Danaher: No Need To Fix What Isn't Broken

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Summary

Danaher's (DHR) multiyear shift away from industrial end-markets and towards life sciences and diagnostics continues to benefit shareholders, with the stock continuing to outperform its former industrial peer group, while performing more or less in line with newer peers like Thermo Fisher (TMO). Although an upcoming CEO transition holds some modest risk, Danaher has amply demonstrated that it has a deep management bench and that it reinvests in internal executive talent development.

The only real issue, and this will be no surprise to most readers, is the valuation. Even though I assume that Danaher will actually grow faster over the next decade than the trailing 10-15 years (growing FCF at a compounded rate of around 10%), that still only suggests mid-single-digit total returns. Maybe that's enough given the above-average quality of this company, but I remain concerned about relatively limited prospects for positive re-rating with what is already a widely-loved company.

Some COVID-19 Impact In Q1, But Business Is Holding Up

As was the case for most companies, the sell-side cut expectations for earnings throughout the first quarter, so Danaher's final results relative to average sell-side estimates are perhaps not as informative of a comparison as usual. Either way, though, Danaher's business held up well, underlining the benefits of the company's shift toward a less industrial, less cyclical, more recurring business model.

Revenue rose more than 4% in organic terms, with growth in all three businesses. Gross margin improved modestly (about 40bp), while adjusted operating income rose 4% with operating margin up about 30bp.

By business, the Life Sciences segment saw a little less than 3% growth in the quarter, as several businesses were hurt by purchase deferrals and lower end-user activity as labs and customer sites started closing due to COVID-19. Beckman grew at a high-single-digit rate, helped by COVID-19-related demand, and Pall grew in the high single-digits as well, with double-digit growth in biotech on ongoing bioproduction investments. IDT and Cytiva both grew double-digits in the quarter, with IDT boosted by COVID-19. Leica was down double-digits, and Sciex down mid-single-digits, on COVID-19 pressures. Segment profit rose 4%, with margin improving about 70bp.

Diagnostics revenue improved 8%, driven by strong COVID-19-related growth at Radiometer (up high teens) and Cepheid (up 40%), with the later also boosted by flu testing. Leica was down low single-digits, and I was a little surprised at the mid-single-digit decline at Beckman given recent share gains (Roche (OTCQX:RHHBY) did a little better this quarter, and Danaher was roughly on par with Abbott (ABT)). Segment profit rose 6% with flat margins.

The E&AS business reported almost 3% organic growth this quarter, as healthy demand in Water (up mid-single-digits) offset weakness in Product ID (down low single-digits). Danaher appeared to outperform Dover (DOV) this quarter in the marking/coding business, while the performance in water was broadly consistent with reports from a wider selection of players in the market.

A Business Built To Last

Danaher isn't going to be immune to the impacts of COVID-19, and management guided for a Q2 organic revenue performance of flat to down 10%. Still, that's far better than the 20%-plus decline expected by most industrial companies, and it is another testament to the benefits of Danaher's strategic shift over the years away from cyclical industrial end-markets toward acyclical growth opportunities in life sciences and diagnostics (as well as less-cyclical industrial/process end-markets like water and product ID).

The COVID-19 outbreak has disrupted operations at many academic centers and commercial labs (to a lesser extent), but many of these are slowly starting to re-open and business should normalize toward the end of 2020. From a long-term perspective, there's little to worry about in terms of opportunities like bioproduction, particularly with the highly synergistic Cytiva acquisition. I'm a little more concerned about some risks to capital equipment budgets over the next year or two, but I believe Danaher's growing consumables and service mix will largely offset that.

On the diagnostics side, a resumption of normal operations at hospitals (elective procedures in particular) should help the core diagnostics operations. It remains to be seen if Beckman can continue to reclaim share in the market; Roche has (relatively) new leadership with its diagnostics business, and I believe they could benefit from some business restructuring/improvement that could have some modest impact on Danaher's growth. Cepheid continues to be a growth engine, though; the 20% growth rate excluding flu and COVID-19 was remarkable, and Danaher has built the installed base to over 20,000 instruments, while continuing to expand the testing menu.

With the E&AS business, I expect a pretty ugly second quarter (more so in Product ID than Water), but some recovery in the first half of 2021. Water should stay relatively more stable, but the price of that stability is that it could be a comparative drag on growth in 2021 and 2022 (it's not going to get hit as hard, so it won't really have a strong "recovery" cycle).

As all that plays out, Danaher will also see a CEO transition, with Rainer Blair (the EVP of Life Sciences) taking over the spot. This isn't the first transition at Danaher, and I believe the company does a good job of developing its internal management talent. With life sciences arguably offering the widest array of growth opportunities (including end-market expansion and product development), it would make sense for this to continue to be the focus of the company, though I wouldn't be surprised if Danaher made a few select M&A deals to add specific capabilities in diagnostics.

The Outlook

Perhaps the biggest unknown in the outlook for Danaher is whether the E&AS segment will remain with the company over the long term. Water is arguably less anomalous than the Product ID business, particularly since it's not an especially cyclical market and Danaher's focus on testing and treatment gives it a strong recurring revenue base. The Product ID business could be a sales candidate, though it's hardly a bad business and it does Danaher no harm to have it until and unless an attractive sale/disposal opportunity appears.

My core expectations for Danaher really haven't changed, and I believe mid-single-digit revenue growth (around 5%) is a fair expectation over the next decade. The company's debt load likely limits significant M&A for a few years, but I wouldn't expect the growth-by-M&A part of Danaher's business plan to stop. On the margin/cash flow side, I expect the company's shift towards higher-value consumables and services in markets like bioproduction to drive higher margins and FCF generation, pushing FCF margins into the mid-20%'s over time. I believe it'll be tough to go much beyond that, but if any company could, it would probably be Danaher.

The Bottom Line

Danaher enjoys exceptional profitability and above-average growth potential, but all of that is amply reflected in the share price. I've always maintained that quality companies deserve a premium, and Danaher is certainly that, but it's hard for me to see how the stock will generate robust returns from here - inputs like low Fed Funds rate for an extended time certainly help valuations, but that's also already factored into the model. As we saw in the March panic, though, these shares do occasionally offer buy-in opportunities, and that's what I'd be looking for again before establishing a full position.

Disclosure: I am/we are long 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.