the top performers in terms of organic growth among industrial conglomerates. Moreover, I see no reason to believe that the company won't continue to build shareholder value over time. The only real question is how much to pay for that growth.

I expect Danaher to remain one of the strongest long-term growth stories among the larger industrial conglomerates, with annual revenue growth in excess of 5% for the long-term. At the same time, I see ongoing potential for margin leverage and improved free cash flow (FCF) production such that free cash flow growth could be a point or so higher. Even so, putting those numbers in a discounted cash flow model suggests a fair value in the mid-$60s.

That's not much appreciation potential, and though bulls could argue that Danaher seldom ever trades at a bargain (and/or that you get what you pay for), I'd wait for a better entry price that gives at least 10% upside potential.

At the time of writing, Stephen D. Simpson owned shares of 3M for more than five years.

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